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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

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Chapter 5 More about Consumption, Investment and Fiscal Policy

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Chapter 5 more about consumption investment and fiscal policy

Chapter 5

More about Consumption, Investment and Fiscal Policy


Contents

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

Advanced Material 5.2 Short term and long term effects of investment

Contents:


Chapter 5 more about consumption investment and fiscal policy

More about Consumption Function


Chapter 5 more about consumption investment and fiscal policy

Propensity to consume

  • Average propensity to consume (APC) is

  • the consumption per unit of disposable income.

APC =

Note: When Yd increases, APC drops.


Chapter 5 more about consumption investment and fiscal policy

C

C

C1

Slope = C1/Yd1 = APC1

C*

APC1

+1

Yd

0

Yd1

Graphical illustration


Chapter 5 more about consumption investment and fiscal policy

Marginal propensity to consume

  • 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.


Chapter 5 more about consumption investment and fiscal policy

C

Slope = ΔC/ΔYd = MPC

C

C1

MPC

Slope = C1/Yd1 = APC1

C*

+1

Yd

0

Yd1

Graphical illustration


Chapter 5 more about consumption investment and fiscal policy

Graphical representation of consumption function

Plotting C against Yd

C

C = cYd + C*

C

c

+1

C*

Yd

0


Chapter 5 more about consumption investment and fiscal policy

Plotting C against Y

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


Chapter 5 more about consumption investment and fiscal policy

Determinants of consumption function


Chapter 5 more about consumption investment and fiscal policy

Q5.1:

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


Chapter 5 more about consumption investment and fiscal policy

Q5.2:

(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.


More about saving function

More about Saving Function


Chapter 5 more about consumption investment and fiscal policy

Propensity to save

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

APS =

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


Chapter 5 more about consumption investment and fiscal policy

Slope = S1/Yd1 = APS1

S1

APS1

0

Yd1

+1

Graphical illustration

S

S

Yd

S* = -C*


Chapter 5 more about consumption investment and fiscal policy

Marginal propensity to save

  • 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.


Chapter 5 more about consumption investment and fiscal policy

Slope = S1 /Yd1 = APS1

S1

MPS1

0

Yd1

+1

Slope= ΔS/ΔYd = MPS

Graphical illustration

S

S

Yd

S* = -C*


Chapter 5 more about consumption investment and fiscal policy

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*


Chapter 5 more about consumption investment and fiscal policy

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*


Chapter 5 more about consumption investment and fiscal policy

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*


Chapter 5 more about consumption investment and fiscal policy

S

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?


Chapter 5 more about consumption investment and fiscal policy

T

T

T

Y

Y

C

C

Y

C

Yd

Yd

Yd

S

S

S

Determinants of saving function


Chapter 5 more about consumption investment and fiscal policy

Determinants of saving function


More about investment function

More about Investment Function


Chapter 5 more about consumption investment and fiscal policy

Components of investment 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

  • advancement of technology

  • but is negatively related to:

  • interest rate


Chapter 5 more about consumption investment and fiscal policy

Components of investment function

  • 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


Chapter 5 more about consumption investment and fiscal policy

Determinants of net investment function

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.


Chapter 5 more about consumption investment and fiscal policy

%

%

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


Chapter 5 more about consumption investment and fiscal policy

Determinants of net investment function


Fiscal policy

Fiscal Policy


Chapter 5 more about consumption investment and fiscal policy

What is 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


Chapter 5 more about consumption investment and fiscal policy

Automatic fiscal policy

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


Chapter 5 more about consumption investment and fiscal policy

Instruments:

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


Chapter 5 more about consumption investment and fiscal policy

Boom

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


Chapter 5 more about consumption investment and fiscal policy

Limitations

  • 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.


Chapter 5 more about consumption investment and fiscal policy

Q5.8:

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


Chapter 5 more about consumption investment and fiscal policy

Discretionary fiscal policy

  • 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)


Chapter 5 more about consumption investment and fiscal policy

Mechanisms:

  •  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.


Chapter 5 more about consumption investment and fiscal policy

Corresponding multipliers:


Chapter 5 more about consumption investment and fiscal policy

What is government budget?

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


Chapter 5 more about consumption investment and fiscal policy

=

<

>


Chapter 5 more about consumption investment and fiscal policy

Balanced budget

  • A balanced budget is expansionary.

  • Its effect on equilibrium income :

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

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

Balanced budget multiplier =


Chapter 5 more about consumption investment and fiscal policy

  • 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).


Chapter 5 more about consumption investment and fiscal policy

Deficit budget and surplus budget

  • 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.


Chapter 5 more about consumption investment and fiscal policy

What is public debt?

  • 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.


Chapter 5 more about consumption investment and fiscal policy

  • 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.


Chapter 5 more about consumption investment and fiscal policy

  • 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.


Chapter 5 more about consumption investment and fiscal policy

Advanced Material 5.1

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.


Chapter 5 more about consumption investment and fiscal policy

Advanced Material 5.2

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

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.


Chapter 5 more about consumption investment and fiscal policy

Correcting Misconceptions:

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 misconceptions1

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.


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