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Chapter 4

Chapter 4. Consumption, Saving, and Investment. Goals of Chapter 4 . A) Examine the factors that underlie economywide demand for goods and services B) Assumes closed economy (for now) C) Focuses on consumption and investment D) Equivalent to studying saving and capital formation

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Chapter 4

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  1. Chapter 4 Consumption, Saving, and Investment

  2. Goals of Chapter 4 • A) Examine the factors that underlie economywide demand for goods and services • B) Assumes closed economy (for now) • C) Focuses on consumption and investment • D) Equivalent to studying saving and capital formation • E) Examines trade-off of present vs. future • F) Goods market equilibrium when desired saving equals desired investment • G) Real interest rate plays key role in bringing goods market to equilibrium

  3. I. Consumption and Saving (Sec. 4.1) • A) The importance of consumption and saving • 1. Desired consumption: consumption amount desired by households • 2. Desired national saving: • Sd = Y – Cd – G (4.1) • B) The consumption and saving decision of an individual • 1. A person can consume less than current income (saving is positive) • 2. A person can consume more than current income (saving is negative) • 3. Trade-off between current consumption and future consumption • a. The price of current consumption • b. Consumption-smoothing motive • C) Effect of changes in current income • E) Effect of changes in wealth • F) Effect of changes in real interest rate • 1. Increased real interest rate has two opposing effects • a. Substitution effect • b. Income effect • c. Empirical studies

  4. 2. Taxes and the real return to saving • a. Expected after-tax real interest rate: • ra–t= (1 – t)i – e (4.2) • b. Simple examples: i= 5%, e= 2%; if t= 30%, ra–t= 1.5%; if t= 20%, ra–t= 2% • 3. In touch with the macroeconomy: interest rates • G) Fiscal policy • 1. Affects desired consumption through changes in current and expected future income • 2. Directly affects desired national saving, Sd = Y – Cd – G • 3. Government purchases (temporary increase) • 4. Taxes • a. Lump-sum tax cut today • b. Decline in future income • c. Ricardian equivalence proposition • H) Application: a Ricardian tax cut?

  5. II. Investment (Sec. 4.2) • A) Why is investment important? • B) The desired capital stock • 1. Desired capital stock • 2. costs and benefits of additional capital • 3. future marginal product of capital (MPKf) • 4. The user cost of capital • 5. Determining the desired capital stock (Figure 4.2)

  6. Changes in the desired capital stock • 1. Factors that shift the MPKf curve user cost of capital 2. These factors are changes in the real interest rate, depreciation rate, price of capital, or technological changes that affect the MPKf • 3. Taxes and the desired capital stock • a. With taxes, the return to capital is only (1 – )MPKf • b. Setting the return equal to the user cost gives • MPKf = uc/(1 – ) = (r + d)pK/(1 – ) • c. Tax-adjusted user cost of capital is uc/(1 – ) • d. An increase in τ raises the tax-adjusted user cost and reduces the desired capital stock • e. In reality, there are complications to the tax-adjusted user cost • different countries; some are negative, implying a subsidy to capital • f. Application: measuring the effects of taxes on investment

  7. D) Box 4.1: investment and the stock market • 1. Firms change investment in the same direction as the stock market: Tobin’s q theory of investment • 2. If market value > replacement cost, then firm should invest more • 3. Tobin’s q = capital’s market value divided by its replacement cost • 4. Stock price times number of shares equals firm’s market value, which equals value of firm’s capital • 5. Empirical Data • 6. This theory is similar to text discussion

  8. E) From the desired capital stock to investment • 1. The capital stock changes from two opposing channels • a. New capital • b. The capital stock depreciates • c. Net investment • 2. Rewriting (4.5) gives It = Kt+1 – Kt + dKt • a. desired capital stock (K*) = Kt+1 • b. So It = K* – Kt + dKt (4.6) • c. Thus investment has two parts • (1) (K* – Kt) • (2) (dKt) • 3. Lags and investment • F) Investment in inventories and housing

  9. III. Goods Market Equilibrium (Sec. 4.3) • A) The real interest rate adjusts to bring the goods market into equilibrium • 1. Y = Cd + Id + G (4.7) • goods market equilibrium condition • 2. Differs from income-expenditure identity • 3. Alternative representation: since • Sd = Y – Cd – G, • Sd = Id (4.8) • B) The saving-investment diagram • 1. Plot Sd vs. Id (Figure 4.6) • 2. Equilibrium where Sd = Id • 3. How to reach equilibrium? Adjustment of r

  10. 4. Shifts of the saving curve • Saving curve shifts right due to a rise in current output, a fall in expected future output, a fall in wealth, a fall in government purchases, a rise in taxes (unless Ricardian equivalence holds, in which case tax changes have no effect) • 5. Shifts of the investment curve • Investment curve shifts right due to a fall in the effective tax rate or a rise in expected future marginal productivity of capital

  11. C) Application: Macroeconomic consequences of the boom and bust in stock prices • 1. Sharp changes in stock prices affect consumption spending (a wealth effect) and capital investment (via Tobin’s q) • 2. Consumption and the 1987 crash • 3. Consumption and the rise in stock market wealth in the 1990s • 4. Consumption and the decline in stock prices in the early 2000s • 5. Investment and Tobin’s q

  12. IV. Appendix 4.A: A Formal Model of Consumption and Saving • d. The permanent income theory • (1) Different types of changes in income • (2) Permanent income increase causes bigger increase in PVLR than a temporary income • (a) So current consumption will rise more with a permanent income increase • (b) So saving from a permanent increase in income is less than from a temporary increase in income • (3) This distinction between permanent and temporary income changes was made by Milton Friedman in the 1950s and is known as the permanent income theory

  13. H) Consumption and Saving Over Many Periods: The Life-Cycle Model • 1. Life-cycle model was developed by Franco Modigliani and associates in the 1950s • a. Looks at patterns of income, consumption, and saving over an individual’s lifetime • b. Typical consumer’s income and saving pattern shown in Figure 4.A.5 • c. Real income steadily rises over time until near retirement; at retirement, income drops sharply • d. Lifetime pattern of consumption is much smoother than the income pattern • e. Saving has the following lifetime pattern

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