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
