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Chapter 4

Chapter 4. Consumption, Saving, and Investment. Chapter Outline. Consumption and Saving Investment Goods Market Equilibrium. 1. Consumption and Saving. The importance of consumption and saving

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Chapter 4

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  1. Chapter 4 Consumption, Saving, and Investment

  2. Chapter Outline • Consumption and Saving • Investment • Goods Market Equilibrium

  3. 1. Consumption and Saving • The importance of consumption and saving • Desired consumption: consumption amount desired by households – in response to income and interest rates • Consumers’ desired consumption is directly linked to his desired savings. • Desired national saving: level of national saving when consumption is at its desired level: Sd = Y – Cd – G (4.1)

  4. 1. Consumption and Saving • Effect of changes in current income • Increase in current income: both consumption and saving increase (vice versa for decrease in current income) • Marginal propensity to consume (MPC) = fraction of additional current income consumed in current period; between 0 and 1 • Aggregate level: When current income (Y) rises, Cd rises, but not by as much as Y, so Sdrises

  5. 2. Consumption and Savings Decision of an Individual • C < Y  Saving is positive • C > Y  Saving is negative • Trade off between current consumption and future consumption. • The price of 1 unit of current consumption is 1 + r units of future consumption, where r is the real interest. • Consumption-smoothing motive: the desire to have relatively even pattern of C over time.

  6. 2.1 Effect of changes in current Income •  in current Y  C,  S •  in current Y  C,  S • MPC = fraction of additional current Y consumed in current period: between 0 and 1. • At aggregate level, when current Y, Cd, but not as much as Y, so Sd

  7. 2.2 Effect of changes in Expected Future Income • Higher expected future Y leads to more consumption today, so saving falls.

  8. 2.3 Effect of changes in wealth • (Wealth = assets – liabilities) • Increase in wealth raises current consumption, so lowers current saving – increase in one’s wealth does no affect ones current income earned. - it is matched by the decrease in current savings o f the same size. - hence, increase in wealth increase in current consumption, matched by the decrease in current savings of the same size. Note: same line of reasoning, decrease in wealth reduces current consumption and increase in savings – consumption smoothing motives.

  9. 2.3 Effect of changes in wealth •  in wealth,  C, so  current S.

  10. 2.4 Effect of changes in real interest rate • Interest rates vary • Increased real interest rate has two opposing effects • Substitution effect: Positive effect on saving, since rate of return is higher; greater reward for saving elicits more saving • [ reflects the tendency to reduce current consumption and increase future consumption as the price of current consumption increase by 1 + r ] In response to increase in price of current consumption consumers substitute away from current consumption –which is relatively more expensive – towards future consumption - which is relatively less expensive.

  11. 2.4 Effect of changes in real interest rate • Income effect: • Higher interest rates can make consumer richer or poorer. • If one saves and not a borrower, he is the recipient of interest payment – effectively as increase in wealth. Therefore benefit in the increase of interest rate, savings increase. • For a saver: higher real interest rate has Negative effect on saving, since it takes less saving to obtain a given amount in the future (target saving) [increase consumption and reduce savings] • For a borrower: Positive effect on saving, since the higher real interest rate means a loss of wealth – since can longer afford same level of current and future consumption. • Reduction in consumption means current savings incease and borrowing decreases. • Empirical studies have mixed results; probably a slight increase in aggregate saving – the nation economy is composed of both borrowers and savers

  12. 2.4 Effect of changes in real interest rate • Effect of changes in real interest rate • Taxes and the real return to saving – returns on savings are taxed • Real returns on savings actually less then difference between nominal interest rates and expected inflation. • Expected after-tax real interest rate: [useful measure of returns received bysavers] ra-t= (1 – t)i – e (4.2) where i is nominal i/rate tis rate at which interest income is taxed. ( 1- t )i amount received by savers after payment. ra-t is after-tax nominal interest rate e is expected inflation rate. [Expected after-tax real interest rate is appropriate for consumers to use in making consumption and savings decisions]

  13. 3. Taxes and Real Return to Savings • Interest earnings are taxed as a result savers actually earned less than the difference between nominal interest rate and expected inflation. • The actual return a saver earned is the after-tax real interest rate.

