Assumptions for discussion on this topic

In our class on National Income we saw that outputY = C + I + G + NX

We shall ignore NX. This means we are assuming that our economy is closed.

In this class we shall focus on C and I.G has implications for both C and I. But we

shall try to limit discussion on G in this class as we shall have a full discussion on G in our Fiscal Policy class.

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What do C and I imply?C indicates the level of consumption. Therefore, C

also stands for aggregate demand for goods and services by the households.

C also indicates how much is saved by the household.

I stands for investment. This indicates how much is spent for producing goods and services to be consumed by the households.

I includes acquisition of capital goods by the firms, which actually indicates the productive capacity of economy.

I indicates CAPITAL FORMATION, which is important to understand economic growth.

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Consumption and savingFrom our class on National Income recall that

National savings (S) = Private savings + Govt. saving= Y – (T – TR – INT) + NFP – C + (T – TR – INT) – G = Y + NFP – C – G

As our economy is closed NFP in the above equation is equal to zero. Therefore, saving in a closed economy is equal to: Y – C – G

We shall start looking at consumption and saving at the individual level. Because, individual level behavior determines the aggregate level behavior.

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Decision of an individual on C and S Consumption is about spending during present time. Savings is

for consuming in the future. However, consumption more than current income during present

time means negative savings for future. A person can always trade-off current and future consumption. Economic theories suggest that this trade-off depends on the

REAL INTERESRT RATE Real interest rate is defined as:

Nominal interest rate – inflation Example: A person spends Tk. 100 to consume potato today.

Nominal interest rate is 10% and inflation rate is 5%. At present, price of potato is Tk. 10/kg. Another person saves Tk. 100 in bank account to consume potato one year later. How would you compare consumption of these two persons?

The higher the real interest rate, the more people will want to save for future consumption.

However, people generally tend to spread their consumption rationally over time. This is called “consumption smoothing”.

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Determinants of C and SSome important determinants of economic

wellbeing of a person are-Current incomeExpected future income Wealth andReal interest rate

Changes in any of these will affect consumption of the individual.

To see how the effects work let us assume that the real interest rate is fixed

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Effect of changes in current incomeA change in the current income works in two ways-

It may change the individual’s current consumption It may change the individual’s future consumption by

changing savings todayThe decision about how much the consumption today

changes depending on a change in today’s income is called “marginal propensity to consume” (MPC).

MPC indicates the percentage of the increased income that is spent for consumption.

Example: If MPC is 0.40, it means that if income of an individual increases Tk. 100 today, she will spend Tk. 40 of this additional income for consumption.

Note that in this case the person is saving 60% of her increased income for future consumption. This rate of savings is called “marginal propensity to save”.

MPC + MPS is always equal to 1.

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Effect of changes in expected future incomeDepending on the expected future income a person’s

current consumption may also change.The consumption smoothing motive will guide the person to

consume today at least some of the expected future income.Note that if the person increases her current consumption,

her current savings will reduce. If needed, she might even consume more than her current income.

Example: We use credit cards to consume today. This is actually consuming by borrowing based on the expectation that we shall be able to pay it back in future. If a person expects that she will be promoted to a higher rank in her office having better remuneration, she might actually increase the use of her credit card today, before she gets the promotion.

Example: We spend on Eid shopping before we get Eid bonus.

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Effect of changes in wealthWealth is defined as: Assets – Liabilities Increase in wealth induces current

consumption and therefore reduces savings.

A decrease in wealth will do just the opposite.

Example: During stock market boom we tend to consume more than normal times. When the market crashes we consume less.

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Effect of change in real interest rateAn increase in the real interest rate means that

savings will have higher payoff in future. Therefore, it increases savings.

It also means that a targeted future consumption level can be reached by saving smaller amounts today! This means: real interest rate may induce current consumption and reduce current savings.

These two forces work in opposite direction. The first phenomenon is known as the substitution

effect of the real interest rate on saving.The second phenomenon is known as the income

effect of the real interest rate on saving.

