Modelling Consumption & Investment Flashcards
Household spending consists of
consumption on non-durable goods and durable goods
housing - investment
Aggregate consumption (C) consists of
autonomous consumption (Co)
and consumption that depends on income
autonomous consumption
fixed amount one will spend, independent of income
expectations about future income are reflected in autonomous consumption
household wealth impacts autonomous consumption
Keynesian Consumption function
C = Co + C1Y
C = aggregate consumption spending
C1 = marginal propensity to consume (0
Consumption function
Aggregate consumption spending against current income
autonomous consumption is the intercept
slope = marginal propensity to consume (proportion of increase in income spent on consumption)
MPC and marginal propensity to save (MPS) are related by MPC + MPS = 1
MPC is important to policy makers as higher MPC implies higher demand and so creating its own supply and consequently increasing output or income
How big is the MPC?
Varies:
- households with credit constraints react a lot to variation in current income so MPC is large
- for wealthier and non-credit constrained households, current income matters little for current consumption so MPC is small
- consumption isn’t affected by predictable changes in income. What changes their consumption is news about income
- Also, considerations of whether the unpredicted change in income is permanent or temporary - if temporary consumption changes by smaller amount
Shortcomings of Keynesian consumption function
‘Ad hoc’ - isn’t micro founded
function isn’t forward looking
- we don’t look at expected income in future (models are important but not always the truth)
Determinants of investment
- expectations about the future, interest rate
what to do with profit depends on:
- owners discount rate (p) - measure of persons impatience (p = MRS -1)
- discount rate depends on consumption smoothing and pure impatience - interest rates on assets (r)
- Net profit rate on investment (pi) - expected profit rate
Firms don’t have preferences to smooth consumption
- will consume extra income (dividends) if discount rate > interest rate > expected profit rate
- if so will save this extra profit/repay debts
- will invest if net profit rate on investment > discount rate > interest rate
Demand side for firms investment
a lower interest rate makes investments more likely
Supply side for firms investment
- higher expected rate of net profit of investment increases investment, holding interest rate constant
- improvement of business environment e.g decline in risk expropriation by the government increases investment
Aggregate Investment Function
I = ao - a1r
r = interest rate ao = autonomous investment a1 = interest sensitivity of investment, >0
the main determinant of firm investment is the expected future post-tax profits which is capture by autonomous investment
A higher interest rate will:
- Reduce demand for new houses
2. Makes firms rein in their spending plans on new capital equipment and houses (lower investment)
Goods market equilibrium
Goods market clearing:
Y = AD
(aggregate demand = output in equilibrium)
assuming no gov spending or trade:
Y(output) = consumption + investment
= Co + C1Y + (ao - a1r)
Holding interest rate constant: goods market equilibrium given by 45 degree line (on aggregate demand vs output graph)
Aggregate demand line shifts upwards with investment
aggregate demand function with government and NX
AD = C + I + G + NX (net exports, trade balance)
Government enters aggregate demand via:
- government spending: exogenous, shifts AD curve up
- consumption: households’ MPC is out of disposable income = (1-t)Y where t is the tax rate on income
- investment: depends on the interest rate and after tax rate of profit
Disposable income equation
Yd = Y - T + TR
Y = income T = taxes TR = transfer payments (effectively negative taxes)
when taxes proportional to income, T = tY & TR = 0
then we get the special case of (1-t)Y
Net exports
amount taken as exogenous
amount of imports depends on domestic income
NX = X - mY
mY = marginal propensity to import (MPI)
Multiplier model
shows how spending decisions affect the economy, how impact in changes in autonomous demand affects output and how gov spending affects output
Multiplier process
mechanism through which direct and indirects affects of change in autonomous spending affects aggregate output
Decrease in investment - multiplier process
looking at AD against output model
a decrease in investment causes aggregate demand to fall
if decrease in investment is 1.5 and subsequently causes output to fall by 3.75, multiplier = 3.75/1.5 = 2.5
following assumption that firms don’t adjust their prices
Rise in gov spending in a close economy
rise in gov spending causes aggregate demand to rise thus increasing output
conclusions of multiplier process
- indirect effects through the economy amplify the direct effects of a shock to aggregate demand
- the total change in output an be greater than the initial change in aggregate demand (due to the circular flow of expenditure, income and output)
- the multiplier represents the relative magnitude of this change
Multiplier affect
if = 1, increase in GDP = initial increase in spending
if >1, increase in GDP> initial increase in spending
if<1, increase in GDP< initial increase in spending
Multiplier model mathematically
- AD = C + I + G + NX
- substitute functions of AD
AD = Co + C1(1-t)Y + Ir + G + X -mY
- State goods market clearing equilibrium
Y = AD
- equate components of AD to output and collect all the Y terms on the left hand side
- Divide both sides by the marginal propensity terms and the tax rate to solve for Y:
Y = 1/1-C1(1-t +m) x (Co + Ir + t + G + X)
bottom term is the multiplier denoted by K
right term is the autonomous demand
taxes and imports reduce the size of the multiplier as 1 - C1(1-t) + m > 1- C1 as long as t>0 and m>0
