Chapter 4 1 Consumption, Saving, and Investment

Chapter 42 Theories of consumer behavior:  Keynes absolute income hypothesis  Permanent income hypothesis  Life-cycle hypothesis

Chapter 43 Keynes’ Consumption function  Absolute-income hypothesis  Psychological law--as income rises consumption rises but not by as much as income  Keynes assumes that consumption is a function of current income.  C = Co +cY

Chapter 44 Life-cycle hypothesis  Concerned how households allocate their income between consumption and saving households earn a stream of income over a lifetime (flood) households earn a stream of income over a lifetime (flood) households may consume more or less than their income for any given year households may consume more or less than their income for any given year

Chapter 45 household consumption depends on household consumption depends on rate of interestrate of interest expectations regarding future incomeexpectations regarding future income decision-making is intertemporal, meaning that households carefully consider how their present expenditures affect future consumption decision-making is intertemporal, meaning that households carefully consider how their present expenditures affect future consumption

Chapter 46 The Permanent income hypothesis  People maximize utility based on their permanent (expected life-time) income  Allocate their income intertemporally

Chapter 47 Household  Assumptions: One type of good Y the price of which is 1, serving as the numerarie (in other words, we use this good as a composite good, a unit of real GNP) One type of good Y the price of which is 1, serving as the numerarie (in other words, we use this good as a composite good, a unit of real GNP) Households produce a stream of output over T periods: Y 1, Y 2, …, Y T Households produce a stream of output over T periods: Y 1, Y 2, …, Y T Household consumes an amount: C 1, C 2, …, C T Household consumes an amount: C 1, C 2, …, C T

Chapter 48  If there is no saving, Y 1 = C 1, Y 2 = C 2, and so on  If the commodity is storable, then the household may save: C 1 < Y 1 -- Saving C 1 < Y 1 -- Saving C 2 > Y 2 -- Dissaving C 2 > Y 2 -- Dissaving

Chapter 49 Consumption and Investment  Equilibrium GDP: C + I g = GDP  Real Domestic Output  Aggregate Expenditures Aggregate Expenditures Schedule Aggregate Expenditures Schedule  Equilibrium GDP  Disequilibrium

Chapter 410 Consumption and Investment (1)40 (2)45 (3)50 (4)55 (5)60 (6)65 (7)70 (8)75 (9)80 (10)85 $ $ $ $ $ (2) Real Domestic Output (and Income) (GDP=DI) (3) Con- sump- tion (C) (4) Saving (S) (1-2) (5) Investment (I g ) (6) Aggregate Expenditures (C+I g ) (7) Unplanned Changes in Inventories (+ or -) (8) Tendency of Employment Output and Income (1) Employ- ment …in Billions of Dollars

Chapter ° Disposable Income (billions of dollars) Consumption (billions of dollars) Equilibrium GDP C I g = $20 Billion Aggregate Expenditures C = $450 Billion C + I g (C + I g = GDP) Equilibrium Point G 9.1

Chapter ° Real GDP (billions of dollars) Aggregate Expenditures (billions of dollars) Increase in Investment (C + I g ) 0 Decrease in Investment (C + I g ) 2 (C + I g ) 1

Chapter 413 Effect of changes in income and wealth on Consumption and saving:  An increase in current income  An increase in future income  An increase in wealth

Chapter 414 Effect of Fiscal Policy on consumption  Fiscal policy: Government’s power to tax and spend  Fiscal policy affects desired consumption by affecting household’s current and future incomes

Chapter 415 Effect of Government spending  Government increases spending: Consumers will anticipate future tax increases to pay for the increase in government spending Consumers will anticipate future tax increases to pay for the increase in government spending Consumers will reduce their consumption, although generally not as much as the increase in government spending Consumers will reduce their consumption, although generally not as much as the increase in government spending Ricardian equivalence: proposition that the decline in consumer spending will match anticipated future tax increases, negating the expansionary effect of fiscal policy Ricardian equivalence: proposition that the decline in consumer spending will match anticipated future tax increases, negating the expansionary effect of fiscal policy

Chapter 416 Types of Capital and Investment  Fixed business investment  inventory investment  investment in residential structures