Chapter 4: Consumption, Saving, and Investment

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Chapter 4 Consumption, Saving, and Investment
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Assumptions

• Aggregate demand AD CIG(X-IM)
• Closed economy no foreign sector
• G is given
• Assume two major components of AD C and I

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Theories of consumer behavior

• Keynes absolute income hypothesis
• Permanent income hypothesis
• Life-cycle hypothesis

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Keynes Consumption function

• Absolute-income hypothesis
• Psychological law--as income rises consumption
  rises but not by as much as income
• Keynes assumes that consumption is a function of
  current income.
• C Co cY

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Implications

• redistribute income from the wealthy to the poor
  as a means of increasing AD.
• Refute the classical notion that the saving of
  the wealthy is a necessary and sufficient
  condition for economic growth.

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• Keynes consumption function served as the basis
  of Alvin Hansens interpretation of Keynes "The
  gist of the matter, then, is this Say's law is
  not valid because consumption in real terms rises
  absolutely less than output, or real income, . .
  . and this widening gap may or may not be filled
  by investment depending upon the prevailing
  strength of the factors (technology and
  population growth) which determine the volume of
  investment outlays." Alvin Hansen, A Guide to
  Keynes. (New York McGraw-Hill, 1953., p. 34).

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Life-cycle hypothesis

• Concerned how households allocate their income
  between consumption and saving
• households earn a stream of income over a
  lifetime
• households may consume more or less than their
  income for any given year

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• household consumption depends on
• rate of interest
• expectations regarding future income
• decision-making is intertemporal, meaning that
  households carefully consider how their present
  expenditures affect future consumption

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The Permanent income hypothesis

• People maximize utility based on their permanent
  (expected life-time) income
• Allocate their income intertemporally

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Household

• Assumptions
• One type of good Y the price of which is 1,
  serving as the numerarie (in other words, we use
  this good as a composite good, a unit of real
  GNP)
• Households produce a stream of output over T
  periods Y1, Y2, , YT
• Household consumes an amount C1, C2, , CT

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• If there is no saving, Y1 C1, Y2 C2, and so
  on
• If the commodity is storable, then the household
  may save
• C1 lt Y1 -- Saving
• C2 gt Y2 -- Dissaving

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Intertemporal Budget Constraint

• Assumptions
• Two periods
• Over a life-time income consumption,
• no assets at birth, no debt or assets upon death,
  no bequests to children
• Y1 Y2/(1 r) C1 C2/(1 r) W
• Hence, Y1 - C1 -(Y2 - C2)/(1 r)
• S1 -S2/(1 r)

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Household decision making

• Household will maximize utility subject to the
  intertemporal budget constraint
• In effect, the individual allocates his or her
  expected income over a life time in order to
  maximize utility
• Permanent income or wealth depends on
• Expected income
• Interest rate
• Inheritance

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Optimal Level of Consumption Maximizing utility

• Utility is maximized where the indifference curve
  is tangent to the intertemporal budget constraint
• This defines the optimal level of consumption
• UL UL(C1 , C2)
• Indifference curves are convex to the origin
  because
• Both goods are substitutes
• Diminishing marginal rate of substitution, as we
  take one unit of income away, we must compensate
  with higher levels of income to keep the
  individual at the same level of utility

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Effect of changes in interest rates

• Interest rate opportunity cost of consuming in
  the present (future income that could have been
  earned)
• An increase in interest rates people substitute
  away from current consumption
• A decrease in interest rates people substitute
  towards current consumption

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Effect of changes in income and wealth on
Consumption and saving

• An increase in current income
• An increase in future income
• An increase in wealth

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Permanent-Income Theory of Consumption

• Consumption depends on permanent income, which
  depends on current income and expected future
  income
• Households try to smooth out consumption over a
  lifetime

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Effect of Fiscal Policy on consumption

• Fiscal policy Governments power to tax and
  spend
• Fiscal policy affects desired consumption by
  affecting households current and future incomes

