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Chapter 4
Consumption, Saving, and Investment
Learning Objectives
I. Goals of Chapter 4
A) Examine the factors that underlie economy wide 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
II. Notes to Fifth Edition Users

A) The application on Consumer sentiment and the 1990-1991 recession has been deleted,
though it is available in this instructors manual if you would still like to use it
B) A new application, Consumer sentiment and forecasts of consumer spending discusses
whether indexes of consumer sentiment are in fact useful for forecasting consumer spending
C) In section 4.2, new data are available on effective tax rates on capital in many countries
Teaching Notes
I. Consumption and Saving (Sec. 4.1)
A) The importance of consumption and saving
1. Desired consumption: consumption amount desired by households
2. Desired national saving: level of national saving when consumption is at its desired level
S =YC G
d d
(4.1)
Data Application
Recall from Chapter 2 that measured consumption in the national income accounts includes
spending on durable consumption goods, like autos and major appliances. But consumption
theory requires that consumption be defined to include only the services from durable consumer
goods. So empirical researchers must adjust the national income data to arrive at a measure of
consumption that matches the theory. For example, they might assume that durable goods provide
services proportional to the stock of durables.
Chapter 4 Consumption, Saving, and Investment 59
B) The consumption and saving decision of an individual

1. A person can consume less than current income (saving is positive)
2. A person can consume more than current income (saving is negative)
3. Trade-off between current consumption and future consumption
a. The price of 1 unit of current consumption is 1 + r units of future consumption, where
r is the real interest rate
b. Consumption-smoothing motive: the desire to have a relatively even pattern of
consumption over time
C) Effect of changes in current income
1. Increase in current income: both consumption and saving increase (vice versa for decrease
in current income)
2. Marginal propensity to consume (MPC) = fraction of additional current income consumed
in current period; between 0 and 1
d
3. Aggregate level: When current income (Y) rises, C rises, but not by as much as Y,
d
so S rises
Theoretical Application
The classic discussions of consumption are the permanent-income hypothesis of Milton Friedman
(A Theory of the Consumption Function, Princeton: Princeton University Press, 1957) and the
life-cycle hypothesis of Franco Modigliani and Richard Brumberg (Utility Analysis and the
Consumption Function: An Interpretation of Cross-Section Data, in Ken Kurihara, ed., Post-
Keynesian Economics, New Brunswick, N.J.: Rutgers University Press, 1954). The permanent
income hypothesis focuses on what consumers do with stochastic income receipts; the life-cycle
hypothesis is concerned with predictable changes in income over the life cycle.
D) Effect of changes in expected future income

1. Higher expected future income leads to more consumption today, so saving falls
2. Application: consumer sentiment and forecasts of consumer spending
a. Do consumer sentiment indexes help economists forecast consumer spending?
b. Data do not seem to give much warning before recessions
c. Data on consumer spending are correlated with data on consumer confidence
d. But formal statistical analysis shows that data on consumer confidence do not improve
forecasts of consumer spending based on other macro data
E) Effect of changes in wealth

1. Increase in wealth raises current consumption, so lowers current saving
F) Effect of changes in real interest rate
1. Increased real interest rate has two opposing effects
a. Substitution effect: Positive effect on saving, since rate of return is higher; greater
reward for saving elicits more saving
b. Income effect
(1) For a saver: Negative effect on saving, since it takes less saving to obtain a given
amount in the future (target saving)
(2) For a borrower: Positive effect on saving, since the higher real interest rate means a
loss of wealth
c. Empirical studies have mixed results; probably a slight increase in aggregate saving
60 Abel/Bernanke/Croushore Macroeconomics, Sixth Edition
You can use the concept of income and substitution effects to show your class how saving responds to
an effective change in the expected real interest rate that occurs because of IRAs (individual retirement
accounts). Since IRAs allow people to avoid taxes on a portion of their income, they produce two
kinks in the budget constraint. Whether IRAs will boost saving or consumption depends on a persons
preferences, namely how strong the income and substitution effects are. Theres a substitution effect
because the slope of the budget line gets steeper (the return to saving rises), so people will want more
future consumption and less current consumption. Theres an income effect because the budget line is
shifted out, which increases both future and current consumption. So the overall effect on current
consumption, and hence saving, is ambiguous, depending on how strong are the income and
substitution effects. The exception is that if a person would have saved more than the IRA limit both
with and without IRAs, then theres only an income effect and saving will decline. Or if, in the
presence of IRAs, a person would save exactly the amount of the IRA limit, then whether saving rises
or falls depends on whether, in the absence of IRAs they would have saved more or less. Empirical
evidence suggests that every $100 of IRA saving reduces current consumption by $32, so at least for
some people, the substitution effect is strong enough to increase saving.
2. Taxes and the real return to saving

a. Expected after-tax real interest rate:
rat = (1 t)i
e
(4.2)
b. Simple examples: i = 5%, = 2%; if t = 30%, rat = 1.5%; if t = 20%, rat = 2%
e
Data Application
Eytan Sheshinski, in Treatment of Capital Income in Recent Tax Reforms and the Cost of
Capital in Industrialized Countries, in Larry Summers, ed., Tax Policy and the economy 4,
Cambridge, Mass.: MIT Press, 1990, pp. 2542, finds that real after-tax interest rates were
negative for the United States and many other countries in the 1970s. Even with fairly low
inflation, because nominal returns, rather than real returns, are taxed, the real after-tax interest rate
(for taxpayers in the top bracket) is fairly low relative to the pretax real interest rate. For example,
in the United States in 1985, the pretax real interest rate was 6.3%; the after-tax real interest rate
was 0.9% ( = 3.6%, t = 55%). In 1987 the pretax real rate was 4.9%; the after-tax real interest
rate was 2.1% ( = 3.7%, t = 33%).
3. In touch with the macroeconomy: interest rates

a. Discusses different interest rates, default risk, term structure (yield curve), and tax status
b. Since interest rates often move together, we frequently refer to the interest rate
Numerical Problem 1 explores how changes in income, future income, wealth, and interest rates
affect consumption.
G) Fiscal policy
1. Affects desired consumption through changes in current and expected future income
2. Directly affects desired national saving, S = Y C G
d d
3. Government purchases (temporary increase)

a. Higher G financed by higher current taxes reduces after-tax income, lowering desired
consumption
b. Even true if financed by higher future taxes, if people realize how future incomes are affected
c. Since C declines less than G rises, national saving (S = Y C G) declines
d d d
d. So government purchases reduce both desired consumption and desired national saving
Data Application
This theory is confirmed by empirical data. Shaghil Ahmed, in Temporary and Permanent
Government Spending in an Open Economy: Some Evidence for the United Kingdom, Journal
of Monetary Economics, March 1986, pp. 197224, finds, using a long time series of British data,
that temporary government purchases indeed crowd out consumption spending, even though the
expenditures are useful in increasing the marginal productivity of private capital and providing a
substitute for consumption goods.
4. Taxes
a. Lump-sum tax cut today, financed by higher future taxes
b. Decline in future income may offset increase in current income; desired consumption
could rise or fall
c. Ricardian equivalence proposition
(1) If future income loss exactly offsets current income gain, no change in consumption
(2) Tax change affects only the timing of taxes, not their ultimate amount
(present value)
(3) 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
There are a number of reasons why Ricardian equivalence may not hold. The text notes that if
people dont see that future taxes are equal (in present value) to a current tax cut, then Ricardian
equivalence may not hold. An additional reason for the failure of Ricardian equivalence, liquidity
constraints, is covered in Appendix 4.A. It may also be possible for people to avoid future taxes,
even if they foresee them, by moving or dying; however, in the latter case, if those people planned
to leave bequests to future generations, they would increase their bequests by the increased tax
liability (Robert Barro, Are Government Bonds Net Wealth? Journal of Political Economy,
Nov./Dec. 1974, pp. 10951117). Other reasons for the failure of Ricardian equivalence include:
(1) If the current tax cut is given to a different set of people than must pay the future taxes, and
those people have differing marginal propensities to consume; (2) if taxes are distortionary, rather
than lump sum; and (3) if future tax rates or future income arent known with certainty. For a
useful overview and further details, see Andrew B. Abel, Ricardian Equivalence Theorem, in
John Eatwell et al., eds., The New Palgrave: A Dictionary of Economics, London: Macmillan
Press, 1987. Empirically, the evidence on Ricardian equivalence is mixed; for a review, see B.
Douglas Bernheim, Ricardian Equivalence: An Evaluation of Theory and Evidence, in Stanley
Fischer, ed., NBER Macroeconomics Annual, Cambridge, Mass.: MIT Press, 1987, pp. 263304.
H) Application: a Ricardian tax cut?

