Chapter # 3

Lecture # 4

CONSUMPTION, SAVING, AND INVESTMENT

LECTURE OUTLINE:
In last lecture (chapter 3) we discussed the factors which determine the amount of output produced; now we will discuss how that production is used. We will discuss the following in todays lecture: A. Consumption and a!in"
i) ii) iii) iv) v) vi) The importance of consumption and saving The consumption and saving decision of an individual Effect of changes in current income Effect of changes in expected future income and wealth Effect of changes in real interest rate Effect of Government policy

#. In!estment
i) ii) iii) iv) Why is investment important The desired capital stock Changes in the desired capital stock the desired capital stock and investment

C. E$$ects on %oods &ar'et E(ui)i*rium

i) ii) Effect of real interest adjustment Effect of shift of Saving and nvestment curves

Initially we assume a closed economy with no overseas transaction. That means ! " # I # $. %ince government spending and purchases are mostly affected &y political decisions and not &y economic forces so if for the sa'e of discussion we ignore $ as well( then there are two ma)or economic constituent components of national income: consumption &y households and investment &y firms.

Y=C Y = C+I

Households

Firms

%avings !

1inance ector

Investment ! I

"I*"+,-* .,/W 1. CONSUMPTION AND SAVING

-s we 'now that decision a&out how much to consume is the same as the decision a*out how much to sa!e for a given level of income( so these two are interre)ated rather interdependent. These two decisions are the two sides of the same coin. A. The importance o$ consumption and sa!in" +. ,esired consumption: It is the consumption amount desired &y households &ut from macroeconomic view point( we will discuss the aggregate or national levels of consumption and saving. We define the national level of desired consumption (Cd) as the aggregate quantity of goods and services that households want to consume, given income and other factors that determine households economic opportunities! "d is the sum of desired consumption of all households in the economy. ("0 # "1 # "3 # 22222. # "n) ! "d( when there are 3n4 households in the economy). -. ,esired nationa) sa!in": 5ust as households consumption decision and saving decisions are closely lin'ed( a countrys desired consumption is )in'ed to its desired nationa) sa!in" ( d) which is defined as level of national saving that occurs when aggregate consumption is at its desired level. While discussing 6ational Income -ccounting we saw that 6ational %avings is the sum of private and government savings: % ! (%pvt # %govt) ! # 6.7 8 " 8 $. %ince we assumed here closed economy so 6.7 ! 9 and national savings &ecome . / 0 C 0 %. To o&tain

e:pression for desires national savings we replace and Cd. %o

d.

and C with

d.

. / 0 Cd 2 %

#. The consumption and sa!in" decision o$ an indi!idua) 0. - person can consume )ess than current income. %aving is positi!e when scari$3in" present $or $uture. 1. - person can consume more than current income. %aving is ne"ati!e when scari$3in" $uture $or present. 3. Trade;off &etween current consumption and future consumption. The rate o$ trade2o$$ *etween current consumption and $uture consumption is the rea) interest rate. a. The price of 0 unit of current consumption is 0 # r units of future consumption( where r is the real interest rate. %o + unit sa!ed wi)) *e worth + 4 r ne5t 3ear that means there is a trade of 0 unit worth of consumption today for 0 # r units of consumption a year from now. &. Consumption2smoothin" moti!e : To current)3 consume hea!i)3 and pa3 a )ot in $uture or to star!e toda3 and sa!e a)most a)) $or $uture are two e5treme ends . The desire to have a relatively e!en pattern o$ consumption over time instead of consuming heavily or saving unrealistically is under consumption2smoothin" moti!e. C. E$$ect o$ chan"es in current income "urrent income is an important factor affecting consumption and saving decisions. +. Increase in current income: either or &oth consumption and saving increase (vice versa for decrease in current income) -. &ar"ina) 6ropensit3 to Consume 7&6C8 . $raction o$ additiona) current income consumed in current period9 $or norma) *eha!ior It is assumed to *e *etween : and + . (&6C ; : <+) If with an increase of *s. <9(999( some&odys =7" under consumption;smoothing motive( is 9.> that means he?she will increase current consumption &y >9@ (1>(999) and savings will

increase with <9@ (3<(999). =7" also applies when there is decline in income. 3. A""re"ate )e!e): %imilar to the case of individual households( when current nationa) output or income 7/8 rises= C d rises= *ut *ecause &6C is )ess than + so rise in C d does not rise as much as /= resu)tant)3 there is a rise in d too. ,. E$$ect o$ chan"es in e5pected $uture income and wea)th 0. A:pected future income also affects current consumption. >i"her e5pected $uture income )eads to more consumption toda3 ( resultantly sa!in" $a))s or even goes negative sometimes. %o if / then Cd and
d

