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 trade-off 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 Notes to Fifth Edition Users A) The application on Consumer sentiment and the 1990-1991 recession has been deleted, though it is available in this instructors manual if you would still like to use it B) A new application, Consumer sentiment and forecasts of consumer spending discusses whether indexes of consumer sentiment are in fact useful for forecasting consumer spending C) In section 4.2, new data are available on effective tax rates on capital in many countries

II.

Teaching Notes
I. Consumption and Saving (Sec. 4.1) A) The importance of consumption and saving 1. Desired consumption: consumption amount desired by households 2. Desired national saving: level of national saving when consumption is at its desired level S =YC G
d d

(4.1)

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 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. Trade-off 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 b. Consumption-smoothing motive: the desire to have a relatively even pattern of consumption over time C) Effect of changes in current income 1. Increase in current income: both consumption and saving increase (vice versa for decrease in current income) 2. Marginal propensity to consume (MPC ) = fraction of additional current income consumed in current period; between 0 and 1 d 3. Aggregate level: When current income (Y ) rises, C rises, but not by as much as Y, d so S rises

Theoretical Application
The classic discussions of consumption are the permanent-income hypothesis of Milton Friedman (A Theory of the Consumption Function, Princeton: Princeton University Press, 1957) and the life-cycle hypothesis of Franco Modigliani and Richard Brumberg (Utility Analysis and the Consumption Function: An Interpretation of Cross-Section Data, in Ken Kurihara, ed., PostKeynesian Economics, New Brunswick, N.J.: Rutgers University Press, 1954). The permanent income hypothesis focuses on what consumers do with stochastic income receipts; the life-cycle hypothesis is concerned with predictable changes in income over the life cycle. D) Effect of changes in expected future income 1. Higher expected future income leads to more consumption today, so saving falls 2. Application: consumer sentiment and forecasts of consumer spending a. Do consumer sentiment indexes help economists forecast consumer spending? b. Data do not seem to give much warning before recessions c. Data on consumer spending are correlated with data on consumer confidence d. But formal statistical analysis shows that data on consumer confidence do not improve forecasts of consumer spending based on other macro data E) Effect of changes in wealth 1. Increase in wealth raises current consumption, so lowers current saving F) Effect of changes in real interest rate 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 b. Income effect (1) For a saver: Negative effect on saving, since it takes less saving to obtain a given amount in the future (target saving) (2) For a borrower: Positive effect on saving, since the higher real interest rate means a loss of wealth c. Empirical studies have mixed results; probably a slight increase in aggregate saving

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Theoretical Application
You can use the concept of income and substitution effects to show your class how saving responds to an effective change in the expected real interest rate that occurs because of IRAs (individual retirement accounts). Since IRAs allow people to avoid taxes on a portion of their income, they produce two kinks in the budget constraint. Whether IRAs will boost saving or consumption depends on a persons preferences, namely how strong the income and substitution effects are. Theres a substitution effect because the slope of the budget line gets steeper (the return to saving rises), so people will want more future consumption and less current consumption. Theres an income effect because the budget line is shifted out, which increases both future and current consumption. So the overall effect on current consumption, and hence saving, is ambiguous, depending on how strong are the income and substitution effects. The exception is that if a person would have saved more than the IRA limit both with and without IRAs, then theres only an income effect and saving will decline. Or if, in the presence of IRAs, a person would save exactly the amount of the IRA limit, then whether saving rises or falls depends on whether, in the absence of IRAs they would have saved more or less. Empirical evidence suggests that every $100 of IRA saving reduces current consumption by $32, so at least for some people, the substitution effect is strong enough to increase saving. 2. Taxes and the real return to saving a. Expected after-tax real interest rate: rat = (1 t)i
e e

(4.2)

b. Simple examples: i = 5%, = 2%; if t = 30%, rat = 1.5%; if t = 20%, rat = 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. 2542, finds that real after-tax 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 after-tax 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 after-tax real interest rate was 0.9% ( = 3.6%, t = 55%). In 1987 the pretax real rate was 4.9%; the after-tax real interest rate was 2.1% ( = 3.7%, t = 33%). 3. In touch with the macroeconomy: interest rates 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 Numerical Problem 1 explores how changes in income, future income, wealth, and interest rates affect consumption. G) Fiscal policy 1. Affects desired consumption through changes in current and expected future income d d 2. Directly affects desired national saving, S = Y C G 3. Government purchases (temporary increase) a. Higher G financed by higher current taxes reduces after-tax income, lowering desired consumption b. Even true if financed by higher future taxes, if people realize how future incomes are affected d d d c. Since C declines less than G rises, national saving (S = Y C G ) declines d. So government purchases reduce both desired consumption and desired national saving

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Data Application
This theory is confirmed by empirical data. Shaghil Ahmed, in Temporary and Permanent Government Spending in an Open Economy: Some Evidence for the United Kingdom, Journal of Monetary Economics, March 1986, pp. 197224, finds, using a long time series of British data, that temporary government purchases indeed crowd out consumption spending, even though the expenditures are useful in increasing the marginal productivity of private capital and providing a substitute for consumption goods. 4. Taxes a. Lump-sum tax cut today, financed by higher future taxes b. Decline in future income may offset increase in current income; 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 dont see that future taxes are equal (in present value) to a current tax cut, then Ricardian equivalence may not hold. An additional reason for the failure of Ricardian equivalence, liquidity constraints, is covered in Appendix 4.A. 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 (Robert Barro, Are Government Bonds Net Wealth? Journal of Political Economy, Nov./Dec. 1974, pp. 10951117). 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 arent known with certainty. For a useful overview and further details, see Andrew B. Abel, Ricardian Equivalence Theorem, in John Eatwell et al., eds., The New Palgrave: A Dictionary of Economics, London: Macmillan Press, 1987. Empirically, the evidence on Ricardian equivalence is mixed; for a review, see B. Douglas Bernheim, Ricardian Equivalence: An Evaluation of Theory and Evidence, in Stanley Fischer, ed., NBER Macroeconomics Annual, Cambridge, Mass.: MIT Press, 1987, pp. 263304. H) Application: a Ricardian tax cut? 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 $277 billion (at an annual rate) but private saving increased $180 billion, so national saving declined only $97 billion, so about 2/3 of the tax cut was saved 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

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II.

