Consumption, Investment and Stabilisation

1. Macroeconomics 2 (BEC ECO 311
(Sessions-03, Weeks 03)
Consumption, Investment, and Stabilization Policy
Mathew Abraham

2. Keynes’ Consumption Function
• The relationship between aggregate consumption and current disposable
income is “propensity to consume.” (Keynes,1936).
• The sensitivity of consumption to income is measured through:
(1) The average propensity to consume (APC) = C/Y.
(2) The marginal propensity to consume (MPC) = ΔC/ΔY.
• APC and MPC are generally believed to be between zero and one.
• MPC measures the change in the average propensity to consume.
• The average propensity to consume (APC) measures the percentage of
income that is spent rather than saved.

3. Keynesian CF
• The linear Keynesian consumption function is:
C = a + b Y
• b = MPC in the equation is constant since in a linear function
the marginal effect (slope) is constant.
• APC = C / Y = [ (a + b Y) / Y] = (b + a /Y).
• How the APC varies as income changes depends on (a).
• If a > 0, then the MPC < APC and people spend a decreasing
share of their incomes as incomes rise. If a = 0, then the MPC =
APC and spending is a constant proportion b of income.

4. MPC and APC
• MPC >1 if the consumer borrowed money or dissaved to finance
expenditures higher than his/her income.
• MPC < 0 if an increase in income leads to a reduction in consumption
(which might occur if, for example, the increase in income makes it
worthwhile to save up for a particular purchase).
• In a standard Keynesian model, MPC < APC because in the short-run
some (autonomous) consumption does not change with income.
• Over the long run, as wealth and income rise, consumption also rises;
MPC out of long-run income is closer to the APC.

5. Empirical Estimation of Keynes CF
• Empirical estimation of equation C = a+ b Y yields a value of b (MPC)
close to 0.75 and a positive value of ‘a.’
• Early empirical estimates showed that the MPC was less than the APC.
• Simon Kuznets pointed out that the share of income consumed seemed to
remain constant over almost a century of data spanning the latter half of
the 19th century and the first half of the 20th.
• If the APC > MPC or (MPC < APC) as C = a+ b Y suggest, then the share
of income consumed should decline as income increases.

6. Short-run and Long-run CFs
• Short-run CF studies found MPC < APC and long-run data showed that MPC = APC
(Kuznets paradox).
• In the Keynesian CF, MPC<APC because in the short run some consumption
(autonomous) does not change with income.
• The conflict between short-run and long-run evidence is shown graphically on the next
slide.
• The long-run consumption function has a slope equal to the long-run APC (and equal to
MPC). The short-run consumption function shown has a slope (MPC) that is smaller than
the APC (MPC <APC).
• Empirical evidence supports the short-run CF (MPC <APC), showing that high-income
households saved a larger fraction of their income than lower-income households.

7. Short-run C F v/s Long-run CF

8. Reconciling Short-run and Long-run CFs
• The relative-income hypothesis, described by James Dusenbery (1949) tried to reconcile
this paradox.
• The relative-income model was formulated in two variants: a cross-section version and
a time-series version. These variants correspond to the cross-section and time-series
aspects of the Kuznets paradox.
• In both variants, consumption depends on current income relative to some income
standard that the household sets based on its own past income or on the income of other
households around it.
• In the cross-section version, a household’s consumption would depend not just on its own
current level of income, but on its income relative to those in the subgroup of the
population with which it identifies itself.
• Households with lower income within the group will consume a larger share of their
income to “keep up,” while households with high incomes relative to the group will save
more and consume less.

9. Long run CF (Timeseries Version)
• In the time-series variant of the relative-income hypothesis, households instead
of comparing their income to those of other households, each household is
assumed to consider its current income relative to its own past income levels.
• A household that has in the past achieved income levels higher than its present
levels would attempt to maintain the high consumption levels that it achieved
earlier. Thus, when incomes fall, consumption would not fall in proportion.
• The result of this behavior for aggregate consumption is called a “ratchet effect.”
When incomes rise, consumption increases along the steeper long-run
consumption function. However, when a recession hits and incomes decline,
households reduce consumption less than proportionally and fall back along the
flatter short-run consumption function.

