Chapter 4: Consumption, Saving and Investment (Goods market)

How do we denote desired consumption? What is desired consumption?

the aggregate consumption of the US 

What is desired national saving? How do we denote desired national saving?

Desired national saving is the aggregate level of desired saving in the US

What is the consumption smoothing motive?

This is the concept that consumers want to avoid periods of extremely high and low consumption to maintain their lifestyle. They will save and consume as necessary to keep up with the consumption pattern they wish.

What is the marginal propensity to consume?

This is the amount of desired consumption that increases when current income rises by 1 unit, MPC will fall in between 1 and 0 if current income is consumed. It is represented by the fraction of current consumption/current income. Current income minus current consumption will equal current saving.

What is the real interest rate, how does it relate current consumption to future consumption?

The real interest rate is the conversion rate of current consumption to future consumption, meaning that if $600 of current income is consumed today then 600(1 + 0.06)- with r being equal to 0.06 then 600 ×1.06= 636 of future income was consumed today. If total income was $1000, then 636 of the future was consume and 400 was saved, meaning that there will be $424 left for future consumption (b/c 400 × 1.06= 424).

What will happen to national saving if the real interest rate rises?

National saving will rise because, you will better off saving with higher interest as that interest will cause you to have higher future savings. This is known as the substitution effect of a higher real interest rate. You will substitute current consumption for more future consumption.

What will happen to consumption if the real interest rate rises?

Current consumption will decline as it will cost more to borrow against future consumption

What is the income effect of a higher real interest rate?

The income effect of a real interest rate is the effect of a real interest rate is mainly on lenders, it’s when the real interest rate is expected to be higher over time, meaning that lenders will earn more income over time on their savings and they feel rich enough to spend their savings and increase current consumption.

How does the substitution effect and income effect of a higher real interest rate function for borrowers?

Both effects work in the same direction for borrowers, with the substitution effect, they have to temporarily decrease their current consumption because they have borrowing constraints, this decrease in consumption will mean an increase in their saving. The income effect will cause the same situation as borrowers will see the decrease in income over time causing them to reduce consumption over time and save more as a result.

How does the substitution effect and income effect of a higher real interest rate function for lenders?

The substitution effect and income effect work in opposite directions. For the substitution effect, lenders will temporarily decrease current consumption and increase current saving to ensure that they are able to make the most of the temporary increase. The income effect allows lenders to earn more income over time, so they will smooth their consumption by consuming more over time and reducing saving as a result.

What is the effect of higher wealth on saving and consumption?

Saving will decrease as higher wealth will encourage higher consumption

What is the effect of an expected rise in future income on current saving and consumption?

Current consumption will rise

What is the expected real after tax-interest rate?

This is the after-tax interest rate on savings. Otherwise known as the after tax nominal interest rate minus the expected inflation rate, pie to e (shown in the photo)

i= nominal interest rate

t= the rate at which income is taxed

(1-t)= total interest earned

(1-t)i= nominal after tax interest rate received by savers after taxes

r sub a-t= the expected real after tax interest rate

pie to the e power= the expected inflation rate

What does the expected real after-tax interest rate measure?

It measures the increase in the purchasing power of their savings after the payment of taxes. (It measures how much savings is worth after taxes).

What does a higher expected real after-tax interest rate imply about saving?

More savings are acquired with a higher interest rate, because the taxes will be at a certain amount while a higher interest rate allows savings to be compounded at higher rates.

How does Fiscal Policy affect desired consumption and desired saving (assuming that it’s not affecting supply and the economy is at full employment)?

Fiscal policy is related to desired consumption and saving in terms of taxes, government spending will lead to higher taxes and a tax cuts will also lead to higher future taxes.

What does an increase in government purchases imply about future taxes?

Future taxes will be higher to make up for the increase in government purchases.

How does a rise in current output affect desired national saving?

Desired national saving will rise as a result of the extra income that is not consumed (it will be saved for future consumption).

How does a rise in expected future output affect the desired national saving?

The rise in expected future output causes desired national saving to fall, this is because current consumption will rise to meet with the rise in expected future income. That future income is expected to compensate the current loss in saving.

How does a rise in wealth affect desired national saving?

A rise in wealth reduces current saving by increasing the current consumption, this is because some of the extra wealth will be consumed before it is saved.

How does a rise in the expected real interest rate affect the desired national saving?

This will cause desired national saving to rise because there’s an increase on the return to saving, less will have to be saved to meet a certain saving target.

How does a rise in Government purchases affect the desired national saving?

A rise in government purchases directly lowers national saving, because they are taking away what was saved.

What is the Ricardian Equivalence?