Investment (Sec. 4.2) A) Why is investment important? 1. Investment fluctuates sharply over the business cycle, so we need to understand investment to understand the business cycle 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 2. Desired capital stock depends on costs and benefits of additional capital 3. Since investment becomes capital stock with a lag, the benefit of investment is the future f marginal product of capital (MPK ) 4. The user cost of capital a. Example of Kyles Bakery: cost of capital, depreciation rate, and expected real interest rate b. User cost of capital = real cost of using a unit of capital for a specified period of time = real interest cost + depreciation (4.3) c. uc = rpK + dpK = (r + d )pK 5. Determining the desired capital stock (Figure 4.1; like text Figure 4.3)

Figure 4.1 a. b. c. d. e. f. Desired capital stock is the level of capital stock at which MPK = uc f MPK falls as K rises due to diminishing marginal productivity uc doesnt vary with K, so is a horizontal line f If MPK > uc, profits rise as K is added (marginal benefits > marginal costs) f If MPK < uc, profits rise as K is reduced (marginal benefits < marginal costs) f Profits are maximized where MPK = uc
f

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Theoretical Application
The first general use of the user cost of capital concept was by Dale Jorgenson, Capital Theory and Investment Behavior, American Economic Review Papers and Proceedings, May 1963, pp. 247259. C) Changes in the desired capital stock f 1. Factors that shift the MPK curve or change the user cost of capital cause the desired capital stock to change 2. These factors are changes in the real interest rate, depreciation rate, price of capital, or f technological changes that affect the MPK (text Figure 4.4 shows effect of change in uc) 3. Taxes and the desired capital stock f a. With taxes, the return to capital is only (1 )MPK b. A firm chooses its desired capital stock so that the return equals the user cost, so f (1 )MPK = uc, which means: MPK = uc/(1 ) = (r + d )pK/(1 )
f

(4.4)

c. Tax-adjusted user cost of capital is uc/(1 ) d. An increase in raises the tax-adjusted user cost and reduces the desired capital stock Numerical Problems 2 and 4 give students practice in working with the marginal product of capital and the user cost of capital. e. In reality, there are complications to the tax-adjusted user cost (1) We assumed that firm revenues were taxed (a) In reality, profits, not revenues, are taxed (b) So depreciation allowances reduce the tax paid by firms, because they reduce profits (2) Investment tax credits reduce taxes when firms make new investments (3) Summary measure: the effective tax ratethe 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 (4) Table 4.2 shows effective tax rates for many different countries

Data Application
Another simplification that is used in this chapter is the assumption that taxes are based on a firms real revenue. In reality, taxes on nominal revenue combine with inflation to create a large distortion to investment. The first broad discussion of this issue is by Martin Feldstein, Inflation, Tax Rules, and Investment: Some Econometric Evidence, Econometrica, July 1982, pp. 825862.

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f. Application: measuring the effects of taxes on investment (1) Do changes in the tax rate have a significant effect on investment? (2) 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)

Theoretical Application
For further discussions of the effects of tax policy on investment, see Robert E. Hall and Dale W. Jorgenson, Tax Policy and Investment Behavior, American Economic Review, June 1967, pp. 391414. D) Box 4.1: investment and the stock market 1. Firms change investment in the same direction as the stock market: Tobins q theory of investment 2. If market value > replacement cost, then firm should invest more 3. Tobins q = capitals market value divided by its replacement cost a. If q < 1, dont invest b. If q > 1, invest more 4. Stock price times number of shares equals firms market value, which equals value of firms capital a. Formula: q = V/(pKK ), where V is stock market value of firm, K is firms capital, pK is price of new capital b. So pKK is the replacement cost of firms capital stock 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 isnt strong because many other things change at same time 6. This theory is similar to text discussion f a. Higher MPK 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 4.6 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 a. Some capital can be constructed easily, but other capital may take years to put in place

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Theoretical Application
Acknowledging that it may take time to get capital in place may be crucial to modeling the business cycle. See Finn E. Kydland and Edward C. Prescott, Time to Build and Aggregate Fluctuations, Econometrica, November 1982, pp. 13451370. b. So investment needed to reach the desired capital stock may be spread out over several years F) Investment in inventories and housing 1. Marginal product of capital and user cost also apply, as with equipment and structures Numerical Problem 3 applies the user-cost concept to the purchase or rental of a home. III. Goods Market Equilibrium (Sec. 4.3) A) The real interest rate adjusts to bring the goods market into equilibrium 1. Y = C + I + G (4.7) goods market equilibrium condition 2. Differs from income-expenditure identity, as goods market equilibrium condition need not hold; undesired goods may be produced, so goods market wont be in equilibrium 3. Alternative representation: since d d S = Y C G,
d d

S =I
d

(4.8)

B) The saving-investment diagram d d 1. Plot S vs. I (Figure 4.2; Key Diagram 3; like text Figure 4.7)

Figure 4.2 2. Equilibrium where S = I 3. How to reach equilibrium? Adjustment of r

d d

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4. Shifts of the saving curve a. Saving curve shifts right due to a rise in current output, a fall in expected future output, a fall in wealth, a fall in government purchases, 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 c. Result of lower savings: higher r, causing crowding out of I Numerical Problem 5 and 6 and Analytical Problem 5 examine what happens when government spending changes.

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 theres no shift in national saving, theres no change in the equilibrium real interest rate. Suppose, however, that people dont 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 todays government debt. 5. Shifts of the investment curve a. Investment curve shifts right due to a fall in the effective tax rate or a rise in expected future marginal productivity of capital b. Result of increased investment: higher r, higher S and I C) Application: Macroeconomic consequences of the boom and bust in stock prices 1. Sharp changes in stock prices affect consumption spending (a wealth effect) and capital investment (via Tobins 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 wasnt 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 run-up in stock prices between December 1986 and August 1987, so the crash mostly erased this run-up 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 Tobins q a. Investment and Tobins q were not closely correlated following the 1987 crash in stock prices b. But the relationship has been tighter in the 1990s and early 2000s, as theory suggests

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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 weve seen in this chapter, such policies could indeed affect peoples decisions to save (by affecting the aftertax real rate of interest) and to invest (by reducing the after-tax cost of capital). But what isnt 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 isnt perfectly 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. Analytical Problems 1, 2, 3, and 4 all looks at shocks to the economy and changes in variables needed to restore equilibrium. For a useful summary of research on consumption and investment, see Andrew B. Abel, Consumption and Investment, in B. Friedman and F. Hahn, eds., Handbook of Monetary Economics, vol. 2, Netherlands: Elsevier Science Publishers, 1990, pp. 725778. IV. Appendix 4.A: A Formal Model of Consumption and Saving A) How much can the consumer afford? The budget constraint f 1. Current income y; future income y ; initial wealth a f 2. Choice variables: a = wealth at beginning of future period; c = current consumption; f c = future consumption f f f 3. a = (y + a c)(1 + r), so c = (y + a c)(1 + r) + y (4.A.1) the budget constraint B) The budget line f 1. Graph budget line in (c, c ) space (Figure 4.A.1)

