Chapter 4

Consumption, Saving, and

Investment
 Goals of Chapter 4
• Examine the factors that underlie economywide
demand for goods and services
• Assumes closed economy (for now)
• Focuses on consumption and investment
• Equivalent to studying saving and capital formation
• Examines trade-off of present vs. future
• Goods market equilibrium when desired saving equals
desired investment
• Real interest rate plays key role in bringing goods
market to equilibrium
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 4.1 Consumption and Saving
• The importance of consumption and saving
– Desired consumption: consumption amount desired by households
– Desired national saving: level of national saving when consumption is
at its desired level, Sd = Y - Cd - G (4.1)
• The consumption and saving decision of an individual
– A person can consume less than current income (saving is positive)
– A person can consume more than current income (saving is negative)
– Trade-off between current consumption and future consumption
• The price of 1 unit of current consumption is 1 + r units of future
consumption, where r is the real interest rate
• Consumption-smoothing motive: the desire to have a relatively even
pattern of consumption over time

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 4.1 Consumption and Saving
• Effect of changes in current income
– Increase in current income: both consumption and
saving increase (vice versa for decrease in current
income)
– Marginal propensity to consume (MPC) = fraction
of additional current income consumed in current
period; between 0 and 1
– Aggregate level: When current income (Y) rises, Cd
rises, but not by as much as Y, so Sd rises

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 4.1 Consumption and Saving
• Effect of changes in expected future income
– Higher expected future income leads to more
consumption today, so saving falls
• Effect of changes in wealth
– Increase in wealth raises current consumption, so
lowers current saving

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 4.1 Consumption and Saving
• Effect of changes in real interest rate
– Increased real interest rate has two opposing effects
• Substitution effect: Positive effect on saving, since rate of
return is higher; greater reward for saving elicits more
saving
• Income effect
– For a saver: Negative effect on saving, since it takes less saving to
obtain a given amount in the future (target saving)
– For a borrower: Positive effect on saving, since the higher real
interest rate means a loss of wealth
• Empirical studies have mixed results; probably a slight
increase in aggregate saving

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 4.1 Consumption and Saving
– Taxes and the real return to saving
• Expected after-tax real interest rate:
ra-t = (1 - t)i - πe (4.2)

• Simple examples: i = 5%, πe = 2%; if t = 30%,

• ra-t = 1.5%; if t = 20%, ra-t = 2%

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Table 4.1 Calculating After-Tax Interest Rates

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 4.1 Consumption and Saving
• Fiscal policy
– Affects desired consumption through changes in current and
expected future income
– Directly affects desired national saving, Sd = Y - Cd - G
– Government purchases (temporary increase)
• Higher G financed by higher current taxes reduces after-tax income,
lowering desired consumption
• Even true if financed by higher future taxes, if people realize how
future incomes are affected
• Since Cd declines less than G rises, national saving (Sd = Y - Cd - G)
declines
• So government purchases reduce both desired consumption and
desired national saving
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 4.1 Consumption and Saving
– Taxes
• Lump-sum tax cut today, financed by higher future taxes
• Decline in future income may offset increase in current
income; desired consumption could rise or fall
• Ricardian equivalence proposition
– If future income loss exactly offsets current income gain, no
change in consumption
– Tax change affects only the timing of taxes, not their ultimate
amount (present value)
– 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

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 4.2 Investment
• Why is investment important?
– Investment fluctuates sharply over the business cycle, so we
need to understand investment to understand the business
cycle
– Investment plays a crucial role in economic growth
• The desired capital stock
– Desired capital stock is the amount of capital that allows
firms to earn the largest expected profit
– Desired capital stock depends on costs and benefits of
additional capital
– Since investment becomes capital stock with a lag, the
benefit of investment is the future marginal product of
capital (MPKf)
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 4.2 Investment
– The user cost of capital
• Example of Kyle's Bakery: cost of capital, depreciation rate, and
expected real interest rate
• User cost of capital = real cost of using a unit of capital for a specified
period of time
• uc = rpK + dpK = (r + d)pK (4.3)
– Determining the desired capital stock (Fig. 4.2)
• Desired capital stock is the level of capital stock at which MPKf = uc
• MPKf falls as K rises due to diminishing marginal productivity
• uc doesn't vary with K, so is a horizontal line
• If MPKf > uc, profits rise as K is added (marginal benefits > marginal
costs)
• If MPKf < uc, profits rise as K is reduced (marginal benefits < marginal
costs)
• Profits are maximized where MPKf = uc
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Figure 4.2 Determination of the desired capital stock

