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Chapter 4

Consumption,Saving, andInvestment

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4-2

Consumption and Saving

Changes in consumers’ willingnessto spend have major implications

for the behaviour of the economy. Consumption accounts for about 6!

of total spending.

"he decision to consume and to saveare closely lin#ed.

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4-3

Consumption and Saving$continued%

&esired consumption $C d % is theaggregate 'uantity of goods and

services that household want toconsume, given income and otherfactors.

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4-4

Consumption and Saving$continued%

&esired national saving $Sd % is thelevel of national saving that occurs

when aggregate consumption is atits desired level.

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4-5

Consumption and Saving$continued%

(hen NFP ), national saving is*

S=Y-C-G

"hen, desired national saving is*

Sd =Y-C d -G

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4-6

"he Consumption andSaving &ecision

+ lender can earn, and a borrowerwill have to pay, a real interest

rate of r per year. 1 dollars worth of consumption

today is e'uivalent to 1+r  dollar’s

worth of consumption in the nettime period. $assuming inflation ) %

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"he Consumption andSaving &ecision $continued%

"he consumption-smoothingmotive is the desire to have a

relatively even pattern ofconsumption over time.

+ one-time income bonus is li#ely

to be saved and the income earnedon that saving spread over time.

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Changes in Current Income

arginal propensity to consume$MPC % is the fraction of additional

current income that is consumedin the current period.

(hen Y  rises by /*

C d  rises by less than /0 Sd  rises by the fraction of / not spent

on consumption.

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4-9

Changes inIncome and (ealth

Current consumption will increaseand current savings will decrease

when* epected future income increases,

because of the smoothing motive0

wealth increases, because one doesnot need to save as much for thefuture anymore.

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4-10

Changes inIncome and (ealth

1utureconsumption 

can beestimatedusing theconsumerconfidenceinde

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4-11

Changes in the 2ealInterest 2ate

1or a lender an increase in r  hastwo opposite effects*

increases the opportunity cost of currentconsumption and thus increases currentsaving $substitution effect%0

increases current income from wealth whichincreases current consumption anddecreases in current saving $income effect%.

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4-12

Changes in the 2ealInterest 2ate $continued%

1or a borrower when r  increasesthe substitution and income effects

both result in increased S. "he empirical evidence is that an

increase in r  reduces C  and

increases S, but the effect is notvery strong.

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4-13

"aes and the 2eal 2eturnto Saving

"he epected after-ta realinterest rate $ % is the after-ta

nominal interest rate minus theepected inflation rate.

t ar  −

e

t a

  π t)i (1r    −−=−

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4-14

"aes and the 2eal 2eturnto Saving $continued%

3y reducing the ta rate oninterest the government can

increase the real rate of return forsavers and $possibly% increase therate of saving in the economy.

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4-15

1iscal olicy

5et’s ma#e an assumption that theeconomy’s aggregate output is

given, it is not affected by thechanges in fiscal policy.

"he government fiscal policy has

two major components* thegovernment purchases and taes.

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4-16

overnment urchases

(hen the government increases itspurchases temporarily*

C d  falls, because higher taes andlower income are epected.

Sd  increases, because C d  falls.

Sd 

 falls, because G increases. + total effect on Sd  is a fall.

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4-17

"aes

+ government ta cut withoutreduction of current spending

should* Increase income and, therefore, C d  by

a fraction of the ta cut. 2aise epectations of higher taes

and lower after-ta income in thefuture.

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"aes $continued%

+ccording to the 2icardiane'uivalence proposition the

positive and the negative effects ofthe ta cut without reduction ofthe current spending shouldeactly cancel.

In reality it may be not so, sincemany consumers get deceived.

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4-19

Investment

"here is a trade-off between thepresent and the future.

+ firm commits its resources toincreasing its capacity to produceand earn profits in the future.

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Investment $continued%

Investment spending fluctuatessharply over the business cycle

and typically contributes half of thetotal decline in spending.

Investment plays a crucial role in

determining the long-runproductive capacity of theeconomy and its growth.

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"he &esired Capital Stoc#

&esired capital stoc# is an amountof capital that allows a firm to earn

the largest epected profit. "he marginal product of capital

$MPK % is the firm’s increase in

output due to adding a unit ofcapital $other factors heldconstant%.

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"he &esired Capital Stoc#$continued%

anagers compare the cost andbenefit of using additional capital,

e.g. a new machine. "he firm’s benefit is MPK f  7 the

future MPK .

"he firm’s cost is the user cost ofcapital.

