Consumption, Saving, and Investment

1. Consumption, Saving, and Investment Chapter 4

2. Theories of consumer behavior: • Keynes absolute income hypothesis • Permanent income hypothesis • Life-cycle hypothesis Chapter 4

3. Keynes’ Consumption function • Absolute-income hypothesis • Psychological law--as income rises consumption rises but not by as much as income • Keynes assumes that consumption is a function of current income. • C = Co +cY Chapter 4

4. Life-cycle hypothesis • Concerned how households allocate their income between consumption and saving • households earn a stream of income over a lifetime (flood) • households may consume more or less than their income for any given year Chapter 4

5. household consumption depends on • rate of interest • expectations regarding future income • decision-making is intertemporal, meaning that households carefully consider how their present expenditures affect future consumption Chapter 4

6. The Permanent income hypothesis • People maximize utility based on their permanent (expected life-time) income • Allocate their income intertemporally Chapter 4

7. Household • Assumptions: • One type of good Y the price of which is 1, serving as the numerarie (in other words, we use this good as a composite good, a unit of real GNP) • Households produce a stream of output over T periods: Y1, Y2, …, YT • Household consumes an amount: C1, C2, …, CT Chapter 4

8. If there is no saving, Y1 = C1, Y2 = C2, and so on • If the commodity is storable, then the household may save: • C1 < Y1 -- Saving • C2 > Y2 -- Dissaving Chapter 4

9. Consumption and Investment • Equilibrium GDP: C + Ig = GDP • Real Domestic Output • Aggregate Expenditures • Aggregate Expenditures Schedule • Equilibrium GDP • Disequilibrium Chapter 4

10. (2) Real Domestic Output (and Income) (GDP=DI) (3) Con- sump- tion (C) (7) Unplanned Changes in Inventories (+ or -) (8) Tendency of Employment Output and Income (5) Investment (Ig) (6) Aggregate Expenditures (C+Ig) (1) Employ- ment (4) Saving (S) (1-2) Consumption and Investment …in Billions of Dollars • 40 • 45 • 50 • 55 • 60 • 65 • 70 • 75 • 80 • 85 $370 390 410 430 450 470 490 510 530 550 $375 390 405 420 435 450 465 480 495 510 $-5 0 5 10 15 20 25 30 35 40 20 20 20 20 20 20 20 20 20 20 $395 410 425 440 455 470 485 500 515 530 $-25 -20 -15 -10 -5 0 +5 +10 +15 +20 Chapter 4

11. 530 510 490 470 450 430 410 390 370 Consumption (billions of dollars) 45° • 390 410 430 450 470 490 510 530 550 Disposable Income (billions of dollars) G 9.1 Equilibrium GDP C + Ig (C + Ig = GDP) C Equilibrium Point Aggregate Expenditures Ig = $20 Billion C = $450 Billion Chapter 4

12. 510 490 470 450 430 Aggregate Expenditures (billions of dollars) 45° 430 450 470 490 510 Real GDP (billions of dollars) (C + Ig)1 (C + Ig)0 (C + Ig)2 Increase in Investment Decrease in Investment Chapter 4

13. Effect of changes in income and wealth on Consumption and saving: • An increase in current income • An increase in future income • An increase in wealth Chapter 4

14. Effect of Fiscal Policy on consumption • Fiscal policy: Government’s power to tax and spend • Fiscal policy affects desired consumption by affecting household’s current and future incomes Chapter 4

15. Effect of Government spending • Government increases spending: • Consumers will anticipate future tax increases to pay for the increase in government spending • Consumers will reduce their consumption, although generally not as much as the increase in government spending • Ricardian equivalence: proposition that the decline in consumer spending will match anticipated future tax increases, negating the expansionary effect of fiscal policy Chapter 4

16. Types of Capital and Investment • Fixed business investment • inventory investment • investment in residential structures Chapter 4