Download Chapter 4

Chapter 4: Consumption, Saving , and
Investment
Focus:
1)
2)
3)
4)
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?
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Consumption
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1)
2)
3)
4)
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
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The real rate of interest determines the cost
of today’s 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.
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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.
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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.
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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
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The desired stock of capital is determined by
the condition:
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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
Kt+1 – Kt = It - dkt
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If the desired capital stock (K*t) is
same as the actual capital stock, then
we have :
It = K*t+1 – Kt + dkt
For making investment in inventories
and housing as well, one compares the
cost of investment with the benefit of
investment.
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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
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