Econ prelim 2

Consumption (C)

all household spending on final goods and services; roughly 68% of US GDP

Consumption function

C = C₀ + MPC × Y

C₀ (autonomous consumption)

baseline spending that happens even at zero income; the y-intercept of the consumption line

MPC (Marginal Propensity to Consume)

fraction of each extra $1 of income that gets spent; always between 0 and 1; slope of the consumption line

MPS (Marginal Propensity to Save)

fraction of each extra $1 of income that gets saved; MPS = 1 - MPC

MPC + MPS = ?

1 (always — every dollar is either spent or saved)

Saving formula

S = Y - C = -C₀ + MPS × Y

Dissaving

consuming more than your income; funded by drawing down savings or borrowing

Flow variable

a value measured over a time period (e.g., saving $5,000 this year)

Stock variable

an accumulated level at a point in time (e.g., total wealth = $50,000)

Is saving a flow or stock?

flow — it builds up the stock of wealth over time

Nominal interest rate formula

i = r + π (nominal = real + inflation)

Real interest rate

nominal rate minus inflation; what you actually gain in purchasing power

Rational rule for consumers

spend an extra dollar today only if its marginal benefit ≥ benefit of saving it and having (dollar + interest) tomorrow

Consumption smoothing

maintaining a stable, steady path of consumption over your lifetime regardless of income timing

Permanent income

your best estimate of your average income over your entire lifetime

Permanent Income Hypothesis (PIH)

households base consumption on permanent income, not current income

Temporary unanticipated income rise → effect on consumption smoothers

small ↑C — they spread the windfall over their remaining life

Permanent unanticipated income rise → effect on consumption smoothers

large ↑C — they revise permanent income upward

Anticipated income rise → effect on consumption smoothers

no change — already priced into permanent income

News of future income rise → effect on consumption smoothers

large ↑C NOW — they factor the news into permanent income immediately

Temporary income rise → effect on hand-to-mouth consumers

large ↑C — they spend it immediately

Permanent income rise → effect on hand-to-mouth consumers

large ↑C

Anticipated income rise → effect on hand-to-mouth consumers

large ↑C when it arrives — they couldn’t borrow against it before

News of future income rise → effect on hand-to-mouth consumers

no change — can’t borrow against future income

Hand-to-mouth consumers

people who consume almost all income on necessities; no savings buffer; can’t smooth consumption

Credit constraints

inability to borrow as much as desired; caused by lack of collateral or insufficient current income

Collateral

an asset a bank can seize if you fail to repay a loan

Precautionary saving

saving extra as a buffer against uncertainty; spiked to ~32% during COVID in spring 2020

What shifts the consumption curve down?

higher real interest rates, pessimism, higher taxes, wealth decrease

Investment (macro definition)

purchases of NEW capital that expand productive capacity; NOT buying stocks or bonds

Investment as % of GDP

roughly 18%

Is investment a flow or stock?

flow — it builds up the capital stock over time

Capital stock

the total accumulated stock of productive capital in the economy

Depreciation

decline in capital stock due to wear, obsolescence, or aging

Types of investment (5)

business equipment, business structures, intellectual property, housing, inventory changes

Why is investment important to business cycles?

it is far more volatile than GDP and a major driver of recessions and expansions

Present value of profits formula

Next Year’s Profit ÷ (r + d)

Future Value formula

FV = PV × (1 + r)^T

Present Value formula

PV = FV ÷ (1 + r)^T

Rational rule for investors

invest only if Upfront Costs ≤ Next Year’s Profit ÷ (r + d)

Why does higher r reduce investment?

higher r raises opportunity cost of capital AND reduces present value of future profits

Investment function

I = a - b × r (downward sloping — investment falls as real interest rate rises)

What shifts the investment curve right?

tech advances, business optimism, cheaper capital goods, looser lending

What shifts the investment curve left?

higher corporate taxes, tighter lending, business pessimism

Loanable funds market

market where savers supply funds and businesses demand funds for investment; determines equilibrium interest rate

Supply of loanable funds

private saving + government saving + foreign saving

Demand for loanable funds

business investment borrowing

Neutral real interest rate (r*)

equilibrium rate at which the economy produces at full potential

Crowding out

government borrowing competes with private sector for savings, pushing up interest rates and reducing private investment

Government deficit → effect on r*

pushes r* UP → less private investment (crowding out)

Increase in private saving → effect on r*

shifts supply right → r* falls → more investment

Bond

an IOU in which a borrower specifies repayment terms; used when loan is too large for a single bank

Face value / par value / principal

the amount repaid at maturity (NOT the market price of the bond)

Maturity date

the date the bond issuer repays the principal

Coupon

regular interest payments made on the face value of a bond

Buying a bond at par

paying exactly face value

Buying a bond below par (at discount)

paying less than face value (e.g., $950 for a $1,000 bond)

Buying a bond above par (at premium)

paying more than face value (e.g., $1,050 for a $1,000 bond)

Current yield formula

Coupon payment ÷ Price paid

Current yield example: 5% coupon $1,000 FV bond bought for $950

$50 ÷ $950 = 5.26%

Yield to Maturity (YTM)

total annual return if you buy at today’s price, collect all coupons, and hold until maturity

YTM example: 5% coupon $1,000 bond bought for $950 with 1 year to maturity

($50 + $50 capital gain) ÷ $950 = 10.5%

Bond prices and yields move in what direction?

opposite directions — price up = yield down, price down = yield up

4 functions of the bond market

channeling funds from savers to borrowers; funding government debt; spreading risk; creating liquidity

Default risk

risk the borrower won’t repay; rated AAA (safest) to CCC (riskiest) by Fitch/Moody’s/S&P

Higher default risk → effect on coupon

higher coupon payments demanded by investors

Term risk

uncertainty about future interest rates; longer maturity = more term risk = higher yield demanded

Liquidity risk

risk of not finding a buyer quickly at a fair price if you need to sell your bond early