Chapter 4

Consumption,
Saving, and
Investment

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Consumption and Saving
 Changes in consumers’ willingness
to spend have major implications
for the behaviour of the economy.
 Consumption accounts for about 60%
of total spending.
 The decision to consume and to save

are closely linked.

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Consumption and Saving
(continued)
 Desired consumption (Cd) is the
aggregate quantity of goods and
services that household want to
consume, given income and other
factors.

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Consumption and Saving
(continued)
 Desired national saving (Sd) is the
level of national saving that occurs
when aggregate consumption is at
its desired level.

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Consumption and Saving
(continued)
 When NFP (Net Factor
Payment)=0, national saving is:
S=Y-C-G
 Then, desired national saving is:

Sd=Y-Cd-G
*(Govt. Expenditures)

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The Consumption and
Saving Decision
 A lender can earn, and a borrower
will have to pay, a real interest
rate of r per year.
 1 dollars worth of consumption
today is equivalent to 1+r dollar’s
worth of consumption in the next
time period. (assuming inflation = 0)

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The Consumption and
Saving Decision (continued)
 The consumption-smoothing
motive is the desire to have a
relatively even pattern of
consumption over time.
 A one-time income bonus is likely
to be saved and the income
earned on that saving spread over
time.
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Changes in Current Income
 Marginal propensity to consume
(MPC) is the fraction of additional
current income that is consumed in
the current period.
 When Y rises by 1:
 Cd rises by less than 1;
 Sd rises by the fraction of 1 not spent

on consumption.

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Changes in
Income and Wealth
 Current consumption will increase
and current savings will decrease
when:
 expected future income increases,
because of the smoothing motive;
 wealth increases, because one does

not need to save as much for the

future anymore.

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Changes in
Income and Wealth
 Future
consumption
can be
estimated
using the
consumer
confidence
index

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Changes in the Real Interest
Rate
 For a lender an increase in r has
two opposite effects:
 increases the opportunity cost of current
consumption and thus increases current
saving (substitution effect);
 increases current income from wealth which
increases current consumption and
decreases in current saving (income effect).

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Changes in the Real Interest
Rate (continued)
 For a borrower when r increases
the substitution and income effects
both result in increased S.
 The empirical evidence is that an
increase in r reduces C and
increases S, but the effect is not
very strong.

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Taxes and the Real Return
to Saving
 The expected after-tax real
interest rate ( ra  )t is the after-tax
nominal interest rate minus the
expected inflation rate.
e
ra  t (1  t)i  π

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Taxes and the Real Return
to Saving (continued)
 By reducing the tax rate on
interest the government can
increase the real rate of return for
savers and (possibly) increase the
rate of saving in the economy.

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Fiscal Policy
 Let’s make an assumption that the
economy’s aggregate output is
given, it is not affected by the
changes in fiscal policy.
 The government fiscal policy has
two major components: the
government purchases and taxes.

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Government Purchases
 When the government increases
its purchases temporarily:
 Cd (Desired Consumption) falls,
because higher taxes and lower
income are expected.
 Sd (Desired Saving) increases,

because Cd falls.
 Sd falls, because G increases.

 A total effect on Sd is a fall.

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Taxes
 A government tax cut without
reduction of current spending
should:
 Increase income and, therefore, Cd by
a fraction of the tax cut.
 Raise expectations of higher taxes
and lower after-tax income in the
future.

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Taxes (continued)
 According to the Ricardian
equivalence proposition the
positive and the negative effects of
the tax cut without reduction of
the current spending should
exactly cancel.
 In reality it may be not so, since
many consumers get deceived.

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Investment
 There is a trade-off between the
present and the future.
 A firm commits its resources to
increasing its capacity to produce
and earn profits in the future.

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Investment (continued)
 Investment spending fluctuates
sharply over the business cycle
and typically contributes half of
the total decline in spending.
 Investment plays a crucial role in
determining the long-run
productive capacity of the
economy and its growth.
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The Desired Capital Stock
 Desired capital stock is an amount
of capital that allows a firm to earn
the largest expected profit.
 The marginal product of capital
(MPK) is the firm’s increase in
output due to adding a unit of
capital (other factors held
constant).
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The Desired Capital Stock
(continued)
 Managers compare the cost and
benefit of using additional capital,
e.g. a new machine.
 The firm’s benefit is MPKf – the
future MPK.
 The firm’s cost is the user cost of
capital.

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The User Cost of Capital
 User cost of capital is the expected
real cost of using a unit of capital
for a specified period of time.