10. Life-cycle Theory of Consumption
• Modigliani’s model (life-cycle) states that consumers prefer to borrow during the early low-
income years, repay those loans and build up wealth during the high-income years, then
spend off the accrued savings during retirement.
• Implicit in the life-cycle approach is the idea of a lifetime budget constraint that links
consumption at various dates during their lifetime.
• The position of the budget constraint depends on the present value of lifetime earnings
(wealth) .
• Stock of Wealth (human and non-human) at time 0 = 𝐀𝟎 + 𝒕=𝟎
𝑻
𝒀𝒕/(𝟏 + 𝒓)^𝒕.
• A0 = Value of current non-human (financial and physical) assets. Yt for t= 0,1,2.3,……..,T
is the expected stream of real labour income over the life-time and r is the real interest
rate

11. Permanent income hypothesis of consumption
• Friedman distinguished between a “normal” level of income that they expect over their
lives, which he called permanent income, and (positive or negative) deviations from that
level, which he termed transitory income.
• Similarly, Friedman distinguished permanent consumption, which is the part of
consumption that is planned and steady, and transitory consumption, such as
unexpected medical bills or temporary college tuition expenses.
• Friedman argues that permanent consumption will be proportional to permanent income.
• Both permanent and transitory consumption are independent of transitory income and that
transitory consumption in any period is independent of permanent income.

12. Calculation of permanent income
• Permanent income can be thought of as the size of a constant annual flow of income that
would have the same present value as the (possibly uneven) flow of income that is
actually expected. If we know the future income path, we can calculate permanent income
from the budget constraint as:
𝒕=𝟎
∞
𝒀𝑷
𝟏 + 𝒓 𝒕
= 𝑨𝟎 +
𝒕=𝟎
∞
𝒀𝒕
𝟏 + 𝒓 𝒕
• Where Y p is permanent income. A0 = Value of Current Assets.
• Permanent income could be expressed as a linear function of current and past incomes.

13. Random-Walk Hypothesis of Consumption
• The independence of consumption changes from expected changes in income is knows as
the random-walk hypothesis of consumption (Robert Hall, 1978).
𝐂 𝐭 + 𝟏 = 𝛃𝟎 + 𝛃𝟏 𝐂𝐭 + µ,t+1
• The disturbance term u t+1 in the equation is treated as a random variable, capturing the
effect on the consumption path of changes in income that the household finds out about in
period t + 1.
• Thus, the equation expresses consumption in period t + 1 as a constant term β0 plus a
coefficient β1 times period t consumption, plus a random term that reflects new information
received at t + 1, and is uncorrelated with anything that was known at time t.

14. Intertemporal CF (Fisher ,1930)
• In the first period, saving (S) is the difference between income and consumption:
S = Y1 – C1 … (1)
• In the second-period consumption equals the accumulated saving (which includes the
interest earned on that saving), plus second-period income:
C2 = (1 + r) S + Y2 … (2)
• Where r is the real interest rate (nominal interest adjusted for inflation). Since we do not
consider the third period, the consumer is not required to save in the second period.
• We can now derive the consumer’s budget constraint by combining equations (1) and (2).
If we substitute the first equation for S into the second equation we get:
C2 = (1 + r) (Y1 – C1) + Y2 OR (1 + r) C1 + C2 = (1 + r)Y1 + Y2
(3)
• Finally by dividing both sides of equation (3) by 1 + r we get:
C1 + C2 / 1 + r = Y1 + Y2 / 1 + r (4)

15. Australian Household Consumption Pattern

16. Investments
• If firms attempt to maximize profit, as we assume, a firm's desired
capital stock is the amount of capital that allows the firm to earn the
largest expected profit.
• Managers can determine the profit-maximizing level of the capital
stock by comparing the costs and benefits of using additional capital.
• The user cost of capital is the expected real cost of using a unit of
capital for a specified period of time.
• The user cost of capital is the sum of the depreciation cost and the
interest cost.

17. The Desired Stock of Capital
• A firm's desired capital stock is the capital stock at which the expected
future marginal product of capital equals the user cost of capital.
• Any factor that shifts the MPK curve or changes the user cost of
capital changes the firm's desired capital stock.
• A decline in the real interest rate raises the desired capital stock.
• A technological advance raises the expected future marginal product
of capital (MPK).
• An increase in the expected future MPK raises the desired capital
stock.

