1 / 55

Chapter 5 More about Consumption, Investment and Fiscal Policy - PowerPoint PPT Presentation

Chapter 5 More about Consumption, Investment and Fiscal Policy. More about consumption function More about saving function More about investment function Fiscal policy Advanced Material 5.1 Net investment is sustained by a favorable and continuous change in determinants

I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.

PowerPoint Slideshow about ' Chapter 5 More about Consumption, Investment and Fiscal Policy' - sasha-hanson

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript

More about Consumption, Investment and Fiscal Policy

Fiscal policy

Advanced Material 5.1 Net investment is sustained by a favorable and continuous change in determinants

Advanced Material 5.2 Short term and long term effects of investment

Contents:

• Average propensity to consume (APC) is

• the consumption per unit of disposable income.

APC =

Note: When Yd increases, APC drops.

C

C1

Slope = C1/Yd1 = APC1

C*

APC1

+1

Yd

0

Yd1

Graphical illustration

• Marginal propensity to consume (MPC) is the change in consumption resulting from a unit change in disposable income.

MPC=

Note: When Yd increases, MPC is unchanged.

Slope = ΔC/ΔYd = MPC

C

C1

MPC

Slope = C1/Yd1 = APC1

C*

+1

Yd

0

Yd1

Graphical illustration

Plotting C against Yd

C

C = cYd + C*

C

c

+1

C*

Yd

0

C = cYd+C* = c(Y-tY-T*+qY+Q*)+C*

= (c-ct+cq)Y + (C*-cT*+cQ*)

C

C

c (1-t+q)

+1

C*- cT* + cQ*

Y

0

What would happen to the aggregate consumption if income is redistributed from

(a) the group of high MPC to the group of low MPC

(b) the group of high APC to the group of low APC

(c) the group of high C to the group of low C

(a) In general, who have a higher MPC, the rich or the poor? Explain.

(b) In general, who have a higher MPC, the young or the old? Explain.

Q5.3:

Explain why the cost of real consumption is the real interest rate instead of the nominal interest rate.

• Average propensity to save (APS) is the saving per unit of disposable income.

APS =

Note: As S* is negative, when Yd increases, APS increases.

Slope = S1/Yd1 = APS1

S1

APS1

0

Yd1

+1

Graphical illustration

S

S

Yd

S* = -C*

• Marginal propensity to save (MPS) is the change in saving resulting from a unit change in disposable income.

MPS =

Note: When Yd increases, MPS remains unchanged.

Slope = S1 /Yd1 = APS1

S1

MPS1

0

Yd1

+1

Slope= ΔS/ΔYd = MPS

Graphical illustration

S

S

Yd

S* = -C*

S1

C1

S1

Yd

Relation between consumption and saving

C

C

At Yd1

C*

• Yd1 < C1

0

Yd1

Yd

• S1 =Yd1 - C1

S

S = (1-c)Yd - C*

• S1 < 0

Dissaving

Yd1

Yd

-C*

At Yd2

Yd

C

• Yd2 = C2

C*

C2 =Yd2

• S2 =Yd2 – C2 = 0

0

Yd2

Yd

No dissaving or saving

S

S = (1-c)Yd - C*

S2 = 0

Yd2

Yd

-C*

S3

S3

C

Yd

At Yd3

C

• Yd3 > C3

• S3 =Yd3 – C3

C3

C*

• S3 > 0

0

Yd3

Yd

S

Saving

S = (1-c)Yd - C*

Yd

Yd3

-C*

S

Yd

0

Mathematical relation:

• S = Yd - C

• APS=(Yd - C)/Yd = 1 - APC

• MPS =

Q5.5:

Refer to the given diagram. When Yd increases, what would happen to C, APC, MPC, S, APS and MPS?

T

T

T

Y

Y

C

C

Y

C

Yd

Yd

Yd

S

S

S

Determinants of saving function

Gross investment = Depreciation + Net investment

• The amount spent on replacing depreciated capital (depreciation) is positively related to:

• amount of capital possessed

• rate of utilization

• but is negatively related to:

• interest rate

• The amount spent on raising capital stock

• (net investment) is positively related to:

• the desired increase in capital stock

• but is negatively related to:

• interest rate

Suppose expected net receipts = {Y1, Y2, Y3, …}

purchase price of capital = Pc , and MEC = e.

Then

• Whenever e  r, it is worth buying until e = r.

• The MEC curve is the demand curve for capital.

• When r falls, the optimal size of capital stock increases.

• The difference is the amount of net investment.

• The portion of MEC curve below r0 is the net I curve.

