CHAPTER 4

1. CHAPTER 4 Consumption, Saving and Investment

2. The Income-Expenditure Identity Y = C + I + G + XM NX = 0 in a closed economy or a balanced trade ??? ??? ??? ??? What determines Saving & Capital Formation ? G = depends on government policy

3. Desired C and S Sd = Y – Cd – G Government purchases National income The national level of desired consumption is the aggregate quantity of goods and services that households want to consume. The national level of desired saving occurs when aggregate consumption is at its desired level, Cd.

4. Consumption vs Saving Option 1: Earn $20,000. Consume $20,000. Option 2: Earn $20,000. Consume < $20,000. Save some. Option 3: Earn $20,000. Borrow $5,000. Consume $25,000. Trade-off between current consumption vs future consumption  depends on real interest rate. Option 4: Current consumption less $1. Future consumption extra $1 + r. (from saving) Option 5: Current consumption extra $1. Future consumption less $1 + r. (pay back loan)

5. Consumption-Smoothing Motive “The desire to have a relatively even pattern of consumption over time and to avoid periods of very high or very low consumption.” The real interest rate determines the relative price of current consumption and future consumption. Finding the balance between: Saving too much and spending less in current consumption, and spending too much in future consumption. OR Saving too little or take out loans in current consumption but spending too little in future consumption.

6. Changes in Current Income Case 1: Receive one-time bonus of $3000. Effect: Spend $3000 now (current consumption) or save now and spend $3000+ later (future consumption) If MPC = 0.4, then an ↑ in Y by $3000 will ↑C by $1200, ↑S by $1800. By consumption-smoothing motive: Spend some, save some. Case 2: A pay-cut causes a ↓ in Y by $4000. Effect: C will ↓ by $1600 and ↓S by $2400. OVERALL = ↑current income leads to ↑S from additional saving.

7. Changes in Expected Future Income Case: Receive one-time bonus of $3000 next year. Effect: Current consumption ↑, current saving ↓. i.e. ↑ Current consumption by $1000 = ↓ current saving by $1000. Previously, if save $1000 now, then future consumption will have extra $1000 x (1+r). If r = 0.5, then by saving $1000 now, future consumption should have extra $1050 to spend. But since current saving ↓ now by $1000, then net increase in resources available next year = $3000 (next-year-bonus) minus $1050 (should-have from saving) = $1950 only.

8. Changes in Expected Future Income (cont.) But since current saving ↓ now by $1000, then net increase in resources available next year = $3000 minus $1050 (next-year-bonus) (should-have from saving) = $1950 only. OVERALL = ↑future income leads to ↓S.

9. Changes in Wealth Wealth: Case: Receive family inheritance of $3000 in stocks. Effect: ↑ current consumption, ↓ current saving. As assets have increased and recipient feels wealthier, current consumption will be increased. But since current income does not change, current saving has to be decreased to cover for the increase in current consumption. OVERALL = ↑wealth leads to ↓S.

10. Changes in Real Interest Rate Case: Increase in real interest rate, r. Effect 1: For someone who saves … Substitution effect = ↓ current consumption, ↑ current saving. Income effect = ↑ current consumption, ↓ current saving. Effect 2: For someone who borrows … Substitution effect = ↓ current consumption, ↑ current saving. Income effect = ↓ current consumption, ↑ current saving. OVERALL = ↑real r leads to ↑S.

11. After-tax Real Interest Rate Real interest rate = Nominal interest rate – inflation rate Interest earnings are subjected to taxes, so real return to saving < real interest rate. Expected after-tax real interest rate: ra-t = (1-t)I - πe i.e. nominal interest rate = 5%, expected inflation rate = 2%. If t = 0.3, expected after-tax real interest rate = (1-0.3)5% - 2% = 1.5% If t = 0.2, expected after-tax real interest rate = (1-0.2)5% - 2% = 2%

12. Changes in Fiscal Policy Assumptions: full-employment and no significant effect on supply. Changes in fiscal policy will affect Cd and G, subsequently affecting Sd. Effect 1: When government ↑ G through subsidies and government projects, then Cd may ↓ but not as much. Effect 2: When government ↑ G, then Sd ↓ because Sd = Y – Cd – G. OVERALL = ↑govt purchases leads to ↓S. Sd = Y – Cd – G

13. Changes in Taxes Taxes will affect Cd. Ricardian equivalence proposition = when govt cut taxes, Cd should ↑ due to ↑ in disposable income. But, ↓tax now means ↑tax in the future, so ppl may want to ↓Cd. So changes in tax may not have any effect on national saving, S. In practice, people may not see that future taxes will rise if taxes are cut today; then a tax cut leads toincreased desired consumption (↑Cd) and reduced desired national saving (↓S). OVERALL = ↓income tax leads to ↓S.

14. End of Lecture 1 Week 4 • Desired C vs S • Consumption-Smoothing Motive • Changes in: • - Current Income - Expected Future Income • - Wealth - Real Interest Rate • - Fiscal Policy - Taxes