Figure 4.A.1 2. Slope of line = (1 + r)

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Analytical Problem 7 looks at what happens to the budget line when the interest rate on borrowing differs from the interest rate on lending. C) Present values 1. Present value is the value of payments to be made in the future in terms of todays dollars or goods 2. Example: At an interest rate of 10%, $12,000 today invested for one year is worth $13,200 ($12,000 1.10); so the present value of $13,200 in one year is $12,000 3. General formula: Present value = future value/(1 + i), where amounts are in dollar terms and i is the nominal interest rate 4. Alternatively, if amounts are in real terms, use the real interest rate r instead of the nominal interest rate i Once youve established the intuition about the present value formula for one period, you can extend it to additional periods to show that the present value of an amount X to be received in n n years is X/(1 + i) . D) Present value and the budget constraint 1. Present value of lifetime resources: PVLR = y + y /(1 + r) + a
f

(4.A.2)

2. Present value of lifetime consumption: PVLC = c + c /(1 + r)

f

3. The budget constraint means PVLC = PVLR f f 4. c + c /(1 + r) = y + y /(1 + r) + a f 5. Horizontal intercept of budget line is c = PVLR, c = 0

(4.A.3)

E) What does the consumer want? Consumer preferences 1. Utility = a persons satisfaction or well-being 2. Graph a persons preference for current versus future consumption using indifference curves f 3. An indifference curve shows combinations of c and c that give the same utility (Figure 4.A.2)

Figure 4.A.2

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4. A person is equally happy at any point on an indifference curve 5. Three important properties of indifference curves a. Slope downward from left to right: Less consumption in one period requires more consumption in the other period to keep utility unchanged b. Indifference curves that are farther up and to the right represent higher levels of utility, because more consumption is preferred to less c. Indifference curves are bowed toward the origin, because people have a consumptionsmoothing motive, they prefer consuming equal amounts in each period rather than consuming a lot one period and little the other period If students want more help on indifference curves, you can refer them to a principles of economics or intermediate microeconomics text, such as Michael Parkin, Economics, 5th edition, Reading, Mass.: Addison Wesley Longman, 2000. F) The optimal level of consumption 1. Optimal consumption point is where the budget line is tangent to an indifference curve (Figure 4.A.3)

Figure 4.A.3 2. Thats the highest indifference curve that its possible to reach 3. All other points on the budget line are on lower indifference curves

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G) The Effects of Changes in Income and Wealth on Consumption and Saving 1. The effect on consumption of a change in income (current or future) or wealth depends only on how the change affects the PVLR a. An increase in current income (Figure 4.A.4)

Figure 4.A.4 (1) Increases PVLR, so shifts budget line out parallel to old budget line (2) If there is a consumption-smoothing motive, both current and future consumption will increase (3) Then both consumption and saving rise because of the rise in current income b. An increase in future income (1) Same outward shift in budget line as an increase in current income (2) Again, with consumption smoothing, both current and future consumption increase (3) Now saving declines, since current income is unchanged and current consumption increases c. An increase in wealth (1) Same parallel shift in budget line, so both current and future consumption rise (2) Again, saving declines, since c rises and y is unchanged Numerical Problem 8 deals with the income effect on consumption and saving. d. The permanent income theory (1) Different types of changes in income f (a) Temporary increase in income: y rises and y is unchanged f (b) Permanent increase in income: Both y and y rise (2) Permanent income increase causes bigger increase in PVLR than a temporary income increase (a) So current consumption will rise more with a permanent income increase (b) So saving from a permanent increase in income is less than from a temporary increase in income (3) This distinction between permanent and temporary income changes was made by Milton Friedman in the 1950s and is known as the permanent income theory (a) Permanent changes in income lead to much larger changes in consumption (b) Thus permanent income changes are mostly consumed, while temporary income changes are mostly saved

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H) Consumption and Saving Over Many Periods: The Life-Cycle Model 1. Life-cycle model was developed by Franco Modigliani and associates in the 1950s a. Looks at patterns of income, consumption, and saving over an individuals lifetime b. Typical consumers income and saving pattern shown in Figure 4.A.5

Figure 4.A.5 c. Real income steadily rises over time until near retirement; at retirement, income drops sharply d. Lifetime pattern of consumption is much smoother than the income pattern (1) In reality, consumption varies somewhat by age (2) For example, when raising children, household consumption is higher than average (3) The model can easily be modified to handle this and other variations e. Saving has the following lifetime pattern (1) Saving is low or negative early in working life (2) Maximum saving occurs when income is highest (ages 50 to 60) (3) Dissaving occurs in retirement 2. Bequests and saving a. What effect does a bequest motive (a desire to leave an inheritance) have on saving? b. Simply consume less and save more than without a bequest motive

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3. Ricardian equivalence a. We can use the two-period model to examine Ricardian equivalence b. The two-period model shows that consumption is changed only if the PVLR changes c. Suppose the government reduces taxes by 100 in the current period, the interest rate is 10%, and taxes will be increased by 110 in the future period d. Then the PVLR is unchanged, and thus there is no change in consumption 4. Excess sensitivity and borrowing constraints a. Generally, theories about consumption, including the permanent income theory, have been supported by looking at real-world data b. But some researchers have found that the data show that the impact of an income or wealth change is different than that implied by a change in the PVLR c. There seems to be excess sensitivity of consumption to changes in current income (1) This could be due to shortsighted behavior (2) Or it could be due to borrowing constraints d. Borrowing constraints mean people cant borrow as much as they want Lenders may worry that a consumer wont pay back the loan, so they wont lend e. If a person wouldnt borrow anyway, the borrowing constraint is said to be nonbinding f. But if a person wants to borrow and cant, the borrowing constraint is binding g. A consumer with a binding borrowing constraint spends all income and wealth on consumption (1) So an increase in income or wealth will be entirely spent on consumption as well (2) This causes consumption to be excessively sensitive to current income changes h. How prevalent are borrowing constraints? Perhaps 20% to 50% of the U.S. population faces binding borrowing constraints Numerical Problem 9 deals with borrowing constraints. I) The Real Interest Rate and the Consumption-Saving Decision 1. The real interest rate and the budget line (Figure 4.A.6)