1. The Economic Growth and Tax Relief Reconstruction Act (EGTRRA) of 2001 gave rebate
checks to taxpayers and cut tax rates substantially
2. 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
3. Most consumers saved their tax rebates and did not spend them
4. As a result, the tax rebate and tax cut did not stimulate much additional spending
by households
II. Investment (Sec. 4.2)

A) Why is investment important?
1. Investment fluctuates sharply over the business cycle, so we need to understand investment
to understand the business cycle
2. Investment plays a crucial role in economic growth
B) The desired capital stock
1. Desired capital stock is the amount of capital that allows firms to earn the largest expected
profit
2. Desired capital stock depends on costs and benefits of additional capital
3. Since investment becomes capital stock with a lag, the benefit of investment is the future
f
marginal product of capital (MPK )
4. The user cost of capital
a. Example of Kyles Bakery: cost of capital, depreciation rate, and expected real interest
rate
b. User cost of capital = real cost of using a unit of capital for a specified period of time =
real interest cost + depreciation
c. uc = rpK + dpK = (r + d)pK (4.3)
5. Determining the desired capital stock (Figure 4.1; like text Figure 4.3)
Figure 4.1
Desired capital stock is the level of capital stock at which MPK = uc

f
a.
f
b. MPK falls as K rises due to diminishing marginal productivity
c. uc doesnt vary with K, so is a horizontal line
If MPK > uc, profits rise as K is added (marginal benefits > marginal costs)
f
d.
If MPK < uc, profits rise as K is reduced (marginal benefits < marginal costs)
f
e.
Profits are maximized where MPK = uc
f
f.
The first general use of the user cost of capital concept was by Dale Jorgenson, Capital Theory
and Investment Behavior, American Economic Review Papers and Proceedings, May 1963,
pp. 247259.
C) Changes in the desired capital stock

f
1. Factors that shift the MPK curve or change the user cost of capital cause the desired capital
stock to change
2. These factors are changes in the real interest rate, depreciation rate, price of capital, or
f
technological changes that affect the MPK (text Figure 4.4 shows effect of change in uc)
3. Taxes and the desired capital stock
a. With taxes, the return to capital is only (1 )MPK
f
b. A firm chooses its desired capital stock so that the return equals the user cost, so
(1 )MPK = uc, which means:
f
MPK = uc/(1 ) = (r + d)pK/(1 )

f
(4.4)
c. Tax-adjusted user cost of capital is uc/(1 )
d. An increase in raises the tax-adjusted user cost and reduces the desired capital stock
Numerical Problems 2 and 4 give students practice in working with the marginal product of
capital and the user cost of capital.
e. In reality, there are complications to the tax-adjusted user cost

(1) We assumed that firm revenues were taxed
(a) In reality, profits, not revenues, are taxed
(b) So depreciation allowances reduce the tax paid by firms, because they
reduce profits
(2) Investment tax credits reduce taxes when firms make new investments
(3) Summary measure: the effective tax ratethe tax rate on firm revenue that would
have the same effect on the desired capital stock as do the actual provisions of the
tax code
(4) Table 4.2 shows effective tax rates for many different countries
Data Application
Another simplification that is used in this chapter is the assumption that taxes are based on a
firms real revenue. In reality, taxes on nominal revenue combine with inflation to create a large
distortion to investment. The first broad discussion of this issue is by Martin Feldstein, Inflation,
Tax Rules, and Investment: Some Econometric Evidence, Econometrica, July 1982,
pp. 825862.
f. Application: measuring the effects of taxes on investment

(1) Do changes in the tax rate have a significant effect on investment?
(2) A 1994 study by Cummins, Hubbard, and Hassett found that after major tax reforms,
investment responded strongly; elasticity about 0.66 (of investment to user cost
of capital)
For further discussions of the effects of tax policy on investment, see Robert E. Hall and Dale W.
Jorgenson, Tax Policy and Investment Behavior, American Economic Review, June 1967,
pp. 391414.
D) Box 4.1: investment and the stock market

1. Firms change investment in the same direction as the stock market: Tobins q theory of
investment
2. If market value > replacement cost, then firm should invest more
3. Tobins q = capitals market value divided by its replacement cost
a. If q < 1, dont invest
b. If q > 1, invest more
4. Stock price times number of shares equals firms market value, which equals value
of firms capital
a. Formula: q = V/(pKK), where V is stock market value of firm, K is firms capital, pK is
price of new capital
b. So pKK is the replacement cost of firms capital stock
c. Stock market boom raises V, causing q to rise, increasing investment
5. Data show general tendency of investment to rise when stock market rises; but relationship
isnt strong because many other things change at same time
6. This theory is similar to text discussion
f
a. Higher MPK increases future earnings of firm, so V rises
b. A falling real interest rate also raises V as people buy stocks instead of bonds
c. A decrease in the cost of capital, pK, raises q
E) From the desired capital stock to investment
1. The capital stock changes from two opposing channels
a. New capital increases the capital stock; this is gross investment
b. The capital stock depreciates, which reduces the capital stock
c. Net investment = gross investment (I) minus depreciation:
Kt+1 Kt = It dKt (4.5)
where net investment equals the change in the capital stock
d. Text Figure 4.6 shows gross and net investment for the United States
2. Rewriting (4.5) gives It = Kt+1 Kt + dKt
a. If firms can change their capital stocks in one period, then the desired capital stock
(K ) = Kt+1
*
b. So It = K Kt + dKt
*
(4.6)
c. Thus investment has two parts
*
(1) Desired net increase in the capital stock over the year (K Kt)
(2) Investment needed to replace depreciated capital (dKt)
3. Lags and investment
a. Some capital can be constructed easily, but other capital may take years to put in place
Acknowledging that it may take time to get capital in place may be crucial to modeling the
business cycle. See Finn E. Kydland and Edward C. Prescott, Time to Build and Aggregate
Fluctuations, Econometrica, November 1982, pp. 13451370.
b. So investment needed to reach the desired capital stock may be spread out over several
years
F) Investment in inventories and housing
1. Marginal product of capital and user cost also apply, as with equipment and structures
Numerical Problem 3 applies the user-cost concept to the purchase or rental of a home.
III. Goods Market Equilibrium (Sec. 4.3)

