Macroeconomic Analysis I

Topic 4

Consumption, Saving and Investment

(Abel, Bernanke & Croushore: Chapter 4)

1
 Learning Objectives

o Discuss the factors that affect consumption and saving decisions

-

o Discuss the factors that affect the investment behavior of firms

.

o Explain the factors affecting goods market equilibrium

works
TO know how the goods market

2
 Consumption and Saving

o The importance of consumption and saving

( planned consumption )

Desired consumption: consumption amount desired by households

Desired national saving: level of national saving when consumption is at

its desired level:
Sd = Y – Cd – G (4.1)

3
 Consumption and Saving

o The consumption and saving decision of an individual

Trade-off between current consumption and future consumption

The price of 1 unit of current (this year’s) consumption is 1 + r units of

future (next year’s) consumption, where r is the real interest rate

Consumption-smoothing motive: the desire to have a relatively even

pattern of consumption over time

4
^
Ocr

F
OCR
Ocp
>
Cp
Consumption and Saving
$ IOOM

>

o The consumption smoothing guides changes in consumption and saving

behaviors when there are changes in current income, expected future
^
& behaviors
income and wealth. Can affect consumer 's consumption saving

of
additional
one 0 consumption
period
.

fraction
that
e-
#
Current Income TC
45 .
the

Current
income
in
the
Current

, consumes

/
One time increase in current income would increase current
consumption
With marginal propensity to consume (MPC) less than 1, consumer
consumes some but not all of her extra income
Unspent portion of the additional income will be saved, resulting in
an increase in current savings
5
 Consumption and Saving

o Current consumption not only depends on current income, but also the
income a person expects to earn in future.

Expected Future Income

If expected future income increases, consumption smoothing motive

tends to cause an increase in current consumption
With current income unchanged, an increase in current consumption is
equivalent to a decrease in current savings

FTE
sighted
'

,
any ⇒
CY

( unchanged ) 6
ISI
 Consumption and Saving

o Another factor which affects consumption and saving is wealth.

Wealth

An increase in wealth provides more resources for consumption,

resulting in a rise in current consumption
With current income unchanged, an increase in current consumption
is equivalent to a decrease in current savings

7
 -

increase in r ⇒ each dollar of current saving

have terms of increased

Will a
higher payoff
in

Consumption and Saving -

future

this increased
consumption

reward for current

saving
tends

to increase
saving

current Consumption
the of
Effect of changes in real interest rate , in
price
terms of future consumption

Increased real interest rate has two opposing effects

• Substitution effect: Positive effect on saving, since rate of return is higher; greater reward for
future
saving elicits more saving (i.e. saving rises) reflects tendency
Current
to reduce

Consumption
current

Hr ,
consumption
increases In
and

response
increase

to this ,
they
consumption
substitute
as the price of ,
.

toward CF

• Income effect
more
has become relatively expensive ,

Away from current consumption which

,

changftncuwnt
'

reflects the .
: 4 Sc ,
t C ,
Tcf
consumption

when a
higher
that

r
results

makes
For a saver: Negative effect on saving, since it takes less saving to obtain a given amount in the
a
H
'
a
so would have some additional resources to ⇒ the same As 4 in Wealth
effectively
Consumer richer or poorer future (target saving) * ( y spend ,

For a borrower: Positive effect on saving, since the higher real interest rate means a loss of
wealth hence saving rises (i.e. borrowing falls) -

thereby
Increases

making
the

the
amount

borrower
of
unable
interest

to
payments

afford the
that

same
a

levels
borrower

of Cc
must

and
make

Cf
,

as

before .
He has
effectively Suffered a loss of wealth as a
result of the increase in r
,

&
responds this KCC & tcf ⇒ #
to by
• Empirical studies showed results - widely accepted conclusion that saving rises and current
consumption falls when real interest rate increases

8
 Consumption and Saving

Effect of changes in real interest rate

the
of paid as earned
by Savers
part earned ⇒ the real return is
⇒
interest less than the diff blw the
actually for to
.

Consumers use
's
ljt
the r

/
appropriate
expectedtnflation
+0*5
'

nominal r and
&
.

decisions
n consumption saving
real making

y
r
.

- =

Taxes and the real return to saving

.

it the purchasing
'

: measures the increase in

Power of their
saving after payment of taxes .

• Expected after-tax real interest rate:

=) fraction
ra-t = (1 – t)i – e
this

(4.2)
Savers retain

total interest earned

Of
.

