Download Consumption, Savings & Investment

Assumptions for discussion on this topic
 In our class on National Income we saw that output
Y = C + I + G + NX
 We shall ignore NX. This means we are assuming
that our economy is closed.
 In this class we shall focus on C and I.
 G has implications for both C and I. But we shall try
to limit discussion on G in this class as we shall have
a full discussion on G in our Fiscal Policy class.
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What do C and I imply?
 C indicates the level of consumption. Therefore, C also
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stands for aggregate demand for goods and services by the
households.
C also indicates how much is saved by the household.
I stands for investment. This indicates how much is spent
for producing goods and services to be consumed by the
households.
I includes acquisition of capital goods by the firms, which
actually indicates the productive capacity of economy.
I indicates CAPITAL FORMATION, which is important to
understand economic growth.
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Consumption and saving
 From our class on National Income recall that
National savings (S) = Private savings + Govt. saving
= Y – (T – TR – INT) + NFP – C + (T – TR – INT) – G
= Y + NFP – C – G
 As our economy is closed NFP in the above equation is
equal to zero. Therefore, saving in a closed economy is
equal to: Y – C – G
 We shall start looking at consumption and saving at
the individual level. Because, individual level behavior
determines the aggregate level behavior.
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Decision of an individual on C and S
 Consumption is about spending during present time. Savings is for consuming
in the future.
 However, consumption more than current income during present time means
negative savings for future.
 A person can always trade-off current and future consumption.
 Economic theories suggest that this trade-off depends on the REAL
INTERESRT RATE
 Real interest rate is defined as:
Nominal interest rate – inflation
 Example: A person spends Tk. 100 to consume potato today. Nominal interest
rate is 10% and inflation rate is 5%. At present, price of potato is Tk. 10/kg.
Another person saves Tk. 100 in bank account to consume potato one year later.
How would you compare consumption of these two persons?
 The higher the real interest rate, the more people will want to save for future
consumption.
 However, people generally tend to spread their consumption rationally over
time. This is called “consumption smoothing”.
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Determinants of C and S
 Some important determinants of economic wellbeing
of a person are Current income
 Expected future income
 Wealth and
 Real interest rate
 Changes in any of these will affect consumption of the
individual.
 To see how the effects work let us assume that the real
interest rate is fixed
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Effect of changes in current income
 A change in the current income works in two ways It may change the individual’s current consumption
 It may change the individual’s future consumption by changing savings
today
 The decision about how much the consumption today changes
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depending on a change in today’s income is called “marginal
propensity to consume” (MPC).
MPC indicates the percentage of the increased income that is spent for
consumption.
Example: If MPC is 0.40, it means that if income of an individual
increases Tk. 100 today, she will spend Tk. 40 of this additional income
for consumption.
Note that in this case the person is saving 60% of her increased income
for future consumption. This rate of savings is called “marginal
propensity to save”.
MPC + MPS is always equal to 1.
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Effect of changes in expected future income
 Depending on the expected future income a person’s current
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consumption may also change.
The consumption smoothing motive will guide the person to
consume today at least some of the expected future income.
Note that if the person increases her current consumption, her
current savings will reduce. If needed, she might even consume
more than her current income.
Example: We use credit cards to consume today. This is actually
consuming by borrowing based on the expectation that we shall
be able to pay it back in future. If a person expects that she will
be promoted to a higher rank in her office having better
remuneration, she might actually increase the use of her credit
card today, before she gets the promotion.
Example: We spend on Eid shopping before we get Eid bonus.
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Effect of changes in wealth
 Wealth is defined as: Assets – Liabilities
 Increase in wealth induces current consumption
and therefore reduces savings.
 A decrease in wealth will do just the opposite.
 Example: During stock market boom we tend to
consume more than normal times. When the
market crashes we consume less.
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Effect of change in real interest rate
 An increase in the real interest rate means that savings will
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have higher payoff in future. Therefore, it increases savings.
It also means that a targeted future consumption level can
be reached by saving smaller amounts today! This means:
real interest rate may induce current consumption and
reduce current savings.
These two forces work in opposite direction.
The first phenomenon is known as the substitution effect
of the real interest rate on saving.
The second phenomenon is known as the income effect
of the real interest rate on saving.
