Chapter 4 Consumption, Saving, and Investment 51
Chapter 4 Consumption, Saving, and Investment Learning Objectives I.
Goals of Chapter 4 A) Examine the factors that underlie economy wide demand for goods and services B) Assumes closed economy (for now) C) Focuses on consumption and investment D) Equivalent to studying saving and capital formation E) Examines tradeoff of present vs. future F) Goods market equilibrium when desired saving equals desired investment G) Real interest rate plays key role in bringing goods market to equilibrium
Teaching Notes I.
Consumption and Saving (Sec. 4.1) A) The importance of consumption and saving Question: How do we make our consumption and saving decisions? Answer: In general terms, compare benefits of consuming today versus in the future. Expectations (about economic factors) play an important role. 1. Desired consumption (Cd): aggregate consumption amount desired by households 2. Desired national saving (Sd): level of national saving when consumption is at its desired level Sd Y – Cd – G
(4.1)
This is because once you know Cd automatically know Sd
Data Application Recall from Chapter 2 that measured consumption in the national income accounts includes spending on durable consumption goods, like autos and major appliances. But consumption theory requires that consumption be defined to include only the services from durable consumer goods. So empirical researchers must adjust the national income data to arrive at a measure of consumption that matches the theory. For example, they might assume that durable goods provide services proportional to the stock of durables.
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B) The consumption and saving decision of an individual
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1. A person can consume less than current income (saving is positive) 2. A person can consume more than current income (saving is negative) 3. Tradeoff between current consumption and future consumption a. The price of 1 unit of current consumption is 1 r units of future consumption, where r is the real interest rate. (Give a numerical example.) b. Consumptionsmoothing motive: the desire to have a relatively even pattern of consumption over time FACTORS THAT AFFECT CONSUMPTION: 1) Effect of changes in CURRENT INCOME. Consider a one time increase ($1000) in your income. How does this affect C versus S? 1. C smoothing motive: both consumption and saving increase (vice versa for decrease in current income). By how much: 2. Marginal propensity to consume (MPC) fraction of additional current income consumed in current period; between 0 and 1. If MPC=0.4, then C increases by 0.4*1000 and S increases by 0.6*1000. 3. Aggregate level: When current income (Y) rises, Cd rises, but not by as much as Y, so Sd rises 2) Effect of changes in EXPECTED FUTURE INCOME Consider you learn your income will increase ($1000) next year. How does this affect C versus S? 1. Higher expected future income leads to more consumption today, so saving falls 2. Application: consumer sentiment and the 1990–91 recession; sharp contraction in consumer sentiment in 1990 led to fall in consumer spending. FIGURE 4.1a 3)
Effect of changes in WEALTH 1. Same effect as 1. Increase in wealth raises current consumption, so lowers current saving
4)
Effect of changes in REAL INTEREST RATE
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Question: Ask here what they think. See if they can see both effects. 1. Increased real interest rate has TWO opposing effects a. Substitution effect: Positive effect on saving, since rate of return is higher; greater reward for saving elicits more saving. In other words, price of current consumption (1+r) is higher, consumers substitute away from current consumption. b. Income effect (1) For a saver: Same effect as increased wealth. Negative effect on saving, since it takes less saving to obtain a given amount in the future (target saving). With the increase in interest rate, the person can afford the same levels of current and future consumption and have some additional resources to spend. So the person increases both current and future consumption. (2) For a borrower (payer of interest): Positive effect on saving, since the higher real interest rate means a loss of wealth c. Effects on national saving unclear because economy consists of both borrowers and lenders. Empirical studies have mixed results; probably a slight increase in aggregate saving 2. Taxes and the real return to saving. What if interest income is taxed? People have to use their expectations to make decisions. a. Expected aftertax real interest rate: ra–t (1 – t)i – e
(4.2)
b. Simple examples: i 5%, e 2%; if t 30%, ra–t 1.5%; if t 20%, ra–t 2%
Data Application Eytan Sheshinski, in “Treatment of Capital Income in Recent Tax Reforms and the Cost of Capital in Industrialized Countries,” in Larry Summers, ed., Tax Policy and the economy 4, Cambridge, Mass.: MIT Press, 1990, pp. 25–42, finds that real aftertax interest rates were negative for the United States and many other countries in the 1970s. Even with fairly low inflation, because nominal returns, rather than real returns, are taxed, the real aftertax interest rate (for taxpayers in the top bracket) is fairly low relative to the pretax real interest rate. For example, in the United States in 1985, the pretax real interest rate was 6.3%; the aftertax real interest rate was 0.9% ( 3.6%, t 55%). In 1987 the pretax real rate was 4.9%; the aftertax real interest rate was 2.1% ( 3.7%, t 33%). 3. In touch with the macroeconomy: interest rates. Box on page 122. a. Discusses different interest rates, default risk, term structure (yield curve), and tax status b. Since interest rates often move together, we frequently refer to “the” interest rate G) Fiscal policy Assume changes in G does not affect Y. Fiscal policy affects desired consumption (Cd ) through changes in current and expected future income. Also, it directly affects desired national saving through Sd Y – Cd – G. Two cases: 1. Government purchases (temporary increase) a. Higher G financed by higher current taxes reduces aftertax income, lowering desired consumption
