# © Pilot Publishing Company Ltd. 2005 Chapter 5 More about Consumption, Investment and Fiscal Policy.

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© Pilot Publishing Company Ltd. 2005 Chapter 5 More about Consumption, Investment and Fiscal Policy

© Pilot Publishing Company Ltd. 2005 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 determinantsAdvanced 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 investmentAdvanced Material 5.2 Short term and long term effects of investment

© Pilot Publishing Company Ltd. 2005 Propensity to consume Average propensity to consume (APC) is the consumption per unit of disposable income. Note: When Y d increases, APC drops. APC =

© Pilot Publishing Company Ltd. 2005 Y d1 Slope = C 1 /Y d1 = APC 1 C YdYd 0 C* C Graphical illustration C1C1 +1 APC 1

© Pilot Publishing Company Ltd. 2005 Marginal propensity to consume Marginal propensity to consume (MPC) is the change in consumption resulting from a unit change in disposable income.. Note: When Y d increases, MPC is unchanged. MPC=

© Pilot Publishing Company Ltd. 2005 Y d1 Slope = C 1 /Y d1 = APC 1 C YdYd 0 C* C Graphical illustration C1C1 +1 MPC Slope = Δ C/ Δ Y d = MPC

© Pilot Publishing Company Ltd. 2005 C YdYd 0 C C* c +1 Graphical representation of consumption function Plotting C against Y d C = cY d + C*

© Pilot Publishing Company Ltd. 2005 C Y 0 C C*- cT* + cQ* c (1-t+q) +1 Plotting C against Y C = cY d +C* = c(Y-tY-T*+qY+Q*)+C* = (c-ct+cq)Y + (C*-cT*+cQ*)

© Pilot Publishing Company Ltd. 2005 Determinants of consumption function Change in determinantEffect 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

© Pilot Publishing Company Ltd. 2005 Change in determinantEffect on consumption function (plotting C against Y) Expectation o Future price level↑ o Future income↑  Shifts upward More willing to saveShifts downward Income redistribution (low MPC  high MPC) Shifts upward

© Pilot Publishing Company Ltd. 2005 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

© Pilot Publishing Company Ltd. 2005 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.

© Pilot Publishing Company Ltd. 2005 Propensity to save Average propensity to save (APS) is the saving per unit of disposable income. Note: As S* is negative, when Y d increases, APS increases. APS =

© Pilot Publishing Company Ltd. 2005 S S YdYd S* = -C* S1S1 0 Y d1 Slope = S 1 /Y d1 = APS 1 Graphical illustration +1 APS 1

© Pilot Publishing Company Ltd. 2005 Marginal propensity to save Marginal propensity to save (MPS) is the change in saving resulting from a unit change in disposable income. Note: When Y d increases, MPS remains unchanged. MPS =

© Pilot Publishing Company Ltd. 2005 S S YdYd S* = -C* S1S1 0 Y d1 Slope = S 1 /Y d1 = APS 1 Graphical illustration +1 MPS 1 Slope= Δ S/ Δ Y d = MPS

© Pilot Publishing Company Ltd. 2005 Y d1 S1S1 Relation between consumption and saving At Y d1 Y d1 < C 1 YdYd S = (1-c)Y d - C* -C* S S1S1 Dissaving YdYd YdYd Y d1 C 0 C1C1 C* C S 1 = Y d1 - C 1 S 1 < 0

© Pilot Publishing Company Ltd. 2005 Y d2 YdYd S = (1-c)Y d - C* -C* S 2 = 0 S Y d2 C YdYd YdYd C 2 =Y d2 0 Y d2 = C 2 No dissaving or saving At Y d2 C* C S 2 = Y d2 – C 2 = 0

© Pilot Publishing Company Ltd. 2005 Y d3 YdYd S = (1-c)Y d - C* -C* S3S3 S Y d3 C YdYd YdYd S3S3 C3C3 0 Y d3 > C 3 At Y d3 Saving C* C S 3 > 0 S 3 = Y d3 – C 3

