© 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 determinants
• Advanced Material 5.2 Short term and long term effects of investment
© Pilot Publishing Company Ltd. 2005
More about Consumption Function
© Pilot Publishing Company Ltd. 2005
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 =
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Yd1
Slope = C1/Yd1 = APC1Slope = C1/Yd1 = APC1
C
Yd0
C*
C
Graphical illustration
C1
+1APC1
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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=
© Pilot Publishing Company Ltd. 2005
Yd1
Slope = C1/Yd1 = APC1Slope = C1/Yd1 = APC1
C
Yd0
C*
C
Graphical illustration
C1
+1MPC
Slope = ΔC/ΔYd = MPCSlope = ΔC/ΔYd = MPC
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C
Yd0
C
C*
c
+1
Graphical representation of consumption function Plotting C against Yd
C = cYd + C*
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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*)
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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
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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
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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
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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.
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More about Saving Function
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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 =
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S
S
Yd
S* = -C*
S1
0 Yd1
Slope = S1/Yd1 = APS1Slope = S1/Yd1 = APS1
Graphical illustration
+1APS1
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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 =
© Pilot Publishing Company Ltd. 2005
S
S
Yd
S* = -C*
S1
0 Yd1
Slope = S1 /Yd1 = APS1 Slope = S1 /Yd1 = APS1
Graphical illustration
+1MPS1
Slope= ΔS/ΔYd = MPS Slope= ΔS/ΔYd = MPS
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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
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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
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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
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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
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Determinants of saving function
YY
T
YdC
S
Y
T
Yd
CC
S
Y
TT
YdC
S
© Pilot Publishing Company Ltd. 2005
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
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Change in determinant Effect on
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
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More about Investment Function
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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
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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
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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
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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
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Determinants of net investment function
Change in determinant Effect 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
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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
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Fiscal Policy
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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
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Automatic fiscal policy
Automatic stabilizers or built-in stabilizers are government measures that reduce cyclical fluctuations of an economy automatically.
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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
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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
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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.
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Q5.8:
Are corporate savings and family savings built-in stabilizers? Do they create disincentives?
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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)
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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.
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Corresponding multipliers:
Instrument MultiplierMultiplier
Government expenditure
Transfer payment
Tax
mcqctic1
1
mcqctic1
c
mcqctic1
c-
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What is government budget?
Budget is a financial statement proposing the estimated revenue and expenditure of the public sector in a fiscal year.
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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
=
<
>
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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)
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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.
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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
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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.
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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.
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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.
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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.
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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
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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.
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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:
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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.
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