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 4.2 Investment
• Changes in the desired capital stock
– Factors that shift the MPKf 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 MPKf (Fig. 4.3 shows effect of change in uc)
– Taxes and the desired capital stock
• With taxes, the return to capital is only (1 - τ)MPKf
• Setting the return equal to the user cost gives
MPKf = uc/(1 - τ) = (r + d)pK/(1 - τ)
• Tax-adjusted user cost of capital is uc/(1 - τ)
• An increase in τ raises the tax-adjusted user cost and reduces the
desired capital stock

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Figure 4.3 A decline in the real interest rate
raises the desired capital stock

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 4.2 Investment
• In reality, there are complications to the tax-adjusted user cost
– We assumed that firm revenues were taxed
» In reality, profits, not revenues, are taxed
» So depreciation allowances reduce the tax paid by firms,
because they reduce profits
– Investment tax credits reduce taxes when firms make new
investments
– Summary measure: the effective tax rate—the 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 shows effective tax rates for nine different
countries; some are negative, implying a subsidy to capital

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Table 4.2 Effective Tax Rate on Capital,
1990, Selected Countries

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 4.2 Investment
• Box 4.1: investment and the stock market
– Firms change investment in the same direction as
the stock market: Tobin’s q theory of investment
– If market value > replacement cost, then firm
should invest more
– Tobin’s q = capital’s market value divided by its
replacement cost (V/replacement cost)
• If q < 1, don't invest
• If q > 1, invest more

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 4.2 Investment
– Stock price times number of shares equals firm’s market value,
which equals value of firm’s capital
• Formula: q = V / (pKK), where V is stock market value of firm, K is firm’s
capital, pK is price of new capital
• So pKK is the replacement cost of firm’s capital stock
• Stock market boom raises V, causing q to rise, increasing investment
– Data show general tendency of investment to rise when stock
market rises; but relationship isn’t strong because many other
things change at same time
– This theory is similar to text discussion
• Higher MPKf increases future earnings of firm, so V rises
• A falling real interest rate also raises V as people buy stocks instead of
bonds
• A decrease in the cost of capital, pK, raises q

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 Figure 4.4 An increase in the expected
future MPK raises the desired capital stock

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•
4.2 Investment
From the desired capital stock to investment
– The capital stock changes from two opposing channels
• New capital increases the capital stock; this is gross investment
• The capital stock depreciates, which reduces the capital stock
• Net investment = gross investment (I) minus depreciation:
Kt+1 - Kt = It - dKt (4.5)
where net investment equals the change in the capital stock
• Fig. 4.5 shows gross and net investment for the United States
– Rewriting (4.5) gives It = Kt+1 - Kt + dKt
• If firms can change their capital stocks in one period, then the desired
capital stock (K*) = Kt+1, so It = K* - Kt + dKt (4.6)
• Thus investment has two parts
– Desired net increase in the capital stock over the year (K* - Kt)
– Investment needed to replace depreciated capital (dKt)
– Lags and investment
• Some capital can be constructed easily, but other capital may take years to
put in place
• So investment needed to reach the desired capital stock may be spread out
over several years
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Figure 4.5 Gross and net investment, 1929–2002

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 4.2 Investment
• Investment in inventories and housing
– Marginal product of capital and user cost also
apply, as with equipment and structures

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 4.3 Goods Market Equilibrium
• The real interest rate adjusts to bring the goods
market into equilibrium
– goods market equilibrium condition :
– Y = Cd + Id + G (4.7)
– Differs from income-expenditure identity, as goods market
equilibrium condition need not hold; undesired goods may
be produced, so goods market won't be in equilibrium
– Alternative representation: since
– Sd = Y - Cd - G, Sd = Id (4.9)
• The saving-investment diagram
– Plot Sd vs. Id (Key Diagram 3; Fig. 4.6)
– Equilibrium where Sd = Id
– How to reach equilibrium? Adjustment of r
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Key Diagram 3 The saving– investment diagram

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Figure 4.6 Goods market equilibrium

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Table 4.3 Components of Aggregate Demand
for Goods (An Example)

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 4.3 Goods Market Equilibrium
– Shifts of the saving curve
• Saving curve shifts right due to a rise in current output, a fall
in expected future output, a fall in wealth, a fall in
government purchases, a rise in taxes (unless Ricardian
equivalence holds, in which case tax changes have no effect)
• Example: Temporary increase in government purchases
shifts S left
• Result of lower savings: higher r, causing crowding out of I
– Shifts of the investment curve
• Investment curve shifts right due to 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

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Figure 4.7 A decline in desired saving

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Figure 4.8 An increase in desired investment

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Figure 4.10 Investment and Tobin’s q, 1987–2002

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