Macroeconomics Long Run Economic Performance BBA-II Consumption, Saving and Investment

THE GOODS MARKET

4.1 CONSUMPTION AND SAVING
We begin consideration of the demand for goods and services by discussing the factors that affect
consumer spending. Because consumption spending by households is by far the largest component of
the demand for goods and services—accounting for more than two-thirds of total spending in the
United States—changes in consumers’ willingness to spend have major implications for the behavior of
the economy.

Besides the sheer size of consumption spending, another reason to study consumption is that the
individual’s or household’s decision about how much to consume is closely linked to another important
economic decision, the decision about how much to save. Indeed, for given levels of disposable income,
the decision about how much to consume and the decision about how much to save are really the same
decision. For example, a college student with a part-time job that pays $4000 per year after taxes might
decide to spend $3700 per year on clothes, food, entertainment, and other consumption. If she does
consume this amount, her saving will automatically be $300 ($4000 minus $3700) per year. Equivalently,
she might decide to save $300 per year. If she succeeds in saving $300, her consumption automatically is
$3700 ($4000 minus $300) per year. Because the decision about how much to consume and the decision
about how much to save actually are two sides of the same coin, we analyze them together.

From a macroeconomic perspective, we are interested in 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. We will analyze desired consumption and its response
to various factors, such as income and interest rates, by examining the consumption decisions of
individual households. The aggregate level of desired consumption, Cd, is obtained by adding up the
desired consumption of all households. Thus any factor that increases the desired consumption of
individual households will increase Cd, and any factor that decreases the desired consumption of
individual households will decrease Cd.

Just as a household’s consumption decision and saving decision are closely linked, a country’s desired
consumption is closely linked to its desired national saving. Specifically, desired national saving, Sd, is the
level of national saving that occurs when aggregate consumption is at its desired level.

if net factor payments from abroad (NFP) equal zero (as must be true in a closed economy), national
saving, S, equals Y - C - G, where Y is output, C is consumption, and G is government purchases. Because
desired national saving, Sd, is the level of national saving that occurs when consumption equals its
desired level, we obtain an expression for desired national saving by substituting desired consumption,
Cd, for consumption, C, in the definition of national saving. This substitution yields

Sd = Y - Cd - G. ………. Equ 4.1

Macroeconomics Long Run Economic Performance BBA-II Consumption, Saving and Investment
THE GOODS MARKET
THE CONSUMPTION AND SAVING DECISION OF AN INDIVIDUAL
4.2 INVESTMENT
Let’s now turn to a second major component of spending: investment spending by firms. Like
consumption and saving decisions, the decision about how much to invest depends largely on
expectations about the economy’s future. Investment also shares in common with saving and
consumption the idea of a trade-off between the present and the future. In making a capital investment,
a firm commits its current resources (which could otherwise be used, for example, to pay increased
dividends to shareholders) to increasing its capacity to produce and earn profits in the future.

Investment refers to the purchase or construction of capital goods, including residential and
nonresidential buildings, equipment and software used in production, and additions to inventory stocks.
From a macroeconomic perspective, there are two main reasons to study investment behavior. First,
more so than the other components of aggregate spending, investment spending fluctuates sharply over
the business cycle, falling in recessions and rising in booms. Even though investment is only about one-
sixth of GDP, in the typical recession half or more of the total decline in spending is reduced investment
spending. Hence explaining the behavior of investment is important for understanding the business
cycle.

The second reason for studying investment behavior is that investment plays a crucial role in
determining the long-run productive capacity of the economy. Because investment creates new capital
goods, a high rate of investment means that the capital stock is growing quickly as we know capital is
one of the two most important factors of production (the other is labor). All else being equal, output will
be higher in an
Macroeconomics Long Run Economic Performance BBA-II Consumption, Saving and Investment
THE GOODS MARKET
economy that has invested rapidly and thus built up a large capital stock than in an economy that hasn’t
acquired much capital.