1. Increase in wea)th motivates to spend more so it raises current consumption &ut since an increase in wealth is not an increase in current income so due to increase in current consumption the current saving lowers. E. E$$ect o$ chan"es in rea) interest rate 0. interest rate is the price o$ current consumption in terms o$ $uture consumption. 6ow we will e:amine the effect on current consumption and saving of changes in real interest rate. Increased real interest rate has two opposing effects: +8 u*stitution e$$ect of the real interest rate on saving -8 Income e$$ect of the real interest rate on saving a. u*stitution e$$ect o$ the rea) interest rate on sa!in": 7ositive effect on saving( since rate of return is higher; "reater reward $or sa!in" e)icits reduced current consumption and more sa!in" (or increased future consumption). -lso the cost of current consumption (0#r) will &e higher in terms of future consumption and future consumption &ecomes relatively cheaper so people tend to su*stitute awa3 $rom current consumption to $uture consumption which means 7)ess current consumption and more $uture consumption8 increase in sa!in".

&. Income e$$ect o$ the rea) interest rate on sa!in" :

I.

1or a sa!er: -n increase in real interest rate means additional resources in future which results in additional wealth (additiona) return . increase in wea)th). It means there will &e a negative effect on saving( since it ta'es less saving to o&tain a given amount in the future (target saving). %o the income effect of increase in real interest is more current consumption and reduced current sa!in" . We notice that( $or a sa!er= su*stitution e$$ect and income e$$ect wor' in opposite direction. 1or a *orrower: 7ositive effect on saving( since the increase in real interest rate increases interest payment amount( so reduces its current consumption which means increased saving. .or a &orrower *oth su*stitution e$$ect and income e$$ect operate in positi!e direction for savings( means increased savings. 1or nationa) econom3: %ince &orrowers and savers &oth are part of national economy so one cannot say whether the net effect is increased saving or reduced savingBB

II.

III.

1. Ta:es and the real return to saving The fact is that interest income is ta:ed and receiver gets less than the difference &etween the nominal interest rate and e:pected inflation so the more meaningful varia&le will &e expected after-tax real interest rate. a. E5pected a$ter2ta5 rea) interest rate : If i is the nominal interest rate( and t is the ta: rate( so at after;ta: nominal interest rate what savers receive is 7+ 2 t8 5 i. When we su&tract e:pected inflation rate e then a$ter2ta5 rea) interest 7ra2t8 &ecomes ra2t . 7+ 2 t8i 2 ?e &. %imple e:amples: 0) i ! C@( De ! 1@; if t ! 39@ then ra;t !E 1) if all a&ove is same only t ! 19@( then ra;t !E i t De ra;t Calculation (1 - 0.30)5% - 2% = 1.5%

5.00% 30.00% 2.00% 1.50%

"

20.00%

"

2.00%

(1 - 0.20)5% - 2% = 2%

1. 1isca) po)ic3 -ssuming that economys aggregate output ( ) is constant or at full employment. 0. -ffects desired consumption( ("d) through changes in current and e:pected future income &y increasing or decreasing ta: rate. 1. Firectly affects desired national saving( %d ! 3. $overnment purchases (temporary increase) a. Gigher $ financed &y higher current ta:es reduces after;ta: income( lowering desired consumption. Aven true if financed &y higher future ta:es( if people realiHe how future incomes are affected &. %ince "d declines less than $ rises( national saving (%d ! 8 "d ; $) declines c. %o government purchases reduce &oth desired consumption and desired national saving >. Ta:es %uppose there is a ta: cut( which should lead to increase desired consumption. a. ,ump;sum ta: cut today will &e financed &y higher future interest rate and ta:es &. The fear of decline in future income may offset increase in current income and desired consumption might not increase; desired consumption could rise or fall c. *icardian eIuivalence proposition I. if future income loss e:actly offsets current income gain( no change in consumption. Ta: change affects only the timing of ta:es( not their ultimate amount (present value) 8 "d ; $

II.