A) The real interest rate adjusts to bring the goods market into equilibrium
1. Y = C + I + G
d d
(4.7)
goods market equilibrium condition
2. Differs from income-expenditure identity, as goods market equilibrium condition need not
hold; undesired goods may be produced, so goods market wont be in equilibrium
3. Alternative representation: since
S = Y C G,
d d
S =I
d d
(4.8)
B) The saving-investment diagram
d d
1. Plot S vs. I (Figure 4.2; Key Diagram 3; like text Figure 4.7)
Figure 4.2
2. Equilibrium where S = I
d d
3. How to reach equilibrium? Adjustment of r

4. Shifts of the saving curve

a. 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)
b. Example: Temporary increase in government purchases shifts S left
c. Result of lower savings: higher r, causing crowding out of I
Numerical Problem 5 and 6 and Analytical Problem 5 examine what happens when government
spending changes.
What happens to the economy if government taxes change? Under Ricardian equivalence, a tax cut
today that is financed by higher future taxes has no effect on national saving, because private saving
rises by the amount of the tax cut, just offsetting the decline in government saving. Since theres no
shift in national saving, theres no change in the equilibrium real interest rate. Suppose, however,
that people dont foresee the future tax change, or for some other reason national saving declines.
Then the shift to the left of the desired saving curve leads to a new equilibrium at a higher real
interest rate and lower level of investment. The true burden of the government debt comes about
because the lower investment rate means a lower capital stock, so that the economy is less
productive in the future. Thus future generations bear the burden of todays government debt.
5. Shifts of the investment curve

a. Investment curve shifts right due to a fall in the effective tax rate or a rise in expected
future marginal productivity of capital
b. Result of increased investment: higher r, higher S and I
C) 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 Tobins q)
2. Consumption and the 1987 crash
a. When the stock market crashed in 1987, wealth declined by about $1 trillion
b. Consumption fell somewhat less than might be expected, and it wasnt enough
to cause a recession
c. There was a temporary decline in confidence about the future, but it was quickly
reversed
d. The small response may have been because there had been a large run-up in stock prices
between December 1986 and August 1987, so the crash mostly erased this run-up
3. Consumption and the rise in stock market wealth in the 1990s
a. Stock prices more than tripled in real terms
b. But consumption was not strongly affected by the runup in stock prices
4. Consumption and the decline in stock prices in the early 2000s
a. In the early 2000s, wealth in stocks declined by about $5 trillion
b. But consumption spending increased as a share of GDP in that period
5. Investment and Tobins q
a. Investment and Tobins q were not closely correlated following the 1987 crash
in stock prices
b. But the relationship has been tighter in the 1990s and early 2000s, as theory suggests
Policy Application
Should tax policy be used to promote savings or investment? Many policymakers and economists
have argued that obtaining the correct amount of future economic growth requires us to have a
higher capital stock, so that we need more investment than we have. They suggest tax policies like
IRAs to encourage saving and tax breaks for businesses to encourage investment. As weve seen
in this chapter, such policies could indeed affect peoples decisions to save (by affecting the after-
tax real rate of interest) and to invest (by reducing the after-tax cost of capital). But what isnt so
clear is whether or not investment really is too low. After all, to save today requires reducing
consumption today; people may prefer not to save any more than they are already saving. Also, if
the government goes too far in encouraging investment, we may end up with an inefficiently large
capital stock; as an example, in the late 1980s there was a large overbuilding of commercial real
estate (office buildings) in big cities, due partly to tax incentives (and partly due to myopia about
the future marginal product of office buildings!). In summary, it isnt perfectly clear that
government policies that encourage saving and investment are appropriate; we first need to show
clearly that some externality creates a need for such government intervention.
Analytical Problems 1, 2, 3, and 4 all looks at shocks to the economy and changes in variables
needed to restore equilibrium.
For a useful summary of research on consumption and investment, see Andrew B. Abel,
Consumption and Investment, in B. Friedman and F. Hahn, eds., Handbook of Monetary
Economics, vol. 2, Netherlands: Elsevier Science Publishers, 1990, pp. 725778.
IV. Appendix 4.A: A Formal Model of Consumption and Saving

A) How much can the consumer afford? The budget constraint
f
1. Current income y; future income y ; initial wealth a
2. Choice variables: a = wealth at beginning of future period; c = current consumption;
f
c = future consumption
f
3. a = (y + a c)(1 + r), so c = (y + a c)(1 + r) + y

f f f
(4.A.1)
the budget constraint
B) The budget line
f
1. Graph budget line in (c, c ) space (Figure 4.A.1)
Figure 4.A.1
2. Slope of line = (1 + r)
Analytical Problem 7 looks at what happens to the budget line when the interest rate on borrowing
differs from the interest rate on lending.
C) Present values
1. Present value is the value of payments to be made in the future in terms of todays dollars or
goods
2. Example: At an interest rate of 10%, $12,000 today invested for one year is worth $13,200
($12,000 1.10); so the present value of $13,200 in one year is $12,000
3. General formula: Present value = future value/(1 + i), where amounts are in dollar terms and
i is the nominal interest rate
4. Alternatively, if amounts are in real terms, use the real interest rate r instead of the nominal
interest rate i
Once youve established the intuition about the present value formula for one period, you can
extend it to additional periods to show that the present value of an amount X to be received in
n years is X/(1 + i) .
n
D) Present value and the budget constraint

1. Present value of lifetime resources:
PVLR = y + y /(1 + r) + a
f
(4.A.2)
2. Present value of lifetime consumption:
PVLC = c + c /(1 + r)
f
3. The budget constraint means PVLC = PVLR

4. c + c /(1 + r) = y + y /(1 + r) + a
f f
(4.A.3)
5. Horizontal intercept of budget line is c = PVLR, c = 0
f
E) What does the consumer want? Consumer preferences

1. Utility = a persons satisfaction or well-being
2. Graph a persons preference for current versus future consumption using indifference curves
f
3. An indifference curve shows combinations of c and c that give the same utility
(Figure 4.A.2)
Figure 4.A.2
4. A person is equally happy at any point on an indifference curve

5. Three important properties of indifference curves
a. Slope downward from left to right: Less consumption in one period requires more
consumption in the other period to keep utility unchanged
b. Indifference curves that are farther up and to the right represent higher levels of utility,
because more consumption is preferred to less
c. Indifference curves are bowed toward the origin, because people have a consumption-
smoothing motive, they prefer consuming equal amounts in each period rather than
consuming a lot one period and little the other period
If students want more help on indifference curves, you can refer them to a principles of
economics or intermediate microeconomics text, such as Michael Parkin, Economics, 5th edition,
Reading, Mass.: Addison Wesley Longman, 2000.
F) The optimal level of consumption

1. Optimal consumption point is where the budget line is tangent to an indifference curve
(Figure 4.A.3)
Figure 4.A.3
2. Thats the highest indifference curve that its possible to reach

3. All other points on the budget line are on lower indifference curves
G) The Effects of Changes in Income and Wealth on Consumption and Saving

1. The effect on consumption of a change in income (current or future) or wealth depends
only on how the change affects the PVLR
a. An increase in current income (Figure 4.A.4)
Figure 4.A.4
(1) Increases PVLR, so shifts budget line out parallel to old budget line
(2) If there is a consumption-smoothing motive, both current and future consumption
will increase
(3) Then both consumption and saving rise because of the rise in current income
b. An increase in future income
(1) Same outward shift in budget line as an increase in current income
(2) Again, with consumption smoothing, both current and future consumption increase
(3) Now saving declines, since current income is unchanged and current consumption
increases
c. An increase in wealth
(1) Same parallel shift in budget line, so both current and future consumption rise
(2) Again, saving declines, since c rises and y is unchanged
Numerical Problem 8 deals with the income effect on consumption and saving.
d. The permanent income theory

