Chapter 4: Consumption, Saving, and Investment

after-tax MPK^f

(1-T)MPK^f

substitution effect of the real interest rate

an increases reduces current consumption and increases future consumption so the consumer substitutes away from current consumption

gross investment=

net investment + depreciation; K* - (1-d)Kt

tradeoff

occurs between current and future consumption: consume less today means you can consume more in the future

income effect

on the borrower, an increased interest rate leads to decreased consumption and increased saving, other way around for a saver because future income increases

investment tax credit

permits a firm to subtract a percentage of purchase price of new capital directly from their tax bill

real interest rate

price of current consumption in terms of future consumption

uc=

rPk + dPk = (r+d)Pk

expected after-tax real interest rate=

ra-t= (1-t)I-pie^e

income effect of the real interest rate on saving

reflects the change in current consumption that results when a higher real interest rate makes a consumer richer or poorer

borrowing constraint

restriction imposed by lenders on the amount someone can borrow against future income

utility

satisfaction/well being of an individual

tax adjusted user cost of capital

shows how large the before tax future MPK must be for a firm to add an extra unit of capital

impact of fiscal policy changes

1) affects desired consumption because it affects households' current and expected future incomes--changes that increase taxes or lead people to expect that will decrease consumption 2) affects desired national saving because changes that reduce desired consumption by one dollar will raise desired nat' saving by one dollar 3) tax status

net investment=

Kt+1-Kt = It-dKt (gross investment-amount of depreciation during year t)

desired national saving=

S^d= Y-C^d-G

equilibrium also =

Sd (desired national saving) = Id (desired investment)

Tobin's q=

V/Pk

equilibrium=

Y (goods supplied)= Cd + Id + G (goods demanded)

PVLR=

a + y + y^f/ (1+r)

Ricardian equivalence

a change in current taxes doesn't affect PVLR and shouldn't affect current consumption or saving

income effect of the real interest rate

a saver benefits from an increase in the interest rate because it raises their interest income but the total effect is ambiguous because substitution and income effect work in opposite directions. because the borrower becomes poorer the substitution and income effects work in conjunction to increase saving

depreciation allowances

allow firms to reduce total tax payment by reducing the amount of profit to be taxed

substitution + income effect

budget line pivots= substitution effect because with the increase in real interest rate the current consumption decreases and saving increases. parallel shift= income effect because current and future consumption increases and saving decreases

MPK^f=

change in output/change in capital times price of output

budget line

combinations of current and future consumption that the consumer can afford based on current consumption, future consumption, initial wealth, and the real interest rate

residential investment

construction of housing

fiscal policy

decisions about spending and tax

equilibrium

desired saving=desired investment

user cost of capital

expected real cost of using a unit of capital for a specified period of time

life-cycle model

extends the model to many periods focusing on patterns of income, consumption, and saving throughout an individual's life

budget constraint

for any level of current consumption how much future consumption can you afford

yield curve

graphs the relationship between the interest rate and its maturity

an increase in the real interest rate would

have different effects on a borrower versus a lender. A lender/saver would increase current consumption and decrease current saving. A borrower would decrease current consumption and increase current saving because they are poorer

an increase in wealth would

have the same affect as an increase in future income, increase current consumption and decrease current saving because current income is unaffected

permanent income theory

if income permanently increases it affects both current and future income so they have larger effects on consumption than a temporary change in income does so a temporary change is mostly saved while a permanent one is mostly consumed

an increase in expected future income would

increase current consumption and decrease current saving

an increase in current income would

increase current consumption to a value less than the increase in income and current saving would also rise

a decrease in current taxes

increase in current consumption but the consumer can expect lower after-tax incomes in the future because the government will have to pay interest on borrowed money so can consume less in anticipation

a decrease in taxes

increases the after-tax return that a saver receives and can possible increase the rate of current saving

substitution effect of the real interest rate on saving

it reflects the tendency to reduce current consumption and increase future consumption as the price of current consumption, 1+r increases, consumers substitute away from current consumption, which has become more expensive, to future consumption which has become less expensive

default risk

lenders charge risky borrowers more to compensate for risk

maturity

life of a bond

temporary increase in government purchases

means that taxes will increase and results in decreased consumption by less than how much income decreases and current saving also decreases because the increase in government purchases outweighs the decrease in current consumption

indifference curves

measure utility by representing preferences for current vs. future consumption, shows combinations of current and future consumption that yield the same utility

effective tax rate

measures the tax burden on capital affecting investment

present value

measures the value of payments to be made in the future in terms of today's dollars/goods

indifference curves..

slope downward from left to right because any change in current consumption is accompanied with a change in the opposite direction in future consumption, farther up and to the right is higher utility and is bowed toward the origin because of the consumption-smoothing motive

substitution effect

substitutes away from current consumption to future consumption by increasing saving

user cost=

sum of depreciation and interest rate

excessive sensitivity

tendency of consumption to respond to current income more strongly than the model predicts

expected after-tax real interest rate

the aftertax nominal interest rate minus the expected inflation rate

goods market equilibrium

the aggregate quantity of goods supplied equals the aggregate quantity of goods demanded

national level of desired consumption (C^d)

the aggregate quantity of goods/services that households want to consume given income and other factors that determine economic opportunities

desired capital stock

the amount of capital that allows the firm to earn the largest expected profit and is determined by comparing the cost/benefit of using additional capital

expected future marginal product of capital

the benefit from increasing investment today by one unit of capital

no borrowing, no lending point

the current income and initial wealth is just sufficient enough to pay for current consumption and there are no resources left over

the budget line shifts right when

the current income increases, future income increases, and wealth increases

depreciation rate=

the depreciation times the price of capital; dpk

consumption-smoothing motive

the desire to have a relatively even pattern of consumption over time- avoiding periods of very high or very low consumption

net investment

the difference between gross investment and the depreciation= change in capital stock over the year

interest rate=

the expected real interest rate times the price of capital; rpk

marginal propensity to consume (MPC)

the fraction of additional current income you consume in the current period. the value is between zero and one

Ricardian equivalence proposition

the idea that taxcuts do not affect current consumption and saving because the positive effect of the increase in current income and the negative effect of the decrease in future income cancel each other out

inventory investment

the increase in firms' inventories of unsold goods, unfinished goods/raw materials

MPK

the increase in output a firm can attain with one additional unit of capital

BL slope change

the interest rate increases

desired national saving (S^d)

the level of national saving occurring when aggregate consumption at the desired level

optimal level of consumption

the point where the budget line is tangent to an indifference curve

present value of lifetime resources (PVLR)

the present value of income a consumer expects to receive in current and future periods+ initial wealth

gross investment

the total purchase/construction of new capital goods that take place each year

depreciation rate

the value lost as capital wears out

tax-adjusted user cost of capital=

uc/1-T or (r+d)Pk/1-T

binding borrowing constraint

when a consumer want so to borrow and is prevented from doing so this means they will spend all available current income and wealth on current consumption to get close to desired levels

nonbinding borrowing constraint

when a consumer wouldn't want to borrow even without a constraint

bequests

when people want to leave wealth to their heirs