FIRM’S DESIRED CAPITAL STOCK

To understand what determines the amount of investment, we must consider how firms decide how
much capital they want. If firms attempt to maximize profit, as we assume, a firm’s desired capital stock
is the amount of capital that allows the firm to earn the largest expected profit. In real terms, the
benefit to a firm of having an additional unit of capital is the marginal product of capital, MPK. Recall
from Chapter 3 that the MPK is the increase in output that a firm can obtain by adding a unit of capital,
holding constant the firm’s work force and other factors of production. Because lags occur in obtaining
and installing new capital, the expected future marginal product of capital, MPKf , is the benefit from
increasing investment today by one unit of capital. This expected future benefit must be compared to
the expected cost of using that extra unit of capital, or the user cost of capital.

THE USER COST OF CAPITAL

The user cost of capital is the sum of the depreciation cost and the interest cost. The interest cost is rpK,
the depreciation cost is dpK, and the user cost of capital, uc, is

uc = rpK + dpK = (r + d)pK. Equ. (4.3)

us: user cost of capital

d: depression
 r: expected real interest rate
pk: real price of capital good

DETERMINING THE DESIRED CAPITAL STOCK

The desired capital stock (5000 cubic feet of

oven capacity in this example) is the capital
stock that maximizes profits. When the
capital stock is 5000 cubic feet, the
expected future marginal product of
capital, MPKf , is equal to the user cost of
capital, uc.

If the MPKf is larger than uc, as it is when

the capital stock is 4000 cubic feet, the
benefit of extra capital exceeds the cost,
and the firm should increase its capital
stock. If the MPKf is smaller than uc, as it is
at 6000 cubic feet, the cost of extra capital
exceeds the benefit, and the firm should
reduce its capital stock.
Macroeconomics Long Run Economic Performance BBA-II Consumption, Saving and Investment
THE GOODS MARKET
CHANGES IN THE DESIRED CAPITAL STOCK
An increase in the expected future MPK raises the desired capital stock

A technological advance raises the

expected future marginal product of
capital, MPKf , shifting
the MPKf curve upward from MPK f 1
to MPKf2

The desired capital stock increases

from 5000 (point A) to 6000 (point D)
cubic feet of oven
capacity. At 6000 cubic feet the MPKf
equals the user cost of capital uc at
$18 per cubic foot per year.

A decline in the real interest rate raises the desired capital stock

For the Kyle’s Bakery example, a

decline in the real interest rate from
8% to 6% reduces the user cost, uc, of
oven capacity from $18 to $16 per
cubic foot per year and shifts the user
cost line down from uc1 to uc2. The
desired capital stock rises from 5000
(point A) to 6000 (point C) cubic feet
of oven capacity. At 6000 cubic feet
the MPKf and the user cost of capital
again are equal, at $16 per cubic foot
per year.

Taxes and the Desired Capital Stock.

So far we have ignored the role of taxes in the investment decision. But Kyle is interested in maximizing
the profit his firm gets to keep after paying taxes. Thus he must take into account taxes in evaluating the
desirability of an additional unit of capital.
Suppose that Kyle’s Bakery pays 20% of its revenues in taxes. In this case, extra oven capacity that
increases the firm’s future revenues by, say, $20 will raise Kyle’s after-tax revenue by only $16, with $4
going to the government. To decide whether to add this extra capacity, Kyle should compare the after-
tax MPKf of $16 per cubic foot per year—not the before-tax MPKf of $20 per cubic foot per year— with
the user cost.
Macroeconomics Long Run Economic Performance BBA-II Consumption, Saving and Investment
THE GOODS MARKET
In general, if ‘t’ is the tax rate on firm revenues, the after-tax future marginal product of capital is
(1-‘t’)MPKf. The desired capital stock is the one for which the after-tax future marginal product equals
the user cost, or

(1 – ‘t’)MPKf = uc.

Dividing both sides of this equation by 1 –‘t’, we obtain

In Eq. (4.4), the term uc/(1 - t) is called the tax-adjusted user cost of capital. The tax-adjusted user cost
of capital shows how large the before-tax future marginal product of capital must be for a firm to
willingly add another unit of capital. An increase in the tax rate t raises the tax-adjusted user cost and
thus reduces the desired stock of capital.

From The Desired Capital Stock to Investment

Now let’s look at the link between a firm’s desired capital stock and the amount it invests. In general,
the capital stock (of a firm or of a country) changes over time through two opposing channels. First, the
purchase or construction of new capital goods increases the capital stock. We’ve been calling the total
purchase or construction of new capital goods that takes place each year “investment,” but its precise
name is gross investment. Second, the capital stock depreciates or wears out, which reduces the capital
stock.

