Macroeconomics plus MyEconLab plus eBook 1-semester Student Access Kit (6th Edition)

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Chapter 4 Consumption, Saving, and Investment Learning Objectives I. Goals of Chapter 4 A) Examine the factors that underlie economy wide demand for goods and services B) Assumes closed economy (for now) C) Focuses on consumption and investment D) Equivalent to studying saving and capital formation E) Examines trade-off of present vs. future F) Goods market equilibrium when desired saving equals desired investment G) Real interest rate plays key role in bringing goods market to equilibrium II. Notes to Fifth Edition Users A) The application on “Consumer sentiment and the 1990-1991 recession” has been deleted, though it is available in this instructor’s manual if you would still like to use it B) A new application, “Consumer sentiment and forecasts of consumer spending” discusses whether indexes of consumer sentiment are in fact useful for forecasting consumer spending C) In section 4.2, new data are available on effective tax rates on capital in many countries Teaching Notes I. Consumption and Saving (Sec. 4.1) A) The importance of consumption and saving 1. Desired consumption: consumption amount desired by households 2. Desired national saving: level of national saving when consumption is at its desired level S d = Y C d G (4.1) Data Application Recall from Chapter 2 that measured consumption in the national income accounts includes spending on durable consumption goods, like autos and major appliances. But consumption theory requires that consumption be defined to include only the services from durable consumer goods. So empirical researchers must adjust the national income data to arrive at a measure of consumption that matches the theory. For example, they might assume that durable goods provide services proportional to the stock of durables.
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Chapter 4 Consumption, Saving, and Investment 59 B) The consumption and saving decision of an individual 1. A person can consume less than current income (saving is positive) 2. A person can consume more than current income (saving is negative) 3. Trade-off between current consumption and future consumption a. The price of 1 unit of current consumption is 1 + r units of future consumption, where r is the real interest rate b. Consumption-smoothing motive: the desire to have a relatively even pattern of consumption over time C) Effect of changes in current income 1. Increase in current income: both consumption and saving increase (vice versa for decrease in current income) 2. Marginal propensity to consume ( MPC ) = fraction of additional current income consumed in current period; between 0 and 1 3. Aggregate level: When current income ( Y ) rises, C d rises, but not by as much as Y , so S d rises Theoretical Application The classic discussions of consumption are the permanent-income hypothesis of Milton Friedman ( A Theory of the Consumption Function , Princeton: Princeton University Press, 1957) and the life-cycle hypothesis of Franco Modigliani and Richard Brumberg (“Utility Analysis and the Consumption Function: An Interpretation of Cross-Section Data,” in Ken Kurihara, ed., Post-
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