Chapter 5 More about Consumption, Investment and Fiscal Policy

1. Chapter 5 More about Consumption, Investment and Fiscal Policy

2. More about consumption function More about saving function More about investment function Fiscal policy Advanced Material 5.1 Net investment is sustained by a favorable and continuous change in determinants Advanced Material 5.2 Short term and long term effects of investment Contents:

3. More about Consumption Function

4. Propensity to consume • Average propensity to consume (APC) is • the consumption per unit of disposable income. APC = Note: When Yd increases, APC drops.

5. C C C1 Slope = C1/Yd1 = APC1 C* APC1 +1 Yd 0 Yd1 Graphical illustration

6. Marginal propensity to consume • Marginal propensity to consume (MPC) is the change in consumption resulting from a unit change in disposable income. MPC= Note: When Yd increases, MPC is unchanged.

7. C Slope = ΔC/ΔYd = MPC C C1 MPC Slope = C1/Yd1 = APC1 C* +1 Yd 0 Yd1 Graphical illustration

8. Graphical representation of consumption function Plotting C against Yd C C = cYd + C* C c +1 C* Yd 0

9. Plotting C against Y C = cYd+C* = c(Y-tY-T*+qY+Q*)+C* = (c-ct+cq)Y + (C*-cT*+cQ*) C C c (1-t+q) +1 C*- cT* + cQ* Y 0

10. Determinants of consumption function

12. Q5.1: What would happen to the aggregate consumption if income is redistributed from (a) the group of high MPC to the group of low MPC (b) the group of high APC to the group of low APC (c) the group of high C to the group of low C

13. Q5.2: (a) In general, who have a higher MPC, the rich or the poor? Explain. (b) In general, who have a higher MPC, the young or the old? Explain. Q5.3: Explain why the cost of real consumption is the real interest rate instead of the nominal interest rate.

14. More about Saving Function

15. Propensity to save • Average propensity to save (APS) is the saving per unit of disposable income. APS = Note: As S* is negative, when Yd increases, APS increases.

16. Slope = S1/Yd1 = APS1 S1 APS1 0 Yd1 +1 Graphical illustration S S Yd S* = -C*

17. Marginal propensity to save • Marginal propensity to save (MPS) is the change in saving resulting from a unit change in disposable income. MPS = Note: When Yd increases, MPS remains unchanged.

18. Slope = S1 /Yd1 = APS1 S1 MPS1 0 Yd1 +1 Slope= ΔS/ΔYd = MPS Graphical illustration S S Yd S* = -C*

19. S1 C1 S1 Yd Relation between consumption and saving C C  At Yd1 C* • Yd1 < C1 0  Yd1 Yd • S1 =Yd1 - C1 S S = (1-c)Yd - C* • S1 < 0 Dissaving Yd1 Yd   -C*

20. C At Yd2 Yd C • Yd2 = C2  C* C2 =Yd2 • S2 =Yd2 – C2 = 0 0  Yd2 Yd No dissaving or saving S S = (1-c)Yd - C* S2 = 0  Yd2 Yd -C*

21. S3 S3 C Yd At Yd3 C • Yd3 > C3 • S3 =Yd3 – C3 C3 C* • S3 > 0 0 Yd3 Yd S Saving S = (1-c)Yd - C* Yd Yd3 -C*

22. S S Yd 0 Mathematical relation: • S = Yd - C • APS=(Yd - C)/Yd = 1 - APC • MPS = Q5.5: Refer to the given diagram. When Yd increases, what would happen to C, APC, MPC, S, APS and MPS?

23. T T T Y Y C C Y C Yd Yd Yd S S S Determinants of saving function

24. Determinants of saving function

26. More about Investment Function

27. Components of investment function Gross investment = Depreciation + Net investment • The amount spent on replacing depreciated capital (depreciation) is positively related to: • amount of capital possessed • rate of utilization • advancement of technology • but is negatively related to: • interest rate

28. Components of investment function • The amount spent on raising capital stock • (net investment) is positively related to: • the desired increase in capital stock • but is negatively related to: • interest rate

29. Determinants of net investment function Suppose expected net receipts = {Y1, Y2, Y3, …} purchase price of capital = Pc , and MEC = e. Then • Whenever e  r, it is worth buying until e = r. • The MEC curve is the demand curve for capital. • When r falls, the optimal size of capital stock increases. • The difference is the amount of net investment. • The portion of MEC curve below r0 is the net I curve.

