Chapter 4 Consumption, Saving, and Investment 51

Chapter 4
Consumption, Saving, and Investment
Learning Objectives
I. Goals of Chapter 4
A) Examine the factors that underlie economy wide demand for goods and services
B) Assumes closed economy (for now)
C) Focuses on consumption and investment
D) Equivalent to studying saving and capital formation
E) Examines trade-off of present vs. future
F) Goods market equilibrium when desired saving equals desired investment
G) Real interest rate plays key role in bringing goods market to equilibrium
Teaching Notes
I. Consumption and Saving (Sec. 4.1)
A) The importance of consumption and saving
Question: How do we make our consumption and saving decisions?
Answer: In general terms, compare benefits of consuming today versus in the future. Expectations
(about economic factors) play an important role.
1. Desired consumption (C
d)
: aggregate consumption amount desired by households
2. Desired national saving (S
d)
: level of national saving when consumption is at its desired
level
S
d
= Y C
d
G (4.1)
This is because once you know C
d
automatically know S
d
Data Application
Recall from Chapter 2 that measured consumption in the national income accounts includes
spending on durable consumption goods, like autos and major appliances. But consumption
theory requires that consumption be defined to include only the services from durable consumer
goods. So empirical researchers must adjust the national income data to arrive at a measure of
consumption that matches the theory. For example, they might assume that durable goods provide
services proportional to the stock of durables.
52 Abel/Bernanke Macroeconomics, Fifth Edition
B) The consumption and saving decision of an individual
Chapter 4 Consumption, Saving, and Investment 53
1. A person can consume less than current income (saving is positive)
2. A person can consume more than current income (saving is negative)
3. Trade-off between current consumption and future consumption
a. The price of 1 unit of current consumption is 1 + r units of future consumption, where r
is the real interest rate. (Give a numerical example.)
b. Consumption-smoothing motive: the desire to have a relatively even pattern of
consumption over time
FACTORS THAT AFFECT CONSUMPTION:
1) Effect of changes in CURRENT INCOME.
Consider a one time increase ($1000) in your income. How does this affect C versus S?
1. C smoothing motive: both consumption and saving increase (vice versa for decrease in
current income). By how much:
2. Marginal propensity to consume (MPC) = fraction of additional current income consumed in
current period; between 0 and 1. If MPC=0.4, then C increases by 0.4*1000 and S increases
by 0.6*1000.
3. Aggregate level: When current income (Y) rises, C
d
rises, but not by as much as Y, so S
d

rises
2) Effect of changes in EXPECTED FUTURE INCOME
Consider you learn your income will increase ($1000) next year. How does this affect C versus S?
1. Higher expected future income leads to more consumption today, so saving falls
2. Application: consumer sentiment and the 199091 recession; sharp contraction in consumer
sentiment in 1990 led to fall in consumer spending. FIGURE 4.1a
3) Effect of changes in WEALTH
1. Same effect as 1. Increase in wealth raises current consumption, so lowers current saving
4) Effect of changes in REAL INTEREST RATE
54 Abel/Bernanke Macroeconomics, Fifth Edition
Question: Ask here what they think. See if they can see both effects.
1. Increased real interest rate has TWO opposing effects
a. Substitution effect: Positive effect on saving, since rate of return is higher; greater
reward for saving elicits more saving. In other words, price of current consumption (1+r)
is higher, consumers substitute away from current consumption.
b. Income effect
(1) For a saver: Same effect as increased wealth. Negative effect on saving, since it
takes less saving to obtain a given amount in the future (target saving). With the
increase in interest rate, the person can afford the same levels of current and future
consumption and have some additional resources to spend. So the person increases
both current and future consumption.