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Summary: Determinants of Savings
An increase in
Causes
savings to
Reason
Current income
Rise
Part of the extra income is saved
Expected future
income
Fall
Anticipation of increased future
income induces current consumption
Wealth
Fall
New stock of wealth secures future
consumption level and makes more
of current income free for
consumption.
Expected real
interest rate
Not clear.
Probably rise.
Increased rate produces higher payoffs in future and thus may make
savings more attractive.
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Investment
 Investment is putting money into something to get
some return or avoid loss.
 Investment is related to savings.
 We study investment so that we can assess the longrun productive capacity of economy by looking at
investment
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Determining the level of investment
 We need to determine the desired capital stock of the firms to
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determine the level of investment.
If the marginal product of capital (MPK) is greater than the marginal
cost of capital then firms will use more capital. Marginal cost of capital
is sometimes referred to as “user cost of capital”.
Recall that a firm’s profit is maximized at the point where MC = MR.
Similarly, the desired capital stock of the firm will be at the point where
MPK = user cost of capital.
If the MPK has the property of diminishing return then the curve of
MPK will slope downward.
On the other hand, the user cost of capital will generally be fixed and
therefore the curve of user cost of capital will be a straight horizontal
line. For example: when we borrow from bank, bank charges us fixed
interest rate. If the interest rate were variable, user cost of fund would
not be horizontal straight line.
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Desired level of capital stock
 Like the profit
maximizing level of
employment (where
MPN is equal to wage),
profit maximizing level
of capital is where user
cost of capital and MPK
are equal.
 On the left of K* there is
still room for the firm to
use capital to get more
return than cost of the
capital.
 On the right of K* use of
capital is no more
profitable.
 Desired level of capital
changes when MPK or
user cost of capital
change.
MPK and uc
uc
MPK
K*
K
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From capital stock to investment`
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From capital stock to investment
 Rearranging equation 1 we get:
I t  K t 1  K t  dK t ...............(2)
 Equation 2 has two parts:
 The net increase in capital stock during the year
and
 Investment needed to replace the worn-out
capital stock.
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Goods market equilibrium
 An important question is: how do we know that the goods and
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services that the consumers and investors want to buy will be the
same as the amount that the producers are willing to provide?
The real interest rate is a key element that whose adjustment
helps to find the answer.
If the goods market is in equilibrium, the supply of goods will
match with the demand for goods.
The national income identity for a closed economy is:
Y=C+I+G
The left hand side indicates the amount of output supplied by
the producers.
The right hand side indicates the amount of goods and services
demanded by the consumers, investors and the government.
Therefore, the national income identity can also be perceived as
the goods market equilibrium condition.
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Goods market equilibrium
 Rearranging the national income identity we get:
Y–C–G=I
S=I
 This means that the goods market will be in equilibrium
when savings will be equal to investment.
 This is another way of expressing the goods market
equilibrium.
 Both savings and investment are affected by real interest
rate.
 If real interest rate increases, savings increases and
investment decreases and vice versa.
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Goods market equilibrium
 Goods market equilibrium is
at E.
 Any deviation from point E
will not sustain and will
come back to it again.
 For example: when the real
interest rate is lower than the
equilibrium rate, then the
investors will want to invest
more than the savers want to
lend.
 Note that at the equilibrium
point total output of the
economy will be equal to the
sum of consumption,
investment and government
purchases.
Real interest rate
I
S
E
A
B
C
D
S, I
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Savings and investment in open economy
 Goods market equilibrium in open economy will be established when:
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S = I + NX + NFP
But NX + NFP = current account balance (CA)
Therefore the equilibrium condition for open economy will be:
S = I + CA
This means that when savings is more than investment, the economy
will have more idle money to lend to foreigners. The amount of idle
money that can be lent to the foreigners will be equal to CA. In this
case the current account balance will be positive.
Conversely, if savings is less than investment that means the economy
is using more money for investment purposes than it has. The extra
money comes by borrowing from the foreigners. In this case the
current account balance is negative.
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Savings and investment in open economy
 Alternatively we can also state the open economy goods
market equilibrium as:
Y = C + I + G + NX
NX = Y – (C + I + G)
 This means that the economy’s net export will be equal to
the amount of goods that the economy will not absorb. The
size of absorption is equal to (C + I + G).
 When we consider open economy condition for a small
economy, the goods market equilibrium will depend on the
world real interest rate, not on the domestic interest rate.
However, if the country is large domestic interest rate may
affect the world interest rate.
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