Whether the capital stock increases or decreases over the course of a year depends on whether gross
investment is greater or less than depreciation during the year; when gross investment exceeds
depreciation, the capital stock grows. The change in the capital stock over the year—or, equivalently,
the difference between gross investment and depreciation—is net investment. We express these
concepts symbolically as

It = gross investment during year t,

Kt = capital stock at the beginning of year t, and

Kt+1 = capital stock at the beginning of year t + 1

(equivalently, at the end of year t).

Net investment, the change in the capital stock during period t, equals K t+1 - Kt. The amount of
depreciation during year t is dK t, where d is the fraction of capital that depreciates each year. The
relationship between net and gross investment is

net investment = gross investment - depreciation; (4.5)

Kt+1 - Kt = It - dKt.
Macroeconomics Long Run Economic Performance BBA-II Consumption, Saving and Investment
THE GOODS MARKET

Investment in Inventories and Housing

Our discussion so far has emphasized what is called business fixed investment, or investment by firms in
structures (such as factories and office buildings), equipment (such as drill presses and jetliners), and
software. However, there are two other components of investment spending: inventory investment and
residential investment. Inventory investment equals the increase in firms’ inventories of unsold goods,
unfinished goods, or raw materials. Residential investment is the construction of housing, such as single
family homes, condominiums, or apartment buildings.

Fortunately, the concepts of future marginal product and the user cost of capital, which we used to
examine business fixed investment, apply equally well to inventory investment and residential
investment.

4.3 Goods Market Equilibrium

The goods market is in equilibrium when the aggregate quantity of goods supplied equals the
aggregate quantity of goods demanded. (For brevity, we refer only to “goods” rather than to
“goods and services,” but services always are included.)

Algebraically, this condition is

 Y = Cd + Id + G. …………..Equ 4.7

The left side of Eq. (4.7) is the quantity of goods, Y, supplied by firms. The right side of Eq. (4.7)
is the aggregate demand for goods. If we continue to assume no foreign sector, so that net
exports are zero, the quantity of goods demanded is the sum of desired consumption by
households, Cd, desired investment by firms, Id, and government purchases, G.14 Equation (4.7)
is called the goods market equilibrium condition.

Y – Cd- G = I d

As Y - Cd – G = Sd

So Sd = Id ………….. Eau 4.8

This alternative way of writing the goods market equilibrium condition says that the goods
market is in equilibrium when desired national saving equals desired investment. Because
saving and investment are central to many issues we present in this book and because the
desired-
Macroeconomics Long Run Economic Performance BBA-II Consumption, Saving and Investment
THE GOODS MARKET
saving-equals-desired-investment form of the goods market equilibrium condition often is
easier to work with, we utilize Eq. (4.8) in most of our analyses. However, we emphasize once
again that Eq. (4.8) is equivalent to the condition that the supply of goods equals the demand
for goods.

The Saving–Investment Diagram

Goods market equilibrium occurs when desired national saving equals desired investment. In the figure,
equilibrium occurs when the real interest rate is 6% and both desired national saving and desired
investment equal 1000. If the real interest rate were, say, 3%, desired investment (1500) would not
equal desired national saving (850), and the goods market would not be in equilibrium. Competition
among borrowers for funds would then cause the real interest rate to rise until it reaches 6%.
Shifts of the Saving Curve.
A decline in desired saving
A change that reduces desired national saving, such as a temporary increase in current government
purchases, shifts the saving curve to the left, from S1 to S2. The goods market equilibrium point moves
from E to F. The decline in desired saving raises the real interest rate, from 6% to 7%, and lowers saving
and investment, from 1000 to 850.
Macroeconomics Long Run Economic Performance BBA-II Consumption, Saving and Investment
THE GOODS MARKET

Shifts of the Investment Curve

An increase in desired investment

A change in the economy that increases desired investment, such as an invention that raises the
expected future MPK, shifts the investment curve to the right, from I1 to I 2. The goods market
equilibrium point moves from E to G. The real interest rate rises from 6% to 8%, and saving and
investment also rise, from 1000 to 1100.
Macroeconomics Long Run Economic Performance BBA-II Consumption, Saving and Investment
THE GOODS MARKET