(2) For a borrower (payer of interest): Positive effect on saving, since the higher real
interest rate means a loss of wealth
c. Effects on national saving unclear because economy consists of both borrowers and
lenders. Empirical studies have mixed results; probably a slight increase in aggregate
saving
2. Taxes and the real return to saving. What if interest income is taxed?
People have to use their expectations to make decisions.
a. Expected after-tax real interest rate:
r
at
= (1 t)i
e
(4.2)
b. Simple examples: i = 5%,
e
= 2%; if t = 30%, r
at
= 1.5%; if t = 20%, r
at
= 2%
Data Application
Eytan Sheshinski, in Treatment of Capital Income in Recent Tax Reforms and the Cost of
Capital in Industrialized Countries, in Larry Summers, ed., Tax Policy and the economy 4,
Cambridge, Mass.: MIT Press, 1990, pp. 2542, finds that real after-tax interest rates were
negative for the United States and many other countries in the 1970s. Even with fairly low
inflation, because nominal returns, rather than real returns, are taxed, the real after-tax interest rate
(for taxpayers in the top bracket) is fairly low relative to the pretax real interest rate. For example,
in the United States in 1985, the pretax real interest rate was 6.3%; the after-tax real interest rate
was 0.9% ( = 3.6%, t = 55%). In 1987 the pretax real rate was 4.9%; the after-tax real interest
rate was 2.1% ( = 3.7%, t = 33%).
3. In touch with the macroeconomy: interest rates. Box on page 122.
a. Discusses different interest rates, default risk, term structure (yield curve), and tax status
b. Since interest rates often move together, we frequently refer to the interest rate
G) Fiscal policy
Assume changes in G does not affect Y. Fiscal policy affects desired consumption (C
d
) through
changes in current and expected future income. Also, it directly affects desired national saving
through S
d
= Y C
d
G. Two cases:
1. Government purchases (temporary increase)
a. Higher G financed by higher current taxes reduces after-tax income, lowering desired
consumption
Chapter 4 Consumption, Saving, and Investment 55
b. Even true if financed by higher future taxes, if people realize how future incomes are
affected
c. Since C
d
declines less than G rises, national saving (S
d
= Y C
d
G) declines
d. Example: G increase $10B. C
d
decreases by $6B. So that S
d
decreases by $4B. So
government purchases reduce both desired consumption and desired national saving
2. Taxes
a. Lump-sum tax cut today say by $10B, financed by higher future taxes
So from S
d
= Y C
d
G, we can see that S
d
will change if C
d
changes.
b. First, the tax cut should increase C
d
(less than $10B) because of the increase in income.
But people expect higher taxes in the future. Decline in future income may offset
increase in current income and they might lower consumption. Overall, desired
consumption could rise or fall
c. Ricardian equivalence proposition
(1) If future income loss exactly offsets current income gain, no change in consumption
(2) Tax change affects only the timing of taxes, not their ultimate amount (present
value)
(3) In practice, people may not see that future taxes will rise if taxes are cut today; then
a tax cut leads to increased desired consumption and reduced desired national saving
Theoretical Application
There are a number of reasons why Ricardian equivalence may not hold. The text notes that if
people dont see that future taxes are equal (in present value) to a current tax cut, then Ricardian
equivalence may not hold. It may also be possible for people to avoid future taxes, even if they
foresee them, by moving or dying; however, in the latter case, if those people planned to leave
bequests to future generations, they would increase their bequests by the increased tax liability
Other reasons for the failure of Ricardian equivalence include: (1) If the current tax cut is given to
a different set of people than must pay the future taxes, and those people have differing marginal
propensities to consume; (2) if taxes are distortionary, rather than lump sum; and (3) if future tax
rates or future income arent known with certainty.
H) Application: a Ricardian tax cut? Application on page 126.
1. The Economic Growth and Tax Relief Reconstruction Act (EGTRRA) of 2001 gave rebate
checks to taxpayers and cut tax rates substantially
2. From the first quarter to the third quarter, government saving fell $245 billion (at an annual
rate) but private saving increased $212 billion, so national saving declined only $33 billion,
a result consistent with Ricardian equivalence
3. Most consumers saved their tax rebates and did not spend them
4. As a result, the tax rebate and tax cut did not stimulate much additional spending by
households
II. Investment (Sec. 4.2)
A) Why is investment important?
1. Investment fluctuates sharply over the business cycle. Most volatile component!
56 Abel/Bernanke Macroeconomics, Fifth Edition
2. Investment plays a crucial role in economic growth
B) The desired capital stock
1. Desired capital stock is the amount of capital that allows firms to earn the largest expected
profit. Firms consider costs and benefits of additional capital and make investment
decisions.
