Transcript 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
• 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
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Consumption and Saving (Sec. 4.1)
The importance of consumption and saving
Desired consumption: consumption amount desired by households
Desired national saving:
Sd = Y – Cd – G (4.1)
The consumption and saving decision of an individual
A person can consume less than current income (saving is positive)
A person can consume more than current income (saving is negative)
Trade-off between current consumption and future consumption
The price of current consumption
Consumption-smoothing motive
Effect of changes in current income
Effect of changes in wealth
Effect of changes in real interest rate
Increased real interest rate has two opposing effects
Substitution effect
Income effect
Empirical studies
• 2. Taxes and the real return to saving
• a. Expected after-tax real interest rate:
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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?
II.
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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)
• 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
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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
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
• 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
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)
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goods market equilibrium condition
• 2. Differs from income-expenditure identity
• 3. Alternative representation: since
• Sd = Y – Cd – G,
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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
• 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
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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
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
• 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