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b. Even true if financed by higher future taxes, if people realize how future incomes are affected c. Since Cd declines less than G rises, national saving (Sd Y – Cd – G) declines d. Example: G increase $10B. Cd decreases by $6B. So that Sd decreases by $4B. So government purchases reduce both desired consumption and desired national saving 2. Taxes a. Lumpsum tax cut today say by $10B, financed by higher future taxes So from Sd Y – Cd – G, we can see that Sd will change if Cd changes. b. First, the tax cut should increase Cd (less than $10B) because of the increase in income. But people expect higher taxes in the future. Decline in future income may offset increase in current income and they might lower consumption. Overall, desired consumption could rise or fall c. Ricardian equivalence proposition (1) If future income loss exactly offsets current income gain, no change in consumption (2) Tax change affects only the timing of taxes, not their ultimate amount (present value) (3) 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
Theoretical Application There are a number of reasons why Ricardian equivalence may not hold. The text notes that if people don’t see that future taxes are equal (in present value) to a current tax cut, then Ricardian equivalence may not hold. It may also be possible for people to avoid future taxes, even if they foresee them, by moving or dying; however, in the latter case, if those people planned to leave bequests to future generations, they would increase their bequests by the increased tax liability Other reasons for the failure of Ricardian equivalence include: (1) If the current tax cut is given to a different set of people than must pay the future taxes, and those people have differing marginal propensities to consume; (2) if taxes are distortionary, rather than lump sum; and (3) if future tax rates or future income aren’t known with certainty. H) Application: a Ricardian tax cut? Application on page 126. 1. The Economic Growth and Tax Relief Reconstruction Act (EGTRRA) of 2001 gave rebate checks to taxpayers and cut tax rates substantially 2. From the first quarter to the third quarter, government saving fell $245 billion (at an annual rate) but private saving increased $212 billion, so national saving declined only $33 billion, a result consistent with Ricardian equivalence 3. Most consumers saved their tax rebates and did not spend them 4. As a result, the tax rebate and tax cut did not stimulate much additional spending by households II.
Investment (Sec. 4.2) A) Why is investment important? 1. Investment fluctuates sharply over the business cycle. Most volatile component!
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2. Investment plays a crucial role in economic growth B) The desired capital stock 1. Desired capital stock is the amount of capital that allows firms to earn the largest expected profit. Firms consider costs and benefits of additional capital and make investment decisions. 3. Since investment becomes capital stock with a lag, the benefit of investment is the future marginal product of capital (MPKf) 4. The user cost of capital a. Example of Kyle’s Bakery: cost of capital, depreciation rate, and expected real interest rate. Follow from book, page 128. b. User cost of capital real cost of using a unit of capital for a specified period of time c. uc rpK dpK (r d)pK (4.3) 5. Determining the desired capital stock (Figure 4.1; like text Figure 4.2)
Figure 4.1 a. b. c. d. e. f.
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
C) Changes in the desired capital stock 1. 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 (FIGURE 4.3 and 4.4) 2. Assume revenues are taxed by a. With taxes, the return to capital is only (1 – )MPKf
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b. Setting the return equal to the user cost gives MPKf uc/(1 – ) (r d)pK/(1 – ) c. Taxadjusted user cost of capital is uc/(1 – ) d. An increase in τ raises the taxadjusted user cost and reduces the desired capital stock. Draw a graph to show this. MPK curve shifts downward cause return to capital is (1 – )MPKf e. In reality, there are complications to the taxadjusted user cost (1) We assumed that firm revenues were taxed. In reality, profits, not revenues, are taxed (2) Firms are allowed to deduct part of the purchase price of capital from its taxable profit in both the year of purchase and later. So depreciation allowances reduce the tax paid by firms, because they reduce profits (3) Also, Investment tax credits allow firms to subtract a percentrage of the purchase price of capital directly from its tax bill. (4) There is a 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 f. Application: measuring the effects of taxes on investment Do changes in the tax rate have a significant effect on investment? Yes! A 1994 study by Cummins, Hubbard, and Hassett found that after major tax reforms, investment responded strongly; elasticity about –0.66 (of investment to user cost of capital) D) BOX 4.1: investment and the stock market 1. Firms change investment in the same direction as the stock market: Tobin’s q theory of investment 2. If market value replacement cost, then firm should invest more 3. Tobin’s q capital’s market value divided by its replacement cost a. If q 1, don’t invest b. If q 1, invest more 4. Stock price times number of shares equals firm’s market value, which equals value of firm’s capital a. Formula: q V/(pKK), where V is stock market value of firm, K is firm’s capital, pK is price of new capital b. So pKK is the replacement cost of firm’s capital stock