© Pilot Publishing Company Ltd. 2005 Mathematical relation: S = Y d - C Q5.5: Refer to the given diagram. When Y d increases, what would happen to C, APC, MPC, S, APS and MPS? APS = (Y d - C)/Y d = 1 - APC MPS = S YdYd S 0

© Pilot Publishing Company Ltd. 2005 Determinants of saving function YYYY TT YdYd CC SS Y T Y d CCCC SS Y TTTT YdYd CC SS

© Pilot Publishing Company Ltd. 2005 Determinants of saving function Change in determinantEffect 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

© Pilot Publishing Company Ltd. 2005 Change in determinantEffect on saving function (plotting S against Y) Expectation Future price level  Future income   Shifts downward More willing to saveShifts upward Income redistribution (low MPC  high MPC) Shifts downward

© Pilot Publishing Company Ltd. 2005 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

© Pilot Publishing Company Ltd. 2005 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

© Pilot Publishing Company Ltd. 2005 Determinants of net investment function Suppose expected net receipts = {Y 1, Y 2, Y 3, …} purchase price of capital = P c, 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 r 0 is the net I curve. Then

© Pilot Publishing Company Ltd. 2005 MEC curve = Demand for capital I Capital Stock % 00 r0r0 r0r0 K0K0 r1r1 r1r1 K1K1 ( I 1 = K 1 - K 0 ) I1I1 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

© Pilot Publishing Company Ltd. 2005 Determinants of net investment function Change in determinantEffect on 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

© Pilot Publishing Company Ltd. 2005 Change in determinantEffect on investment function Profits tax rate  Shifts downward Technological improvement and innovation Shifts upward Optimistic expectation on future net receipts Shifts upward

© Pilot Publishing Company Ltd. 2005 Fiscal Policy

© Pilot Publishing Company Ltd. 2005 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

© Pilot Publishing Company Ltd. 2005 Automatic fiscal policy Automatic stabilizers or built-in stabilizers are government measures that reduce cyclical fluctuations of an economy automatically.

© Pilot Publishing Company Ltd. 2005 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

© Pilot Publishing Company Ltd. 2005 Boom Trough Recession Recovery 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 Automatic stabilizers reduce the size of fluctuations and stabilize national income. 4 phases of a business cycle The stabilizing effect of automatic stabilizers is reflected by the drop in the size of multipliers. % Growth rate of real national income

© Pilot Publishing Company Ltd. 2005 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.

© Pilot Publishing Company Ltd. 2005 Q5.8: Are corporate savings and family savings built-in stabilizers? Do they create disincentives?

© Pilot Publishing Company Ltd. 2005 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)

© Pilot Publishing Company Ltd. 2005 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.

© Pilot Publishing Company Ltd. 2005 Corresponding multipliers: InstrumentMultiplier Government expenditure Transfer payment Tax

© Pilot Publishing Company Ltd. 2005 What is government budget? Budget is a financial statement proposing the estimated revenue and expenditure of the public sector in a fiscal year.

© Pilot Publishing Company Ltd. 2005 Type of budget: Balanced budget ( 平衡預算 ) Estimated revenue expenditure Deficit budget ( 赤字預算 ) Estimated revenue expenditure Surplus budget ( 盈餘預算 ) Estimated revenue expenditure = < >

© Pilot Publishing Company Ltd. 2005 Balanced budget  A balanced budget is expansionary. Balanced budget multiplier =  Its effect on equilibrium income : = Δ G G-multiplier + Δ T T-multiplier = Δ Budget (G-multiplier + T-multiplier)

© Pilot Publishing Company Ltd. 2005  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.

© Pilot Publishing Company Ltd. 2005 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

© Pilot Publishing Company Ltd. 2005 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.

© Pilot Publishing Company Ltd. 2005 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.

© Pilot Publishing Company Ltd. 2005 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.

© Pilot Publishing Company Ltd. 2005 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.

© Pilot Publishing Company Ltd. 2005 Advanced Material 5.2 Short-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

© Pilot Publishing Company Ltd. 2005 Correcting Misconceptions: 1. C = c Y + C*; APC = C/Y; MPC = Δ C/ Δ Y 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.

© Pilot Publishing Company Ltd. 2005 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:

© Pilot Publishing Company Ltd. 2005 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.