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Consumption and taxes

• C1 C2/(1 r) (Y1 - T1) (Y2 T2)/(1 r)
• Yd1 Yd2/(1 r)
• The effect of taxes on consumption and saving
  depend on whether tax changes are permanent,
  anticipated, or transitory
• Individuals will try to maintain their level of
  consumption over time

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• Transitory tax increase will reduce both saving
  and consumption in the present
• Permanent tax increase reduce consumption by the
  amount of the tax
• Anticipated tax increase and Ricardian
  equivalence
• A temporary tax cut today leads to anticipated
  tax increase
• result a rise in present saving equal to the tax
  cut
• Fiscal policy (tax cut) has no effect

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Effect of Government spending

• Government increases spending
• Consumers will anticipate future tax increases to
  pay for the increase in government spending
• Consumers will reduce their consumption, although
  generally not as much as the increase in
  government spending
• Ricardian equivalence proposition that the
  decline in consumer spending will match
  anticipated future tax increases, negating the
  expansionary effect of fiscal policy

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Household Liquidity Constraints

• Liquidity constraintinability of individuals to
  borrow
• Appears to be a relationship between savings
  rates and liquidity constraints

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Investment is

• most unstable component of GDP. changes in
  investment are the primary cause of the business
  cycle
• Investment comprises 15 of GDP

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Types of Capital and Investment

• Fixed business investment
• inventory investment
• investment in residential structures

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Gross and Net Investment

• I J dK
• where I gross investment
• J net investment
• dK depreciation of the capital stock
• K1 - K J
• K1 I K(1 - d) capital accumulation equation

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Shortcomings measuring investment

• Investment as defined by the national income
  accounts does not include all durable goods that
  raise future productivity
• Omits
• durable consumer goods
• spending on infrastructure
• human capital

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• Professor Robert Eisner argues that investment
  spending is probably greater, around 37 of GDP

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Theory of Investment

• We begin with how households make investment
  decisions
• Household allocates income between consuming now
  and saving for the future
• We now allow the household to purchase
  investment goods

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Ignore

• role of demand
• price level

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Production function

• Y Y(K,L)
• Characteristics
• MPk MPL gt 0
• diminishing returns to each factor, holding the
  other factor constant

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Households investment Decision

• Households may increase future output 2 ways
• lend money at interest rate of r (purchase bonds)
• purchase capital assets
• Q1 - C1 S1 B1 I1
• C2 Q2 (1 r)B1

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Household must make 2 choices

• How much to consume and save
• How much to divide between saving and investing
• If households knew the MPk gt r, the decision
  would be to invest

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Investment as a negative function of r

• Since MPk is downward sloping with respect to K,
  an increase in r must mean a decline in K
• Hence, I function is negatively sloped
• I I1(r)

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Max wealth under many periods the general case

• MPK1 d r
• Assume we purchase a computer, which will yield a
  return next year, and then sold

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• Pk Price of capital
• PV of income stream Pk(MPk1)/(1r)
• PV of scrap value Pk(1-d)/(1r)
• NPV - Pk Pk(MPk1)/(1r) Pk(1-d)/(1r) 0
• PkMPk1 - (r d)/(1r) 0
• PkMPk1/(1r) Pk(r d)/(1r)
• MPk1 (r d)
• NPV is positive if MPk1 gt r d

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Investment Decision

• Marginal product (MPK vs r depreciation)
• PV of income stream scrap value versus the cost

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Introducing taxes

• MPK1(1-t) d r
• MPK1 (d r)/((1-t)

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Role of Expectations

• Pk(MPk1) future revenue stream not discounted
• This revenue steam is uncertain
• it is the anticipated income from a prospective
  investment
• J.M Keynes asserted that investment largely
  depends on the expectations of entrepreneurs,
  what Keynes called animal spirits
• optimism or pessimism that is reflected in the
  prospective return

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Goods Market Equilibrium

• Y Cd Id G
• Y - Cd G Sd
• Sd Id

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Saving and Invesment

• Classical view interest rates adjust to ensure
  that S I
• Keynes
• Decisions to save and invest are made by
  different economic agents for different reasons
• No reason to think that interest rates will
  ensure that S I at full employment
• Implication the economy may achieve equilibrium
  at less than full employment