(1) Different types of changes in income
f
(a) Temporary increase in income: y rises and y is unchanged
f
(b) Permanent increase in income: Both y and y rise
(2) Permanent income increase causes bigger increase in PVLR than a temporary
income increase
(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
(a) Permanent changes in income lead to much larger changes in consumption
(b) Thus permanent income changes are mostly consumed, while temporary income
changes are mostly saved
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 individuals lifetime
b. Typical consumers income and saving pattern shown in Figure 4.A.5
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
(1) In reality, consumption varies somewhat by age
(2) For example, when raising children, household consumption is higher than average
(3) The model can easily be modified to handle this and other variations
e. Saving has the following lifetime pattern
(1) Saving is low or negative early in working life
(2) Maximum saving occurs when income is highest (ages 50 to 60)
(3) Dissaving occurs in retirement
2. Bequests and saving
a. What effect does a bequest motive (a desire to leave an inheritance) have on saving?
b. Simply consume less and save more than without a bequest motive
3. Ricardian equivalence
a. We can use the two-period model to examine Ricardian equivalence
b. The two-period model shows that consumption is changed only if the PVLR changes
c. Suppose the government reduces taxes by 100 in the current period, the interest rate is
10%, and taxes will be increased by 110 in the future period
d. Then the PVLR is unchanged, and thus there is no change in consumption
4. Excess sensitivity and borrowing constraints
a. Generally, theories about consumption, including the permanent income theory, have
been supported by looking at real-world data
b. But some researchers have found that the data show that the impact of an income or
wealth change is different than that implied by a change in the PVLR
c. There seems to be excess sensitivity of consumption to changes in current income
(1) This could be due to shortsighted behavior
(2) Or it could be due to borrowing constraints
d. Borrowing constraints mean people cant borrow as much as they want Lenders may
worry that a consumer wont pay back the loan, so they wont lend
e. If a person wouldnt borrow anyway, the borrowing constraint is said to be nonbinding
f. But if a person wants to borrow and cant, the borrowing constraint is binding
g. A consumer with a binding borrowing constraint spends all income and wealth on
consumption
(1) So an increase in income or wealth will be entirely spent on consumption as well
(2) This causes consumption to be excessively sensitive to current income changes
h. How prevalent are borrowing constraints? Perhaps 20% to 50% of the U.S. population
faces binding borrowing constraints
Numerical Problem 9 deals with borrowing constraints.
I) The Real Interest Rate and the Consumption-Saving Decision

1. The real interest rate and the budget line (Figure 4.A.6)
Figure 4.A.6
a. When the real interest rate rises, one point on the old budget line is also on the
new budget line: the no-borrowing, no-lending point
b. Slope of new budget line is steeper
2. The substitution effect

a. A higher real interest rate makes future consumption cheaper relative to current
consumption
b. Increasing future consumption and reducing current consumption increases saving
c. Suppose a person is at the no-borrowing, no-lending point when the real interest rate
rises (Figure 4.A.7)
Figure 4.A.7
(1) An increase in the real interest rate unambiguously leads the person to increase
future consumption and decrease current consumption
(2) The increase in saving, equal to the decrease in current consumption, represents the
substitution effect
3. The income effect
a. If a person is planning to consume at the no-borrowing, no-lending point, then a rise in
the real interest rate leads just to a substitution effect
b. But if a person is planning to consume at a different point than the no-borrowing,
no-lending point, there is also an income effect
c. The intuition of the income effect
(1) If the person originally planned to be a lender, the rise in the real interest rate gives
the person more income in the future period; the income effect works in the opposite
direction of the substitution effect, since more future income increases current
consumption
(2) If the person originally planned to be a borrower, the rise in the real interest rate
gives the person less income in the future period; the income effect works in the
same direction as the substitution effect, since less future income reduces current
consumption further
4. The income and substitution effects together

a. Split the change in the budget line into two parts (Figure 4.A.8)
Figure 4.A.8
(1) A budget line with the same slope as the new budget line, but going through the
int
original consumption point (BL )
1
(2) The substitution effect is shown by the change from budget line BL to budget line
int
BL , with the consumption point changing from point D to point P
int 2
(3) The income effect is shown by the change from budget line BL to budget line BL ,
with consumption point changing from point P to point Q
b. The substitution effect decreases current consumption, but the income effect increases
current consumption; so saving may increase or decrease
c. Both effects increase future consumption
d. For a borrower, both effects decrease current consumption, so saving definitely increases
but the effect on future consumption is ambiguous
Analytical Problem 6 asks the student to show the income and substitution effects for a borrower.
e. The effect on aggregate saving of a rise in the real interest rate is ambiguous theoretically
(1) Empirical research suggests that saving increases
(2) But the effect is small
Additional Teaching Notes

The following material was deleted from the Fifth Edition of the textbook, but is presented here for
instructors who wish to present the material in class. You may copy these pages and hand them out to
your students.
Consumer Sentiment and the 1990-1991 Recession

The theory of consumer behavior tells us that consumers decisions about how much to consume and how
much to save should depend on their expectations about the economys future. When consumers are
optimistic about the future, they will consume more and save less than when they are pessimistic about it.
For this reason, economic forecasters and other analysts find it useful to know what consumers are thinking
about the future at any particular time.
Various surveys regularly try to measure consumers expectations. Two of the best known are the
consumer confidence index published by The Conference Board and the index of consumer sentiment
published by The Survey Research Center at the University of Michigan. Here we focus on the index of
consumer sentiment, which is based on the responses of several hundred households to questions about their
current and expected future financial situation and their expectations about the economys performance in
the next one to five years. The index is measured relative to a value of 100 for 1966, with higher values
corresponding to greater consumer optimism. The Survey Research Center publishes the index in a detailed
monthly report called Surveys of Consumer Attitudes, with these findings being available on the Internet at
www.sca.isr.umich.edu.
Historically, the index of consumer sentiment has been a sensitive indicator of recessions and other
macroeconomic shocks. Figure 4.1(a) shows monthly data for the index of consumer sentiment for the
eight-year period January 1987December 1994, and Fig. 4.1(b) shows quarterly data for real total
consumption and real consumption expenditures on durable goods during the same period. Expenditures on
durable goods, which are measured on the scale on the right side of the figure, are only about one-eighth of
total consumption expenditures, which are measured on the scale on the left side of the figure. We show
expenditures on durable goods in addition to total consumption because expenditures on durable goods
(such as automobiles, appliances, and furniture) tend to display sharper fluctuations than expenditures on the
other components of consumption (such as food and heating oil). When consumers become pessimistic
about the future, they may delay the purchase of a new car more easily than they would delay the purchase
of food or heating oil, so the effects of consumer sentiment may be more readily evident in durable goods
expenditures than in overall consumption.
When Iraq invaded Kuwait in August 1990, the index of consumer sentiment took its sharpest tumble in
almost a decade, reflecting consumers concerns about the long-term implications of the invasion and
perhaps broader economic worries as well. As Fig. 4.1(b) shows, consumer spending also fell sharply in the
fourth quarter of 1990 as a recession began. Total consumption expenditures fell by 0.8% and expenditures
on durable goods declined by 3.0% during that quarter.
As Fig. 4.1(a) shows, the index of consumer sentiment was quite volatile during 1991, soaring in March
after the Gulf War, then plummeting later in the year. In 1992, the index of consumer sentiment dropped in
each of the four months pre-ceding the presidential election, perhaps reflecting the economic concerns of
voters that led them to vote President George H. W. Bush out of office. The index of consumer sentiment
strengthened sharply after the election, only to fall again in the spring of 1993. As a consequence of this
consumer pessimism and uncertainty, growth in overall consumption and growth in expenditures on durable
goods were slow and erratic during the early stages of the economic recovery that began in March 1991.
Additional Issues for Classroom Discussion

