Chapter 4 Flashcards
In the context of Consumption and Saving:
What is the formula of the Income Expenditure Identity?
Y = C + I + G + NX
The G is given while the net exports is 0 (closed economy)
Desired Consumption and Desired Saving are decisions about
How much to consume and how much to save
Desired Consumption and Desired Saving:
National Level of Desired Consumption (C^d) is
The aggregate quantity of goods and services that households want to consume
Given income and other factors that determine households’ economic opportunities.
Desired Consumption and Desired Saving:
National Level of Desired Consumption (C^d) is obtained by
Adding up the desired consumption of all households
Desired Consumption and Desired Saving:
National Level of Desired saving (S^d) is
Level of national saving that occurs when aggregate consumption is at its desired level
Desired Consumption and Desired Saving:
The fromula of National Level of Desired saving (S^d) is
S^d = Y – C^d - G
S = Y + NFP – C - G NFP = 0 (closed economy) so technically
(S = Y – C - G) = (S^d = Y – C^d - G)
Consumption and Saving Decision of an Individual:
Given r, the consumer could either
r ~ interest
- Current consumption
- Future consumption (Current Saving)
Smooth Pattern of consumption involves
Creating a balance between spending and saving
Consumption and Saving Decision of an Individual:
Factors that affect Desired national saving
- Current Income
- Expected Future Income
- Wealth
- Real Interest rate
- Fiscal policy
In all cases the G is given except with Fiscal Policy similarly r is given in all cases except with Real interest rate
Effect of Changes in Current Income
(i.e. increase in current income – current bonus)
- (C^d) will rise by the Marginal Propensity to Consume (MPC)
- (S^d) will rise by the Marginal Propensity to Save (MPS)
- Increase in Aggregate Income (output) (Y)
MPC is
change in consumption due to one unit change in
income.
Similarly MPS is change in saving due to one unit change in income.
Effect of Changes in Current Income
Increase in current income would result in a more proportional increase in
Output(Y) than Desired consumption
C^d increase with the value of the MPC only while output with MPC & MPS
An increase in future income – next year bonus
The consumption-smoothing motive would result in
Individuals increasing their current desired consumption (Cd)
This increase is in anticipation for higher future income
Given that current income is constant
An increase in current desired consumption is matched by
a reduction in current desired saving (S^d)
Effect of Changes in Expected Future Income:
An increase in future income will result in
What will happen in terms of output?
Increase in expected aggregate income (output) (Y) increases C^d
and reduces S^d
Where Y is constant
The opposite happens in case of reduction in expected future income
Effect of Changes in Wealth:
Increase in Financial assets lead to
Change in wealth has similar effect to that of expected future income
an increase in current desired consumption (Cd)
Given current income:
Increase in current desired consumption
reduces
current desired saving (S^d)
↑Wealth, Y is constant → ↑Cd and ↓Sd
How would a reduction in wealth affect C^d and S^d?
decreases desired consumption (C^d)
↓Wealth, Y is constant → ↓Cd and ↑Sd
Given current income, decrease in C^d is matched by an increase in current desired saving (S^d).
Effect of Changes in Real Interest Rate (Increase):
2 effects arises when real interest rate increase
- Substitution Effect
- Income efffect
Increase in Real interest Rate:
Explain the Subtitution Effect in terms of consumption
Tendency to reduce current desired consumption and increase future consumption
Increase current desired saving due to increase in r
Increase in real interest rate:
Explain Income effect
Reflects change in current desired
consumption when higher r makes consumer richer or poorer
Depends on whether consumer is a saver or borrower.
Income Effect of Increase in Real Interest Rate:
How does it depend whether the consumer is a borrower or a lender
Borrower experiences a decrease in wealth while lender experience an increase in wealth
Due to Income Effect of Increase in Real Interest Rate:
A saver expriences an increase in wealth therefore
What ahppens in terms of c^d and s^d
- Increase current desired consumption
- Reduce current desired
saving
Due to Income Effect of Increase in Real Interest Rate:
A Borrower expriences a decrease in wealth therefore
What ahppens in terms of c^d and s^d
- Decrease current desired consumption
- Increase current desired
saving (reduces dissaving)
Due to an increase in Real interest rates:
A saver could either Increase desire saving or decrease desire saving, but Why?
