• People weight the present against the future in deciding the level of consumption and saving
• Consumption is the largest component of spending

Expenditure approach Y= C + I + G + NX

• Two uses for private disposable income Consumption and Saving
• Saving occurs when individuals limit current consumption to provide for future consumption as a hedge against uncertainty
• Going to assume for now that the economy is a Closed Economy

A. Current Income

1) If current income increases then consumption ad saving both increase

If current income decreases then consumption and saving both decrease

2) Desired Consumption and Desired National Saving

= Amount households want to consume

= Amount of national saving that occurs when consumption is at its desired level

Closed Economy ( no foreign trade) so National Saving is equal to Y-C-G

Given Desired Consumption National Saving = (1)

3) Keynesian Consumption function explain why when income (Y) increases both consumption and saving increase.

(2)

Where = autonomous consumption = the amount of cosumption with occurs regardless of income.

= Marginal propensity to consume (MPC) = the increase in consumption which occurs from an increase in income (Y) of one unit will be between 0 and 1.

Given (1) and (2) if Y increases by one dollar increases by less then one dollar looking at (1) the combined increase in and must be the same as the increase in Y.

Keynesian Consumption Function does not explain all the factors which determine consumption

B. Expected Future Income

An increase in expected future income will cause current consumption to increase the current saving to decrease.

Keeping Y and G constant if increases decreases

C. Wealth

Assets – Liabilities

An Increase in Wealth will increase current consumption and decrease saving since less need to

save for the future.

Example Stick Market decrease in 1987 or maybe last week.

D. The expected real interest rate

1) An increase in the expected real interest rate had two opposite reactions

a) Less saving occurs since rates are higher; If saving for a goal less saving must occur to reach goal

b) More Saving occurs since the reward for saving increases.

c) Empirical evidence on which affect occurs is mixed.

2) Taxes and the real return to saving

a) Expected after tax real interest rate adjust for return after taxes

return after taxes = ( the nominal interest rate times one minus the tax rate) minus expected inflation

b) Various interest rates, default risk, term structure of interest rates.

E. Fiscal Policy – Gov’t Expenditure and taxation Policy

1) Changes current and expected future income

2) Change in G and will directly affect desired national saving

3) Increase in the Government purchases needs to be financed by the government.

Two possibilities if there is not a budget surplus:

a) Increase current taxes

b) Increase borrowing ( sell government bonds – could increase future taxes)

will decrease by less than the increase in G therefore will decrease

Could happen in either case above.

4) Change in taxes

Ricardian Equivalence Proposition

Decrease in lump sum taxes – will increase the government deficit ( keeping G constant) Individuals will expect future taxes to increase to pay for the current budget deficit.

If future income loss exactly offsets current income gain ( in terms of present value), there will be no change in consumption

Only change is the timing of taxes.

A. Importance of investment

Is an important determinant of growth

Fluctuates sharply over the business cycle, need to understand investment to understand the

business cycle

B. The desired capital stock

1) The amount of capital that allows the firm to earn the largest expected profit. The Firm compares the cost and benefit of additional capital similar to the decision to hire additional workers.

2) The benefit of investment is that it becomes capital stock in the future. Therefore investment pays off for the firm in terms of an increase in the future marginal\ productivity of capital.

3) The user cost of capital is the expected real cost of using a unit of capital for a specified period of time.

Depreciation cost is the value of the capital lost due as the capital wears out

Interest cost is the price of the capital times the real interest rate. (The firm is either borrowing the money at the real interest rate or foregoing the return equal to real rate of interest on the money used to purchase the capital.)

4) The desired capital stock is the level of capital at which the future marginal product of capital () is equal to the user cost of capital.

a) falls as K rises due to diminishing marginal productivity

b) User cost of capital (uc) does not vary with capital so it is a horizontal line.

c) If > uc then the marginal benefit>marginal cost (profits rise as K increases)

d) If <uc then the marginal benefit<marginal cost (profits rise as K decreases)

e) Profits are maximized when =uc

C. Changes in the desired capital stock

1) Factors that shift the curve or change the user cost of capital will desired stock of capital to change.

Changes in Real interest rate, depreciation rate, price of capital, affect the

Technological changes affect the See graphs 4.3 and 4.4 in the text

2) Taxes change the return on the marginal productivity of capital to is the tax rate.

3) Taxes change the equilibrium level of the desired capital stock.

is the tax-adjusted user cost of capital

An increase in the tax rate raises the tax adjusted user cost of capital and reduces the desired capital stock as do the actual provisions of the tax code.

D. From the desired capital stock to investment

1) New capital increases the capital stock = gross investment

Depreciation reduced the capital stock

Net investment = Gross investment – depreciation.

where I is the gross investment and the net investment is the change in the capital stock. ()

2) Rearranging above

If firms can change their capital stock in one period then the desired stock of capital. Then investment has two parts

Desired net increase in the capital stock over year (K*-)

Investment needed to replace depreciation

Time to build and investment – Some capital takes time to put in place therefore the investment is spread out over many years.

A. The real interest rate adjusts to bring the goods market to equilibrium

1) when the goods market is in equilibrium (Closed economy – no trade)

2) Undesired goods might be produced keeping the goods market from being in equilibrium

3) Saving is equal to investment in equilibrium

B. Saving Investment diagram

1) Putting real interest rates on vertical axis and investment and saving on the horizontal axis.

Investment will be downward sloping and saving will be upward sloping.

Intersection of the curves is the equilibrium condition.

2) Adjustment of the real interest rate brings the market to equilibrium

3) Saving shifts right: rise in current output; fall in expected future output; fall in wealth; fall in government purchases; rise in taxes

4) A decrease in saving will crowd out investment as interest rate increase.

5) Investment shifts right when the effective tax rate decreases or the future marginal productivity rises. Increase in investment will increase investment and saving and the real interest rate.