Yousuf_16_20894_2_Chapter04 3

Chapter 4: Consumption, Saving, and Investment

Page 1: Overview

• Focus on consumption, saving, and investment within the economy.

Page 2: Introduction

• Previous chapter examined the supply side of the economy.

• Current chapter addresses the demand for goods and services.

• Aim to develop an equilibrium condition for the goods market.

Page 3: Components of Aggregate Demand

• Key Elements of Desired Spending:

  • Consumption

  • Investment

  • Government Purchases (considered given)

  • Net Exports (assumed zero)

Page 4: Spending and Saving

• Analysis of desired spending inherently involves saving.

• Consumers typically spend part of their income and save the rest.

• Spending indicates demand for output, while saving indicates potential for future investment.

Page 5: Saving

• Definition from Chapter 2:

  • Aggregate saving in a closed economy context.

Page 6: Desired Spending

• Essential to distinguish between “planned” and actual spending.

• Government spending is assumed to match planned expenditure.

Page 7: Goods Market Equilibrium

• Equilibrium condition: desired spending = output.

• This translates to desired saving = desired investment after adjusting for consumption and government spending.

Page 8: Further Exploration of Spending

• Equilibrium requires that desired spending matches output, necessitating an analysis of consumption, investment, and government spending determinants.

Page 9: Consumption and Saving Decisions

• Decisions on how to allocate income between current consumption and future saving.

• Real interest rate influences choices between immediate consumption and future benefits from saving.

Page 10: Consumption Timing and Interest Rates

• Example with real interest rate (r) of 3% highlights the trade-off between today's consumption and future consumption value.

• Changes in the price of consumption today will affect individual decisions.

Page 11: Income Effect vs. Substitution Effect

• Income Effect: Consumers opt for higher-quality goods when they feel wealthier or if prices rise.

• Substitution Effect: Consumers replace pricier items with more affordable alternatives as circumstances shift.

Page 12: Real vs. Nominal Interest Rate

• Real Interest Rate: Adjusted for inflation, indicating true cost to borrowers and yield to lenders.

• Example calculation demonstrating the relationship between nominal rates and inflation effect.

Page 13: Real Interest Rate Impact on Consumption

• Changes in real interest rate cause both income and substitution effects on consumption behavior.

• Higher r discourages current consumption while encouraging saving (substitution effect).

Page 14: Aggregate Effects of Real Interest Rates

• Mixed outcomes from income and substitution effects; real interest rate increases likely decrease current consumption but increase saving.

Page 15: Expected After-Tax Real Rate of Interest

• Taxes on interest complicate true returns; focus must shift to the expected after-tax real return.

Page 16: Calculating After-Tax Interest Rates

• Examples showing how taxation impacts expected real interest rates.

Page 17: Other Consumption Determinants

• Factors affecting desired current consumption:

  • Current income fluctuations

  • Expected future income

  • Changes in wealth (e.g., stock market effects)

  • Government spending and taxes

Page 18: Determinants of Desired Consumption vs. National Saving

• Analysis of how consumption and saving relate to economic indicators and expectations about the future.

Page 19: Government Purchases and Consumption Dynamics

• Short-term government spending boost impacts consumption behavior; consumers may smooth consumption rather than respond dollar-for-dollar.

Page 20: Tax Cuts and Consumption Behavior

• Tax reductions may not significantly influence current consumption due to anticipatory behaviors regarding future taxation (Ricardian equivalence).

Page 21: Government Purchases Impact on Consumption

• Expected future tax increases can prompt immediate consumption reductions even if current tax burdens are lightened.

Page 22: Revisiting Equilibrium

• Recap of goods market equilibrium conditions; reinforcing the relationship between desired consumption, saving, and investment.

Page 23: Investment and Capital Stock

• Investment sees a crucial role in augmenting the existing capital stock, related to firms' capital needs.

Page 24: Firm's Capital Stock Decisions

• Capital operates similar to labor; firms' decisions on capital use are rooted in profit maximization strategies.

Page 25: Understanding User Cost of Capital

• Define the expected real cost tied to using capital effectively.

Page 26: Analyzing User Cost of Capital

• Breakdown of costs associated with capital, focused on depreciation and foregone interest earnings.

Page 27: Desired Capital Stock Dynamics

• Capital stock aligned with expected returns versus the user cost defines optimal investment behavior.

Page 28: Influences on Desired Capital Stock

• Changes in either marginal product of capital or user cost will affect desired capital stock and investment levels.

Page 29: Taxation and Capital Stock Decisions

• Revenue taxation necessitates adjustments in profit expectations affecting capital stock decisions.

Page 30: Investment Flows

• Investment represents spending that enhances capital stock based on current needs versus desired future state.

Page 31: Summary of Investment Determinants

• Overview of conditions influencing desired investment levels and the ripple effects of various economic changes.

Page 32: Goods Market Equilibrium Restated

• Confirmation that desired spending equals output, elucidating equilibrium dynamics.

Page 33: Distinguishing Equilibrium Condition from Identity

• Clarify that equilibrium is contingent on desired spending aligning with output versus mere national accounting identities.

Page 34: Pressure Dynamics in Equilibrium

• Describes market reactions when desired spending does not meet output, prompting adjustments from producers.

Page 35: Equilibrium Diagram Exploration

• Diagram showing relationships between desired saving and investment, with emphasis on interest rate impact.

Page 36: Visualizing Equilibrium

• Graphical representation of desired saving and investment curves demonstrating their interactions at different rate levels.

Page 37: Adjustments to Expected Real Rate of Interest

• Discusses shifts due to mismatches between output and desired spending affecting interest rates' role in economic adjustments.

Page 38: Shifting Curves in Response to Economic Changes

• Outlines how changes in external factors (like government spending or technological advances) shift saving and investment curves accordingly.

Page 39: Recap of Economic Components

• Summary of labor market equilibrium and its interplay with goods market dynamics, integral to overall economic modeling.

Page 40: Conclusion of the Chapter

• Wrap-up of discussion around consumption, saving, investment, and their economic implications.