Consumption, Saving and Investment

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Consumption, Saving and Investment

• Part I

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Overview

• Desired Consumption and Saving
• Current and Future Income
• Wealth
• The Real Interest Rate
• Government Saving
• Desired Investment
• Desired Capital Stock
• Flow of Investment
• Goods Market Equilibrium

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Assumptions

• Closed Economy
• With Government
• GDP GNP Y

Sd desired (national) saving Cd desired
consumption G - government purchases Sd Y Cd
- G
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Consumer Attitudes and Consumption
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Life-cycle of consumption and income
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Life-cycle consumption, income, and saving
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Current vs. Future Consumption
Imagine that individuals have to choose between
consumption over two time periods. c current
consumption cf future consumption s saving r
real interest rate y current income yf
future income
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Period 1 c s y Period 2 cf (1r)s
yf Combining these two equations cf (1 r)(
y - c) yf cf (1 r)y - (1 r)c yf (1 r)
represents the relative price of current
consumption to future consumption. Alternatively,
the relative price of future consumption is 1/(1
r).
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Determining Consumption and Savings
cf
(1r)y yf
s y c
Slope -(1r)
cf
U2
U1
U0
c
c
y yf
1r
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Determinants of Consumption and Savings

• Current and Future Income
• Wealth
• The Real Interest Rate

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An increase in income or wealth
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An increase in the real interest rate
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Real after-tax interest rates
Expected after tax interest rate
Tax rate on interest earnings
Nominal interest rate
Expected inflation rate
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Ricardian Equivalence

• A tax cut should have no effect on consumption or
  national saving.
• Individuals recognize that all government
  purchases will have to be paid now or in future
  periods and save the amount of the tax cut.
• Private saving increases by the same amount as
  the fall in government saving, leaving national
  saving unchanged.

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A Ricardian Tax Cut?
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National Saving

• National Saving Y C - G
• Determinants of National Saving
• Current Output
• Expected Future Output
• Wealth
• Expected real interest rate
• Government Purchases
• Taxes

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Desired Investment

• Future Marginal Product of Capital MPKf

• User cost of Capital (uc)

Expected real interest rate
Real price of capital goods
Rate of depreciation of capital
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Determination of the desired capital stock
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A decline in the real interest rate raises the
desired capital stock
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An increase in the expected future MPK raises the
desired capital stock
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Effective tax rate on capital
The tax rate on firms revenue that would have
the same affect on the desired capital stock as
the actual provisions in the tax code.
Tax rate on firms revenue
After-tax future MPK
Tax-adjusted user cost of capital
New optimal condition for firm
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Effective Tax Rate on Capital, 1990, Selected
Countries
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Gross and net investment, 19262000
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Determinants of Desired Investment

• Real interest rate
• Effective tax rate
• Expected future MPK