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c. Stock market boom raises V, causing q to rise, increasing investment 5. 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 6. This theory is similar to text discussion a. Higher MPKf increases future earnings of firm, so V rises b. A falling real interest rate also raises V as people buy stocks instead of bonds c. A decrease in the cost of capital, pK, raises q E) From the desired capital stock to investment 1. The capital stock changes from two opposing channels a. New capital increases the capital stock; this is gross investment b. The capital stock depreciates, which reduces the capital stock c. Net investment gross investment (I) minus depreciation: Kt+1 – Kt It – dKt
(4.5)
where net investment equals the change in the capital stock d. Text Figure 4.5 shows gross and net investment for the United States 2. Rewriting (4.5) gives It Kt+1 – Kt dKt a. If firms can change their capital stocks in one period, then the desired capital stock (K*) Kt+1 b. So It K* – Kt dKt (4.6) c. Thus investment has two parts (1) Desired net increase in the capital stock over the year (K* – Kt) (2) Investment needed to replace depreciated capital (dKt) 3. Lags and investment
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Some capital may take years to put in place. So investment needed to reach the desired capital stock may be spread out over several years III. Goods Market Equilibrium (Sec. 4.3) A) We’ll shoe that the real interest rate adjusts to bring the goods market into equilibrium 1. Y Cd Id G (4.7) goods market equilibrium condition 2. Differs from incomeexpenditure identity, as goods market equilibrium condition need not hold; undesired goods may be produced, so goods market won’t be in equilibrium 3. Alternative representation: since Sd Y – Cd – G, Sd Id
(4.8)
B) The savinginvestment diagram FIGURE 4.6
2. Equilibrium where Sd Id Interes rate r adjusts to determine equilibrium. 3. How can the Saving curve shift? It shifts right (increase in savings) due to: a. a rise in current output. b. a fall in expected future output. c. a fall in wealth. d. a fall in government purchases. e. a rise in taxes (unless Ricardian equivalence holds, in which case tax changes have no effect) b. Example: Temporary increase in government purchases shifts S left. FIGURE 4.7 Result of lower savings: higher r, causing crowding out of I
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Theoretical Application What happens to the economy if government taxes change? Under Ricardian equivalence, a tax cut today that is financed by higher future taxes has no effect on national saving, because private saving rises by the amount of the tax cut, just offsetting the decline in government saving. Since there’s no shift in national saving, there’s no change in the equilibrium real interest rate. Suppose, however, that people don’t foresee the future tax change, or for some other reason national saving declines. Then the shift to the left of the desired saving curve leads to a new equilibrium at a higher real interest rate and lower level of investment. The true burden of the government debt comes about because the lower investment rate means a lower capital stock, so that the economy is less productive in the future. Thus future generations bear the burden of today’s government debt. 5. How can the investment curve shift? It shifts right due to: a. 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 C) Application: Macroeconomic consequences of the boom and bust in stock prices. FIGURE 4.9 1. Sharp changes in stock prices affect consumption spending (a wealth effect) and capital investment (via Tobin’s q) 2. Consumption and the 1987 crash a. When the stock market crashed in 1987, wealth declined by about $1 trillion b. Consumption fell somewhat less than might be expected, and it wasn’t enough to cause a recession c. There was a temporary decline in confidence about the future, but it was quickly reversed d. The small response may have been because there had been a large runup in stock prices between December 1986 and August 1987, so the crash mostly erased this runup 3. Consumption and the rise in stock market wealth in the 1990s a. Stock prices more than tripled in real terms b. But consumption was not strongly affected by the runup in stock prices 4. Consumption and the decline in stock prices in the early 2000s a. In the early 2000s, wealth in stocks declined by about $5 trillion b. But consumption spending increased as a share of GDP in that period 5. Investment and Tobin’s q a. Investment and Tobin’s q were not closely correlated following the 1987 crash in stock prices
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b. But the relationship has been tighter in the 1990s and early 2000s, as theory suggests
Policy Application Should tax policy be used to promote savings or investment? Many policymakers and economists have argued that obtaining the correct amount of future economic growth requires us to have a higher capital stock, so that we need more investment than we have. They suggest tax policies like IRAs to encourage saving and tax breaks for businesses to encourage investment. As we’ve seen in this chapter, such policies could indeed affect people’s decisions to save (by affecting the after tax real rate of interest) and to invest (by reducing the aftertax cost of capital). But what isn’t so clear is whether or not investment really is too low. After all, to save today requires reducing consumption today; people may prefer not to save any more than they are already saving. Also, if the government goes too far in encouraging investment, we may end up with an inefficiently large capital stock; as an example, in the late 1980s there was a large overbuilding of commercial real estate (office buildings) in big cities, due partly to tax incentives (and partly due to myopia about the future marginal product of office buildings!). In summary, it isn’t perfecly clear that government policies that encourage saving and investment are appropriate; we first need to show clearly that some externality creates a need for such government intervention.