Due to the substitution and income effect
When real interest rate increase, one can feel wealthier thus increasing desired consumption (income effect) while other might increase desired saving due to the higher intreset (substitution)
Due to an increase in Real interest rates:
For whom has the two Effects in the same direction
Substitution and Income effect
Borrower
When real interest rate increase, borrower can feel less wealthy thus decreasing desired consumption (income effect) similarly borrower will decrease desired saving due to the higher intreset (substitution)
Taxes and Real Return to Saving:
Expected real after-tax interest rate reflects
the purchasing power of saving
The formula of After-tax real interest rate
r_a-t= (1 – t)i – π^e
Given nominal interest rate and inflation, a reduction in tax rate increase real interest rate
Fiscal Policy:
Changes in Fiscal
Policy (Y given) is experienced because of a change in
Either G changes (temporarily) or G is fixed and taxes changes
Changes in Fiscal Policy (Y given):
If G changes
(Temporarily), the impact on S^d and C^d are
- Affects S^d directly
- Affects C^d depending on mean of financing change in G
Fisical Policy:
Show how a Temporary Increase in G would result in a reduction in S^d
↓S^d = Y – Cd - ↑G
In context of Fiscal Policy, show how:
A temporary increase in G has a Direct Effect on Cd and Indirect Effect on Sd
- Increase in G could be funded by a raise in taxes therefore reducing current income thus reducing C^d
- Increases in G could be funded by borrowing (future taxes) therefore Reduces expected future income and hence ↓Cd
For a given current level of output (Y), a temporary
increase in G reduces both C^d and S^d
According to Ricardian Equivalence Proposition:
Why a Lump Sum Tax Cut has No effect on Cd and Sd
It Increases Current Income and reduces future income (borrowing or future taxes)
With no change in current or planned G, Ricardian Equivalence Proposition expects a tax cut to have no effect on Cd and Sd
Otherwise, a tax cut increases Cd and reduces Sd
Definition of investment:
The two types of Investments
- Fixed Investment
- Inventory Investment
Definition of Investment:
Types of Fixed Investment
- Business Fixed Investment
- Residntial Investment
Definition of Investment:
The decision to invest implies a trade-off between
present (current resources) and future (higher capacity and profits in the future)
Definition of Investment:
It is important to track investments because
- Investment spending fluctuates sharply during business cycles.
- Investment plays a crucial role in determining the long-run productive capacity of the economy.
Investment:
The Desired Capital Stock
It is the amount of capital that allows the firm to maximize its
profit (earn the largest expected profit).
Desired Capital Stock:
What is the cost of Additional Unit of Capital
User Cost of Capital (uc)
Desired Capital Stock:
What is the Benefit of additional unit of Capital
Expected Future
Marginal Product of Capital (MPK^f)
The Benefit of increasing today by one unit of capital
The Desired Capital Stock:
The User cost of capital
Expected real cost of using a unit of capital for a specified period of time.
The Desired Capital Stock:
The User Cost of Capital formula
uc = rpK + dpK = (r + d)pK
rpK is the Interest cost of using capital and dpk is the depreciation cost on capital
Calculate The User Cost of Capital: Example:
Kyle’s Bakery Co produces specialty cookies. The manager,
Kyle, wants to invest in a new solar-powered oven.
➢ The new oven’s price measured in real (base-year) dollars is $100.
➢ No maintenance or energy cost.
➢ The oven depreciates (its value fall) by 10% per year.
➢ Kyle can borrow from the bank or buy government bond at
expected real interest rate of 8% per year.
The user cost of capital is the sum of depreciation cost and
interest cost.
➢ Depreciation cost (dpK) = d* pK = 0.10100 = $10.
➢ Interest cost (rpK) = r pK = 0.08*100 = $8.
➢ User cost of capital = dpK + rpK = $10+$8 = $18.
Desired a capital stock:
How to determine the desired capital stock
MPKf = uc
Changes in the Desired Capital Stock:
Anything that changes uc causes the uc curve to
Shift
Changes in the Desired Capital Stock:
What changes the uc
- Changes in r
- Changes in pk
- Changes in d
All these changes causes the uc curve to shift
Changes in the Desired Capital Stock:
A Fall in interest rates causes the uc curve to
Shift downwards
Indicating that it lowers uc
Changes in the Desired Capital Stock:
A downward shift in the uc curve causes the desired capital stock to
Increase
Changes in the Desired Capital Stock:
In our example (Kyle’s Bakery) assumes that a new type of cookie dough is invented that requires less baking time and hence increases MPKf by 12.5% at each K. What happens to the MPKf curve?
Shifts Upward
The new equilibrium point with uc curve is further to the right indicating an increase in desired capital stock.
Changes in desired capital stock:
Taxes and the Desired Capital Stock
What is the formula
(1 – t) MPK^f = uc
(1-t) is the tax rate on revenues where
(1 – t) MPK^f as a whole is After-tax future marginal product of capital
Changes in Fisical Policy can happen because of
- A change in G (temporarily)
- A change in Taxes
Fisical Policy:
Changes in G affect
- Desired Saving directly
- Desired Consumption depending on mean of financing change in G
A change in Taxes While G is fixed will affect
- Current Income or expected Future Income therefore affecting Desired consumption
Fiscal Policy: Temporary Increase in G
How it has a direct effect on Desired Saving
Reduces Desired Saving
↓Sd = Y – Cd- ↑G
Fiscal Policy: I) Temporary Increase in G
How it has Direct Effect on Cd & Indirect Effect on Sd
- Funded by raising
current T hence Reducing current income and hence ↓Cd - Funded by borrowing (future taxes) therefore Reducing expected future income and
hence ↓Cd
For a given current level of output (Y), a temporary increase in G reduces
Both Cd and Sd
What is the effect of:
Lump Sum Tax Cut
(G Given)
- Increases Current Income thus reduces future income (borrowing or future taxes)
- Increase after tax Current Income Increases Cd and Reduces Sd
Lump Sum Tax Cut :
What does the Ricardian Equivalence Proposition state?