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Summary: Determinants of SavingsAn increase in Causes

savings toReason

Current income Rise Part of the extra income is saved

Expected future income

Fall Anticipation of increased future income induces current consumption

Wealth Fall New stock of wealth secures future consumption level and makes more of current income free for consumption.

Expected real interest rate

Not clear. Probably rise.

Increased rate produces higher pay-offs in future and thus may make savings more attractive.

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InvestmentInvestment is putting money into

something to get some return or avoid loss.Investment is related to savings.We study investment so that we can assess

the long-run productive capacity of economy by looking at investment

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Determining the level of investment We need to determine the desired capital stock of the

firms to determine the level of investment. If the marginal product of capital (MPK) is greater than the

marginal cost of capital then firms will use more capital. Marginal cost of capital is sometimes referred to as “user cost of capital”.

Recall that a firm’s profit is maximized at the point where MC = MR. Similarly, the desired capital stock of the firm will be at the point where MPK = user cost of capital.

If the MPK has the property of diminishing return then the curve of MPK will slope downward.

On the other hand, the user cost of capital will generally be fixed and therefore the curve of user cost of capital will be a straight horizontal line. For example: when we borrow from bank, bank charges us fixed interest rate. If the interest rate were variable, user cost of fund would not be horizontal straight line.

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Desired level of capital stock Like the profit

maximizing level of employment (where MPN is equal to wage), profit maximizing level of capital is where user cost of capital and MPK are equal.

On the left of K* there is still room for the firm to use capital to get more return than cost of the capital.

On the right of K* use of capital is no more profitable.

Desired level of capital changes when MPK or user cost of capital change.

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uc

MPK

MPK and uc

KK*

From capital stock to investment`

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From capital stock to investment

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Rearranging equation 1 we get:

Equation 2 has two parts:The net increase in capital stock during

the year andInvestment needed to replace the worn-

out capital stock.

)2.....(..........dKKKI tt1tt

Goods market equilibriumAn important question is: how do we know that the

goods and services that the consumers and investors want to buy will be the same as the amount that the producers are willing to provide?

The real interest rate is a key element that whose adjustment helps to find the answer.

If the goods market is in equilibrium, the supply of goods will match with the demand for goods.

The national income identity for a closed economy is:Y = C + I + G

The left hand side indicates the amount of output supplied by the producers.

The right hand side indicates the amount of goods and services demanded by the consumers, investors and the government.

Therefore, the national income identity can also be perceived as the goods market equilibrium condition. 17

Goods market equilibriumRearranging the national income identity we get:

Y – C – G = IS = I

This means that the goods market will be in equilibrium when savings will be equal to investment.

This is another way of expressing the goods market equilibrium.

Both savings and investment are affected by real interest rate.

If real interest rate increases, savings increases and investment decreases and vice versa.

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Goods market equilibrium Goods market

equilibrium is at E. Any deviation from point

E will not sustain and will come back to it again.

For example: when the real interest rate is lower than the equilibrium rate, then the investors will want to invest more than the savers want to lend.

Note that at the equilibrium point total output of the economy will be equal to the sum of consumption, investment and government purchases.

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SI

Real interest rate

EA

B

S, IC D

Savings and investment in open economyGoods market equilibrium in open economy will be

established when:S = I + NX + NFP

But NX + NFP = current account balance (CA)Therefore the equilibrium condition for open economy will

be: S = I + CA

This means that when savings is more than investment, the economy will have more idle money to lend to foreigners. The amount of idle money that can be lent to the foreigners will be equal to CA. In this case the current account balance will be positive.

Conversely, if savings is less than investment that means the economy is using more money for investment purposes than it has. The extra money comes by borrowing from the foreigners. In this case the current account balance is negative.

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Savings and investment in open economyAlternatively we can also state the open economy

goods market equilibrium as:Y = C + I + G + NXNX = Y – (C + I + G)

This means that the economy’s net export will be equal to the amount of goods that the economy will not absorb. The size of absorption is equal to (C + I + G).

When we consider open economy condition for a small economy, the goods market equilibrium will depend on the world real interest rate, not on the domestic interest rate. However, if the country is large domestic interest rate may affect the world interest rate.

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