3. Since investment becomes capital stock with a lag, the benefit of investment is the future
marginal product of capital (MPK
f
)
4. The user cost of capital
a. Example of Kyles Bakery: cost of capital, depreciation rate, and expected real interest
rate. Follow from book, page 128.
b. User cost of capital = real cost of using a unit of capital for a specified period of time
c. uc = rp
K
+ dp
K
= (r + d)p
K
(4.3)
5. Determining the desired capital stock (Figure 4.1; like text Figure 4.2)
Figure 4.1
a. Desired capital stock is the level of capital stock at which MPK
f
= uc
b. MPK
f
falls as K rises due to diminishing marginal productivity
c. uc doesnt vary with K, so is a horizontal line
d. If MPK
f
> uc, profits rise as K is added (marginal benefits > marginal costs)
e. If MPK
f
< uc, profits rise as K is reduced (marginal benefits < marginal costs)
f. Profits are maximized where MPK
f
= uc
C) Changes in the desired capital stock
1. Factors that shift the MPK
f
curve or change the user cost of capital cause the desired capital stock
to change. These factors are changes in the real interest rate, depreciation rate, price of capital, or
technological changes that affect the MPK
f
(FIGURE 4.3 and 4.4)
2. Assume revenues are taxed by %.
a. With taxes, the return to capital is only (1 )MPK
f
Chapter 4 Consumption, Saving, and Investment 57
b. Setting the return equal to the user cost gives
MPK
f
= uc/(1 ) = (r + d)p
K
/(1 )
c. Tax-adjusted user cost of capital is uc/(1 )
d. An increase in raises the tax-adjusted user cost and reduces the desired capital stock. Draw a
graph to show this. MPK curve shifts downward cause return to capital is (1 )MPK
f
e. In reality, there are complications to the tax-adjusted user cost
(1) We assumed that firm revenues were taxed. In reality, profits, not revenues, are taxed
(2) Firms are allowed to deduct part of the purchase price of capital from its taxable profit in
both the year of purchase and later. So depreciation allowances reduce the tax paid by firms,
because they reduce profits
(3) Also, Investment tax credits allow firms to subtract a percentrage of the purchase price of
capital directly from its tax bill.
(4) There is a summary measure: the effective tax ratethe tax rate on firm revenue that would
have the same effect on the desired capital stock as do the actual provisions of the tax code.
TABLE 4.2
f. Application: measuring the effects of taxes on investment
Do changes in the tax rate have a significant effect on investment? Yes!
A 1994 study by Cummins, Hubbard, and Hassett found that after major tax reforms, investment
responded strongly; elasticity about 0.66 (of investment to user cost of capital)
D) BOX 4.1: investment and the stock market
1. Firms change investment in the same direction as the stock market: Tobins q theory of
investment
2. If market value > replacement cost, then firm should invest more
3. Tobins q = capitals market value divided by its replacement cost
a. If q < 1, dont invest
b. If q > 1, invest more
4. Stock price times number of shares equals firms market value, which equals value of firms
capital
a. Formula: q = V/(p
K
K), where V is stock market value of firm, K is firms capital, p
K
is
price of new capital
b. So p
K
K is the replacement cost of firms capital stock
58 Abel/Bernanke Macroeconomics, Fifth Edition
c. Stock market boom raises V, causing q to rise, increasing investment
5. Data show general tendency of investment to rise when stock market rises; but relationship
isnt strong because many other things change at same time
6. This theory is similar to text discussion
a. Higher MPK
f
increases future earnings of firm, so V rises
b. A falling real interest rate also raises V as people buy stocks instead of bonds
c. A decrease in the cost of capital, p
K
, raises q
E) From the desired capital stock to investment
1. The capital stock changes from two opposing channels
a. New capital increases the capital stock; this is gross investment
b. The capital stock depreciates, which reduces the capital stock
c. Net investment = gross investment (I) minus depreciation:
K
t+1
K
t
= I
t
dK
t
(4.5)
where net investment equals the change in the capital stock
d. Text Figure 4.5 shows gross and net investment for the United States
2. Rewriting (4.5) gives I
t
= K
t+1
K
t
+ dK
t
a. If firms can change their capital stocks in one period, then the desired capital stock (K
*
) =
K
t+1
b. So I
t
= K
*
K
t
+ dK
t
(4.6)
c. Thus investment has two parts
(1) Desired net increase in the capital stock over the year (K
*
K
t
)
(2) Investment needed to replace depreciated capital (dK
t
)
3. Lags and investment
Chapter 4 Consumption, Saving, and Investment 59
Some capital may take years to put in place. So investment needed to reach the desired
capital stock may be spread out over several years
III. Goods Market Equilibrium (Sec. 4.3)
A) Well shoe that the real interest rate adjusts to bring the goods market into equilibrium
1. Y = C
d
+ I
d
+ G (4.7)
goods market equilibrium condition
2. Differs from income-expenditure identity, as goods market equilibrium condition need not
hold; undesired goods may be produced, so goods market wont be in equilibrium
3. Alternative representation: since
S
d
= Y C
d
G,
S
d
= I
d
(4.8)
B) The saving-investment diagram FIGURE 4.6
2. Equilibrium where S
d
= I
d
Interes rate r adjusts to determine equilibrium.
