Macroeconomics

Ninth Canadian Edition

Chapter 4
Consumption, Saving, and
Investment

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Main Questions
• What factors determine the economywide demand
for goods & services?
• What factors determine how much households
choose to consume?
• What factors determine how much firms choose to
invest?
• What forces bring the goods market into
equilibrium?

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Consumption and Saving (1 of 4)
• Changes in consumers’ willingness to spend have
major implications for the behaviour of the
economy.
– Consumption accounts for about 60% of total
spending.
– The decision to consume and to save are closely
linked.

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Consumption and Saving (2 of 4)
• Desired consumption (Cd) is the aggregate
quantity of goods and services that household
want to consume, given income and other factors.

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Consumption and Saving (3 of 4)
• Desired national saving (Sd) is the level of national
saving that occurs when aggregate consumption
is at its desired level.

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Consumption and Saving (4 of 4)
• When NFP = 0, national saving is
S=Y−C−G
• Then, desired national saving is
Sd = Y − Cd − G

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The Consumption and Saving Decision
(1 of 2)

• A lender can earn, and a borrower will have to

pay, a real interest rate of r per year.
• 1 dollars worth of consumption today is equivalent
to 1+r dollar’s worth of consumption in the next
time period (assuming inflation = 0).

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The Consumption and Saving Decision
(2 of 2)

• The consumption-smoothing motive is the

desire to have a relatively even pattern of
consumption over time.
• A one-time income bonus is likely to be saved and
the income earned on that saving spread over
time.

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Changes in Current Income
• Marginal propensity to consume (MPC) is the
fraction of additional current income that is
consumed in the current period.
• When Y rises by 1
– Cd rises by less than 1
– Sd rises by the fraction of 1 not spent on consumption

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Changes in Expected Future Income
• Current consumption will increase and current
savings will decrease when
– Expected future income increases, because of the
smoothing motive
– Wealth increases, because one does not need to save
as much for the future anymore

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Changes in Wealth
• Future consumption can be estimated
using the consumer confidence index

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Changes in the Real Interest Rate (1 of 2)
• For a lender an increase in r has two opposite
effects
– Increases the opportunity cost of current consumption
and thus increases current saving (substitution
effect)
– Increases current income from wealth which increases
current consumption and decreases in current saving
(income effect)

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Changes in the Real Interest Rate (2 of 2)
• For a borrower when r increases the substitution
and income effects both result in increased S.
• The empirical evidence is that an increase in r
reduces C and increases S, but the effect is not
very strong.

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Taxes and the Real Return to Saving (1 of 2)

• The expected after-tax real interest rate (ra−t) is

the after-tax nominal interest rate minus the
expected inflation rate.

ra  t  (1  t )i   e

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Taxes and the Real Return to Saving (2 of 2)

• By reducing the tax rate on interest the

government can increase the real rate of return for
savers and (possibly) increase the rate of saving
in the economy.

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Fiscal Policy
• Let’s make an assumption that the economy’s
aggregate output is given, it is not affected by the
changes in fiscal policy.
• The government fiscal policy has two major
components
– government purchases
– taxes

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Government Purchases
• When the government increases its purchases
temporarilyCd falls, because higher taxes and
lower income are expected.
– Sd increases, because Cd falls
– Sd falls, because G increases
– A total effect on Sd is a fall

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Taxes (1 of 2)
• A government tax cut without reduction of current
spending should
– Increase income and, therefore, Cd by a fraction of the
tax cut
– Raise expectations of higher taxes and lower after-tax
income in the future

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Taxes (2 of 2)
• According to the Ricardian equivalence
proposition the positive and the negative effects
of the tax cut without reduction of the current
spending should exactly cancel.
• In reality it may be not so, since many consumers
get deceived.

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Investment (1 of 5)
• There is a trade-off between the present and the
future.
• A firm commits its resources to increasing its
capacity to produce and earn profits in the future.

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Investment (2 of 5)
• Investment spending fluctuates sharply over the
business cycle and typically contributes half of the
total decline in spending.
• Investment plays a crucial role in determining the
long-run productive capacity of the economy and
its growth.

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The Desired Capital Stock (1 of 2)
• Desired capital stock is an amount of capital that
allows a firm to earn the largest expected profit.
• The marginal product of capital (MPK) is the firm’s
increase in output due to adding a unit of capital
(other factors held constant).

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The Desired Capital Stock (2 of 2)
• Managers compare the cost and benefit of using
additional capital, e.g. a new machine.
• The firm’s benefit is MPKf – the future MPK.
• The firm’s cost is the user cost of capital.

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The User Cost of Capital (1 of 2)
• User cost of capital is the expected real cost of
using a unit of capital for a specified period of
time.

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The User Cost of Capital (2 of 2)

uc  rpK  dpK  ( r  d ) pK

uc is the user cost of capital

r is the expected rate of interest
d is the rate at which capital depreciates
pK is the real price of capital goods

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Determining the Desired Capital Stock
(1 of 3)

• The desired capital stock is the capital stock

where expected profit is maximized—
at which the MPKf equals the uc.