1. Do You Believe in Ricardian Equivalence?
Economists have debated the idea of Ricardian equivalence for some time now (Robert Barros classic
article, Are Government Bonds Net Wealth? appeared in 1974). An interesting debate for students is for
them to take sides as to whether or not Ricardian equivalence holds. You can discuss many possible
reasons why it might not hold and other reasons why it may be a useful benchmark for comparison to
other theories.
2. The Interaction of Taxation and Inflation

Macroeconomists like to debate whether the central bank should drive inflation down to zero or merely
maintain it at a fairly low level. But the evidence on the interaction of inflation with the tax system may
convince some people that inflation should be zero. As the example in text table 4.1 shows, if you get a
nominal interest rate (i) of 5%, expected inflation ( ) is 2%, and you are in the 30% tax (t) bracket, your
e
expected after-tax real interest rate is (1 t)i = 1.5%. If you invested $10,000, you get a nominal
e
return of $500, of which you get to keep $150 in real terms, inflation eats away $200, and the government
gets $150. So the government gets the same amount as you doso your real tax rate is 50%. In the 1970s
and early 1980s when inflation reached double digits, the real tax rate on investment income was well
over 100%, so that nearly any investment had a negative return, but the government made a large return.
Present this idea to your students and see how many change their minds about the desirability of reducing
inflation to zero (or at least reforming the tax system).
3. Should the Government Reduce Taxes on Capital?

Our analysis of investment and the desired capital stock shows that taxes are important. A policy issue
thats been discussed by economists in recent years is a proposal to reduce or eliminate capital taxation.
You might ask your students to debate the pros and cons of doing so. What would be the benefits? What
would happen to real interest rates and to investment and the capital stock? Are there any costs to such a
policy? Who do you think earns most of the capital income in the United States? What would the
consequences be for the distribution of income among people of different income groups?
4. Is Saving Too Low in the United States?

The analytical framework that is developed in the textbook can be used to analyze the consequences of
the fall in the U.S. saving rate. Over the last 20 years, saving as a proportion of GDP has declined
substantially. Can your students provide some economic rationale for why this has occurred? One
rationale that doesnt work is the change in demographics, which should have boosted saving in the 1980s
as baby boomers reached their prime working years; instead, the saving rate declined. What other reasons
can your students come up with that explains the decline?
Next, you may wish to discuss the consequences of the decline. Based on the textbook model, the decline
in saving raises the real interest rate and reduces the equilibrium amount of investment. But is this
something the government should try to counteract? Does the answer to this question depend on the
reasons listed above for the decline in the saving rate?
5. Should Social Security Funds Be Invested in the Stock Market?

The Social Security trust fund is projected to decline to zero around the year 2030, thanks to demographic
changes, especially the aging of the population and lower birth rates. A number of solutions are possible,
including reducing Social Security benefits or increasing taxes. Another possibility is to allow the trust
fund to invest in the stock market, so the returns to the fund would be higher than they are now.
Currently, the trust fund buys just federal government bonds, which have a significantly lower return over
time than do investments in the stock market.
The question to discuss with your class is: Should Social Security funds be invested in the stock market?
Your students will likely point out the key issue, which is risk versus return. There are also important
details that affect the decision that are worth thinking about, such as: (1) Should individuals control their
own portfolios? (2) What happens if the stock market crashes? (3) What happens in the transition to
people who have put money into the current plan (which is pay-as-you-go)? (4) What if people make bad
investment decisions, considering that Social Security is supposed to provide a safety net?
6. How Are You Trading Off the Present for the Future?
The material in the appendix may seem theoretical and abstract, but its easy to show students that theyre
really acting in the way the chapter describes. Ask them what tradeoffs theyre making between the
present and the future. The most obvious tradeoff is the fact that theyre in college, acquiring human
capital, rather than working for pay. Even more, many of them have borrowed money to pay for college,
so they are accumulating debt today to increase income and consumption in the future. And what is the
rate at which they trade off the present for the future? Its the interest ratethe additional amount theyll
owe because of their borrowing today.
7. What Borrowing Constraints Do You Face?

Some of your students may have already faced severe borrowing constraints in their lives. Some may note
that they could not obtain credit very easily. Fortunately, many will have been able to borrow enough
money to go to college, thanks to government programs that allow equal opportunity in education. But in
terms of borrowing for consumption spending, your students are likely to have faced dramatically
different circumstances.
Answers to Textbook Problems

