Chapter 5 More about Consumption, Investment and Fiscal Policy

© Pilot Publishing Company Ltd. 2005

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


More about Consumption Function


Propensity to consume

Average propensity to consume (APC) is the consumption per unit of disposable income.

dd

d

d Y

*Cc

Y

*CcY

Y

C

Note: When Yd increases, APC drops.

APC =


Yd1

Slope = C1/Yd1 = APC1Slope = C1/Yd1 = APC1

C

Yd0

C*

C

Graphical illustration

C1

+1APC1


Marginal propensity to consume

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

cY

Yc

Y

C*)(cYC*])Y[c(Y

Y

C

d

d

d

ddd

d

Note: When Yd increases, MPC is unchanged..

MPC=


Yd1

Slope = C1/Yd1 = APC1Slope = C1/Yd1 = APC1

C

Yd0

C*

C


C1

+1MPC

Slope = ΔC/ΔYd = MPCSlope = ΔC/ΔYd = MPC


C

Yd0

C

C*

c

+1

Graphical representation of consumption function Plotting C against Yd

C = cYd + C*


C

Y0

C

C*- cT* + cQ*

c (1-t+q)

+1

Plotting C against Y

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

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


Determinants of consumption function

Change in determinant Effect on consumption function

(plotting C against Y)

National income Moves upward along C-function

Income taxes o Lump sum tax o Proportional tax rate

Shifts downward

Tilts downward (slope)

Wealth Shifts upward

Interest rate Shifts downward


Change in determinant Effect on

consumption function

(plotting C against Y)

Expectation o Future price level↑o Future income↑

Shifts upward

Shifts upward

More willing to save Shifts downward

Income redistribution

(low MPC high MPC)

Shifts upward


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


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


Propensity to save

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

ddd

d

d Y

*C-c)1(

Y

*Ss

Y

*SsY

Y

S

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

APS =


S

S

Yd

S* = -C*

S1

0 Yd1

Slope = S1/Yd1 = APS1Slope = S1/Yd1 = APS1


+1APS1


Marginal propensity to save

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

c-1sY

Ys

Y

S*)(sYS*])Y[s(Y

Y

S

d

d

d

ddd

d

Note: When Yd increases, MPS remains unchanged.

MPS =


S

S

Yd

S* = -C*

S1

0 Yd1

Slope = S1 /Yd1 = APS1 Slope = S1 /Yd1 = APS1


+1MPS1

Slope= ΔS/ΔYd = MPS Slope= ΔS/ΔYd = MPS


Yd1

S1

Relation between consumption and saving

At Yd1

Yd1 < C1

Yd

S = (1-c)Yd - C*

-C*

S

S1

DissavingDissaving

Yd

YdYd1

C

0C1

C*

C

S1 = Yd1 - C1

S1 < 0


Yd2 Yd

S = (1-c)Yd - C*

-C*

S2 = 0

S

Yd2

C

Yd

Yd

C2 =Yd2

0

Yd2 = C2

No dissaving or saving No dissaving or saving

At Yd2

C*

C

S2 = Yd2 – C2 = 0


Yd3

Yd

S = (1-c)Yd - C*

-C*

S3

SYd3

C

Yd

Yd

S3

C3

0

Yd3 > C3

At Yd3

SavingSaving

C*

C

S3 > 0

S3 = Yd3 – C3


Mathematical relation:

S = Yd - C

Q5.5:Refer to the given diagram. When Yd increases, what would happen to C, APC, MPC, S, APS and MPS?

APS = (Yd - C)/Yd = 1 - APC

MPS = MPC1Y

CY

Y

S

d

d

d

S

Yd

S

0


Determinants of saving function

YY

T

YdC

S

Y

T

Yd

CC

S

Y

TT

YdC

S


Determinants of saving function

Change in determinant Effect on saving function (plotting S against Y)

National income Moves upward along

S-function

Income taxes • Lump sum tax • Proportional tax rate

Shifts downward

Tilts downward (slope)

Wealth Shifts downward

Interest rate Shifts upward



saving function

(plotting S against Y)

Expectation • Future price level • Future income

Shifts downward

Shifts downward

More willing to save Shifts upward

Income redistribution

(low MPC high MPC)

Shifts downward


More about Investment Function


Components of investment function

Gross investment = Depreciation + Net investment 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


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


Determinants of net investment function

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

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

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.

...e)(1

Y

e)(1

Y

e)(1

YP

3

3

2

2

1

1c

Then


MEC curve = Demand for capital

I

Capital Stock

%%

0 0

r0 r0

K0

r1r1

K1 (I1=K1-K0)

I1

The net investment function

I = br + I*; & b < 0

The larger the in r

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

Net investment


Determinants of net investment function


investment function

Interest rate Moves upward

along I-function

National income Shifts upward (rightward)

Purchase price of capital

Shifts downward (leftward)

Operating cost of

other factors Shifts downward


Change in determinant Effect on investment function

Profits tax rate Shifts downward

Technological improvement and innovation

Shifts upward

Optimistic expectation on future net receipts

Shifts upward


Fiscal Policy


What is fiscal policy?

Fiscal policy is the government measure which achieves economic objectives through manipulating the government revenue and expenditure.

Types: Automatic fiscal policy

Discretionary fiscal policy


Automatic fiscal policy

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


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


Boom

Trough

Recession

Rec

over

y

RecoveryRecovery Transfer payments (injection) Income taxes Rise in national income is reduced.

Recession Transfer payments (injection) Income taxes (withdrawals) Fall in national income is reduced

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

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

4 phases of a business cycle

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

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

%

Growth rate of real national income


Limitations

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

Fiscal drag will weaken the effectiveness of discretionary fiscal policy.

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

Built-in stabilizers bring disincentives to work and investment.


Q5.8:

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


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)


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.


Corresponding multipliers:

Instrument MultiplierMultiplier

Government expenditure

Transfer payment

Tax

mcqctic1

1

mcqctic1

c

mcqctic1

c-


What is government budget?

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


Type of budget:

Balanced budget ( 平衡預算 )

Estimated Estimated revenue expenditure

Deficit budget ( 赤字預算 )

Estimated Estimated revenue expenditure

Surplus budget

( 盈餘預算 )Estimated Estimated revenue expenditure

=

<

>


Balanced budget

A balanced budget is expansionary.

mcqctic1

c1

Balanced budget multiplier =

Its effect on equilibrium income :

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

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


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 annually balanced budget is destabilizing (pro-cyclical) while a cyclically balanced budget is stabilizing (counter–cyclical).

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


Deficit budget and surplus budget

A deficit budget is more expansionary than a balanced budget.

The effect of a surplus budget can be: expansionary

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

neutral or contractionary


What is public debt?

Public debt is 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 rate which crowds 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:

2. The debt is for financing public investment.

1. The economy is under a serious depression.

3. The debt is an internal debt.


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.


Advanced Material 5.2Short-term and long-term effects of investment

the aggregate demand in the short term

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

Net investment raises


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.




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.

Documents

Chapter 5 More about Consumption, Investment and Fiscal Policy