Figure 4.A.6 a. When the real interest rate rises, one point on the old budget line is also on the new budget line: the no-borrowing, no-lending point b. Slope of new budget line is steeper

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2. The substitution effect a. A higher real interest rate makes future consumption cheaper relative to current consumption b. Increasing future consumption and reducing current consumption increases saving c. Suppose a person is at the no-borrowing, no-lending point when the real interest rate rises (Figure 4.A.7)

Figure 4.A.7 (1) An increase in the real interest rate unambiguously leads the person to increase future consumption and decrease current consumption (2) The increase in saving, equal to the decrease in current consumption, represents the substitution effect 3. The income effect a. If a person is planning to consume at the no-borrowing, no-lending point, then a rise in the real interest rate leads just to a substitution effect b. But if a person is planning to consume at a different point than the no-borrowing, no-lending point, there is also an income effect c. The intuition of the income effect (1) If the person originally planned to be a lender, the rise in the real interest rate gives the person more income in the future period; the income effect works in the opposite direction of the substitution effect, since more future income increases current consumption (2) If the person originally planned to be a borrower, the rise in the real interest rate gives the person less income in the future period; the income effect works in the same direction as the substitution effect, since less future income reduces current consumption further

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4. The income and substitution effects together a. Split the change in the budget line into two parts (Figure 4.A.8)

Figure 4.A.8 (1) A budget line with the same slope as the new budget line, but going through the int original consumption point (BL ) 1 (2) The substitution effect is shown by the change from budget line BL to budget line int BL , with the consumption point changing from point D to point P int 2 (3) The income effect is shown by the change from budget line BL to budget line BL , with consumption point changing from point P to point Q b. The substitution effect decreases current consumption, but the income effect increases current consumption; so saving may increase or decrease c. Both effects increase future consumption d. For a borrower, both effects decrease current consumption, so saving definitely increases but the effect on future consumption is ambiguous Analytical Problem 6 asks the student to show the income and substitution effects for a borrower. e. The effect on aggregate saving of a rise in the real interest rate is ambiguous theoretically (1) Empirical research suggests that saving increases (2) But the effect is small

Additional Teaching Notes

The following material was deleted from the Fifth Edition of the textbook, but is presented here for instructors who wish to present the material in class. You may copy these pages and hand them out to your students.

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Consumer Sentiment and the 1990-1991 Recession

The theory of consumer behavior tells us that consumers decisions about how much to consume and how much to save should depend on their expectations about the economys future. When consumers are optimistic about the future, they will consume more and save less than when they are pessimistic about it. For this reason, economic forecasters and other analysts find it useful to know what consumers are thinking about the future at any particular time. Various surveys regularly try to measure consumers expectations. Two of the best known are the consumer confidence index published by The Conference Board and the index of consumer sentiment published by The Survey Research Center at the University of Michigan. Here we focus on the index of consumer sentiment, which is based on the responses of several hundred households to questions about their current and expected future financial situation and their expectations about the economys performance in the next one to five years. The index is measured relative to a value of 100 for 1966, with higher values corresponding to greater consumer optimism. The Survey Research Center publishes the index in a detailed monthly report called Surveys of Consumer Attitudes, with these findings being available on the Internet at www.sca.isr.umich.edu. Historically, the index of consumer sentiment has been a sensitive indicator of recessions and other macroeconomic shocks. Figure 4.1(a) shows monthly data for the index of consumer sentiment for the eight-year period January 1987December 1994, and Fig. 4.1(b) shows quarterly data for real total consumption and real consumption expenditures on durable goods during the same period. Expenditures on durable goods, which are measured on the scale on the right side of the figure, are only about one-eighth of total consumption expenditures, which are measured on the scale on the left side of the figure. We show expenditures on durable goods in addition to total consumption because expenditures on durable goods (such as automobiles, appliances, and furniture) tend to display sharper fluctuations than expenditures on the other components of consumption (such as food and heating oil). When consumers become pessimistic about the future, they may delay the purchase of a new car more easily than they would delay the purchase of food or heating oil, so the effects of consumer sentiment may be more readily evident in durable goods expenditures than in overall consumption. When Iraq invaded Kuwait in August 1990, the index of consumer sentiment took its sharpest tumble in almost a decade, reflecting consumers concerns about the long-term implications of the invasion and perhaps broader economic worries as well. As Fig. 4.1(b) shows, consumer spending also fell sharply in the fourth quarter of 1990 as a recession began. Total consumption expenditures fell by 0.8% and expenditures on durable goods declined by 3.0% during that quarter. As Fig. 4.1(a) shows, the index of consumer sentiment was quite volatile during 1991, soaring in March after the Gulf War, then plummeting later in the year. In 1992, the index of consumer sentiment dropped in each of the four months pre-ceding the presidential election, perhaps reflecting the economic concerns of voters that led them to vote President George H. W. Bush out of office. The index of consumer sentiment strengthened sharply after the election, only to fall again in the spring of 1993. As a consequence of this consumer pessimism and uncertainty, growth in overall consumption and growth in expenditures on durable goods were slow and erratic during the early stages of the economic recovery that began in March 1991.

Additional Issues for Classroom Discussion

1. Do You Believe in Ricardian Equivalence?
Economists have debated the idea of Ricardian equivalence for some time now (Robert Barros classic article, Are Government Bonds Net Wealth? appeared in 1974). An interesting debate for students is for them to take sides as to whether or not Ricardian equivalence holds. You can discuss many possible reasons why it might not hold and other reasons why it may be a useful benchmark for comparison to other theories.

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2.

The Interaction of Taxation and Inflation

Macroeconomists like to debate whether the central bank should drive inflation down to zero or merely maintain it at a fairly low level. But the evidence on the interaction of inflation with the tax system may convince some people that inflation should be zero. As the example in text table 4.1 shows, if you get a e nominal interest rate (i) of 5%, expected inflation ( ) is 2%, and you are in the 30% tax (t) bracket, your e expected after-tax real interest rate is (1 t)i = 1.5%. If you invested $10,000, you get a nominal return of $500, of which you get to keep $150 in real terms, inflation eats away $200, and the government gets $150. So the government gets the same amount as you doso your real tax rate is 50%. In the 1970s and early 1980s when inflation reached double digits, the real tax rate on investment income was well over 100%, so that nearly any investment had a negative return, but the government made a large return. Present this idea to your students and see how many change their minds about the desirability of reducing inflation to zero (or at least reforming the tax system).