Review Questions
1. Saving is current income minus consumption. For given income, any increase in consumption means
an equal decrease in saving, so consumption and saving are inversely related. The basic motivation
for saving is to provide for future consumption.
2. When a consumer gets an increase in current income, both current consumption and future
consumption increase. Since current consumption rises, but by less than the increase in current
income, saving increases. When the consumer gets an increase in expected future income, again both
current and future consumption increase. Since current income does not increase, but current
consumption does, saving decreases. When the consumer gets an increase in wealth, both current and
future consumption again rise. Again, there has been no increase in current income, so saving
decreases. At the aggregate level, these changes in consumption and saving made by individuals are
decisions that change the aggregate level of desired consumption and saving.
3. The effect on desired saving of an increase in the expected real interest rate is potentially ambiguous.
An increase in the real interest rate has two effects on desired saving: (1) the substitution effect
increases saving, because the amount of future consumption that can be obtained in exchange for
giving up a unit of current consumption rises; and (2) the income effect may increase or reduce
saving. The income effect reduces saving for a lender, because a person who saves is better off as a
result of having a higher real interest rate, so he or she increases current consumption. However, for
a borrower, the income effect increases saving, because the borrower is worse off having to face a
higher real interest rate, and so reduces current consumption. So the income effects work in different
directions depending on whether a person is a lender or a borrower. For a borrower, then, both the
income and substitution effects work in the same direction, and saving definitely increases. For a
lender, however, the income and substitution effects work in opposite directions, so the result on
desired saving is ambiguous.
4. The expected after-tax real interest rate is the after-tax nominal interest rate, (1 t)i, minus the
expected rate of inflation, , and represents the real return earned by a saver when a portion, t, of
e
interest income must be paid as taxes. If the tax rate on interest income declines (that is, t declines),
then 1 t becomes larger, so the expected after-tax real interest rate increases.
5. When government purchases increase temporarily, consumers see that higher taxes will be required
in the future to pay off the deficit. They reduce both current consumption and future consumption,
but current consumption declines by less than the amount of the government purchases. Since
national saving is output minus desired consumption minus government purchases, and government
purchases have increased more than current desired consumption has decreased, national saving
declines at a given real interest rate.
In the case of a lump-sum tax increase, consumers have higher taxes today, but lower taxes in the
future. If consumers take this into account, current desired consumption is unchanged, and since
output and government purchases didnt change, desired national saving is unchanged as well. This
is the case of Ricardian equivalence, and is controversial because consumers may not understand that
higher taxes today imply lower future taxes. As a result, they may reduce desired consumption today,
increasing desired national saving.
6. The two components of the user cost of capital are the interest cost and the depreciation cost. The
depreciation cost is the value lost as the capital wears out during the period. The interest cost
represents the opportunity cost of not using the funds that purchased the capital in some other way;
an example would be if the money was invested in bonds rather than buying capital goods.
7. The desired capital stock is the amount of capital that allows the firm to earn the largest possible
profit. The higher the expected future marginal product of capital, the higher the desired capital
stock, since any given amount of capital will be more productive in the future. The higher the user
cost of capital, the lower the desired capital stock, since a higher user cost yields lower profits on
each unit of capital. The higher the effective tax rate, the lower the desired capital stock, again
because the firm gets lower profits on each unit of capital.
8. Gross investment represents the total purchase or construction of new capital goods that takes place
during a period. Net investment is gross investment minus the depreciation on existing capital. Thus
net investment is the overall increase in the capital stock. Yes, it is possible for gross investment to
be positive when net investment is negative. This occurs whenever gross investment is less than the
amount of depreciation (and, in fact, happened in the United States during World War II).
9. Equilibrium in the goods market occurs when the aggregate supply of goods (Y) equals the aggregate
demand for goods (C + I + G). Since desired national saving (S ) is Y C G, an equivalent
d d d d
condition is S = I . Equilibrium is achieved by the adjustment of the real interest rate to make the
d d
desired level of saving equal to the desired level of investment, as shown in text Figure 4.6.
10. The saving curve slopes upward because saving is assumed to increase with an increase in the
expected real interest rate. The investment curve slopes downward because investment is lower the
higher is the expected real interest rate. The saving curve would be shifted to the right by an increase
in current output, a decrease in expected future output, a decrease in wealth, a decrease in
government purchases, and possibly by a rise in taxes. The investment curve would shift to the right
by a decline in the effective tax rate or a rise in expected future marginal product of capital.
Numerical Problems
1. First, a general formulation of the problem is useful. With income of Y1 in the first year and Y2 in the
second year, the consumer saves Y1 C in the first year and Y2 C in the second year, where C is the
consumption amount, which is the same in both years. Saving in the first year earns interest at rate r,
where r is the real interest rate. And the consumer needs to accumulate just enough after two years to
pay for college tuition, in the amount T. So the key equation is (Y1 C)(1 + r) + (Y2 C) = T.
(a) Y1 = Y2 = $50,000, r = 10%, T = $12,600. The key equation gives ($50,000 C)1.1 + ($50,000 C)
= $12,600. This can be simplified to $50,000 C = $12,600/2.1 = $6000, which can be solved to
get C = $44,000. Then S = Y C = $50,000 $44,000 = $6000.
(b) Y1 = $54,200. The key equation is now ($54,200 C)1.1 + ($50,000 C) = $12,600. This can be
simplified to ($54,200 1.1) + $50,000 $12,600 = 2.1 C, or $97,020 = 2.1 C, so C = $46,200.
Then S = Y1 C = $54,200 $46,200 = $8000. This illustrates that a rise in current income
increases saving.
(c) Y2 = $54,200. The key equation is now ($50,000 C)1.1 + ($54,200 C) = $12,600. This can be
Then S = Y1 C = $50,000 $46,000 = $4000. This illustrates that a rise in future income
decreases saving.
(d) With the increase in wealth of W, the total amount invested for the second period is W + Y1 C,
so the key equation becomes ($1050 + $50,000 C)1.1 + ($50,000 C) = $12,600. This can be
Then S = Y1 C = $50,000 $44,550 = $5450. This illustrates that a rise in wealth decreases
saving.
(e) T = $14,700. The key equation is now ($50,000 C)1.1 + ($50,000 C) = $14,700. This can be
simplified to $50,000 C = $14,700/2.1 = $7000, which can be solved to get C = $43,000. Then
S = Y C = $50,000 $43,000 = $7000. The rise in targeted wealth needed in the future raises
current saving.
(f) r = 25%. The key equation is now ($50,000 C)1.25 + ($50,000 C) = $12,600. This can be
simplified to $50,000 C = $12,600/2.25 = $5600, which can be solved to get C = $44,400.
Then S = Y C = $50,000 $44,400 = $5600. The rise in the real interest rate, with a given
wealth target, reduces current saving.
f
2. (a) This chart shows the MPK as the increase in output from adding another fabricator:
f
# Fabricators Output MPK
0 0
1 100 100
2 150 50
3 180 30
4 195 15
5 205 10
6 210 5
(b) uc = (r + d)pK = (0.12 + 0.20)$100 = $32. HHHHC should buy two fabricators, since at two
fabricators, MPK = 50 > 32 = uc. But at three fabricators, MPK = 30 < 32 = uc. You want to
f f
add fabricators only if the future marginal product of capital exceeds the user cost of capital. The
f
MPK of the third fabricator is less than its user cost, so it should not be added.
(c) When r = 0.08, uc = (0.08 + 0.20)$100 = $28. Now they should buy three fabricators, since
MPK f = 30 > 28 = uc for the third fabricator and MPK f = 15 < 28 = uc for the fourth fabricator.
(d) With taxes, they should add additional fabricators as long as (1 )MPK > uc. Since = 0.4,
f
1 = 0.6. They should buy just one fabricator, since (1 )MPK = 0.6 100 = 60 > 32 = uc.
f
They shouldnt buy two, since then (1 )MPK = 0.6 50 = 30 < 32 = uc.
f
(e) When output doubles, the MPK doubles as well. At r = 0.12, they should buy three fabricators,
f
since then MPK = 60 > 32 = uc; they shouldnt buy four, since then MPK = 30 < 32 = uc.
f f
At r = 0.08, they should buy four fabricators, since then MPK = 30 > 28 = uc; they shouldnt
f
buy five, since then MPK = 20 < 28 = uc.

f
(a) The expected after-tax real interest rate is r = i(1 t) = 0.10 (1 0.30) 0.05 = 0.07 0.05 =
e
3.
0.02.
(b) The cost of maintaining the house is depreciation. So the annual user cost of capital is uc =
(r + d)pK = (0.02 + 0.06)$200,000 = $16,000.
(c) You should be indifferent between buying and renting if the rent is $16,000 per year.
4. Since the price of capital declines from 60 to 51, the depreciation rate is 9/60 = .15.
(a) uc = (r + d)pK = (.10 + .15)60 = 15 units of output per year.
(b) The desired capital stock is such that MPK = uc, so 165 2K = 15, or 2K = 150, so K = 75.
f
(c) The tax-adjusted user cost of capital is uc/(1 ), so with = .4, the condition for the desired
capital stock is 165 2K = 15/0.6, or 2K = 140; the solution is K = 70. Thus taxation decreases
the firms desired capital stock.
(d) The investment tax credit basically lowers the price of capital from 60 to (1 0.2)60 = 48. So the
tax-adjusted user cost of capital is only (.25 48)/0.6 = 20. Then the equation for setting the
desired capital stock is 165 2K = 20, or 2K = 145; the solution is K = 72.5. Thus the investment
tax credit increases the firms desired capital stock.
5. (a) Desired consumption declines as the real interest rate rises because the higher return to saving
encourages higher saving; desired investment declines as the real interest rate rises because the
user cost of capital is higher, reducing the desired capital stock, and thus investment.
(b) Use the following table, where S = Y C G = 9000 C 2000 = 7000 C .
d d d d
C +I +G
d d d d d
r C I S
2 6100 1500 900 9600
3 6000 1400 1000 9400
4 5900 1300 1100 9200
5 5800 1200 1200 9000
6 5700 1100 1300 8800
(c) Equation (4.7) says that Y = C + I + G at equilibrium. Looking at the last column of the table,
d d
with Y = 9000, this is true only at r = 5%. At this point, S = I = 1200. Equation (4.8) says that S
d d d
= I at equilibrium. From the table, this occurs at r = 5%.