18. Desired Capital Stock and Investment
• The capital stock changes over time through two opposing channels.
• First, the purchase or construction of new capital goods that takes
place each year is called gross investment.
• Second, the capital stock depreciates or wears out, which reduces the
capital stock.
• The change in the capital stock over the year is the difference
between gross investment and depreciation or net investment.

19. Goods market Equilibrium (S = I)
• The goods market is in equilibrium when the aggregate quantity of
goods supplied equals the aggregate quantity of goods demanded.
Y = C +I+ G (1)
• Alternatively, the goods market is in equilibrium when desired
national saving equals desired investment.
• Subtracting C + G from both sides of equation (1), we get:
Y- C- G = C +I + G – C – G
Y – C – G = I
• Y –C – G = Desired National Savings.
• Thus the goods market equilibrium condition becomes: S = I

20. Stabilization Policy
Efficiency Wage Model
• The effort curve shows the relationship between work effort and the
real wage workers receive.
• A higher real wage leads to more effort, but above a certain point,
higher wages are unable to spur effort much, so the effort curve is S-
shaped.
• For any point on the curve, the amount of effort per dollar of real
wage is the slope of the line from the origin to that point.
• Firms will choose the level of the real wage that gets the most effort
from workers for each dollar of real wages paid.

21. Effort Curve

22. Efficiency wage and wage rigidity
• Since the employer chooses the real wage that maximizes effort
received per dollar paid, as long as the effort curve doesn't change,
the employer will not change the real wage.
• Therefore, the efficiency wage theory implies that the real wage is
rigid and equals the efficiency wage.
• The real wage that maximizes effort or efficiency per dollar of real
wages is called the efficiency wage.

23. Unemployment in the absence of job and worker mismatch

24. Explanation of diagram
• The upward-sloping curve is the labor supply curve and this curve
shows the number of hours of work that people would like to supply
at each level of the real wage.
• The labor demand curve is identical to the marginal product of the
labor curve, which in tum relates the marginal product of labor to the
quantity of labor input being used.
• The MPN curve and hence the labor demand curve slope down
because of the diminishing marginal productivity of labor.

25. Explanation of diagram (Continued)
• In the classical model, the marginal product of labor depends only on
the production function and the capital stock.
• In the efficiency wage model, the amount of output produced by an
extra worker (or hour of work) also depends on the worker's effort.
• At the efficiency wage, the quantity of labor supplied is greater than
the quantity demanded.
• This means when wages have adjusted and the economy is technically
at "full employment," an excess supply of labor remains
(unemployment).

26. Neutrality of Money
• Money is not neutral in the short run but neutral in the long- run (Keynesians).
• In the case of money expansion, firms find that demand for their products in the short run
is greater than they had planned (aggregate output demanded is greater than full-
employment output), so eventually, they raise their prices.
• The rise in the price level returns the real money supply to its initial level and restores the
general equilibrium.
• Keynesian model predicts that money is not neutral in the short run but is neutral in the
long run.
• In the Keynesian model, short-run price stickiness prevents the economy from reaching
its general equilibrium, but in the long-run prices are flexible, ensuring general
equilibrium.

27. Government Expenditure, Taxes, Output, and Employment
• The multiplier associated with any particular type of spending is the short-
run change in total output resulting from a one-unit change in that type of
spending.
• Keynesians usually argue that the fiscal policy multiplier is greater than 1,
so if government purchases rise by $1 billion, the output will rise by more
than $1 billion.
• A temporary increase in government purchases increases the demand for
goods and reduces desired national savings at any level of the real
interest rate so that the IS curve shifts up and to the right.
• A fiscal policy change that shifts the IS curve up and to the right and raises
output and employment is an expansionary change.

28. Fiscal Policy Change
• A fiscal policy change (such as a reduction in government purchases)
that shifts the IS curve down and to the left and reduces output and
employment is a contractionary change.
• A lump-sum reduction in current taxes is expansionary. In other
words, a tax cut will shift the IS curve up and to the right, raising
output and employment in the short run.
• A tax increase to be contractionary, shifting the IS curve down and to
the left.

29. Philip’s Curve and Natural Rate of Unemployment
Ch 12

30. Supply Shock and Natural Rate of Unemployment
• Adverse supply shocks raise both expected inflation and the natural
unemployment rate.
• According to the Friedman-Phelps analysis adverse supply shocks
should cause the Phillips curve to shift up and to the right.
• Beneficial supply shocks should shift the Phillips curve down and to
the left.
• Overall, the Phillips curve should be particularly unstable during
periods of supply shocks.

