Consumption, Saving, and Investment

Chapter 4
Consumption,
Saving, and
Investment
Chapter Outline
• Consumption and Saving

• Investment
• Goods Market Equilibrium
Copyright ©2017 Pearson Education, Ltd. All rights reserved. 4-2

Consumption and Saving
• Desired consumption (Cd): consumption

amount desired by households
• Desired national saving (Sd): level of
national saving when consumption is at its
desired level:
Sd = Y – Cd – G (4.1)
– Note: We are assuming a closed economy, so
NFP=0.

• The consumption and saving decision of an

individual
– A person can consume less than current income
(saving is positive)
– A person can consume more than current
income (saving is negative)

• The consumption and saving decision of an

individual
– Trade-off between current consumption and
future consumption
• The price of 1 unit of current consumption is 1 + r units
of future consumption, where r is the real interest rate
• Consumption-smoothing motive: the desire to have
a relatively even pattern of consumption over time,
avoiding sharp fluctuations in consumption

• Factors that affect the consumption (saving)

decision
– Changes in current income
– Changes in expected future income
– Changes in wealth
– Changes in the expected real interest rate

• Effect of changes in current income

– Increase in current income: both consumption
and saving increase (vice versa for decrease in
current income)
– Because of the consumption smoothing motive,
people spend part of the increase in their current
income and save the rest so that their future
consumption also increases


– Marginal propensity to consume (MPC) =
fraction of additional current income consumed in
current period; between 0 and 1
– Example: MPC=0.8 and current income increases
by 400 TL
 Current spending increases by 0.8 x 400 = 320 TL
Saving increases by 80 TL
Future spending increases by 80 x (1+i) TL


– Aggregate level: when current income (Y) rises, Cd
rises, but not by as much as Y, so Sd rises
Y Cd
Sd = Y – Cd – G

• Effect of changes in expected future

income
– Higher expected future income (Yf) leads to
more consumption today, so saving falls
Yf Cd
Sd = Y – Cd – G since Y is constant

• Effect of changes in wealth

– Increase in wealth raises current consumption,
so lowers current saving
Wealth Cd
Sd = Y – Cd – G since Y is constant

• Effect of changes in real interest rate

– Increased real interest rate has two opposing
effects
• Substitution effect: Positive effect on saving, since rate
of return is higher; greater reward for saving elicits
more saving
• Income effect
– For a saver: Negative effect on saving, since it takes less
saving to obtain a given amount in the future (target
saving)
– For a borrower: Positive effect on saving, since the higher
real interest rate means a loss of wealth
• Empirical studies: an increase in aggregate saving

• Fiscal policy
– Fiscal policy refers to government policies
related to taxes and government spending
– Affects desired consumption through changes in
after-tax current and expected future income
– Directly affects desired national saving,
Sd = Y – Cd – G

• Fiscal policy
– Government purchases
• A temporary increase in government purchases
• Higher G financed by higher current taxes reduces
current after-tax income, lowering desired consumption
– Desired consumption falls less than the increase in G (or
the fall in after-tax income) since 0<MPC<1
• Higher G financed by higher future taxes reduces

future after-tax income, lowering desired consumption
– The decline in future after-tax-income leads to lower
consumption today. Again desired consumption falls less
than G increases

• Fiscal policy
– Government purchases
• Since Cd declines less than G rises in both cases,
national saving (Sd = Y – Cd – G) declines
Sd = Y – Cd – G
• So government purchases reduce both desired

consumption and desired national saving

• Fiscal policy
– Taxes
• Lump-sum tax cut today, financed by higher future
taxes
• Decline in future after-tax income may offset increase
in current after-tax income; desired consumption could
rise or fall

• Fiscal policy
– Taxes
• Ricardian equivalence proposition
– If future income loss exactly offsets current income gain,
no change in consumption
– Tax change affects only the timing of taxes, not their
ultimate amount (present value)
– 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
S d = Y – Cd – G

Summary 5: Determinants of Desired
National Saving

Investment
• Why is investment important?

– Investment fluctuates sharply over the business
cycle
– Investment plays a crucial role in economic
growth

Investment
• The desired capital stock

– Desired capital stock is the amount of capital
that allows firms to earn the largest expected
profit
– 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 expected
future marginal product of capital (MPKf)

Investment

– The user cost of capital
• User cost of capital = real cost of using a unit of capital
for a specified period of time = real interest cost +
depreciation cost
uc = rpK + dpK = (r + d)pK (4.3)
where d is the depreciation rate (the rate at which capital
loses value as it wears out) and pK is the real price of
capital

Investment

– Determining the desired capital stock (Fig. 4.3)
– Compare the cost and benefit of an additional
unit of capital
• Cost = user cost
• Benefit = MPKf

