ECON CHAP 10

economists define personal saving as

"not spending" or as "that part of disposable (after-tax) income not consumed." Saving (S) equals disposable income (DI) minus consumption (C). OR S = DI − C)

determinants other than income might prompt households to consume more or less at each possible level of income and thereby change the locations of the consumption and saving schedules.

wealth, borrowing, expectations, and interest rates.

Simultaneous shifts

Changes in wealth, expectations, interest rates, and household debt will shift the consumption schedule in one direction and the saving schedule in the opposite direction. If households decide to consume more at each possible level of real GDP, they must save less, and vice versa. (Even when they spend more by borrowing, they are, in effect, reducing their current saving by the amount borrowed since borrowing is, effectively, "negative saving.")

Variability

of profits High current profits often generate optimism about the future profitability of new investments, whereas low current profits or losses spawn considerable doubt about the wisdom of new investments. Additionally, firms often save a portion of current profits as retained earnings and use these funds (as well as borrowed funds) to finance new investments. So current profits affect both the incentive and ability to invest. But profits themselves are highly variable from year to year, contributing to the volatility of investment.

average propensity to save (APS)

the fraction of total income that is saved APS= savings divided by income

APC + APS =

1 at any level of disposable income

MPS + MPC=

1 at any level of disposable income

non-interest-rate determinants of investment demand

1,Acquisition, maintenance, and operating costs, 2,Business taxes, 3, Technological change 4,Stock of capital goods on hand 5, Planned inventory changes 6, Expectations

investment demand curve

A curve that shows the amounts of investment demanded by an economy at a series of real interest rates.

Wealth

A household's wealth is the dollar amount of all the assets that it owns minus the dollar amount of its liabilities (all the debt that it owes). Households build wealth by saving money out of current income. The point of building wealth is to increase consumption possibilities. The larger the stock of wealth that a household can build up, the larger will be its present and future consumption possibilities.

expected rate of return

A summary measure of an investment's performance, stated as a percentage, based on the possible rates of return and on the likelihood of those rates of return occurring. investment minus return +p then p divided by investment = rate of return

consumption schedule

A table of numbers showing the amounts households plan to spend for consumer goods at different levels of disposable income.

saving schedule

A table of numbers that shows the amounts households plan to save (plan not to spend for consumer goods), at different levels of disposable income.

Durability

Because of their durability, capital goods have indefinite useful lifespans. Within limits, purchases of capital goods are discretionary and therefore can be postponed. Firms can scrap or replace older equipment and buildings, or they can patch them up and use them for a few more years. Optimism about the future may prompt firms to replace their older facilities and such modernizing will call for a high level of investment. A less optimistic view, however, may lead to smaller amounts of investment as firms repair older facilities and keep them in use.

ariability of expectations

Business expectations can change quickly when some event suggests a significant possible change in future business conditions. Changes in exchange rates, trade barriers, legislative actions, stock market prices, government economic policies, the outlook for war or peace, court decisions in key labor or antitrust cases, and a host of similar considerations may cause substantial shifts in business expectations.

Borrowing

Household borrowing also affects consumption. When a household borrows, it can increase current consumption beyond what would be possible if its spending were limited to its disposable income. By allowing households to spend more, borrowing shifts the current consumption schedule upward.

exspectations

Household expectations about future prices and income may affect current spending and saving

intrest rate

If the expected rate of return (10 percent) exceeds the interest rate (here, 7 percent), the investment should be undertaken. The firm expects the investment to be profitable. But if the interest rate (say, 12 percent) exceeds the expected rate of return (10 percent), the investment should not be undertaken.

Shifts of the investment demand curve

Increases in investment demand are shown as rightward shifts of the investment demand curve; decreases in investment demand are shown as leftward shifts of the investment demand curve.

Expectations

Most capital goods are durable, with a life expectancy of 10 or 20 years. Thus, the expected rate of return on capital investment depends on the firm's expectations of future sales, future operating costs, and future profitability of the product that the capital helps produce. These expectations are based on forecasts of future business conditions as well as on such elusive and difficult-to-predict factors as changes in the domestic political climate, international relations, population growth, and consumer tastes. If executives become more optimistic about future sales, costs, and profits, the investment demand curve will shift to the right; a pessimistic outlook will shift the curve to the left.

Irregularity of innovation

New products and processes stimulate investment. Major innovations such as railroads, electricity, airplanes, automobiles, computers, the Internet, and cell phones induce vast upsurges or "waves" of investment spending that in time recede. But such innovations occur quite irregularly, adding to the volatility of investment.

Planned inventory changes

Since the investment demand curve deals only with planned investment, it is only affected by planned changes that firms desire to make to their inventory levels. If firms are planning to increase their inventories, the investment demand curve shifts to the right. If firms are planning on decreasing their inventories, the investment demand curve shifts to the left.