With no change in current or planned G, Ricardian Equivalence
Proposition expects a tax cut to have no effect on Cd and Sd
. Otherwise, a tax cut increases Cd and reduces Sd
Definition of Investment:
Investment is divided into
- Fixed Investment
1. Business Fixed Investment
2. Resdential Investment - Inventory Investment
1. Change in Inventory
If the Taxes and the Desired Capital Stock formula is
(1 – t) MPK^f = uc
then in terms of MPK the Formula is
MPKf = uc / (1 – t)
Where uc equals
(r + d)pK
Therefore
= (r + d)pK/ (1 – t)
- Changes in the Desired Capital Stock:
What will happen to the desired capital stock if t increased??
Increase in t raises the tax-adjusted user cost of capital and reduces K.
tax-adjusted user cost of capital is uc / (1 – t)
Taxes and the Desired Capital Stock:
Why In reality, taxes are much more complicated?
- Taxes are paid on profits not revenues.
- Depreciation allowance affects tax payments.
- The presence of investment tax credit.
Effective tax rate
A single measure of tax burden on capital.
How Changes in tax law that raises the effective tax rate affect the tax-adjusted user cost of capital
Raises the effective tax rate… increases
the tax-adjusted user cost of capital and decreases K.
Changes in the capital Stock over the year can happen because of
- Purchase of new Capital goods
- Depreciation
Net Investment is equal to
Gross Investment - Depreciation
Net Investmentt = Gross investmentt – depreciationt
= I_t – dK_t
Net Investment as a concept of Changes in the capital Stock over the year, its Formula is
Net Investment= K_t+1 – K_t
If Net Investment = Kt+1– Kt
and also Net Investment = Gross investment_t – depreciation_t
= I_t – dK_t then I_t equals
Kt+1 – Kt = I_t – dK_t
I_t = Kt+1 – Kt + dK_t
From the Desired Capital Stock to Investment:
If by the end of year t, the firm acquired the desired level of
capital (K*) then I_t equals
It = K* – Kt + dKt
According to this formula
I_t = (K* – Kt) + dKt
What each part of this formula denote?
- Desired net increase in K
(K*- Kt) - Replace depreciated capital (dKt)
Desired net increase in K
(K*- Kt) include
Taxes, interest rates, MPK^f
Replacing depreciated capital (dKt) involves
Depreciation rate and initial K
From the Desired Capital Stock to Investment
Why investment needed to reach the desired capital stock may be spread out over several years
Since Some capital can be constructed easily, but other capital may take years to put in place
Investment in Inventories and Housing:
Inventory investment equals
The increase in firms’ inventories of unsold goods, unfinished goods or raw materials.
Investment in Inventories and Housing:
Residential investment is
The construction of housing
How firms decide whether to increase inventory by one unit or build one apartment
By comparing between MPKf and uc.
Example for Inventory Investment:
Car dealer decided to increase number of cars…. expected increase in sales commission from selling extra car vs. depreciation and interest.
Example for residential investment
Building apartment …
potential revenues from rent vs. depreciation and interest.
Good Market equilibrium occurs when
Aggregate quantity of goods demanded equals the aggregate quantity of goods supplied.
Good Market
Equilibrium
Condition
Y = Cd + Id + G
Y is the Quantity of Goods Supplied (Output) and (Cd + Id + G) is thr Aggregate demand for goods (Spending)
How to deduce that
Sd = Id is the Good market equilibrium
Y = Cd + Id + G
Y - Cd – G = Id
Y - Cd – G = Sd
then Sd=Id
Sd is the fundSupplied by savers and Id is Fund Demanded by investors
The Saving- Investment Diagram
It shows amount of funds supplied by savers
and amount of funds demanded by investors
Where r is on the vertical axis while I is on the Horizontal Axis Where adjustments in r bring the market into equilibrium
The Factors that would shift S^d curve
- Current Output
- Expected Future Output
- Wealth
- Fisical Policy
How a temporary increase in G affect the Goods Market Equilibrium
It causes an upper Shift in the Saving Curve therefore the new equilibrium point is at a higher interest rate and a lower desired Investment and Saving
What is the Crowding effect
When increased government purchases cause investment to decline, economists say that investment has been crowded out. The crowding out of investment by increased government purchases occurs, in effect, because the government is using more real resources, some of which would otherwise have gone into investment.
Goods Market Equilibrium:
When there is a temporary increase in G, desired Investment falls. This is often refered as
Crowding out
Goods Market Equilibrium:
When there is a temporary increase in G, desired Saving falls causing an increase in
Real interest rate
Goods Market Equilibrium:
What are the factors that shift Id curve??
- Taxes
- Depreciation
- MPK^f
Goods Market Equilibrium
What Happens to the Good market euilibrium when there is new technological Invention
Shifts of the Investment Curve to the right therefore the new equilibrium is at a higher real interest rate and National Savimg and desired investment increase