  14. 3.1 Expected after-tax real interest rate • Expected after-tax real interest rate = after-tax nominal interest rate minus the expected inflation rate or: • ra-t = (1 – t) i - e • t = income tax rate • (1 – t) = savers retain • i = nominal interest rate • e = expected inflation rate

  15. 3.1 Expected after-tax real interest rate • The expected after-tax real interest rate is the appropriate interest rate for consumer to make C and S decision because it measure the increase in the purchasing power of their savings after payment of taxes.

  16. 3.1 Expected after-tax real interest rate • Theoretically, when government  t, the government can the real rate of return earned by savers and (possibly)  the rate of saving in the economy. However, economists disagree about the effect of higher real interest rates on saving.

  17. 4. Fiscal Policy (FP) • Fiscal policy – decisions about spending and taxes • Affects desired consumption through changes in current and expected future income [ government fiscal policy –aren’t intentionally directed towards affecting saving this policy has important implications on amount of savings and consumption in the economy.] • Directly affects desired national saving, Sd = Y – Cd – G Sd - desired national savings. Y - economy’s aggregate output. Cd - desired consumption. G - government expenditure

  18. 4.1 How FP  can affect output (Y)? • For any level of output Y fiscal policy can affect national savings in 2 ways: • 1. for any level of Y and G fiscal policy can influence desired consumption Cd. E.g. If Cd reduced by one ringgit, Sd will increase by one ringgit. 2. for any level of Cd, increase G will directly lower Sd, as is apparent in the following: Sd = Y – Cd – G.

  19. 4.1 How FP  can affect output (Y)? • (i) Current Government purchases (G)  • Higher G financed by higher current taxes  after-tax Y, lowering Cd. • If finance by higher future taxes, and people realize future Y are affected,  after-tax Y, lowering Cd. • Since Cd declines less than G rises, national S (Sd = Y – Cd – G)  • So government purchases  both Cd and Sd.

  20. 4.1 How FP  can affect output (Y)? • (ii) Government reduces current • taxes T • G remains constant. • Government reduces tax by a lump sum tax (T) cut.

  21. 4.1 How FP  can affect output (Y)? • With G and Y constant, Sd will  only if Cd . How will Cd respond to the tax cut? This will depend how the tax cut affect people current and expected future income. • Rm 10 billion tax cut  current (after tax) income by RM10 billion, so should  Cd by less than 10 billion. • The 10 billion tax cut also should lead people to expect lower after tax incomes in future

  22. 4.1 How FP  can affect output (Y)? • Because G is constant, to cut tax government need to finance its G by  borrowing 10 billion. • 10 billion debts have to be repaid with interest in future, future tax will be higher, which mean lower future disposable income for household. • In principle a tax cut today, which current income but  expected future income could either raise or lower Cd.

  23. 4.1 How FP  can affect output (Y)? • Some economists argue that the positive effect of increased current income and the negative effect of decrease future income on Cd should exactly cancel so the overall effect is zero. • The idea that tax cut do not affect Cd and therefore do not affect Sd is called Ricardian Equivalence Proposition.

  24. 5. RICARDIAN EQUIVALENCE -THEOREM • David Ricardo (1772-1823) a leading figure in classical school. • Conventional macroeconomics theory –  in G, will have expansionary effect on GDP when financed by borrowing rather by tax . A tax  will reduce C, partly offsetting the  in G.

  25. 5. RICARDIAN EQUIVALENCE -THEOREM • Ricardian Equivalence (RE) propositions: • In LR all G must be paid for by taxes. • If future Y loss exactly offsets current Y gain, no  in C. • Tax  affects only the timing of tax collection, not their ultimate tax burden borne by consumers.

