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ES10002- Introductory Macroeconomics > Topic 3- Consumption, Saving and Investment > Flashcards

Topic 3- Consumption, Saving and Investment Flashcards

1
Q

What is national desired consumption (C^d)?

A

The aggregate quantity of goods and services that households optimally consume, given income and other factors that determine economic opportunities

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2
Q

What is desired national saving (S^d)?

A

Level of aggregate saving when consumption is at its desired level

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3
Q

What is the formula for desired national saving (S^d)?

A

S^d = Y - C^d - G

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4
Q

What are the 2 periods of an individual’s consumption lifespan?

A

Current and future period

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5
Q

What is the budget constraint formula of the current period of an individual?

A

assets in the future period = current income + assets - current consumption
a^f = y + a - c

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6
Q

What is the budget constraint formula for the future period?

A

future period consumption = future period income + (1+real interest rate) x assets in the future period
c^f = y^f + (1+r)a^f

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7
Q

What is dissaving (|s|)?

A

Spending more than you have; c > y

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8
Q

When is an individual a borrower?

A

When: consumption > income + assets

c > y + a

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9
Q

When is an individual a lender?

A

When: consumption < income + assets

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10
Q

What is the trade-off between current and future consumption?

A

1 dollar of current consumption is traded for 1+r dollars of future consumption

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11
Q

By combining the current and future budget constraints, what is the overall budget constraint?

A

c + c^f/1+r = y + a + y^f/1+r

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12
Q

What is the utility maximisation problem for a household?

A

max U = u(c) + βu(c^f)

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13
Q

What does β represent?

A

Represents how the individual weighs current and future consumption. The more weight the individual places on future utility, the greater β is

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14
Q

What is the Euler equation/utility optimality condition?

A

u’(c) = β(1+r)u’(c^f)

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15
Q

What should the consumer do if the Euler equation does not hold true? i.e there’s an inequality

A

If the marginal utility of current consumption is greater than future consumption, the consumer should reduce future consumption and raise current consumption until they are indifferent

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16
Q

What is the consumption smoothing motive?

A

The desire to have a relatively even pattern of consumption

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17
Q

What is PVLR?

A

Present value of lifetime resources

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18
Q

What 3 changes does an increase in current income (y) provoke?

A
  • Increase in PVLR
  • The consumption smoothing motive dictates both current and future consumption increase
  • Saving increases
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19
Q

What is marginal propensity to consume (mpc)?

A

The fraction of additional current income (y) that the individual allocates to current consumption (c)

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20
Q

What change does an increase in future income (y^f) provoke?

A

The same as an increase in current income except saving falls because current income remains constant

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21
Q

What does the Euler equation state?

A

That the individual must be indifferent between consuming one more unit today and saving that unit and consuming it in the future

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22
Q

What are the 2 main changes provoked by an increase in the real interest rate (r)?

A
  • Substitution effect: current consumption (c) has become more expensive so falls whilst future consumption (c^f) and saving (s) rise
  • Income effect: an increase in r implies an increase in wealth, hence a fall in c and c^f and a rise in s
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23
Q

What is the equation for expected real after-tax interest rate?

A

expected real after-tax interest rate = (1-tax rate)nominal interest rate - expected inflation
r^e_a-t = (1-t)i - π^e

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24
Q

What is the Ricardian equivalence proposition?

A

The idea that tax cuts do not affect consumption and do not affect national saving

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25
Q

What is the effect on tax on current desired consumption?

A

It’s ambiguous; it may either raise or lower current desired consumption

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26
Q

What are the 2 types of change in income?

A
  • Temporary change: current income (y) changes while expected future income (y^f) is unchanged
  • Permanent change: both current income (y) and future income (y^f) rise
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27
Q

What is the permanent income theory of consumption?

A

A permanent one-unit increase in income will raise current and future consumption more than a temporary one-unit increase will because it has a greater effect on PVLR

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28
Q

What is the Life-Cycle model?

A

Many period model which looks at patterns of income consumption and saving over an individual’s lifetime

29
Q

What 2 main features does the Life-Cycle model show?

A
  • Real income steadily rises overtime until near retirement, income drops sharply
  • Saving is low or negative early in working life; max saving occurs when income is highest and dissaving occurs in retirement
30
Q

What is the main assumption about fiscal policy?

A

That it does not affect aggregate supply

31
Q

How does fiscal policy influence desired consumption (C^d)?

A

By affecting households’ current (Y) and expected future incomes (Y^f). The capital letters denote economy-wide levels

32
Q

Give 2 ways in which fiscal policy affects desired national saving

A
  • By affecting desired consumption (C^d), given the values of Y and G, a fall in C^d by $1 implies an increase of S^d by $1
  • For any given values of Y and C^d, an increase in G will directly lower S^d
33
Q

How do government purchases affect consumption?

