Chapter 4Chapter 4 11

Consumption, Saving, and Consumption, Saving, and InvestmentInvestment

Chapter 4Chapter 4 22

Theories of consumer behavior:Theories of consumer behavior:

Keynes absolute Keynes absolute income hypothesisincome hypothesis

Permanent income Permanent income hypothesishypothesis

Life-cycle hypothesisLife-cycle hypothesis

Chapter 4Chapter 4 33

Keynes’ Consumption functionKeynes’ Consumption function Absolute-income Absolute-income

hypothesishypothesis Psychological law--as Psychological law--as

income rises income rises consumption rises but consumption rises but not by as much as not by as much as incomeincome

Keynes assumes that Keynes assumes that consumption is a consumption is a function of current function of current income.income.

C = Co +cYC = Co +cY

Chapter 4Chapter 4 44

Life-cycle hypothesisLife-cycle hypothesis

Concerned how Concerned how households allocate their households allocate their income between income between consumption and saving consumption and saving

households earn a stream households earn a stream of income over a lifetime of income over a lifetime (flood) (flood)

households may consume households may consume more or less than their more or less than their income for any given yearincome for any given year

Chapter 4Chapter 4 55

household consumption household consumption depends on depends on

• rate of interestrate of interest• expectations regarding expectations regarding

future incomefuture income decision-making is decision-making is

intertemporal, meaning intertemporal, meaning that households carefully that households carefully consider how their consider how their present expenditures present expenditures affect future affect future consumptionconsumption

Chapter 4Chapter 4 66

The Permanent income The Permanent income hypothesishypothesis

People maximize People maximize utility based on their utility based on their permanent (expected permanent (expected life-time) incomelife-time) income

Allocate their income Allocate their income intertemporallyintertemporally

Chapter 4Chapter 4 77

HouseholdHousehold Assumptions:Assumptions:

One type of good Y the One type of good Y the price of which is 1, price of which is 1, serving as the numerarie serving as the numerarie (in other words, we use (in other words, we use this good as a composite this good as a composite good, a unit of real GNP)good, a unit of real GNP)

Households produce a Households produce a stream of output over T stream of output over T periods: Yperiods: Y11, Y, Y22, …, Y, …, YTT

Household consumes an Household consumes an amount: Camount: C11, C, C22, …, C, …, CTT

Chapter 4Chapter 4 88

If there is no saving, If there is no saving, YY1 1 = C= C11, Y, Y2 2 = C= C22, and , and

so onso on If the commodity is If the commodity is

storable, then the storable, then the household may save: household may save: CC1 1 < Y< Y1 1 -- Saving-- Saving

CC2 2 > Y> Y2 2 -- Dissaving-- Dissaving

Chapter 4Chapter 4 99

Consumption and InvestmentConsumption and Investment Equilibrium GDP:Equilibrium GDP:

C + IC + Igg = GDP = GDP Real Domestic OutputReal Domestic Output Aggregate Aggregate

ExpendituresExpenditures Aggregate Aggregate

Expenditures Expenditures ScheduleSchedule

Equilibrium GDPEquilibrium GDP DisequilibriumDisequilibrium

Chapter 4Chapter 4 1010

Consumption and InvestmentConsumption and Investment

(1) 40

(2) 45

(3) 50

(4) 55

(5) 60

(6) 65

(7) 70

(8) 75

(9) 80

(10) 85

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Income

(1)Employ-

ment …in Billions of Dollars

Chapter 4Chapter 4 1111

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Chapter 4Chapter 4 1212

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Chapter 4Chapter 4 1313

Effect of changes in income and Effect of changes in income and wealth on Consumption and saving:wealth on Consumption and saving: An increase in current An increase in current

incomeincome An increase in future An increase in future

incomeincome An increase in wealthAn increase in wealth

Chapter 4Chapter 4 1414

Effect of Fiscal Policy on Effect of Fiscal Policy on consumptionconsumption

Fiscal policy: Fiscal policy: Government’s power Government’s power to tax and spendto tax and spend

Fiscal policy affects Fiscal policy affects desired consumption desired consumption by affecting by affecting household’s current household’s current and future incomesand future incomes

Chapter 4Chapter 4 1515

Effect of Government spendingEffect of Government spending Government increases Government increases

spending:spending: Consumers will anticipate Consumers will anticipate

future tax increases to pay for future tax increases to pay for the increase in government the increase in government spendingspending

Consumers will reduce their Consumers will reduce their consumption, although consumption, although generally not as much as the generally not as much as the increase in government increase in government spendingspending

Ricardian equivalence: Ricardian equivalence: proposition that the decline in proposition that the decline in consumer spending will match consumer spending will match anticipated future tax anticipated future tax increases, negating the increases, negating the expansionary effect of fiscal expansionary effect of fiscal policypolicy

Chapter 4Chapter 4 1616

Types of Capital and InvestmentTypes of Capital and Investment

Fixed business Fixed business investmentinvestment

inventory investmentinventory investment investment in investment in

residential structuresresidential structures