In practice( people may not see that future ta:es will rise if ta:es are cut today; then a ta: cut leads to increased desired consumption and reduced desired national saving

2. INVESTMENT
%econd ma)or component of spending is investment &y firms. Investment refers to the purchase of capital goods; &uildings( machinery( eIuipment( software( additions to inventory etc. A. @h3 is in!estment importantA 0. Investment fluctuates sharply over the &usiness cycle ( so we need to understand investment to understand the &usiness cycle. Investment rises in &ooms and falls in &usts. Gence to e:plain the &ehavior of investment is important for understanding 1. Investment plays a crucial role in determining long;run productivity which enhances economic growth. -s we 'now capital is one of the two ma)or factors (the other one is la&or) for increasing productivity #. The desired capita) stoc'

0. Fesired capital stoc' is the amount of capital that allows firms to earn the largest e:pected profit. 1. Fesired capital stoc' depends on costs and &enefits of additional capital 3. The user cost of capital a. +ser cost of capital (uc) ! e:pected real cost of using a unit of capital for a specific period of time. &. If p' ! investment amount( r ! rate of interest( d ! rate of depreciation( then uc . rpB 4 dpB . 7r 4 d8pB( A:ample: If r ! J@ and d! 09@( and p' ! K099( then uc ! (9.9J # 9.09)099 ! K0J?year

>. Fetermining the desired capital stoc' a. Fesired capital stoc' is the level of capital stoc' at which &6B$ . uc &. =7Lf falls as L rises due to diminishing marginal productivity c. uc doesnMt vary with L( so is a horiHontal line d. If =7Lf N uc( profits rise as L is added (marginal &enefits N marginal costs) e. If =7Lf O uc( profits rise as L is reduced (marginal &enefits O marginal costs) f. 7rofits are ma:imiHed where =7Lf ! uc

E5pected $uture &6B

3-C &6B$ A

-4 -: +C +D +C 4 + 3 4 E D F

Capita) stoc'= B= 7Thousands8

%uppose the interest rate in a&ove e:ample falls from J@ to <@ then uc will also fall from 0J to 0<( as shown in the figure &elow: in this case further investment is &eneficial as =7L f is higher than uc. 6ow eIuili&rium will &e at point ".

E5pected $uture &6B

3-C -4 -: +C +D +C 4 + 3 4 E D F ,esired Capita) toc' rises &6B$ A

Capita) stoc'= B= 7Thousands8

In case( r stays at J@ &ut due to some technological improvements there is rise in =7Lf then =7Lf0 curve will shift to =7Lf1 and now =7Lf1 will cut uc at K<(999 with possi&ility of additional desired capital.
E5pected &6B

3-C

&6B$Techno)o"ica) ad!ance increases &6B$ A ,

-4 -: +C +D +-

&6B$+

# C ,esired Capita) toc' Rise 4 + 3 4 E D

Capita) stoc'= B= 7Thousands8

C. Chan"es in the desired capita) stoc' 0. .actors that shift the =7Lf curve or change the user cost of capital cause the desired capital stoc' to change 1. These factors are changes in the 0) real interest rate( 1) depreciation rate( 3) price of capital( 3) technological changes that affect the =7Lf 3. Ta:es and the desired capital stoc' a. With ta:es( the return to capital is only (0 ; P)=7Lf &. %etting the return eIual to the user cost gives: 7+ 2 G8&6B$ . uc .; &6B$ . ucH7+ 2 G8 . 7r 4 d8p BH7+ 2 G8. This is called Ta:;ad)usted user cost of capital which is ucH7+ 2 G8 c. -n increase in G raises the ta:;ad)usted user cost and reduces the desired capital stoc' ,. 1rom the desired capita) stoc' to in!estment 0. The capital stoc' changes from two opposing channels a. 6ew capital increases the capital stoc'; this is gross investment &. The capital stoc' depreciates( which reduces the capital stoc'

c. If It ! $ross Investment( Bt ! "apital %toc' at &eginning of year t( Bt4+ ! "apital %toc' at &eginning of year t #0( dBt ! depreciation of capital during year t. 6et investment ! $ross investment 7I8 minus depreciation: Bt4+ 0 Bt . It 2 dBt where net investment eIuals the change in the capital stoc' 1. *ewriting previous eIuation gives It . Bt4+ 0 Bt 4 dBt

3. Goods Market Equi i!riu"

A. The rea) interest rate adIusts to *rin" the "oods mar'et into e(ui)i*rium +. The goods mar'et is in eIuili&rium if ! "d # Id # $ (The income; e:penditure identity is different in way than goods mar'et eIuili&rium &ecause there are always unsold inventories so it is not always eIual) -. -lternative representation: since %d ! here we get(
d

8 "d ; $( 7utting value of

. Id (saving;investment eIuili&rium)

-t 3@ interest rate( the amount of investment that firms want to underta'e (0C99) e:ceeds desired national saving (JC9).

3.

hi$ts o$ the sa!in" cur!e

%aving curve shifts due to a +8 rise in current output( -8 a fall in e:pected future output( 38 a fall in wealth( 48 a fall in government purchases( E8 a rise in ta:es (unless *icardian eIuivalence holds( in which case ta: changes have no effect) 4. hi$ts o$ the in!estment cur!e

Investment curve shifts due to +8 fall in the effective ta: rate( -8 a rise in e:pected future marginal productivity of capital