Chapter 4: Consumption, Saving , and Investment

1

• Chapter 4 Consumption, Saving , and Investment
• Focus
• Determinants of consumption, saving, and
  investment in a closed economy.
• Inter-temporal trade-off between consumption now
  and consumption tomorrow.
• Effects of fiscal policies on consumption,
  saving, and investment
• How goods market achieves equilibrium?

2

• Consumption
• The decision to consume is equivalent to decision
  to save (negative consumption).
• Main Determinants of Consumption (Saving)
• Real Rate of Interest
• Current Income
• Future Income
• Wealth

3

• The real rate of interest determines the cost of
  todays consumption in terms future consumption
  forgone.
• Consumption-smoothing motive The desire to have
  even (or flat) pattern of consumption over time.
• We assume that individuals have
  Consumption-smoothing motive.
• Marginal Propensity to Consume (MPC) Increase in
  consumption for a unit increase in income.

4

• The Substitution Effect of the Real Rate of
  Interest The tendency to reduce the current
  consumption when the real rate of interest rises.
  
• The Income Effect of the Real Rate of Interest
  The tendency to increase the current consumption
  when the real rate of interest rises.
• These two effects have opposite effect on the
  current consumption of a saver.
• In the case of a borrower, these two effects
  reinforce each other and reduce the current
  consumption.

5

• Any change in current taxes, holding current and
  future government expenditure constant, does not
  affect desired consumption and saving. This is
  called the Ricardian Equivalence Proposition.
• The Ricardian Equivalence Proposition holds only
  when consumers take into account offsetting
  changes in future taxes.
• In the case this assumption does not hold, higher
  current taxes reduces desired current consumption
  and increases the desired saving.
• Any increase in the government expenditure (G)
  reduces the desired level of consumption and
  saving.

6

• Investment
• While making investment firms compare the cost of
  making investment (real rate of interest
  depreciation) with the benefit of investment
  (expected MPK).
• Desired capital stock Amount of capital that
  maximizes the expected profit.
• User Cost of Capital real rate of interest
  depreciation
• The desired stock of capital is determined by the
  condition
• User cost (uc) Expected MPK (MPKf)

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• In the case, the government imposes tax on
  output, the desired capital stock is given by the
  condition
• (1 tax rate ) MPKf uc
• Or, MPKf (uc/(1-tax rate))
• Capital stock and investment satisfy following
  identity
• Net Investment Gross Investment -Depreciation
• Kt1 Kt It - dkt

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• If the desired capital stock (Kt) is same as the
  actual capital stock, then we have
• It Kt1 Kt dkt
• For making investment in inventories and housing
  as well, one compares the cost of investment with
  the benefit of investment.

9

• Goods Market Equilibrium
• The equilibrium in goods market is given by the
  condition that supply of goods and services
  equals demand for goods and services
• Y Cd Id G
• Or, Y - Cd G Id
• Or, Sd Id