30. % % MEC curve = Demand for capital r0 r0 r1 r1 I 0 0 I1 K0 K1 Capital Stock (I1=K1-K0) The larger the  in r  The net investment function The larger the  in the optimal size of capital stock & net I  I = br + I*; & b < 0 Net investment

31. Determinants of net investment function

33. Fiscal Policy

34. What is fiscal policy? • Fiscal policyis the government measure which achieves economic objectives through manipulating the government revenue and expenditure. • Types: • Automatic fiscal policy • Discretionary fiscal policy

35. Automatic fiscal policy • Automatic stabilizers or built-in stabilizers are government measures that reduce cyclical fluctuations of an economy automatically.

36. Instruments: Those transfer payments (injection) which are negatively related to income - e.g. unemployment benefits, comprehensive social security assistance Those taxes (withdrawal) which are positively related to income - e.g. property tax, salaries tax and profits tax

37. Boom  Recession  Recovery Trough • Recovery • Transfer payments (injection)  • Income taxes  • Rise in national income is reduced. • Recession • Transfer payments (injection)  • Income taxes (withdrawals)  • Fall in national income is reduced The stabilizing effect of automatic stabilizers is reflected by the drop in the size of multipliers. Automatic stabilizers reduce the size of fluctuations and stabilize national income. % Growth rate of real national income 4 phases of a business cycle

38. Limitations • Automatic stabilizers can only reduce, but not eliminate cyclical fluctuations. • Discretionary fiscal policy is essential to achieve other macroeconomic objectives, e.g., full employment, economic growth, equitable income distribution, etc. • Fiscal drag will weaken the effectiveness of discretionary fiscal policy. • Built-in stabilizers bring disincentivesto work and investment.

39. Q5.8: Are corporate savings and family savings built-in stabilizers? Do they create disincentives?

40. Discretionary fiscal policy • Discretionary fiscal policy is the deliberate government measure which achieves economic objectives through manipulating the government revenue and expenditure. • Instruments: • Government expenditures (G) • Transfer payments (Q) • Taxes (T)

41. Mechanisms: •  in G aggregate expenditure  brings a multiple  in income •  in transfer payment disposable income  in consumption  a multiple  in income •  in (direct) tax disposable income •  in consumption  a multiple  in income Opposite cases also apply.

42. Corresponding multipliers:

43. What is government budget? • Budgetis a financial statement proposing the estimated revenue and expenditure of the public sector in a fiscal year.

44. = < >

45. Balanced budget • A balanced budget is expansionary. • Its effect on equilibrium income : = ΔG • G-multiplier + ΔT • T-multiplier = ΔBudget • (G-multiplier+T-multiplier) Balanced budget multiplier =

46. If income is not subjected to taxation, only a part of it is consumed while the other part is saved. • Under a balanced budget, the whole amount of income taxed is spent on government consumption. • a net increase in aggregate expenditure (= the amount of income saved before taxation) • brings a multiple increase in national income. Note:An annuallybalanced budget is destabilizing (pro-cyclical)whilea cyclicallybalanced budgetis stabilizing (counter–cyclical).

47. Deficit budget and surplus budget • A deficit budget is more expansionary than a balanced budget. • The effect of a surplus budget can be: • expansionary • neutral • or contractionary • Yet, when it is applied, it is usually aimed at bringing in a contractionary effect.

48. What is public debt? • Public debtis the borrowing of the government. Burden of public debt • Microscopically or individually, it is the future taxpayers who bear the burden of public debt. • Macroscopically or in the view of a generation, it is the present generation who bears the burden.

49. Yet, the future generation still bears some burden because: • Taxation brings adverse effects -- indirect taxes bring deadweight losses while direct taxes create disincentives to work & investment. • Issuance of gov’t bonds raises the interest ratewhichcrowds out private investment • Repayment of an external debt involves • a net export of goods and services in the future.

50. Situations • -- that may minimize the burden on the future generation: 1. The economy is under a serious depression. 2. The debt is forfinancing public investment. 3. The debt is an internal debt.