3. Should the Government Reduce Taxes on Capital?

Our analysis of investment and the desired capital stock shows that taxes are important. A policy issue thats been discussed by economists in recent years is a proposal to reduce or eliminate capital taxation. You might ask your students to debate the pros and cons of doing so. What would be the benefits? What would happen to real interest rates and to investment and the capital stock? Are there any costs to such a policy? Who do you think earns most of the capital income in the United States? What would the consequences be for the distribution of income among people of different income groups?

4.

Is Saving Too Low in the United States?

The analytical framework that is developed in the textbook can be used to analyze the consequences of the fall in the U.S. saving rate. Over the last 20 years, saving as a proportion of GDP has declined substantially. Can your students provide some economic rationale for why this has occurred? One rationale that doesnt work is the change in demographics, which should have boosted saving in the 1980s as baby boomers reached their prime working years; instead, the saving rate declined. What other reasons can your students come up with that explains the decline? Next, you may wish to discuss the consequences of the decline. Based on the textbook model, the decline in saving raises the real interest rate and reduces the equilibrium amount of investment. But is this something the government should try to counteract? Does the answer to this question depend on the reasons listed above for the decline in the saving rate?

5.

Should Social Security Funds Be Invested in the Stock Market?

The Social Security trust fund is projected to decline to zero around the year 2030, thanks to demographic changes, especially the aging of the population and lower birth rates. A number of solutions are possible, including reducing Social Security benefits or increasing taxes. Another possibility is to allow the trust fund to invest in the stock market, so the returns to the fund would be higher than they are now. Currently, the trust fund buys just federal government bonds, which have a significantly lower return over time than do investments in the stock market. The question to discuss with your class is: Should Social Security funds be invested in the stock market? Your students will likely point out the key issue, which is risk versus return. There are also important details that affect the decision that are worth thinking about, such as: (1) Should individuals control their own portfolios? (2) What happens if the stock market crashes? (3) What happens in the transition to people who have put money into the current plan (which is pay-as-you-go)? (4) What if people make bad investment decisions, considering that Social Security is supposed to provide a safety net?

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6.

How Are You Trading Off the Present for the Future?

The material in the appendix may seem theoretical and abstract, but its easy to show students that theyre really acting in the way the chapter describes. Ask them what tradeoffs theyre making between the present and the future. The most obvious tradeoff is the fact that theyre in college, acquiring human capital, rather than working for pay. Even more, many of them have borrowed money to pay for college, so they are accumulating debt today to increase income and consumption in the future. And what is the rate at which they trade off the present for the future? Its the interest ratethe additional amount theyll owe because of their borrowing today.

7. What Borrowing Constraints Do You Face?

Some of your students may have already faced severe borrowing constraints in their lives. Some may note that they could not obtain credit very easily. Fortunately, many will have been able to borrow enough money to go to college, thanks to government programs that allow equal opportunity in education. But in terms of borrowing for consumption spending, your students are likely to have faced dramatically different circumstances.

Answers to Textbook Problems

Review Questions
1. Saving is current income minus consumption. For given income, any increase in consumption means an equal decrease in saving, so consumption and saving are inversely related. The basic motivation for saving is to provide for future consumption. When a consumer gets an increase in current income, both current consumption and future consumption increase. Since current consumption rises, but by less than the increase in current income, saving increases. When the consumer gets an increase in expected future income, again both current and future consumption increase. Since current income does not increase, but current consumption does, saving decreases. When the consumer gets an increase in wealth, both current and future consumption again rise. Again, there has been no increase in current income, so saving decreases. At the aggregate level, these changes in consumption and saving made by individuals are decisions that change the aggregate level of desired consumption and saving. The effect on desired saving of an increase in the expected real interest rate is potentially ambiguous. An increase in the real interest rate has two effects on desired saving: (1) the substitution effect increases saving, because the amount of future consumption that can be obtained in exchange for giving up a unit of current consumption rises; and (2) the income effect may increase or reduce saving. The income effect reduces saving for a lender, because a person who saves is better off as a result of having a higher real interest rate, so he or she increases current consumption. However, for a borrower, the income effect increases saving, because the borrower is worse off having to face a higher real interest rate, and so reduces current consumption. So the income effects work in different directions depending on whether a person is a lender or a borrower. For a borrower, then, both the income and substitution effects work in the same direction, and saving definitely increases. For a lender, however, the income and substitution effects work in opposite directions, so the result on desired saving is ambiguous.

2.

3.

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4.

The expected after-tax real interest rate is the after-tax nominal interest rate, (1 t)i, minus the e expected rate of inflation, , and represents the real return earned by a saver when a portion, t, of interest income must be paid as taxes. If the tax rate on interest income declines (that is, t declines), then 1 t becomes larger, so the expected after-tax real interest rate increases. When government purchases increase temporarily, consumers see that higher taxes will be required in the future to pay off the deficit. They reduce both current consumption and future consumption, but current consumption declines by less than the amount of the government purchases. Since national saving is output minus desired consumption minus government purchases, and government purchases have increased more than current desired consumption has decreased, national saving declines at a given real interest rate. In the case of a lump-sum tax increase, consumers have higher taxes today, but lower taxes in the future. If consumers take this into account, current desired consumption is unchanged, and since output and government purchases didnt change, desired national saving is unchanged as well. This is the case of Ricardian equivalence, and is controversial because consumers may not understand that higher taxes today imply lower future taxes. As a result, they may reduce desired consumption today, increasing desired national saving. The two components of the user cost of capital are the interest cost and the depreciation cost. The depreciation cost is the value lost as the capital wears out during the period. The interest cost represents the opportunity cost of not using the funds that purchased the capital in some other way; an example would be if the money was invested in bonds rather than buying capital goods. The desired capital stock is the amount of capital that allows the firm to earn the largest possible profit. The higher the expected future marginal product of capital, the higher the desired capital stock, since any given amount of capital will be more productive in the future. The higher the user cost of capital, the lower the desired capital stock, since a higher user cost yields lower profits on each unit of capital. The higher the effective tax rate, the lower the desired capital stock, again because the firm gets lower profits on each unit of capital. Gross investment represents the total purchase or construction of new capital goods that takes place during a period. Net investment is gross investment minus the depreciation on existing capital. Thus net investment is the overall increase in the capital stock. Yes, it is possible for gross investment to be positive when net investment is negative. This occurs whenever gross investment is less than the amount of depreciation (and, in fact, happened in the United States during World War II). Equilibrium in the goods market occurs when the aggregate supply of goods (Y ) equals the aggregate d d d d demand for goods (C + I + G). Since desired national saving (S ) is Y C G, an equivalent d d condition is S = I . Equilibrium is achieved by the adjustment of the real interest rate to make the desired level of saving equal to the desired level of investment, as shown in text Figure 4.6.

