W2 Flashcards
national level of desired consumption (๐ถ๐)
the aggregate quantity of goods and services that households want to consume
Cd is also linked to ______
Desired national saving (๐^๐
Desired national saving ๐^๐
the level of national saving that occurs when aggregate consumption is at its desired level
desired national saving equation
๐^๐=๐โ๐ถ^๐โ๐บ = Y - national level of desired consumption - G
saving is positive/ negative when
- A person can consume less than current income - A person can consume more than current income
distinction between saving and savings
- Saving refers to the flow of funds that is not consumed out of income.- Savings is the stock of funds that represents the accumulated amount of net saving over time.
Consumption-smoothing
By consuming less today, you accumulate savings, and helps to smooth your consumption
A trade-off between current consumption and future consumption depends on the ___________
real interest rate
5 Determinants of desired national saving
current incomefuture incomewealththe real interest rate fiscal policy
Effect of changes in current income^ in Current Income โ>
^ in Current Income >>> C ^ and S ^However, At the aggregate level: when current income (Y) rises, ๐ถ^๐ rises, but not by as much as Y, so ๐^๐ rises.
MPC
fraction of additional current income consumed in current period
if MPC = 0.4 and MPS = 0.6, and you receive a bonus of $6000 ($60,000 current salary), how much is(i) additional current consumption(ii) saved
(i) 0.4 x $6000 = $2400(ii) 6000-2400 = $3600
Effect of changes in expected future income (
i) higher expected future income leads to _____
(ii) At the aggregate level
(i) more consumption today, so saving falls. (ii) If people expect that aggregate output and income, Y, will be HIGHER in the future, current desired consumption, ๐ถ^๐ , should INCREASE and current desired national saving, ๐^๐, should FALL
Effect of changes in wealth
increase in wealth RAISES current consumption, so LOWERS current saving.
Effect of changes in real interest ratereal return earned by savers is _____
actually less than the difference between the nominal interest rate and expected inflation.
Expected real after-tax interest rate
= nominal after-tax interest rate โ expected inflation rate =(1โ๐ก)๐ โ ๐^๐ * measures the increase in the purchasing power of their saving after payment of taxes.
Summary of Determinants of desired national saving

Crucial role in investment
determining the long-run productive capacity of the economy. Investment creates new capital goods, a high rate of investment means that the capital stock is growing quickly.
desired capital stock
the amount of capital that allows the firm to earn the largest expected profit. -Desired capital stock depends on costs and benefits of additional capital ใ๐ด๐ท๐ฒใ^๐=๐๐
the benefit of investment
is the future marginal product of capital (ใ๐ด๐ท๐ฒใ^๐).
๐๐๐พ. future marginal product of K
expected increase in output that a firm can obtain by adding a unit of capital (ceteris paribus)
User cost of capital
real cost of using a unit of capital for a specified period of time = real interest cost + depreciation. ๐ข๐=๐๐_๐+๐๐_๐=(๐+๐) ๐_๐
Real price of a new oven = $100 per cubic foot. Oven depreciates at rate (produces less cookies) = 10% per year. Can borrow/lend at prevailing exp real interest rate = 8% per year. What is the user cost of capital (oven) per year?
๐ข๐=โ (0.1 + 0.08)โร$100=$18.
MPK>uc MPK
1) profits rise as K is added (marginal benefits > marginal costs). 2) If ใ๐๐๐พใ^๐ < ๐ข๐, profits rise as K is reduced (marginal benefits < marginal costs). 3) Profits are maximized where ใ๐๐๐พใ^๐=๐ข๐.
RII โ- the decline in the real interest rate reduces ๐ข๐, and increases capital stock (K) of oven capacity from $18 to $16 per cubic foot per year and shifts the user-cost line down.

Factor that increases MPK
tech. advancement
tax-adjusted user cost of capital.
ใ๐๐๐พใ^๐=๐ข๐/(1โ๐)=((๐+๐) ๐_๐)/(1โ๐)
An increase in ๐ ______
raises the tax-adjusted user cost and reduces the desired capital stock.
capital stock changes from two opposing channels
New capital increases the capital stock; this is gross investment, ๐ฐ_๐. The capital stock depreciates, which reduces the capital stock.
Net Investment
Net investment = gross investment minus depreciation: ๐พ_(๐ก+1)โ๐พ_๐ก=๐ผ_๐กโ๐๐พ_๐ก ๐ผ_๐ก=๐พ_(๐ก+1)โ๐พ_๐ก+๐๐พ_๐ก
If firms can change their capital stocks in one period, then: ๐ผ_๐ก=๐พ^โโ๐พ_๐ก+๐๐พ_๐ก (4.6) Eq. (4.6) shows that firmsโ gross investment during a year has two parts:
1) The desired net increase in the capital stock over the year (๐พ^โโ๐พ_๐ก) 2) The investment needed to replace worn out or depreciated capital, ๐๐พ_๐ก.
Lags and Investment on desired capital stock
Some capital can be constructed easily, but other capital may take years to put in place. So investment needed to reach the desired capital stock may be spread out over several years.
goods market in equilibrium EQ
AS = AD ๐=๐ช^๐ +๐ฐ^๐ +๐ฎ
๐^๐ = desired national savings =
= (๐โ๐ถ^๐โ๐บ)
goods market equilibrium condition:
๐บ^๐ =๐ฐ^๐
saving-investment diagram

(5) Determinants of desired savings:
- Current output - Expected future output - Wealth - Government purchases - Taxes (unless Ricardian equivalence holds, in which case tax changes have no effect)
what happens if there is a temporary increase in government purchase? (saving-inv diagram)
An increase in G causes ๐^๐ to shift to the left. Result of lower savings: higher ๐, causing crowding out of ๐ผ.

Determinants of desired investment (3)
- RRI - The effective tax rate - Expected future marginal productivity of capital
what happens if there is a fall in the effective tax rate?
A fall in the effective tax rate increases I and causes ๐ผ^๐ to shift to the right. Result of increased investment: higher ๐, higher ๐ and ๐ผ

Give two equivalent ways of describing equilibrium in the goods market. Use a diagram to show how goods market equilibrium is attained.
Equilibrium in the goods market occurs when the aggregate supply of goods (Y) equals the aggregate demand for goods (Cd + Id + G). Since desired national saving (Sd) is Y โ Cd โ G, an equivalent condition is Sd = Id. Equilibrium is achieved by the adjustment of the real interest rate to make the desired level of saving equal to the desired level of investment, as shown in Figure 4.7 in the text.
Why do desired consumption and desired investment fall as the real interest rate rises?
Desired consumption declines as the real interest rate rises because the higher return to saving encourages higher saving. Desired investment declines as the real interest rate rises because the user cost of capital is higher, reducing the desired capital stock, and thus investment.