F T I
at
rate NYMINAI expected
which tax t
nominal after
.

income interest inflation ( It ) [ ⇒

interest rate
taxed rate .

is

• Expected after-tax real interest rate is the appropriate interest rate for
consumers to use in making consumption and saving decisions because
it measures the increase in the purchasing power of their saving after
payment of taxes

9
 Consumption and Saving

Fiscal policy

Affects desired consumption through changes in current and expected future

income

Directly affects desired national saving,

Sd = Y – Cd – G

10
 Consumption and Saving
to decline in their Current income
consumers respond a

in the current period

G only
rises
less than the
by reducing Consumption , although by
>
future spending
Fiscal policy ( plans for got
'
decline in current income .
( " 04412<1 )

/
=

)
are unchanged .

) #

ftp.xgyynremasne.lu#anentinome
purchase

Government purchases (temporary increase)

• Higher G financed by higher current taxes reduces after-tax income, lowering desired
consumption

• Even true if financed by higher future taxes, if people realize how future incomes are
affected
desired ) ( Fallin ( G)
C < Rise in

consumption
( ocd ) ( OG
<
)
,

FALLA
YE
$1
OCT
• Since Cd declines less than G rises, national saving (Sd = Y – Cd – G) declines
t t M

• So government purchases reduce both desired consumption and desired national saving
Consider OG
=
$142155 Gt
'

fcd )
-

#
$1
Cd
'

OT Gt
sat
-

gable
-

dFnP8me -

to .si th , 11
.
1
JASMPCC
.

L↳
$1 (
 Consumption and Saving
must also increase its current
Constant reduce Current taxes
) $10 government
Fiscal policy is cut
G tax
( Assume g. by
e. ,
,
.

borrowing by $-10 .

T
needs to be repaid With interest

4 current income .

/
7

receives

Taxes each

the /
taxpayer
same amount

y
Incomes
lower future disposable

• Lump-sum tax cut today, financed by higher future taxes ⇒

for households .

,
t Current Consumption
y

• Decline in future income may offset increase in current income;

desired consumption could rise or fall
( ambiguous )

12
 Consumption and Saving

Fiscal policy
People
Aressfarrressighthadt
.

/
a
I followed
Taxes Tax cut today
increase
Will

in
be

future
by tax

• Ricardian equivalence proposition

s If future income loss exactly offsets current income gain, no change in consumption
Theory
| Tax change affects only the timing of taxes but has no effect on consumption
• In practice, people may not see that future taxes will rise if taxes are cut
practice
| reduced desired national saving
today; thus a tax cut tends to lead to increased desired consumption and

13
 Consumption and Saving
Application: How consumers respond to tax rebates

Recent evidence on the tax rebates in 2008 and 2009 was provided in a research
paper by Parker et al.
• Consumers spent 50%-90% of the tax rebates
• Inconsistent with Ricardian equivalence

14
 to purchase or construction of Capital goods ,

y
and
including buildings , equipment , software ,

production
Investment intellectual in
property products used ,

and additions to
inventory stocks

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

15
 Investment
The desired capital stock

Desired capital stock is the amount of capital that allows firms to earn the largest
expected profit
marginal marginal
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)

MPK the increase in Output that a firm Can obtain

Capital
by adding
-

a unit of ,

the firm 's of

holding
constant production
workforce and other factors .

16
 Investment
real unit
expected cost of a
using of

The desired capital stock ,

Capital for a
specified period of time .

The user cost of capital

• Example of Kyle’s Bakery: cost of capital, depreciation rate, and expected real
interest rate

• 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)
where r is the expected real interest rate
d is the rate that capital depreciates
pK is the real price of capital goods
17
Figure 4.2 Determination of the desired capital stock
capital
extra
of
benefit the
cost

exceeds

UC
Kf >

↳
more
hire
.
:

'

f-
MPK UC

W Mpkf < UC

q
i. hire less
.

E
real wage
Wo

"

! MPN

N
to
>
*

18
Figure 4.3 A decline in the real interest rate raises the desired capital stock

more
hire
i.

19
Figure 4.4 An increase in the expected future MPK
raises the desired capital stock

20
 Investment
Changes in the desired capital stock
rate
tax

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
pkf =(Y¥
(1 – )MPKf = uc, ,

which means:
MPKf = uc/(1 – ) = (r + d)pK/(1 – ) (4.4)

21
 Investment
Changes in the desired capital stock
shows how large the before
-

tax future magma

1
product of capital must be

for a
firm to
willingly add another unit of capital .