5.

6.

7.

8.

9.

10. The saving curve slopes upward because saving is assumed to increase with an increase in the expected real interest rate. The investment curve slopes downward because investment is lower the higher is the expected real interest rate. The saving curve would be shifted to the right by an increase in current output, a decrease in expected future output, a decrease in wealth, a decrease in government purchases, and possibly by a rise in taxes. The investment curve would shift to the right by a decline in the effective tax rate or a rise in expected future marginal product of capital.

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Numerical Problems
1. First, a general formulation of the problem is useful. With income of Y1 in the first year and Y2 in the second year, the consumer saves Y1 C in the first year and Y2 C in the second year, where C is the consumption amount, which is the same in both years. Saving in the first year earns interest at rate r, where r is the real interest rate. And the consumer needs to accumulate just enough after two years to pay for college tuition, in the amount T. So the key equation is (Y1 C )(1 + r) + (Y2 C ) = T. (a) Y1 = Y2 = $50,000, r = 10%, T = $12,600. The key equation gives ($50,000 C)1.1 + ($50,000 C) = $12,600. This can be simplified to $50,000 C = $12,600/2.1 = $6000, which can be solved to get C = $44,000. Then S = Y C = $50,000 $44,000 = $6000. (b) Y1 = $54,200. The key equation is now ($54,200 C )1.1 + ($50,000 C ) = $12,600. This can be simplified to ($54,200 1.1) + $50,000 $12,600 = 2.1 C, or $97,020 = 2.1 C, so C = $46,200. Then S = Y1 C = $54,200 $46,200 = $8000. This illustrates that a rise in current income increases saving. (c) Y2 = $54,200. The key equation is now ($50,000 C )1.1 + ($54,200 C ) = $12,600. This can be simplified to ($50,000 1.1) + $54,200 $12,600 = 2.1 C, or $96,600 = 2.1 C, so C = $46,000. Then S = Y1 C = $50,000 $46,000 = $4000. This illustrates that a rise in future income decreases saving. (d) With the increase in wealth of W, the total amount invested for the second period is W + Y1 C, so the key equation becomes ($1050 + $50,000 C )1.1 + ($50,000 C ) = $12,600. This can be simplified to ($51,050 1.1) + $50,000 $12,600 = 2.1 C, or $93,555 = 2.1 C, so C = $44,550. Then S = Y1 C = $50,000 $44,550 = $5450. This illustrates that a rise in wealth decreases saving. (e) T = $14,700. The key equation is now ($50,000 C )1.1 + ($50,000 C ) = $14,700. This can be simplified to $50,000 C = $14,700/2.1 = $7000, which can be solved to get C = $43,000. Then S = Y C = $50,000 $43,000 = $7000. The rise in targeted wealth needed in the future raises current saving. (f) r = 25%. The key equation is now ($50,000 C )1.25 + ($50,000 C ) = $12,600. This can be simplified to $50,000 C = $12,600/2.25 = $5600, which can be solved to get C = $44,400. Then S = Y C = $50,000 $44,400 = $5600. The rise in the real interest rate, with a given wealth target, reduces current saving. 2. (a) This chart shows the MPK as the increase in output from adding another fabricator: # Fabricators 0 1 2 3 4 5 6 Output 0 100 150 180 195 205 210 MPK 100 50 30 15 10 5
f f

(b) uc = (r + d )pK = (0.12 + 0.20)$100 = $32. HHHHC should buy two fabricators, since at two f f fabricators, MPK = 50 > 32 = uc. But at three fabricators, MPK = 30 < 32 = uc. You want to add fabricators only if the future marginal product of capital exceeds the user cost of capital. The f MPK of the third fabricator is less than its user cost, so it should not be added.

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(c) When r = 0.08, uc = (0.08 + 0.20)$100 = $28. Now they should buy three fabricators, since MPK f = 30 > 28 = uc for the third fabricator and MPK f = 15 < 28 = uc for the fourth fabricator. f (d) With taxes, they should add additional fabricators as long as (1 )MPK > uc. Since = 0.4, f 1 = 0.6. They should buy just one fabricator, since (1 )MPK = 0.6 100 = 60 > 32 = uc. f They shouldnt buy two, since then (1 )MPK = 0.6 50 = 30 < 32 = uc. f (e) When output doubles, the MPK doubles as well. At r = 0.12, they should buy three fabricators, f f since then MPK = 60 > 32 = uc; they shouldnt buy four, since then MPK = 30 < 32 = uc. f At r = 0.08, they should buy four fabricators, since then MPK = 30 > 28 = uc; they shouldnt f buy five, since then MPK = 20 < 28 = uc. 3. (a) The expected after-tax real interest rate is r = i(1 t) = 0.10 (1 0.30) 0.05 = 0.07 0.05 = 0.02. (b) The cost of maintaining the house is depreciation. So the annual user cost of capital is uc = (r + d )pK = (0.02 + 0.06)$200,000 = $16,000. (c) You should be indifferent between buying and renting if the rent is $16,000 per year.
e

4.

Since the price of capital declines from 60 to 51, the depreciation rate is 9/60 = .15. (a) uc = (r + d )pK = (.10 + .15)60 = 15 units of output per year. f (b) The desired capital stock is such that MPK = uc, so 165 2K = 15, or 2K = 150, so K = 75. (c) The tax-adjusted user cost of capital is uc/(1 ), so with = .4, the condition for the desired capital stock is 165 2K = 15/0.6, or 2K = 140; the solution is K = 70. Thus taxation decreases the firms desired capital stock. (d) The investment tax credit basically lowers the price of capital from 60 to (1 0.2)60 = 48. So the tax-adjusted user cost of capital is only (.25 48)/0.6 = 20. Then the equation for setting the desired capital stock is 165 2K = 20, or 2K = 145; the solution is K = 72.5. Thus the investment tax credit increases the firms desired capital stock. (a) Desired consumption declines as the real interest rate rises because the higher return to saving encourages higher saving; desired investment declines as the real interest rate rises because the user cost of capital is higher, reducing the desired capital stock, and thus investment. d d d d (b) Use the following table, where S = Y C G = 9000 C 2000 = 7000 C . r 2 3 4 5 6 C 6100 6000 5900 5800 5700
d

5.