d
d
(d) When government purchases fall by 400 to 1600, each S entry in the table is higher by 400,
and each C + I + G entry is lower by 400. Then Y = C + I + G occurs at r = 3%, as does S =
d d d d d
I = 1400.
d
C +I +G
d d d d d
r C I S
2 6100 1500 1300 9200
3 6000 1400 1400 9000
4 5900 1300 1500 8800
5 5800 1200 1600 8600
6 5700 1100 1700 8400
(a) S = Y C G
d d
6.
= Y (3600 2000r + 0.1Y) 1200
= 4800 + 2000r + 0.9Y
(b) (1) Using Eq. (4.7): Y = C + I + G
d d
Y = (3600 2000r + 0.1Y) + (1200 4000r) + 1200

= 6000 6000r + 0.1Y
So 0.9Y = 6000 6000r
At full employment, Y = 6000. Solving 0.9 6000 = 6000 6000r, we get r = 0.10.
(2) Using Eq. (4.8):
S =I
d d
4800 + 2000r + 0.9Y = 1200 4000r

0.9Y = 6000 6000r
When Y = 6000, r = 0.10.
So we can use either Eq. (4.7) or (4.8) to get to the same result.
(c) When G = 1440, desired saving becomes S = Y C G = Y (3600 2000r + 0.1Y) 1440 =
d d
5040 + 2000r + 0.9Y. S is now 240 less for any given r and Y; this shows up as a shift in the S
d d
1 2
line from S to S in Figure 4.3.
Figure 4.3
Setting S = I , we get:
d d
5040 + 2000r + 0.9Y = 1200 4000r

6000r + 0.9Y = 6240
At Y = 6000, this is 6000r = 6240 (0.9 6000) = 840, so r = 0.14. The market-clearing real
interest rate increases from 10% to 14%.
7. (a) r = 0.10
uc/(1 ) = (r + d)pK/(1 ) = [(.1 + .2) 1]/(1 .5) = 0.6.
MPK = uc/(1 ), so 20 .02K = .6; solving this gives K = 970.
f f f
Since K K = I dK, I = K K + dK = 970 900 + (.2 900) = 250.

f f
(b) i. Solving for this in general:

uc/(1 ) = (r + d)pK/(1 ) = [(r + .2) 1]/(1 .5) = .4 + 2r.
MPK = uc/(1 ), so 20 .02K = .4 + 2r; solving this gives K = 980 100r.
f f
I = K K + dK = 980 100r 900 + (.2 900) = 260 100r.

f
ii. Y = C + I + G
1000 = [100 + (.5 1000) 200r] +
(260 100r) + 200
1000 = 1060 300r, so 300r = 60
r = 0.2
C = 560; I = 240 = S;
uc/(1 ) = .4 + (2 .2) = 0.8;
K = 960
f
PVLR = y + [y /(1 + r)] + a

f
8. (a)
= 90 + (110/1.10) + 20
= 210.
c + [c / (1 + r)] = PVLR.
f
(b)
c + (c / 1.10) = 210.
f
When c = 0, c = 231; this is the vertical intercept of the budget line, shown in Figure 4.4.
f
When c = 0, c = 210; this is the horizontal intercept of the budget line.

f
Figure 4.4
(c) c = c : c + (c/1.10) = 210.

f
1.10c + c = 210 1.10.

2.1c = 231.
c = 110.
s=yc
= 90 110
= 20.
(d) y increases by 11, so new PVLR = 221.
2.1c = 221 1.1 = 243.1.
c = 115.76.
s = y c = 101 115.76 = 14.76.
So part of the temporary increase in income is consumed and part is saved.
(e) y increases by 11, so PVLR rises by 11/1.10 = 10. New PVLR = 220.
f
2.1c = 220 1.1 = 242.

c = 115.24.
s = y c = 90 115.24 = 25.24.
So a rise in future income leads to an increase in current consumption but a decrease in saving.
(f) A rise in initial wealth has the same effect on the PVLR and thus on consumption as an increase
in current income of the same amount, so c = 115.76 as in part (d).
s = y c = 90 115.76 = 25.76.
So an increase in wealth increases current consumption and decreases saving.
(a) PVLR = a + y + y + y = 1500.

l w r
9.
(1) No borrowing constraint: c + c + c = 1500.
l w r
c = c = c = c = 1500/3 = 500.
l w r
s = 200 500 = 300; s = 800 500 = 300; s = 200 500 = 300.

l w r
(2) A borrowing constraint is nonbinding, since a + y = 500 = c , and c = 500 < 800 = y .
l l w w
So consumption and saving are the same in each period as in part (1) above.
(b) PVLR = 1200.
(1) No borrowing constraint: c = 1200/3 = 400.
s = 200 400 = 200; s = 800 400 = 400; s = 200 400 = 200.
l w r
(2) The borrowing constraint is now binding, since c = 400 > a + y = 200. So c is constrained to
l l l
be 200. That leaves PVLR of 1000 for c + c , so they both equal 500. c = 500 < 800 = y ,
w r w w
so the borrowing constraint is not binding in working age.