A

Increases in G are financed by raising current taxes (T) so consumers’ after-tax incomes (Y_d) fall, hence consumption falls, though by less

34
Q

What equation links the effect of a change in government purchases with desired consumption?

A

ΔC^d = mpc x ΔY_d = -mpc x ΔG

35
Q

What is Investment?

A

The purchases or construction of capital goods

36
Q

What is a firm’s desired (optimal) capital stock?

A

The amount of capital that allows the firm to earn the highest possible profit

37
Q

What is the User cost of capital (uc)?

A

The sum of the interest cost, the depreciation cost and the capital loss

38
Q

What is the equation for the User cost of capital (uc)?

A

User cost of capital = real interest ratexprice of capital goods + depreciation ratexprice of capital goods - change in the price of capital
uc = rp_k + dp_k - Δp_k

39
Q

What is capital gain and how is it calculated?

A

The growth rate of the price of capital (Δp_k/p_k)

40
Q

What is the condition determining a firm’s optimal amount of capital?

A

MPK^f = (r + d - Δp_k/p_k) x p_k

41
Q

How does profit change with capital if MPK^f > uc?

A

Profit rises as K is added because marginal benefit exceeds marginal cost

42
Q

How does profit change with capital if MPK^f < uc?

A

Profit rises as K is reduced because marginal benefit is below marginal cost

43
Q

Where is expected profit maximised?

A

Where MPK^f = uc

44
Q

What does the MPK^f curve show?

A

The value of the MPK^f for different sizes of K, given the size of the firm’s labour force and other factors of production

45
Q

What 2 general factors cause the desired capital stock to change?

A
  • Factors that shift the MPK^f curve

- Factors that change the user cost of capital

46
Q

What 4 specific factors cause the desired capital stock to change?

A
  • Change in real interest rate
  • Changes in depreciation
  • Changes in the price of capital goods
  • Technological changes that affect MPK^f
47
Q

What is the return to capital stock with taxes?

A

(1-t)MPK^f

where t is the tax rate on the firm’s revenue

48
Q

How does a firm choose its desired stock?

A

A firm chooses its desired stock so that the return equals the user cost:
(1-t)MPK^f = uc

49
Q

What is the expression for the tax-adjusted user cost of capital?

A

uc/1-t

50
Q

Give 3 practical flaws with the way corporate taxes are looked at in these models

A
  • We assumed that firm revenues are taxed when in reality profits are taxed
  • Depreciation allowances reduce the amount of profit to be taxed
  • Investment tax credits reduce taxes when firms make new investments
51
Q

What is the effective tax rate?

A

The tax rate on firm revenue that would have the same effect on the desired capital stock as do the actual provisions of the tax code

52
Q

What is the equation of the motion of capital?

A

K_t+1 - K_t = I_t - dK_t

53
Q

What does the equation of the motion of capital state?

A

That net investment is equal to gross investment minus depreciation

54
Q

How do firms optimally choose the level of capital stock for the next period?

A

I_t = K* - K_t + dK_t

where K* is desired capital stock

55
Q

What is the expression for net investment?

A

K* - K_t

56
Q

What are the 2 parts of gross investment?

A
  • The firm’s desired net increase in K over period t

- The investment needed to replace worn-out capital

57
Q

What are 3 factors that cause desired investment to fall and why?

A
  • Increase in real interest rate (r): user cost increases reducing K*
  • Increase in effective tax rate: tax-adjusted user cost increases which reduces K*
  • Decrease in expected future MPK: K* decreases
58
Q

What is the equation for aggregate quantity of goods and services supplied in a closed economy?

A

Y = AF(K,N)

59
Q

What is the equation for demand on domestically produced goods (Y_ad)?

A

Y_ad = C^d + I^d + G

60
Q

What is desired investment synonymous to?

A

Desired investment is synonymous to optimal or planned investment: I^d = I^p

61
Q

What is the goods market equilibrium condition?

A

Y = Y_ad = C^d + I^d + G

62
Q

What do firms do if aggregate demand turns out to be greater than aggregate supply?

A

Firms sell goods from their inventory stock

63
Q

What is the goods market equilibrium condition?

A

Y - C^d - G = I^d = S^d

64
Q

What shifts the saving curve to the right for any interest rate?

A

A change in the economy that raises desired national saving

65
Q

Give 5 main factors that shift the saving curve to the right

A
  • A rise in current output
  • A fall in expected future output
  • A fall in wealth
  • A fall in government purchases
  • A rise in taxes
66
Q

What is the crowding-out effect?

A

Increased government purchases cause private investment to decline because the government is using more real resources

67
Q

What shifts the investment curve to right at any interest rate?

A

A change in the economy that raises optimal private investment

68
Q

Give 3 main factors that shift the investment curve to the right

A
  • Any factor that leads to a fall in the user cost of capital (uc)
  • A fall in the effective tax rate (t)
  • A rise in the expected future MPK

ES10002- Introductory Macroeconomics (6 decks)

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