I 1500 1400 1300 1200 1100

S 900 1000 1100 1200 1300

d d

C +I +G 9600 9400 9200 9000 8800

d d

(c) Equation (4.7) says that Y = C + I + G at equilibrium. Looking at the last column of the table, d d d with Y = 9000, this is true only at r = 5%. At this point, S = I = 1200. Equation (4.8) says that S d = I at equilibrium. From the table, this occurs at r = 5%.

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(d) When government purchases fall by 400 to 1600, each S entry in the table is higher by 400, d d d d d and each C + I + G entry is lower by 400. Then Y = C + I + G occurs at r = 3%, as does S = d I = 1400. r 2 3 4 5 6 6.
d

C 6100 6000 5900 5800 5700

d

I 1500 1400 1300 1200 1100

S 1300 1400 1500 1600 1700

C +I +G 9200 9000 8800 8600 8400

d d

(a) S = Y C G = Y (3600 2000r + 0.1Y ) 1200 = 4800 + 2000r + 0.9Y d d (b) (1) Using Eq. (4.7): Y = C + I + G Y = (3600 2000r + 0.1Y ) + (1200 4000r) + 1200 = 6000 6000r + 0.1Y So 0.9Y = 6000 6000r At full employment, Y = 6000. Solving 0.9 6000 = 6000 6000r, we get r = 0.10. (2) Using Eq. (4.8): d d S =I 4800 + 2000r + 0.9Y = 1200 4000r 0.9Y = 6000 6000r When Y = 6000, r = 0.10. So we can use either Eq. (4.7) or (4.8) to get to the same result. d d (c) When G = 1440, desired saving becomes S = Y C G = Y (3600 2000r + 0.1Y ) 1440 = d d 5040 + 2000r + 0.9Y. S is now 240 less for any given r and Y; this shows up as a shift in the S 1 2 line from S to S in Figure 4.3.

Figure 4.3

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Setting S = I , we get:
d d

5040 + 2000r + 0.9Y = 1200 4000r 6000r + 0.9Y = 6240 At Y = 6000, this is 6000r = 6240 (0.9 6000) = 840, so r = 0.14. The market-clearing real interest rate increases from 10% to 14%. r = 0.10 uc/(1 ) = (r + d )pK/(1 ) = [(.1 + .2) 1]/(1 .5) = 0.6. f f f MPK = uc/(1 ), so 20 .02K = .6; solving this gives K = 970. f f Since K K = I dK, I = K K + dK = 970 900 + (.2 900) = 250. i. Solving for this in general: uc/(1 ) = (r + d)pK/(1 ) = [(r + .2) 1]/(1 .5) = .4 + 2r. f f MPK = uc/(1 ), so 20 .02K = .4 + 2r; solving this gives K = 980 100r. f I = K K + dK = 980 100r 900 + (.2 900) = 260 100r. ii. Y = C + I + G 1000 = [100 + (.5 1000) 200r] + (260 100r) + 200 1000 = 1060 300r, so 300r = 60 r = 0.2 C = 560; I = 240 = S; uc/(1 ) = .4 + (2 .2) = 0.8; f K = 960 f PVLR = y + [y /(1 + r)] + a = 90 + (110/1.10) + 20 = 210. f c + [c / (1 + r)] = PVLR. f c + (c / 1.10) = 210. f When c = 0, c = 231; this is the vertical intercept of the budget line, shown in Figure 4.4. f When c = 0, c = 210; this is the horizontal intercept of the budget line.

7.

(a)

(b)

8.

(a)

(b)

Figure 4.4

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(c) c = c : c + (c/1.10) = 210. 1.10c + c = 210 1.10. 2.1c = 231. c = 110.

f

s=yc = 90 110 = 20. (d) y increases by 11, so new PVLR = 221. 2.1c = 221 1.1 = 243.1. c = 115.76. s = y c = 101 115.76 = 14.76. So part of the temporary increase in income is consumed and part is saved. f (e) y increases by 11, so PVLR rises by 11/1.10 = 10. New PVLR = 220. 2.1c = 220 1.1 = 242. c = 115.24. s = y c = 90 115.24 = 25.24. So a rise in future income leads to an increase in current consumption but a decrease in saving. (f) A rise in initial wealth has the same effect on the PVLR and thus on consumption as an increase in current income of the same amount, so c = 115.76 as in part (d). s = y c = 90 115.76 = 25.76. So an increase in wealth increases current consumption and decreases saving. 9. (a) PVLR = a + y + y + y = 1500. l w r (1) No borrowing constraint: c + c + c = 1500.
l w r

c = c = c = c = 1500/3 = 500.
l w r

s = 200 500 = 300; s = 800 500 = 300; s = 200 500 = 300.

l w r

(2) A borrowing constraint is nonbinding, since a + y = 500 = c , and c = 500 < 800 = y . So consumption and saving are the same in each period as in part (1) above. (b) PVLR = 1200. (1) No borrowing constraint: c = 1200/3 = 400.
l l w w

s = 200 400 = 200; s = 800 400 = 400; s = 200 400 = 200.

l w r

(2) The borrowing constraint is now binding, since c = 400 > a + y = 200. So c is constrained to w r w w be 200. That leaves PVLR of 1000 for c + c , so they both equal 500. c = 500 < 800 = y , so the borrowing constraint is not binding in working age.
l l l

s = 200 200 = 0; s = 800 500 = 300; s = 200 500 = 300.

l w r

Consumption cant be lower in all periods due to a binding borrowing constraint, because the present value of lifetime consumption must be the same with and without borrowing constraints.

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Analytical Problems
1. (a) As Figure 4.5 shows, the shift to the right in the saving curve from S to S causes saving and investment to increase and the real interest rate to decrease.
1 2

Figure 4.5 (b) This is really just a transfer from the general population to veterans. The effect on saving depends on whether the marginal propensity to consume (MPC ) of veterans differs from that of the general population. If there is no difference in MPCs, there will be no shift of the saving curve; neither investment nor the real interest rate is affected. If the MPC of veterans is higher than the MPC of the general population, then desired national saving declines and the saving curve shifts to the left; the real interest rate rises and investment declines. If the MPC of veterans is lower than that of the general population, the saving curve shifts to the right; the real interest rate declines and investment rises. 1 2 (c) The investment tax credit encourages investment, shifting the investment curve from I to I in Figure 4.6. Saving and investment increase, as does the real interest rate.