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Determining the Desired Capital Stock
(2 of 3)

• The desired capital stock (50 cubic metres of oven

capacity) is the capital stock that maximizes profits.

Figure 4.1 Determination of the Desired Capital Stock

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Determining the Desired Capital Stock
(3 of 3)

• The MPKf curve slopes downward because the

marginal product of capital falls as the capital
stock increases.
• The uc curve does not depend in the amount
capital and is a horizontal line.

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Changes in the Desired Capital Stock
(1 of 3)

• If r falls (other factors held constant), the uc falls (shifts

downward), then MPKf>uc, and K rises.
• The same is true when d or pK fall (other factors held
constant).

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Changes in the Desired Capital Stock
(2 of 2)

Figure 4.2 A Decline in the Real Interest Rate Raises the Desired Capital Stock

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Changes in the Desired Capital Stock
(3 of 3)

• When technology improves (other factors held constant)

the MPKf curve shifts upward, then MPKf>uc, and K rises.

Figure 4.3 An Increase in the Expected Future MPK Raises the Desired Capital Stock

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Taxes and the Desired Capital Stock (1 of 2)
• The after-tax MPKf is (1−τ)MPKf.

uc ( r  d ) pk
MPK  f

1  1 

• uc/(1−τ) is tax-adjusted user cost of capital.

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Taxes and the Desired Capital Stock (2 of 2)
• An increase in the tax rate τ raises the
tax-adjusted user cost of capital and so
reduces the desired stock of capital.
• The effective tax rate is a single measure of the
tax burden on capital.

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Investment (3 of 5)
• The capital stock changes
– Gross investment is the total purchase or construction
of new capital goods.
– Depreciation is the capital wearing out.

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Investment (4 of 5)
• Net investment is the difference between gross
investment and depreciation.

K t 1  K t  I t  dK t
I t  K t 1  K t  dK t
• It is gross investment during year t.
• Kt and Kt+1 is capital stock at the beginning of year t
and t+1.

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Investment (5 of 5)
• The firm’s gross investment during has 2 parts
– Desired net increase in capital stock over the year
(K*−Kt)
– Investment needed to replace worn-out or depreciated
capital (dKt)

I t  K  K t  dK t
*

(K* is the desired capital stock in the next period = Kt+1)

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Investment in Inventories (1 of 2)
• A firm’s inventories are unsold goods, unfinished
goods, and raw materials.
• Inventory investment is the most volatile
component of investment spending.

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Investment in Inventories (2 of 2)
• Residential investment is the construction of
housing or apartment buildings.
• A firm’s owner will compare the benefits of
keeping higher inventories or renting out
apartments and the respective user costs.

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Goods Market Equilibrium (1 of 3)
• The real interest rate is the key economic variable
whose adjustments help bring the quantities of
goods supplied and demanded into balance.

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Goods Market Equilibrium (2 of 3)
• The goods market equilibrium condition is:

Y  C  I G
d d

• Y is the quantity of goods supplied by firms.

• The right hand side is the aggregate demand for
goods.

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Goods Market Equilibrium (3 of 3)
• The income-expenditure identity for a closed
economy (Y = C + I + G) is always satisfied.
• The goods market is in equilibrium when desired
national saving equals desired investment (Sd = Id),
since Sd = Y − Cd − G.

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The Saving-Investment Diagram (1 of 3)
• The saving curve, S, is upward sloping.
– A higher real interest rate raises desired national
savings.
• The investment curve, I, is downward sloping.
– A higher interest rate increases the user cost of capital
and, thus, reduces investment.

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The Saving-Investment Diagram (2 of 3)
• Adjustments of the real interest rate, in response
to excess supply or demand for saving, bring the
goods market into equilibrium.

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The Saving-Investment Diagram (3 of 3)
• Goods market equilibrium
– Cd depends on r because a higher r raises Sd
– Id depends on r because a higher r raises uc, which
lowers Id
• Adjustments of r eliminate excess supply or
demand for saving.

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Shifts of the Saving Curve (1 of 2)
• The saving curve shifters are all factors, excluding
the real interest rate, which affect national saving.
• Example: The crowding out of investment by
government purchases
– Increase in G causes a decrease Sd
– Sd curve shifts to the left
– Equilibrium r goes up
– Id falls because of higher uc

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Shifts of the Saving Curve (2 of 2)

Figure 4.6 A Decline in Desired Saving

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Shifts of the Investment Curve (1 of 2)
• The investment curve shifters are all the factors
which affect investment, excluding the real interest
rate (it determines the movement along the
curve).
• Example:
– An innovation or economic reform raises MPKf
– Increase in Id shifts the investment curve to the right
– r rises to a new equilibrium level
– S increases

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Shifts of the Investment Curve (2 of 2)

Figure 4.7 An Increase in Desired Investment

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