31. Supply Shocks
• From the classical perspective, an adverse supply shock raises the
natural rate of unemployment by increasing the degree of mismatch
between workers and jobs.
• For example, an oil price shock eliminates jobs in heavy-energy-using
industries but increases employment in energy-providing industries.
• With a rigid efficiency wage, the drop in labor demand increases the
excess of labor supplied over labor demanded, raising the amount of
unemployment that exists when the economy is at full employment.
• Like the classical model, the Keynesian model predicts that an adverse
supply shock will raise the natural unemployment rate.

32. Macroeconomic policy and unanticipated inflation
• Can the macroeconomic policy be used to create unanticipated inflation?
• Classical economists argue that wages and prices adjust quickly in response to new
economic information, including information about changes in government policies.
• According to classical economists, policies (such as more rapid monetary expansion) that
increase the growth rate of aggregate demand act primarily to raise actual and expected
inflation and so do not lead to a sustained reduction in unemployment.
• Keynesians contend that policymakers do have some ability in the short run, at least to
create unanticipated inflation and thus to bring unemployment below the natural rate.
• Due to price stickiness, when policymakers cause aggregate demand to rise above the
expected level, time is needed for prices to fully reflect this new information. Therefore,
unemployment may remain below the natural rate for a while (Keynesians).

33. Cold Turkey v/s Gradualism
• What are the suggested approaches for reducing inflationary
expectations?
• Classical economists have proposed that disinflation should be implemented
quickly by a rapid and decisive reduction in the growth rate of the money supply,
a strategy sometimes referred to as cold turkey.
• Keynesians point out that the cold-turkey strategy may not lower inflation
expectations, because people may expect the government to abandon the policy
if the resulting unemployment reaches politically intolerable levels.
• Keynesians recommend a policy of gradualism or reducing the rate of money
growth and inflation gradually over a period of years.

34. Monetary Policy (Text Book Chapter 14)
• Monetary policy is the government's decisions about how much money to
supply to the economy.
• The macroeconomic models predict that changes in the money supply will
affect nominal variables such as the price level and the nominal exchange
rate.
• In addition, theories that allow for the non-neutrality of money imply that, in
the short run, monetary policy also affects real variables such as real GDP,
the real interest rate, and the unemployment rate.
• We first examine the basic question of how the nation's money supply is
determined.
• Then we explore the question: How should the central bank conduct
monetary policy?

35. How is the nation's money supply determined?
• Three groups affect the money supply: the central bank, depository
institutions, and the public.
• In nearly all countries the central bank is the government institution
responsible for monetary policy (Reserve Bank of Australia).
• Depository institutions that accept deposits from and make loans directly to
the public (call them banks).
• The public includes every person or firm (except banks) that holds money,
either as currency and coins or as deposits in banks.

36. Monetary Base, Bank Reserves and Fractional Reserve Banking
• The sum of reserve deposits and currency (including both currency held by the nonbank
public and vault cash held by banks) is called the monetary base, or, equivalently, high-
powered money.
• Liquid assets held by banks to meet the demands for withdrawals by depositors or to pay
the checks drawn on depositors' accounts are called bank reserves.
• Bank reserves comprise currency held by banks in their vaults and deposits held by
banks at the Central Bank.
• The reserve-deposit ratio is equal to Reserves divided by Deposits.
• A banking system in which the reserve-deposit ratio is less than 1 is called fractional
reserve banking.
• The alternative to fractional reserve banking is 100% reserve banking, in which bank
reserves equal 100% of deposits.

37. Example of FED (Central Bank of USA)
Hypothetical Balance Sheet of FED.
Federal Reserve Bank
Assets Liabilities
Securities $900 Currency held by non-bank
Public $700
Gold $100 Vault Cash held by Banks $100
Total Assets $1,000 Reserve Deposits $200
Total Liabilities $1,000
The sum of reserve deposits and currency ($1,000) is called Monetary Base or High-
Powered Money.