%

MEC curve = Demand for capital

r0

r0

r1

r1

I

0

0

I1

K0

K1

Capital Stock

(I1=K1-K0)

The larger the  in r

The net investment function

The larger the  in the optimal size of capital stock & net I

I = br + I*; & b < 0

Net investment

Fiscal Policy

• Fiscal policyis the government measure

which achieves economic objectives through

manipulating the government revenue and

expenditure.

• Types:

• Automatic fiscal policy

• Discretionary fiscal policy

• Automatic stabilizers or built-in stabilizers are government measures that reduce cyclical fluctuations of an economy automatically.

Those transfer payments (injection) which are negatively related to income -

e.g. unemployment benefits, comprehensive social security assistance

Those taxes (withdrawal) which are positively

related to income -

e.g. property tax, salaries tax and profits tax

Recession

Recovery

Trough

• Recovery

• Transfer payments (injection) 

• Income taxes 

• Rise in national income is reduced.

• Recession

• Transfer payments (injection) 

• Income taxes (withdrawals) 

• Fall in national income is reduced

The stabilizing effect of automatic stabilizers is reflected by the drop in the size of multipliers.

Automatic stabilizers reduce the size of fluctuations and stabilize national income.

%

Growth rate of real national income

4 phases of a business cycle

• Automatic stabilizers can only reduce, but not eliminate cyclical fluctuations.

• Discretionary fiscal policy is essential to achieve other macroeconomic objectives, e.g., full employment, economic growth, equitable income distribution, etc.

• Fiscal drag will weaken the effectiveness of discretionary fiscal policy.

• Built-in stabilizers bring disincentivesto work and investment.

Are corporate savings and family savings built-in stabilizers? Do they create disincentives?

• Discretionary fiscal policy is the deliberate government measure which achieves economic objectives through manipulating the government revenue and expenditure.

• Instruments:

• Government expenditures (G)

• Transfer payments (Q)

• Taxes (T)

•  in G aggregate expenditure

 brings a multiple  in income

•  in transfer payment disposable income

 in consumption  a multiple  in income

•  in (direct) tax disposable income

•  in consumption  a multiple  in income

Opposite cases also apply.

• Budgetis a financial statement proposing the estimated revenue and expenditure of the public sector in a fiscal year.

<

>

• A balanced budget is expansionary.

• Its effect on equilibrium income :

= ΔG • G-multiplier + ΔT • T-multiplier

= ΔBudget • (G-multiplier+T-multiplier)

Balanced budget multiplier =

• If income is not subjected to taxation, only a part of it is consumed while the other part is saved.

• Under a balanced budget, the whole amount of income taxed is spent on government consumption.

• a net increase in aggregate expenditure

(= the amount of income saved before taxation)

• brings a multiple increase in national income.

Note:An annuallybalanced budget is destabilizing (pro-cyclical)whilea cyclicallybalanced budgetis stabilizing (counter–cyclical).

• A deficit budget is more expansionary than a balanced budget.

• The effect of a surplus budget can be:

• expansionary

• neutral

• or contractionary

• Yet, when it is applied, it is usually aimed at bringing in a contractionary effect.

• Public debtis the borrowing of the government.

Burden of public debt

• Microscopically or individually, it is the future taxpayers who bear the burden of public debt.

• Macroscopically or in the view of a generation, it is the present generation who bears the burden.

• Yet, the future generation still bears some burden because:

• Taxation brings adverse effects -- indirect taxes bring deadweight losses while direct taxes create disincentives to work & investment.

• Issuance of gov’t bonds raises the interest ratewhichcrowds out private investment

• Repayment of an external debt involves

• a net export of goods and services in the future.

• Situations

• -- that may minimize the burden on the future generation:

1. The economy is under a serious depression.

2. The debt is forfinancing public investment.

3. The debt is an internal debt.

Net investment is sustained by a favourable and continuous change in determinants

• If the determinants (including interest rate, national income, etc.) remain constant, the optimal size of capital stock will not be changed.

• Hence net investment is sustained only if the determinants have favourable changes continuously.

Short-term and long-term effects of investment

Net investment raises

• the aggregate demand in the shortterm

• the amount of capital stock, productivity and the aggregate supply (the potential GNP) in the long term

Correcting Misconceptions:

1. C = cY + C*; APC = C/Y; MPC = ΔC/ΔY

2. An increase in C is represented by an upward shift of the C-function.

3. When income is redistributed from consumers of low APC to consumers of high APC, aggregate consumption increases.

4. An increase in C implies a decrease in S.

5. Net investment function relates interest rate to net investment.

6. Transfer payments and taxes are automatic stabilizers.

7. Automatic stabilizers eliminate cyclical fluctuations.

Correcting Misconceptions:

8. All stabilizers create disincentive effects.

9. A balanced budget is neutral to an economy.

10. A surplus budget is contractionary.

11. An annually balanced budget and a cyclically balanced budget bring similar effect to an economy.