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The User Cost of Capital
(continued)

uc rpK  dpK (r  d)pK

uc is the user cost of capital
r is the expected rate of interest
d is the rate at which capital depreciates
pK is the real price of capital goods

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Determining the Desired
Capital Stock
 The desired
capital stock is
the capital stock
where expected
profit is
maximized - at
which the MPKf
equals the uc.

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Determining the Desired
Capital Stock (continued)
 The MPKf curve slopes downward
because the marginal product of
capital falls as the capital stock
increases.
 The uc curve does not depend in
the amount capital and is a
horizontal line.

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Changes in the Desired
Capital Stock
 If r falls (other factors
held constant), the uc
falls (shifts
downward), then
MFKf>uc, and K rises.
 The same is true
when d or pK fall
(other factors held
constant).

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Changes in the Desired
Capital Stock (continued)
 When technology
improves (other
factors held
constant) the MPKf
curve shifts
upward, then
MPKf>uc, and K
rises.

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Taxes and the Desired
Capital Stock
 The after-tax MPKf is (1-τ)MPKf.
uc
f (r  d)pk
MPK  
1 τ 1 τ
 uc/(1-τ) is tax-adjusted user cost of
capital.

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Taxes and the Desired
Capital Stock (continued)
 An increase in the tax rate τ raises
the tax-adjusted user cost and so
reduces the desired stock of
capital.
 The effective tax rate is a single
measure of the tax burden on
capital.

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Investment
 The capital stock changes:
 Gross investment is the total
purchase or construction of new
capital goods.
 Depreciation is the capital wearing
out.

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Investment (continued)
 Net investment is the difference
between gross investment and
depreciation.
K t 1  K t  I t  dK t
I t  K t 1  K t  dK t
It is gross investment during year t.
Kt and Kt+1 is capital stock at the beginning
of year t and t+1.
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Investment (continued)
 The firm’s gross investment during
the year has two parts:
 the desired net increase in capital stock
over the year (K*-Kt);
 the investment needed to replace worn-
out or depreciated capital (dKt).
*
I t K  K t  dK t
(K* is the desired capital stock in the next period = Kt+1)

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Investment in Inventories
 A firm’s inventories are unsold
goods, unfinished goods, and raw
materials.
 Inventory investment is the most
volatile component of investment
spending.

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Investment in Inventories
(continued)
 Residential investment is the
construction of housing or
apartment buildings.
 A firm’s owner will compare the
benefits of keeping higher
inventories or renting out
apartments and the respective
user costs.
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Goods Market Equilibrium
 The real interest rate is the key
economic variable whose
adjustments help bring the
quantities of goods supplied and
demanded into balance.

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Goods Market Equilibrium
(continued)
 The goods market equilibrium
condition is:
d d
Y C  I  G
 Y is the quantity of goods supplied
by firms.
 The right hand side is the
aggregate demand for goods.

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Goods Market Equilibrium
(continued)
 The income-expenditure identity
for a closed economy (Y=C+I+G)
is always satisfied.
 The goods market is in equilibrium
when desired national saving
equals desired investment (Sd=Id),
since Sd=Y-Cd-G.

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The Saving-Investment
Diagram
 The saving curve, S, is upward
sloping. A higher real interest rate
raises desired national savings.
 The investment curve, I, is
downward sloping. A higher
interest rate increases the user
cost of capital and, thus, reduces
investment.

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The Saving-Investment
Diagram (continued)
 Adjustments of
the real interest
rate, in response
to excess supply
or demand for
saving, bring the
goods market into
equilibrium.

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The Saving-Investment
Diagram (Continued)
 Goods market equilibrium:
 Cd depends on r because a higher r
raises Sd.
 Id depends on r because a higher r

raises uc, which lowers Id.

 Adjustments of r eliminate excess
supply or demand for saving.

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Shifts of the
Saving Curve
 The saving curve shifters are all
factors, excluding the real interest
rate, which affect national saving.

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Shifts of the
Saving Curve (continued)
 Example. The crowding
out of investment by
government
purchases:
 increase in G causes a
decrease Sd;
 Sd curve shifts to the
left;
 the equilibrium r goes
up;
 Id falls because of higher
uc.

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Shifts of the
Investment Curve
 The investment curve shifters are
all the factors which affect
investment, excluding the real
interest rate (it determines the
movement along the curve).

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Shifts of the
Investment Curve
 Example:
 An innovation or
economic reform
raises MPKf.
 The increase in Id
shifts the investment
curve to the right.
 r rises to a new
equilibrium level.
 S increases.

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