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4-23

"he 8ser Cost of Capital

8ser cost of capital is the epectedreal cost of using a unit of capital

for a specified period of time.

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"he 8ser Cost of Capital$continued%

uc  is the user cost of capital

r  is the epected rate of interest

d  is the rate at which capital depreciates

 pK  is the real price of capital goods

 K  K  K    d)p(r dprpuc   +=+=

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&etermining the &esiredCapital Stoc#

"he desiredcapital stoc# is

the capital stoc#where epectedprofit is

maimi9ed - atwhich the MPK f  e'uals the uc .

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&etermining the &esiredCapital Stoc# $continued%

"he MPK f  curve slopes downwardbecause the marginal product of

capital falls as the capital stoc#increases.

"he uc  curve does not depend in

the amount capital and is ahori9ontal line.

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4-27

Changes in the &esiredCapital Stoc#

If r  falls $otherfactors heldconstant%, the uc  falls

$shifts downward%,then MFK f :uc , and K  rises.

"he same is true

when d  or pK fall$other factors heldconstant%.

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Changes in the &esiredCapital Stoc# $continued%

(hen technologyimproves $otherfactors heldconstant% the MFK f  curve shiftsupward, then

MFK f 

:uc , and K  rises.

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"aes and the &esiredCapital Stoc#

"he after-ta MPK f  is (1-τ  )MPK f .

uc  ;$/-τ% is ta-adjusted user cost 

of capital.

τ 1

d)p(r 

τ 1

uc MPK 

  k  f 

−

+

=−

=

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"aes and the &esiredCapital Stoc# $continued%

+n increase in the ta rate τ  raisesthe ta-adjusted user cost and so

reduces the desired stoc# ofcapital.

"he effective ta rate is a single

measure of the ta burden oncapital.

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4-31

Investment

"he capital stoc# changes* ross investment is the total

purchase or construction of newcapital goods. &epreciation is the capital wearing

out.

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Investment $continued%

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Investment $continued%

"he firm’s gross investment duringthe year has two parts*

the desired net increase in capital stoc#over the year $K*-K t %0

the investment needed to replace worn-out or depreciated capital $dK t %.

$K* is the desired capita st!c" i# the #e$t peri!d = K t+1%

tt

*

t  dK K K I   +−=

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Investment in Inventories

+ firm’s inventories are unsoldgoods, unfinished goods, and raw

materials. Inventory investment is the most

volatile component of investment

spending.

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oods ar#et ='uilibrium

"he real interest rate is the #eyeconomic variable whose

adjustments help bring the'uantities of goods supplied anddemanded into balance.

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oods ar#et ='uilibrium$continued%

"he goods mar#et e'uilibriumcondition is*

Y  is the 'uantity of goods suppliedby firms.

"he right hand side is theaggregate demand for goods.

G  I C Y    d d  ++=

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oods ar#et ='uilibrium$continued%

"he income-ependiture identityfor a closed economy $Y=C+I+G%

is always satisfied. "he goods mar#et is in e'uilibrium

when desired national saving

e'uals desired investment $Sd 

=I d 

%,since Sd =Y-C d -G.

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4-39

"he Saving-Investment&iagram

"he saving curve, S, is upwardsloping. + higher real interest rate

raises desired national savings. "he investment curve, I , is

downward sloping. + higherinterest rate increases the usercost of capital and, thus, reducesinvestment.

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"he Saving-Investment&iagram $continued%

+djustments ofthe real interestrate, in response

to ecess supplyor demand forsaving, bring thegoods mar#et intoe'uilibrium.

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"he Saving-Investment&iagram $Continued%

oods mar#et e'uilibrium* C d  depends on r  because a higher r  

raises Sd 

. I d  depends on r  because a higher r  

raises uc , which lowers I d .

+djustments of r  eliminate ecesssupply or demand for saving.

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Shifts of theSaving Curve

"he saving curve shifters are allfactors, ecluding the real interest

rate, which affect national saving.

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4-43

Shifts of theSaving Curve $continued%

=ample. "he crowdingout of investment bygovernment

purchases* increase in G causes a

decrease Sd%  Sd  curve shifts to the

left0

the e'uilibrium r  goesup0

I d  falls because of higheruc .

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Shifts of theInvestment Curve

"he investment curve shifters areall the factors which affect

investment, ecluding the realinterest rate $it determines themovement along the curve%.

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Shifts of theInvestment Curve

=ample* +n innovation or

economic reform

raises MPK f 

. "he increase in I d  

shifts the investmentcurve to the right.

r  rises to a new

e'uilibrium level. S increases.