s = 200 200 = 0; s = 800 500 = 300; s = 200 500 = 300.
l w r
Consumption cant be lower in all periods due to a binding borrowing constraint, because
the present value of lifetime consumption must be the same with and without borrowing
constraints.
Analytical Problems
1 2
1. (a) As Figure 4.5 shows, the shift to the right in the saving curve from S to S causes saving and
investment to increase and the real interest rate to decrease.
Figure 4.5
(b) This is really just a transfer from the general population to veterans. The effect on saving
depends on whether the marginal propensity to consume (MPC) of veterans differs from that of
the general population. If there is no difference in MPCs, there will be no shift of the saving
curve; neither investment nor the real interest rate is affected. If the MPC of veterans is higher
than the MPC of the general population, then desired national saving declines and the saving
curve shifts to the left; the real interest rate rises and investment declines. If the MPC of veterans
is lower than that of the general population, the saving curve shifts to the right; the real interest
rate declines and investment rises.
1 2
(c) The investment tax credit encourages investment, shifting the investment curve from I to I in
Figure 4.6. Saving and investment increase, as does the real interest rate.
Figure 4.6
(d) The increase in expected future income decreases current desired saving, as people increase
desired consumption immediately. The rise of the future marginal productivity of capital shifts
the investment curve to the right. The result, as shown in Figure 4.7, is that the real interest rate
rises, with ambiguous effects on saving and investment.
Figure 4.7
2. (a) With a lower capital stock, the marginal product of labor is reduced, so the labor demand curve
1 2
shifts to the left from ND to ND in Figure 4.8. Then the new equilibrium point is one with
lower employment and a lower real wage. With lower employment and a lower capital stock,
full-employment output will be lower.
Figure 4.8
(b) Because the capital stock is lower, the marginal product of capital will be higher, so desired
investment will increase.
(c) Since current output declines, desired saving declines, because people do not want to reduce
their consumption. On the other hand, since future output is also lower, people desire to save
more today to make up for the loss of future income.
d 1 2
(d) The increase in desired investment shows up as a shift to the right in the I curve, from I to I in
Figure 4.9. Then the new equilibrium (assuming no change in desired saving) is at a higher level
of investment and a higher real interest rate.
Figure 4.9
3. (a) The temporary increase in the price of oil reduces the marginal product of labor, causing the
1 2
labor demand curve to shift to the left from ND to ND in Figure 4.10. At equilibrium, there is a
reduced real wage and lower employment.
Figure 4.10
The productivity shock results in a reduction of output. Because the shock is temporary, the only
effect on desired saving or investment is due to the reduction in current output, causing desired
national saving to fall. This shifts the saving curve to the left, raising the real interest rate and
reducing the level of desired investment, as well as desired national saving, as shown in Figure 4.11.
Figure 4.11
(b) The permanent increase in the price of oil reduces the marginal product of labor, causing the
labor demand curve to shift to the left, again as in Figure 4.10. (Also, the decline in future
income means the labor-supply curve will shift to the right; but well assume that this shift is
less than the shift to the left of the labor-demand curve.) At equilibrium, there is a reduced real
wage and lower employment.
The productivity shock results in a reduction of current output. Because the shock is permanent,
it reduces future output as well, and reduces the future marginal product of capital. The desired
1 2
investment curve shifts to the left, from I to I in Figure 4.12, because the future marginal
product of capital is lower. The effect on desired saving is ambiguousthe reduction in current
income reduces desired saving, but the reduction in expected future income increases desired
saving. Lets assume that the former effect outweighs the latter, so that the desired saving curve
1 2
shifts to the left from S to S . Then national saving and investment both decline. Again, the
effect on the real interest rate is ambiguous. (Alternatively, if the effects on desired saving of the
reductions in current income and future income offset each other exactly, the desired saving
curve does not shift. In this case, the leftward shift of the investment curve along an unchanged
saving curve reduces the real interest rate, saving, and investment.)
Figure 4.12
4. A temporary increase in government spending reduces national saving. Whether the spending is
financed by current taxes or by borrowing (and raising future taxes), consumption falls, but not by
the full amount of the spending. Since S = Y C G, national saving declines. This is shown in
d
Figure 4.13 as a shift to the left in the saving curve. The real interest rate must increase to get S = I,
so I declines as well. It makes no difference whether the temporary increase in spending is funded by
taxes or by borrowing.
Figure 4.13
f 1
In the case of infrastructure spending, MPK rises, so investment increases. Saving shifts from S to
2 1 2
S and investment shifts from I to I in Figure 4.14. With upward shifts in both saving and
investment, the new equilibrium is one with a higher real interest rate. However, saving and
investment at the new equilibrium may be higher or lower. The effect on consumption is unclear as
well. The higher real interest rate reduces consumption, but future income is higher, which increases
consumption. If investment actually rises, then the increase in government spending causes private
investment to be crowded in rather than crowded out. In this case consumption is crowded out.
Figure 4.14
5. When there is a temporary increase in government spending, consumers foresee future taxes. As a
result, consumption declines, both currently and in the future. Thus current consumption does not
fall by as much as the increase in G, so national saving (S = Y C G) declines at the initial real
d d
1 2
interest rate, and the saving curve shifts to the left from S to S , as shown in Figure 4.15. Thus the
real interest rate increases and consumption and investment both fall.
Figure 4.15
When there is a permanent increase in government spending, consumers foresee future taxes as well,
with both current and future consumption declining. But if there is an equal increase in current and
future government spending, and consumers try to smooth consumption, they will reduce their
current and future consumption by about the same amount, and that amount will be about the same
amount as the increase in government spending. So the saving curve in the saving-investment
diagram does not shift, and there is no change in the real interest rate.
Since the saving curve shifts upward more in the case of a temporary increase in government
spending, the real interest rate is higher, so investment declines by more. However, consumption
falls by more in the case of a permanent increase in government spending.
1
6. See Figure 4.16. The consumer is originally on budget line BL , with consumption at point D. An
2
increase in the real interest rate shifts the budget line to BL , with consumption at point Q. The
change can be broken down into two steps. First, the substitution effect shifts the budget line from
1 int
BL to BL , and the consumption point changes from point D to point P. The substitution effect
results in higher future consumption and lower current consumption. The income effect shifts the
int 2
budget line from BL to BL , with the consumption point changing from point P to point Q. The
income effect results in lower current and future consumption. Thus the income and substitution
effects work in the same direction, reducing current consumption and increasing saving.
Figure 4.16
7. The difference in interest rates between borrowing and lending means there is a kink in the budget
constraint at the no-lending, no-borrowing point, as shown in Figure 4.17. Borrowing is zero when
c = y + a. If current consumption is less than y + a, the person is a saver (lender), and the budget line
has slope (1 + rl). If current consumption is greater than y + a, the person is a borrower, and faces a
steeper budget constraint with slope (1 + rb), because the interest rate is higher.
Figure 4.17
An increase in either interest rate would steepen only the portion of the budget constraint for which
that interest rate is relevant. An increase in the real interest rate on lending is shown as a shift in the
1 2
budget line segment from BL to BL in Figure 4.18. An increase in the real interest rate on
3 4
borrowing is shown as a shift in the budget line segment from BL to BL . If the indifference curve
hits the budget line at the no-borrowing, no-lending point, as shown, then there will be no change in
current or future consumption due to a change in either interest rate.
Figure 4.18
An increase in the consumers initial wealth would lead to a parallel rightward shift of both segments
of the budget line, as shown in Figure 4.19.
Figure 4.19

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Chapter 4

Consumption, Saving, and Investment

II. Notes to Fifth Edition Users

B) The consumption and saving decision of an individual

D) Effect of changes in expected future income

E) Effect of changes in wealth

2. Taxes and the real return to saving

3. In touch with the macroeconomy: interest rates

3. Government purchases (temporary increase)

H) Application: a Ricardian tax cut?

II. Investment (Sec. 4.2)

Desired capital stock is the level of capital stock at which MPK = uc

C) Changes in the desired capital stock

MPK = uc/(1 ) = (r + d)pK/(1 )

e. In reality, there are complications to the tax-adjusted user cost

f. Application: measuring the effects of taxes on investment

D) Box 4.1: investment and the stock market

III. Goods Market Equilibrium (Sec. 4.3)

3. How to reach equilibrium? Adjustment of r

4. Shifts of the saving curve

5. Shifts of the investment curve

IV. Appendix 4.A: A Formal Model of Consumption and Saving

3. a = (y + a c)(1 + r), so c = (y + a c)(1 + r) + y

D) Present value and the budget constraint

3. The budget constraint means PVLC = PVLR

E) What does the consumer want? Consumer preferences

4. A person is equally happy at any point on an indifference curve

F) The optimal level of consumption

2. Thats the highest indifference curve that its possible to reach

G) The Effects of Changes in Income and Wealth on Consumption and Saving

d. The permanent income theory

H) Consumption and Saving Over Many Periods: The Life-Cycle Model

Numerical Problem 9 deals with borrowing constraints.

I) The Real Interest Rate and the Consumption-Saving Decision

2. The substitution effect

4. The income and substitution effects together

Additional Teaching Notes

Consumer Sentiment and the 1990-1991 Recession

Additional Issues for Classroom Discussion

2. The Interaction of Taxation and Inflation

3. Should the Government Reduce Taxes on Capital?

4. Is Saving Too Low in the United States?

5. Should Social Security Funds Be Invested in the Stock Market?

7. What Borrowing Constraints Do You Face?

Answers to Textbook Problems

buy five, since then MPK = 20 < 28 = uc.

= I at equilibrium. From the table, this occurs at r = 5%.

Y = (3600 2000r + 0.1Y) + (1200 4000r) + 1200

4800 + 2000r + 0.9Y = 1200 4000r

5040 + 2000r + 0.9Y = 1200 4000r

Since K K = I dK, I = K K + dK = 970 900 + (.2 900) = 250.

(b) i. Solving for this in general:

I = K K + dK = 980 100r 900 + (.2 900) = 260 100r.

PVLR = y + [y /(1 + r)] + a

When c = 0, c = 210; this is the horizontal intercept of the budget line.

(c) c = c : c + (c/1.10) = 210.

1.10c + c = 210 1.10.

2.1c = 220 1.1 = 242.