Taxes and the desired capital stock 4

• Tax-adjusted user cost of capital is uc/(1 – )

• An increase in raises the tax-adjusted user cost and reduces the desired
capital stock

22
 Investment
Application: measuring the effects of taxes on investment

Do changes in the tax rate have a significant effect on investment?

yes

A 1994 study by Cummins, Hubbard, and Hassett found that after major tax
reforms, investment responded strongly: elasticity about –0.66 (i.e. a tax
change that lowers the user cost of capital by 10% would raise aggregate
investment by 6.6%) suggesting that the effective tax rate significantly affects
investment

23
 Investment
From the desired capital stock to investment

The capital stock changes from two opposing channels

• New capital increases the capital stock; this is gross investment

• The capital stock depreciates, which reduces the capital stock

24
 Investment
From the desired capital stock to investment

| = gross investment (I) minus depreciation:

Net investment
- rate

Nnetomeysrnossmeanutnngyeart
Kt+1 – Kt = It – dKt (4.5)
-
depreciation
d is

where net investment equals the change in the capital stock

:
Ikb
's
.to#IEruenaofyeaI ,

Fig. 4.5 shows gross and net investment for the United States

25
 Figure 4.5 Gross and net investment, 1929-2014

depreciation
|
✓

net investment < o

Ffeperhetssion .

WWI clattpttal stock was shrinking

←

Sources: GDP, gross private domestic investment, and net private domestic investment from BEA Web site, Tables 1.1.5, 5.1, and 5.2.5.
26
 Investment
From the desired capital stock to investment
grionsvseqments
depreciation
→

Rewriting (4.5) gives It = Kt+1 – Kt + dKt

-

net
investment

If firms can change their capital stocks in one period, then the desired capital
stock (K*) = Kt+1 |✓ Use info available at the
beg . of year
t

about the Mpkf & UC

,
& determine

desired stock k*
the
capital .

Hence, It = K* – Kt + dKt (4.6)

27
 Investment
From the desired capital stock to investment

Thus investment has two parts

• Desired net increase in the capital stock over the year (K* – Kt)

• Investment needed to replace depreciated capital (dKt)

28
 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

29
 Goods Market Equilibrium

The real interest rate adjusts to bring the goods market into equilibrium
Y = Cd + Id + G (4.7)
goods market
1 equilibrium
1 condition
9EieEdmen+↳YpYnmae¥g
doesnisruemdption

The goods market is in equilibrium when the aggregate quantity of goods

supplied by firms (Y) equals the aggregate quantity of goods demanded
(Cd + Id + G)
-

planned expenditure
d to Y
C + Idt G is not
necessarily equal .

in
÷equilibrium

30
 Goods Market Equilibrium

Alternative representation: since Id

-

Sd = Y – Cd – G,
desainrngds -

Hence,
Sd = Id (4.8)

Thus, the alternative way of writing the goods market equilibrium condition says
that the goods market is in equilibrium when desired national savings ( Sd ) equals
desired investment ( Id )

31
 Figure 4.7 Goods market equilibrium

interest rate
higher
Will induce higher saving rate

Id = sd

Sd < Id

want to borrow more than Savers

investors
d
to lend the real interest rate that
I want :
sd
.

>
.

to The return
lenders build
paid recieve will
up
.

return 6%
real to Savers will 1
'
until it reachers
bid
.

Will
Savers of borrowing
.

down cost
higher

Adjust real interest rate →

bring goods market back to equilibrium .
32
 Goods Market Equilibrium

The saving-investment diagram

• Equilibrium where Sd = Id
• The goods market equilibrium is established through the adjustment of r

consumers save less

interest rate

Table 4.4: Components of Aggregate Demand for Goods (An Example) relatively
low
{ firms invest more

ynogoodsmavketequikbnumt
invoke decrease
-

.
=
.

eq
.
)p¥"" 33
'
 Goods Market Equilibrium

Shifts of the saving curve

Consider an increase in government purchases which shifts S leftwards

Result of lower savings (S): higher r, causing crowding out of I (Fig. 4.8)

34
Figure 4.8 A decline in desired saving

For any
r
constant
remain
¥
$d=
fed
'
-

G 4

35
 Goods Market Equilibrium

Shifts of the investment curve

Consider the Investment curve (I) shifts right due to a rise in expected future marginal
productivity of capital

Result of increased investment (I): higher r, higher S and I (Fig. 4.9)

36
Figure 4.9 An increase in desired investment

37