Figure 4.3: Determination of the desired
capital stock

Investment

– Desired capital stock is the level of capital stock
at which MPKf = uc
– MPKf falls as K rises due to diminishing marginal
productivity
– uc doesn’t vary with K, so is a horizontal line

Investment

– If MPKf > uc, profits rise as K is added (marginal
benefits > marginal costs)
– If MPKf  uc, profits rise as K is reduced
(marginal benefits < marginal costs)
– Profits are maximized where MPKf = uc

Investment
• Changes in the desired capital stock

– Factors that shift the MPKf curve or change the
user cost of capital cause the desired capital
stock to change
– These factors are changes in the real interest
rate, depreciation rate, price of capital, or
technological changes that affect the MPKf
(Fig. 4.4 shows effect of change in uc; Fig. 4.5
shows effect of change in MPKf)

Figure 4.4: A decline in the real interest
rate raises the desired capital stock

Figure 4.5: An increase in the expected
future MPK raises the desired capital
stock

Investment

– Taxes and the desired capital stock
• With taxes, the return to capital is only (1 – t) MPKf
• A firm chooses its desired capital stock so that the
return equals the user cost, so
(1 – t)MPKf = uc, which means:
MPKf = uc/(1 – t) = (r + d)pK/(1 – t) (4.4)

Investment

– Taxes and the desired capital stock
• Tax-adjusted user cost of capital is uc/(1 – t)
• An increase in t raises the tax-adjusted user cost and
reduces the desired capital stock

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

Investment

investment
– Net investment = gross investment (I) minus
depreciation:
Kt+1 – Kt = It – dKt (4.5)
where net investment equals the change in the
capital stock

Investment

investment
– Rewriting (4.5) gives It = Kt+1 – Kt + dKt
– If firms can change their capital stocks in one
period, then the desired capital stock
(K*) = Kt+1
– So It = K* – Kt + dKt (4.6)

Investment

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)

Investment

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

Summary 6: Determinants of Desired
Investment

Goods Market Equilibrium
• The goods market is in equilibrium when

the aggregate quantity of goods and
services demanded equals the aggregate
quantity of goods and services supplied.
• Goods Market Equilibrium condition
Y = C d + Id + G (4.7)

• Goods Market Equilibrium condition

Y = C d + Id + G (4.7)
• The real interest rate adjusts to bring the
goods market into equilibrium
– Goods market equilibrium condition differs from
income-expenditure identity (Y = C + I + G), as
goods market equilibrium condition need not
always hold
– When the goods market is not equilibrium, the
real interest rate adjusts

• Alternative representation: since

Sd = Y – Cd – G,
the goods market condition can also be
written as
S d = Id (4.8)

• The saving-investment diagram

• Plot Sd vs. Id

Figure 4.7: Goods market equilibrium

• The saving-investment diagram

– Equilibrium where Sd = Id
– How to reach equilibrium? Adjustment of r

Table 4.4: Components of Aggregate
Demand for Goods (An Example)

• Shifts of the saving curve

– Saving curve shifts right when saving increases,
shifts left when saving decreases


– Saving curve shifts right when saving increases
due to
• a rise in current output (income)
• a fall in expected future output (income)
• 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)


– Example: Temporary increase in government
purchases shifts S left
– Result of lower savings: higher r, causing
crowding out of I (Fig. 4.8)

Figure 4.8: A decline in desired saving

• Shifts of the investment curve

– Investment curve shifts right when investment
increases, shifts left when investment decreases

• Shifts of the investment curve

– Investment curve shifts right when investment
increases due to
• a fall in the effective tax rate
• a rise in expected future marginal productivity of
capital
– Result of increased investment: higher r, higher
S and I (Fig. 4.9)

Figure 4.9: An increase in desired
investment

Consumption, Saving, and Investment

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Chapter 4

• Consumption and Saving

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 4-2

• Desired consumption (Cd): consumption

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 4-3

• The consumption and saving decision of an

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 4-4

• The consumption and saving decision of an

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 4-5

• Factors that affect the consumption (saving)

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 4-6

• Effect of changes in current income

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 4-7

• Effect of changes in current income

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 4-8

• Effect of changes in current income

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• Effect of changes in expected future

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• Effect of changes in wealth

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• Effect of changes in real interest rate

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• Higher G financed by higher future taxes reduces

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• So government purchases reduce both desired

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• Why is investment important?

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• The desired capital stock

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• The desired capital stock

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• The desired capital stock

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Copyright ©2017 Pearson Education, Ltd. All rights reserved. 4-23

• The desired capital stock

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• The desired capital stock

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• Changes in the desired capital stock

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• Changes in the desired capital stock

MPKf = uc/(1 – t) = (r + d)pK/(1 – t) (4.4)

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• Changes in the desired capital stock

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• From the desired capital stock to

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• From the desired capital stock to

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• From the desired capital stock to

Copyright ©2017 Pearson Education, Ltd. All rights reserved. 4-33