38. Consolidated Balance Sheets of a Bank
• Consider the balance sheets of banks in the private sector.
Consolidated Balance Sheet of Banks
Assets Liabilities
Vault Cash $100 Deposits $3,000
Reserve Deposits 200
Loans 2700
Total Assets $3,000 Total Liabilities $3,000

39. Open Market Operations and Money Supply
• Suppose the central bank wants to increase the amount of money in
the economy.
• It could do so by buying securities from private investors in the bond
market.
• The process is explained in your textbook- See Page number 528
(Chapter 14)

40. Money Multiplier
• The central bank uses open-market operations to change the size of the
monetary base.
• A one-dollar increase in the monetary base increases the money supply by
more than one dollar.
• Formula: 𝑴 = (
𝑪𝒖+𝟏
𝑪𝒖+𝑹𝒆𝒔
)*Monetary Base.
• The equation states that the money supply is a multiple of the monetary
base.
• The relationship of the money supply to the monetary base depends on
the currency-deposit ratio chosen by the public (cu) and the reserve-
deposit ratio (Res) chosen by banks.
• The factor (cu + 1)/(cu + res) is called the money multiplier.

41. Money Multiplier (Continued)
• The money multiplier will be greater than 1 as long as Res is less than 1
(that is, with fractional reserve banking).
• Each additional dollar of the monetary base will increase the money supply
by more than one dollar, which is why the monetary base is also known as
high-powered money.
• It can be shown algebraically that the money multiplier decreases when
either the currency-deposit ratio, cu, or the reserve-deposit ratio, res,
increases.

42. Other Means of Controlling the Money Supply
Reserve Requirements.
• An increase in reserve requirements forces banks to hold more reserves
and increases the reserve-deposit ratio.
• A higher reserve-deposit ratio reduces the money multiplier, so an
increase in reserve requirements reduces the money supply.
Discount Window Lending.
• The Fed's lending of reserves to banks is called the discount window
lending and the interest rate it charges for lending reserves is called the
discount rate.
• An increase in borrowing from the discount window raises the monetary
base, and a decrease in discount window borrowing lowers the monetary
base.

43. Interest Rate Targeting
• See Chapter 14.
• Page Numbers: 544 -548.
• Diagrams: 14.8, 14.9 & 14.10.

44. Making Monetary Policy in Practice
• The IS-LM or AD-AS analysis of monetary policy suggests that using
monetary policy to affect output and prices is a relatively simple matter.
• All that the Fed (Central Bank)needs to do is change the money supply
enough to shift the LM curve or the AD curve to the desired point.
• In reality, however, making monetary policy is a complex, ongoing process.
• Two important practical issues that policymakers have to deal with are the
lags in the effects of monetary policy on the economy and uncertainty
about the channels through which monetary policy works.
• The long lags in the operation of monetary policy make it very difficult to
use this policy instrument with precision.

45. The Channels of Monetary Policy Transmission.
• Another practical difficulty faced by monetary policymakers is determining
exactly how monetary policy affects the economy.
• Two primary ways in which monetary policy affects economic activity and prices
are:
• The effects of monetary policy on the economy that works through changes in
real interest rates are called the interest rate channel of monetary policy.
• A reduction in the money supply raises real interest rates, which in turn reduces
aggregate demand, and declining aggregate demand leads to falling output and
prices.
• The effects of monetary policy working through changes in the real exchange rate
are called the exchange rate channel.

46. Exchange Rate Channel and Credit Channel
• A tightening of monetary policy raises the real exchange rate.
• A higher real exchange rate, by making domestic goods more expensive
for foreigners and foreign goods cheaper for domestic residents, reduces
the demand for the home country's net exports.
• This reduced demand for net exports also reduces aggregate demand,
depressing output and prices.
• A tightening of monetary policy also works by reducing both the supply of
and demand for credit, a mechanism referred to as the credit channel of
monetary policy

47. The conduct of Monetary Policy: Rule v/s Discretion.
• Most classical and Keynesians agree that money is neutral in the long
run so that changes in money growth affect inflation but not real
variables in the long run.
• Most would accept that the main long-run goal of monetary policy
should be to maintain a low and stable inflation rate.
• Should monetary policy is conducted according to fixed rules or at the
discretion of the central bank?

48. Rule v/s Discretion
• The use of rules in monetary policy has been advocated primarily by a
group of economists called monetarists, and also by classical
macroeconomists.
• Supporters of rules believe that monetary policy should be essentially
automatic.
• The opposite of the rules approach, which has been supported by most
Keynesian economists, is called discretion.
• The idea behind discretion is that the central bank should be free to
conduct monetary policy to meet the objectives of low and stable inflation,
high economic growth, and low unemployment.