Figure 4.6

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(d) The increase in expected future income decreases current desired saving, as people increase desired consumption immediately. The rise of the future marginal productivity of capital shifts the investment curve to the right. The result, as shown in Figure 4.7, is that the real interest rate rises, with ambiguous effects on saving and investment.

Figure 4.7 2. (a) With a lower capital stock, the marginal product of labor is reduced, so the labor demand curve 1 2 shifts to the left from ND to ND in Figure 4.8. Then the new equilibrium point is one with lower employment and a lower real wage. With lower employment and a lower capital stock, full-employment output will be lower.

Figure 4.8 (b) Because the capital stock is lower, the marginal product of capital will be higher, so desired investment will increase. (c) Since current output declines, desired saving declines, because people do not want to reduce their consumption. On the other hand, since future output is also lower, people desire to save more today to make up for the loss of future income.

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d 1 2

(d) The increase in desired investment shows up as a shift to the right in the I curve, from I to I in Figure 4.9. Then the new equilibrium (assuming no change in desired saving) is at a higher level of investment and a higher real interest rate.

Figure 4.9 3. (a) The temporary increase in the price of oil reduces the marginal product of labor, causing the 1 2 labor demand curve to shift to the left from ND to ND in Figure 4.10. At equilibrium, there is a reduced real wage and lower employment.

Figure 4.10

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The productivity shock results in a reduction of output. Because the shock is temporary, the only effect on desired saving or investment is due to the reduction in current output, causing desired national saving to fall. This shifts the saving curve to the left, raising the real interest rate and reducing the level of desired investment, as well as desired national saving, as shown in Figure 4.11.

Figure 4.11 (b) The permanent increase in the price of oil reduces the marginal product of labor, causing the labor demand curve to shift to the left, again as in Figure 4.10. (Also, the decline in future income means the labor-supply curve will shift to the right; but well assume that this shift is less than the shift to the left of the labor-demand curve.) At equilibrium, there is a reduced real wage and lower employment. The productivity shock results in a reduction of current output. Because the shock is permanent, it reduces future output as well, and reduces the future marginal product of capital. The desired 1 2 investment curve shifts to the left, from I to I in Figure 4.12, because the future marginal product of capital is lower. The effect on desired saving is ambiguousthe reduction in current income reduces desired saving, but the reduction in expected future income increases desired saving. Lets assume that the former effect outweighs the latter, so that the desired saving curve 1 2 shifts to the left from S to S . Then national saving and investment both decline. Again, the effect on the real interest rate is ambiguous. (Alternatively, if the effects on desired saving of the

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reductions in current income and future income offset each other exactly, the desired saving curve does not shift. In this case, the leftward shift of the investment curve along an unchanged saving curve reduces the real interest rate, saving, and investment.)

Figure 4.12 4. A temporary increase in government spending reduces national saving. Whether the spending is financed by current taxes or by borrowing (and raising future taxes), consumption falls, but not by d the full amount of the spending. Since S = Y C G, national saving declines. This is shown in Figure 4.13 as a shift to the left in the saving curve. The real interest rate must increase to get S = I, so I declines as well. It makes no difference whether the temporary increase in spending is funded by taxes or by borrowing.

Figure 4.13

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1

89

In the case of infrastructure spending, MPK rises, so investment increases. Saving shifts from S to 2 1 2 S and investment shifts from I to I in Figure 4.14. With upward shifts in both saving and investment, the new equilibrium is one with a higher real interest rate. However, saving and investment at the new equilibrium may be higher or lower. The effect on consumption is unclear as well. The higher real interest rate reduces consumption, but future income is higher, which increases consumption. If investment actually rises, then the increase in government spending causes private investment to be crowded in rather than crowded out. In this case consumption is crowded out.

Figure 4.14 5. When there is a temporary increase in government spending, consumers foresee future taxes. As a result, consumption declines, both currently and in the future. Thus current consumption does not d d fall by as much as the increase in G, so national saving (S = Y C G) declines at the initial real 1 2 interest rate, and the saving curve shifts to the left from S to S , as shown in Figure 4.15. Thus the real interest rate increases and consumption and investment both fall.

Figure 4.15

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When there is a permanent increase in government spending, consumers foresee future taxes as well, with both current and future consumption declining. But if there is an equal increase in current and future government spending, and consumers try to smooth consumption, they will reduce their current and future consumption by about the same amount, and that amount will be about the same amount as the increase in government spending. So the saving curve in the saving-investment diagram does not shift, and there is no change in the real interest rate. Since the saving curve shifts upward more in the case of a temporary increase in government spending, the real interest rate is higher, so investment declines by more. However, consumption falls by more in the case of a permanent increase in government spending. 6. See Figure 4.16. The consumer is originally on budget line BL , with consumption at point D. An 2 increase in the real interest rate shifts the budget line to BL , with consumption at point Q. The change can be broken down into two steps. First, the substitution effect shifts the budget line from 1 int BL to BL , and the consumption point changes from point D to point P. The substitution effect results in higher future consumption and lower current consumption. The income effect shifts the int 2 budget line from BL to BL , with the consumption point changing from point P to point Q. The income effect results in lower current and future consumption. Thus the income and substitution effects work in the same direction, reducing current consumption and increasing saving.
1

Figure 4.16

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7.

The difference in interest rates between borrowing and lending means there is a kink in the budget constraint at the no-lending, no-borrowing point, as shown in Figure 4.17. Borrowing is zero when c = y + a. If current consumption is less than y + a, the person is a saver (lender), and the budget line has slope (1 + rl). If current consumption is greater than y + a, the person is a borrower, and faces a steeper budget constraint with slope (1 + rb), because the interest rate is higher.

Figure 4.17 An increase in either interest rate would steepen only the portion of the budget constraint for which that interest rate is relevant. An increase in the real interest rate on lending is shown as a shift in the 1 2 budget line segment from BL to BL in Figure 4.18. An increase in the real interest rate on 3 4 borrowing is shown as a shift in the budget line segment from BL to BL . If the indifference curve hits the budget line at the no-borrowing, no-lending point, as shown, then there will be no change in current or future consumption due to a change in either interest rate.

Figure 4.18

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An increase in the consumers initial wealth would lead to a parallel rightward shift of both segments of the budget line, as shown in Figure 4.19.

Figure 4.19