  26. 5. RICARDIAN EQUIVALENCE -THEOREM • RE stated that with no change in G, tax cut does not  Cd and Sd. • In practice, people may not see that future tax will rise if taxes are cut today, then a tax cut leads to  Cd and  Sd. If this is the case than RE does not apply.

  27. 5. RICARDIAN EQUIVALENCE -THEOREM • Fiscal policy-with respect to consumption • Taxes • Ricardian equivalence proposition • If future income loss exactly offsets current income gain, no change in consumption • Tax change affects only the timing of taxes, not their ultimate amount (present value) • In practice, people may not see that future taxes will rise if taxes are cut today; then a tax cut leads to increased desired consumption and reduced desired national saving

  28. 5. RICARDIAN EQUIVALENCE -THEOREM • Example; • Application: a Ricardian tax cut? • The Economic Growth and Tax Relief Reconstruction Act (EGTRRA) of 2001 gave rebate checks to taxpayers and cut tax rates substantially • From the first quarter to the third quarter, government saving fell $277 billion (at an annual rate) but private saving increased $180 billion, so national saving declined only $97 billion, so about 2/3 of the tax cut was saved

  29. 5. RICARDIAN EQUIVALENCE -THEOREM • Application: a Ricardian tax cut? • Most consumers saved their tax rebates and did not spend them • As a result, the tax rebate and tax cut did not stimulate much additional spending by households

  30. Summary

  31. 6. INVESTMENT • Why is investment important? • Investment fluctuates sharply over the business cycle, so we need to understand investment to understand the business cycle. • Investment plays a crucial role in economic growth.

  32. 6. INVESTMENT • The desired capital stock • Desired capital stock is the amount of capital that allows firms to earn the largest expected profit. • Desired capital stock depends on cost and benefits of using additional capital. • Since investment becomes capital stock with a lag, the benefit of investment is the future marginal product of capital (MPKf).

  33. 6. INVESTMENT • MPKf is the benefit of adding one unit of capital holding all other factors constant. • The logic of deciding how much capital to use is the same as the decision of deciding how many labors to employ.

  34. 6.1 The user cost of capital (uc) • User cost of capital = real cost of using a unit of capital for a specified period of time. User cost of capital = interest cost + depreciation cost uc = rpk + dpk = (r + d) pk • uc = user cost of capital • rpk = interest cost • dpk = depreciation cost • pk = real price of capital goods • d = rate at which capital depreciates • r = expected real interest rate

  35. 6.2 Determining the desired capital stock • The desired capital stock • Desired capital stock is the amount of capital that allows firms to earn the largest expected profit • Desired capital stock depends on costs and benefits of additional capital • Since investment becomes capital stock with a lag, the benefit of investment is the future marginal product of capital (MPKf)

  36. 6.2 Determining the desired capital stock • Desired capital stock is the level of capital stock at which MPKf = uc • MPKffalls as K rises due to diminishing marginal productivity. • uc does not vary with K, so it is a horizontal line. • If MPKf > uc, profits rise as K is added. • (marginal benefit > marginal costs) • If MPKf < uc, profits rise as K is added. • (marginal benefit < marginal costs) • Profits are maximized where MPKf = uc

  37. 6.2 Determining the desired capital stock • The desired capital stock (investment perspective) • The user cost of capital • Example of Kyle’s Bakery: decides to invest in a new oven. • cost of capital ($100 per cubic foot), depreciation rate (10% per year), and expected real interest rate (8% per year) • User cost of capital = real cost of using a unit of capital for a specified period of time = real interest cost + depreciation uc = rpK + dpK = (r + d)pK (4.3)

  38. 6.2 Determining the desired capital stock • Desired capital stock is the level of capital stock at which MPKf = uc • MPKf falls as K rises due to diminishing marginal productivity • uc doesn’t vary with K, so is a horizontal line • Determining the desired capital stock (Fig. 4.3)

