Modelling Consumption & Investment

Question 1

Household spending consists of

Answer 1

consumption on non-durable goods and durable goods

housing - investment

Question 2

Aggregate consumption (C) consists of

Answer 2

autonomous consumption (Co)

and consumption that depends on income

Question 3

autonomous consumption

Answer 3

fixed amount one will spend, independent of income

expectations about future income are reflected in autonomous consumption

household wealth impacts autonomous consumption

Question 4

Keynesian Consumption function

Answer 4

C = Co + C1Y

C = aggregate consumption spending

C1 = marginal propensity to consume (0

Question 5

Consumption function

Answer 5

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

Question 6

How big is the MPC?

Answer 6

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

Question 7

Shortcomings of Keynesian consumption function

Answer 7

‘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)

Question 8

Determinants of investment

Answer 8

• expectations about the future, interest rate

what to do with profit depends on:

1. owners discount rate (p) - measure of persons impatience (p = MRS -1)
   - discount rate depends on consumption smoothing and pure impatience
2. interest rates on assets (r)
3. Net profit rate on investment (pi) - expected profit rate

Question 9

Firms don’t have preferences to smooth consumption

Answer 9

• 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

Question 10

Demand side for firms investment

Answer 10

a lower interest rate makes investments more likely

Question 11

Supply side for firms investment

Answer 11

• 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

Question 12

Aggregate Investment Function

Answer 12

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

Question 13

A higher interest rate will:

Answer 13

1. Reduce demand for new houses

2. Makes firms rein in their spending plans on new capital equipment and houses (lower investment)

Question 14

Goods market equilibrium

Answer 14

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

Question 15

aggregate demand function with government and NX

Answer 15

AD = C + I + G + NX (net exports, trade balance)

Question 16

Government enters aggregate demand via:

Answer 16

• 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

Question 17

Disposable income equation

Answer 17

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

Question 18

Net exports

Answer 18

amount taken as exogenous

amount of imports depends on domestic income

NX = X - mY

mY = marginal propensity to import (MPI)

Question 19

Multiplier model

Answer 19

shows how spending decisions affect the economy, how impact in changes in autonomous demand affects output and how gov spending affects output

Question 20

Multiplier process

Answer 20

mechanism through which direct and indirects affects of change in autonomous spending affects aggregate output

Question 21

Decrease in investment - multiplier process

Answer 21

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

Question 22

Rise in gov spending in a close economy

Answer 22

rise in gov spending causes aggregate demand to rise thus increasing output

Question 23

conclusions of multiplier process

Answer 23

• 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

Question 24

Multiplier affect

Answer 24

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

Question 25

Multiplier model mathematically

Answer 25

1. AD = C + I + G + NX
2. substitute functions of AD

AD = Co + C1(1-t)Y + Ir + G + X -mY

3. State goods market clearing equilibrium

Y = AD

4. equate components of AD to output and collect all the Y terms on the left hand side
5. 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