Ch. 4 Consumption, Saving, and Investment

Saving = Income - Consumption

a household's decision about how much to consume and how much to save are really the same decision because

Desired National Saving (S^d)

the level of national saving that occurs when aggregate consumption is at its desired level

[= Y - (C^d) - G]

Desired Consumption (C^d)

the aggregate quantity of goods and services that households want to consume, given income and other factors that determine households' economic opportunities

an increase in current income

raises both desired consumption and desired saving for an individual or household

an increase in current output

raises both desired consumption and desired national saving at the national level

an increase in expected future income or in wealth

raises desired consumption at both the household and national levels

however, because these changes raise desired consumption without affecting current income or output, they cause desired saving to fall

Consumption-Smoothing Motive

the desire to have a relatively even pattern of consumption over time

Marginal Propensity to Consume (MPC)

the fraction of additional current income that an individual consumes in the current period

(between 0 and 1)

2 potential offsetting effects on saving caused by an increase in the real interest rate

1. a higher real interest rate increases the price of current consumption relative to future consumption (each unit of current consumption costs 1 + r units of forgone future consumption)

(Substitution Effect of the Real Interest Rate on Saving)

2. a higher real interest rate increases the wealth of savers by increasing the interest payments they receive, while reducing the wealth of borrowers by increasing the amount of interest they must pay

(Income Effect of the Real Interest Rate on Saving)

The substitution effect of the real interest rate on saving

in response to the increased relative price of current consumption, people substitute future consumption for current consumption by saving more today

tends to boost saving

reflect the tendency to reduce current consumption and increase future consumption as the price of current consumption (1 + r) increase

Income Effect of the Real Interest Rate on Saving

makes savers wealthier, makes savers consume more and reduce their saving

makes borrowers poorer, makes borrowers reduce their consumption and increase their saving

substitution effect (of real interest rate on saving) effect on borrower

increase saving

income effect (of real interest rate on saving) effect on borrower

increase saving

Expected Real After Tax Interest Rate

the real return that savers expect to earn after paying a portion of the interest they receive in taxes

the after-tax nominal interest rate minus the expected inflation rate

(measures the increase in the purchasing power of consumers' saving after payment taxes)

empirical studies suggest than an increase in the real interest rate

increases desired national saving and reduces desired consumption, but not by very much

a temporary increase in government purchases, with total output held constant

reduces desired consumption because higher government purchases imply increases in present or future taxes, which makes consumers poorer

however, the decrease in desired consumption is smaller than the income in government purchases, so that desired national saving falls as a result

Lump-Sum Tax Cut

a fixed amount of taxes assessed equally on all taxpaying entities regardless of their income level

Ricardian Equivalence Proposition

according to this idea, a current lump-sum tax cut should have no effect on desired consumption or desired national saving

the reason is that, if no change occurs in current or planned government purchases, a tax cut that increases current income must be offset by future tax increases that lower expected future income

if consumers do not take into account expected future tax changes, this idea does not hold and a tax cut is likely to raise desired consumption and lower desired national saving

Desired Capital Stock

the amount of capital that allows the firm to earn the largest expected profit

at this amount, the expected future marginal product of capital equals the user cost of capital

this amount is increased by any change that reduces the user cost of capital or increases the expected future marginal product of capital

this amount is also increased by a reduction in the taxation of capital, as measured by the effective tax rate

User Cost of Capital

the expected real cost of using a unit of capital for a specified period of time

it is the sum of the depreciation cost and the interest cost (the interest rate time the price of the capital good)

Depreciation Allowances

deductions of the amount of profit to be taxed that allow the firm to reduce its total tax payment

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

Investment Tax Credit

permits the firm to subtract a percentage of the purchase price of new capital directly from its tax bill

Effective Tax Rate

a single measure of the tax burden on capital that summarizes the many provisions of the tax code affecting investment

(an increase in the effective tax rate lowers the desired capital stock)

Net Investment

the change in capital stock over the year; the difference between gross investment and depreciation

(= gross investment - depreciation)

Gross Investment

the total purchase or construction of new capital goods that takes place each year

Goods Market Equilibrium Condition

when the aggregate quantity of goods supplied equals the aggregate quantity of goods demanded, which (in a closed economy) is the sum of desired consumption, desired investment, and government purchases of goods and services

also, when desired national saving equals desired investment

for any given level of output, the goods market is brought into equilibrium by changes in the real interest rate

for any fixed supply of output Y, it is represented graphically by the saving-investment diagram

alternative way to express: the quantity of goods supplied equals the quantity of goods demanded by households, firms, and the government

Saving Curves

slopes upward because empirical evidence suggests that a higher real interest rate raises desired saving

factors that shift saving curve to the right

any factor that raises desired national saving at a given real interest rate

factors that shift saving curve to the left

any factor that lowers desired national saving

Factors that Affect Desired National Saving

1. current output, Y

2. expected future output

3. wealth

4. expected real interest rate, r

5. government purchases, G

6. taxes, T

an increase in current output Y, causes desired national saving to

rise

because part of the extra income is saved to provide for future consumption

an increase in expected future output caused desired national saving to

fall

because anticipation of future income raises current desired consumption, lowering current desired saving

an increase in wealth causes desired national saving to

fall

because some of the extra wealth is consumed, which reduces saving for given income

an increase in expected real interest rate, r causes desired national saving to

probably rise

because an increase return makes saving more attractive, probably outweighing the fact that less must be saved to reach a specific savings target

an increase in government purchases, G, causes desired national saving to

fall

because higher government purchases directly lower desired national saving

an increase in taxes, T, causes desired national saving to

remain unchanged or rise