Stability

The consumption and saving schedules usually are relatively stable unless altered by major tax increases or decreases. Their stability may be because consumption-saving decisions are strongly influenced by long-term considerations such as saving to meet emergencies or saving for retirement. It may also be because changes in the nonincome determinants frequently work in opposite directions and therefore may be self-canceling.

marginal propensity to consume (MPC)

The fraction of any change in disposable income spent for consumer goods; equal to the change in consumption divided by the change in disposable income. MPC= change in consumption dived by change in income

marginal propensity to save (MPS)

The fraction of any change in disposable income that households save; equal to the change in saving divided by the change in disposable income. MPS =change in savings divided by change in income

average propensity to consume (APC)

The fraction, or percentage, of total income that is consumed, APC = consumption divided by income

Acquisition, maintenance, and operating costs,

The initial costs of capital goods, and the estimated costs of operating and maintaining those goods, affect the expected rate of return on investment. When these costs rise, the expected rate of return from prospective investment projects falls and the investment demand curve shifts to the left.

break-even income

The level of disposable income at which households plan to consume (spend) all their income and to save none of it. Graphically, the consumption schedule cuts the 45° line, and the saving schedule cuts the horizontal axis (saving is zero) at the break-even income level

changes along schedules

The movement from one point to another on a consumption schedule is a change in the amount consumed and is solely caused by a change in real GDP an upward or downward shift of the entire schedule, is a shift of the consumption schedule and is caused by changes in any one or more of the nonincome determinants of consumption

multiplie

The ratio of a change in equilibrium GDP to the change in investment or in any other component of aggregate expenditures or aggregate demand; the number by which a change in any such component must be multiplied to find the resulting change in equilibrium GDP.

45° (degree) line

The reference line in a two-dimensional graph that shows equality between the variable measured on the horizontal axis and the variable measured on the vertical axis. In the aggregate expenditures model, the line along which the value of output (measured horizontally) is equal to the value of aggregate expenditures (measured vertically).

paradox of thrift

The seemingly self-contradictory but possibly true statement that increased saving may be both good and bad for the economy. It is always good in the long run when matched with increased investment spending, but may be bad in the short run if there is a recession because it reduces spending on goods and services. If the increased savings are not translated into increased investment, then the fall in consumption spending will not be made up for by an increase in investment. The overall result will be a decrease in output and employment. If the decline in GDP is severe enough, the attempt to save more will actually lead to less overall savings because the higher rate of saving will be applied to a smaller national income.

wealth effect

The tendency for people to increase their consumption spending when the value of their financial and real assets rises and to decrease their consumption spending when the value of those assets falls.

factors that explain the variability of investment.

Variability of expectations, Durability, irregularity of innovation, and ariability of profits

Switching to real GDP

When developing macroeconomic models, economists change their focus from the relationship between consumption (and saving) and disposable income to the relationship between consumption (and saving) and real domestic output (real GDP)

Business taxes,

When government is considered, firms look to expected returns after taxes in making their investment decisions. An increase in business taxes lowers the expected profitability of investments and shifts the investment demand curve to the left; a reduction of business taxes shifts it to the right.

Real interest rates

When real interest rates (those adjusted for inflation) fall, households tend to borrow more, consume more, and save less

Taxation

a change in taxes shifts the consumption and saving schedules in the same direction. Taxes are paid partly at the expense of consumption and partly at the expense of saving. So an increase in taxes will reduce both consumption and saving, shifting the consumption schedule downward. Conversely, households will partly consume and partly save any decrease in taxes. Both the consumption schedule and saving schedule will shift upward.

investment

consists of expenditures on new plants, capital equipment, machinery, inventories,

dissaving

consuming in excess of after-tax income. this will occur at relatively low DIs. Households can consume more than their current incomes by liquidating (selling for cash) accumulated wealth or by borrowing. Graphically, dissaving is shown as the vertical distance of the consumption schedule above the 45° line or as the vertical distance of the saving schedule below the horizontal axis.

increased borrowing increases

debt (liabilities), which in turn reduces household wealth since wealth = assets − liabilities. This reduction in wealth reduces future consumption possibilities in much the same way that a decline in asset values would

Technological change

echnological progress—the development of new products, improvements in existing products, and the creation of new machinery and production processes—stimulates investment. The development of a more efficient machine, for example, lowers production costs or improves product quality and increases the expected rate of return from investing in the machine. Profitable new products induce a flurry of investment as businesses tool up for expanded production. A rapid rate of technological progress shifts the investment demand curve to the right.

reverse wealth effect

situations in which wealth unexpectedly changes because asset values unexpectedly change.

Stock of capital goods on hand

the stock of capital goods on hand, relative to output and sales, influences investment decisions by firms. When the economy is overstocked with production facilities and when firms have excessive inventories of finished goods, the expected rate of return on new investment declines. Firms with excess production capacity have little incentive to invest in new capital. Therefore, less investment is forthcoming at each real interest rate; the investment demand curve shifts leftward.When the economy is understocked with production facilities and when firms are selling their output as fast as they can produce it, the expected rate of return on new investment increases and the investment demand curve shifts rightward.