3. How can the Saving curve shift? It shifts right (increase in savings) due to:
a. a rise in current output.
b. a fall in expected future output.
c. a fall in wealth.
d. a fall in government purchases.
e. a rise in taxes (unless Ricardian equivalence holds, in which case tax changes have no
effect)
b. Example: Temporary increase in government purchases shifts S left. FIGURE 4.7
Result of lower savings: higher r, causing crowding out of I
60 Abel/Bernanke Macroeconomics, Fifth Edition
Theoretical Application
What happens to the economy if government taxes change? Under Ricardian equivalence, a tax
cut today that is financed by higher future taxes has no effect on national saving, because private
saving rises by the amount of the tax cut, just offsetting the decline in government saving. Since
theres no shift in national saving, theres no change in the equilibrium real interest rate. Suppose,
however, that people dont foresee the future tax change, or for some other reason national saving
declines. Then the shift to the left of the desired saving curve leads to a new equilibrium at a
higher real interest rate and lower level of investment. The true burden of the government debt
comes about because the lower investment rate means a lower capital stock, so that the economy
is less productive in the future. Thus future generations bear the burden of todays government
debt.
5. How can the investment curve shift? It shifts right due to:
a. a fall in the effective tax rate or a rise in expected future marginal productivity of capital
Result of increased investment: higher r, higher S and I
C) Application: Macroeconomic consequences of the boom and bust in stock prices. FIGURE 4.9
1. Sharp changes in stock prices affect consumption spending (a wealth effect) and capital
investment (via Tobins q)
2. Consumption and the 1987 crash
a. When the stock market crashed in 1987, wealth declined by about $1 trillion
b. Consumption fell somewhat less than might be expected, and it wasnt enough to cause a
recession
c. There was a temporary decline in confidence about the future, but it was quickly
reversed
d. The small response may have been because there had been a large run-up in stock prices
between December 1986 and August 1987, so the crash mostly erased this run-up
3. Consumption and the rise in stock market wealth in the 1990s
a. Stock prices more than tripled in real terms
b. But consumption was not strongly affected by the runup in stock prices
4. Consumption and the decline in stock prices in the early 2000s
a. In the early 2000s, wealth in stocks declined by about $5 trillion
b. But consumption spending increased as a share of GDP in that period
5. Investment and Tobins q
a. Investment and Tobins q were not closely correlated following the 1987 crash in stock
prices
Chapter 4 Consumption, Saving, and Investment 61
b. But the relationship has been tighter in the 1990s and early 2000s, as theory suggests
Policy Application
Should tax policy be used to promote savings or investment? Many policymakers and economists
have argued that obtaining the correct amount of future economic growth requires us to have a
higher capital stock, so that we need more investment than we have. They suggest tax policies like
IRAs to encourage saving and tax breaks for businesses to encourage investment. As weve seen
in this chapter, such policies could indeed affect peoples decisions to save (by affecting the after-
tax real rate of interest) and to invest (by reducing the after-tax cost of capital). But what isnt so
clear is whether or not investment really is too low. After all, to save today requires reducing
consumption today; people may prefer not to save any more than they are already saving. Also, if
the government goes too far in encouraging investment, we may end up with an inefficiently large
capital stock; as an example, in the late 1980s there was a large overbuilding of commercial real
estate (office buildings) in big cities, due partly to tax incentives (and partly due to myopia about
the future marginal product of office buildings!). In summary, it isnt perfecly clear that
government policies that encourage saving and investment are appropriate; we first need to show
clearly that some externality creates a need for such government intervention.