  39. Figure 4.3 Determination of the desired capital stock K-stock for Kyle’s Bakery K –expressed in cubic feet of oven capacity – is measured on the horizontal axis. MPKf and uc is measured on the vertical axis.downward-sloping MPKf shows the different sizes of the capital stock of K; it shows MPK falls as K is increased. The desired K-stock that maximizes profit is at 5000 cubic feet where MPKf = uc of K

  40. 6.3 Investment • The desired capital stock • If MPKf > uc, profits rise as K is added (marginal benefits > marginal costs) • If MPKfuc, profits rise as K is reduced (marginal benefits < marginal costs) • Profits are maximized where MPKf = uc

  41. 6.3 Investment • Changes in the desired capital stock • Factors that shift the MPKfcurve or change the user cost of capital cause the desired capital stock to change • These factors are changes in the real interest rate, depreciation rate, price of capital, or technological changes that affect the MPKf (Fig. 4.4 shows effect of change in uc; Fig. 4.5 shows effect of change in MPKf)

  42. Figure 4.4 A decline in the real interest rate raises the desired capital stock • Decline in interest rate; ↓ uc, - is shown by the downward shift of the user cost line from uc1 to uc2. • Kyle can increase its profit by raising the oven capacity to 6000 cubic feet.

  43. Figure 4.5 An increase in the expected future MPK raises the desired capital stock Technological change can affect MPKf, hence the desired K-stock. This will cause MPKf; shifts in MPKf1 to MPKf2. If uc remains constant, technological advancement will caused the desired K-stock to ↑ from 5000 to 6000 cubic feet. In other words, with uc held constant, ↑ in expected MPKf at any level of K, raises the desired K-stock.

  44. Investment • Changes in the desired capital stock • Taxes and the desired capital stock • With taxes, the return to capital is only (1 – ) MPKf • A firm chooses its desired capital stock so that the return equals the user cost, so (1 – )MPKf = uc, which means: MPKf = uc/(1 – ) = (r + d)pK/(1 – ) (4.4) Hence, the desired capital stock is the one for which the after-tax future marginal product = user cost.

  45. Investment • Changes in the desired capital stock • Taxes and the desired capital stock • Tax-adjusted user cost of capital is uc/(1 – ) (it shows how large the before–tax MPKf must be for a firm to willingly add another unit of K.) • An increase in τ raises the tax-adjusted user cost and reduces the desired capital stock

  46. Investment • Changes in the desired capital stock • Taxes and the desired capital stock • In reality, there are complications to the tax-adjusted user cost • We assumed that firm revenues were taxed • In reality, profits, not revenues, are taxed • So depreciation allowances reduce the tax paid by firms, because they reduce profits • Investment tax credits reduce taxes when firms make new investments

  47. Investment • From the desired capital stock to investment - In general the K-stock of a firm or country changes over time through 2 opposing channels: • Purchase or construction of new capital increases the capital stock; this is gross investment • The capital stock depreciates (wears out), which reduces the capital stock • Whether K-stock ↑ or ↓ over course of a year depends on whether gross investment greater or less than depreciation. • Difference between gross investment and depreciation is net investment.

  48. Investment • From the desired capital stock to investment • To express the concept symbolically: • Net investment = gross investment (I) minus depreciation: Kt+1 – Kt = It – dKt(4.5) Where: It = gross investment during year t Kt = capital stock at the beginning of year t Kt+1 = capital stock at the beginning of year t +1 d = fraction of capital that depreciates each year. where net investment equals the change in the capital stock

  49. Investment • From the desired capital stock to investment • Rewriting (4.5) gives It = Kt+1 – Kt + dKt( gross investment equals net investment plus depreciation) • If firms can change their capital stocks in one period, then the desired capital stock (K*) = Kt+1 • So It = K* – Kt + dKt (4.6) Thus, the above shows that investment has two parts • Desired net increase in the capital stock over the year (K* – Kt) • Investment needed to replace depreciated capital (dKt)

  50. Investment • From the desired capital stock to investment • Lags and investment • Some capital can be constructed easily, but other capital may take years to put in place • So investment needed to reach the desired capital stock may be spread out over several years

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