This is when the rise in taxes is met with the fall in taxes, it implies that when taxes are high desired national saving isn’t actually affected because the lump sum taxes will cause current consumption to rise again by the same amount that was originally saved. (This only holds if consumers realizes that the future tax cuts that will result after the taxes are temporarily risen).

How does a rise in taxes affect the desired national saving?

A rise in taxes will cause national desired saving to either remain unchanged due to Ricardian equivalence, if that doesn’t hold then it is assumed that a rise in taxes will cause desired national saving to rise because taxes reduce current consumption.

How much total output is due to gross investment?

1/6th of total output results from investment.

How much does aggregate spending decline to less investments during recessions or stock market busts?

50% or more of the total decline in spending is due to less investment spending, even though investment is 1/6th of GDP.

What is desired capital stock?

A firm’s desired capital stock is the amount of capital that allows firms to earn the maximum amount of profit.

What is the marginal product of capital? How does it relate to expected future marginal product of capital?

Denoted as MPK, this is the extra amount of marginal benefit the firm receives from an additional unit of capital. The expected future marginal product of capital follows the current MPK in that firms will use current MPK to decide if future MPK will be high enough to invest into more units of capital. We take future MPK into account when investing because capital usually takes a while to become marginally useful (i.e. it takes time building laptops, factories, etc.) Future MPK is noted as the image

What is the user cost of capital?

The user cost of capital is the expected real cost of using a unit of capital for a period of time. The terms in the image, denote the terms in the equation of solving for user cost. User cost is equal to the rate of depreciation plus the expected real interest rate times the price of capital.

What is the firm maximizing level of desired capital stock considered to be?

This is when the firm’s future expected MPK of desired capital stock is equal to the user cost of capital. This is because when future expected MPK is equal to the user cost, then the cost of capital is equal to the benefit of capital. If MPK exceeds the user cost then it’s advisable to invest into more capital, when MPK is less than user cost then purchasing more capital is more expensive for what it’s worth.

How do we measure the return on investment after taxes?

We compare the after tax future expected marginal product of capital to the before tax future expected marginal product of capital. More specifically, we would multiply the amount that isn’t being taxed by the expected future marginal product of capital. We would also divide the amount that isn’t being taxed by the user cost.

What is a depreciation allowance?

Because firms are usually taxed on their profits, what most will do to stopped being taxed is use something known as a depreciation allowance. This would allow firms to reduce their total tax payment by deducting taxes off the price of capital.

What is an investment tax credit?

This when firms are able to subtract a proportion of their investment into capital off taxes. For example, A 15,000 investment into capital with a 10% investment tax credit means that firms can take 10% of that 15,000 (1500) and subtract it off their taxable profits, instead of 60,000 in taxable profit, they would only be taxed on 58,500.

What is the effective tax rate?

This is the tax rate that would have the same effect on desired capital stock as actual tax provisions would have on desired capital stock.

What is gross investment?

This is the amount of investment into total capital stock that is either purchased or constructed each year. Denoted by the terms in the image, and the equation describing their relationship in the second image. Gross investment equals net investment (K sub t plus 1 minus k sub 1) minus depreciation (dk sub t).

What is net investment, how would we calculate net investment?

Net investment = Gross investment - depreciation, net investment is the change in capital stock over the year.

How is desired capital stock related to gross investment?

Any factors that affect the desired capital stock, will affect gross investment

How does a rise in the real interest rate affect the desired investment?

Desired investment will fall as a result of the user cost of capital increasing, which reduces the desired capital stock.

How does a rise in the effective tax rate affect desired investment?

Desired investment will fall as a result of the tax adjusted user cost increase, which reduces desired capital stock.

How does a rise in the expected future MPK affect desired investment?

Expected future MPK will cause desired investment to rise because the desired capital stock will have increased.

What is Tobin’s Q/ what is Q theory?

Q theory is the theory that the cost of capital will adjust with the increase in marginal cost. The stock market value of a firm divided by the price of new capital goods and the amount of current is the formula for Tobin’s Q. (Follows our theory of investment so far).

What is the condition required for the goods market to be equilibrium?

When desired national saving is equal to desired investment, this will require a certain interest rate.

What is the relationship between investment, savings and the real interest rate?

As savings rise, investments fall. The interest rate dictates which will be higher at a given moment- if the interest rate is high then savings is high and investment is low, if the interest rate is low then savings are low and investments are high.

What does the term “Crowded out” imply?

This specific term refers to the instance where government spending rises, this will cause national saving to fall, which will then cause the real interest rate of the goods market to rise (lowering investment). It crowds out investors from being able to invest in the goods market, as they have been replaced by government spending.