Because saving equals income minus consumption, a households decisions about how much to consume and how much

to save are really the same decision. Individuals and households save because they value both future consumption and current consumption; for the same amount of income, an increase in current saving reduces current consumption but increases the amount that the individual or household will be able to consume in the future. For an individual or household, an increase in current income raises both desired consumption and desired saving. Analogously, at the national level, an increase in current output raises both desired consumption and desired national saving. At both the household and national levels, an increase in expected future income or in wealth raises desired consumption; however, because these changes raise desired consumption without affecting current income or output, they cause desired saving to fall. An increase in the real interest rate has two potentially offsetting effects on saving. First, a higher real interest rate increases the price of current consumption relative to future consumption ( note: each unit of current consumption costs 1 plus r units of foregone future consumption ). In response to the increased relative price of current consumption, people substitute future consumption for current consumption by saving more today. This tendency to increase saving in response to an increase in the relative price of current consumption is called the substitution effect of the real interest rate on saving. Second, a higher real interest rate increases the wealth of savers by increasing the interest payments they receive, while reducing the wealth of borrowers by increasing the amount of interest they must pay. By making savers wealthier, an increase in the real interest rate leads savers to consume more and reduce their saving; however, because it makes borrowers poorer, an increase in the real interest rate causes borrowers to reduce their consumption and increase their saving The change in current consumption that results because a consumer is made richer or poorer by an increase in the real interest rate is called the income effect of the real interest rate on saving. For a saver, the substitution effect of an increase in the real interest rate (which tends to boost saving) and the income effect (which tends to reduce saving) work in opposite directions, so that the overall effect is ambiguous. For a borrower, both the substitution effect and the income effect of a higher real interest rate act to increase saving. Overall, empirical studies suggest that an increase in the real interest rate increases desired national saving and reduces desired consumption, but not by very much. The real interest rate that is relevant to saving decisions is the expected after-tax real interest rate, which is the real return that savers expect to earn after paying a portion of the interest they receive in taxes. With total output held constant, a temporary increase in government purchases reduces desired consumption. the reason is that higher government purchases imply increases in present or futures taxes, which makes consumers feel poorer. However, the decrease in desired consumption is small than the increase in government purchases, so that desired national saving, Y minus C to the d power minus G, falls as a result of a temporary increase in government purchases. According to the Ricardian equivalence proposition, a current lump-sum tax cut should have no effect on desired consumption or desired national saving. The reason is that, if no change occurs in current or planned government purchases, a tax cut that increase current income must be offset by future tax increases that lower expected future income. If consumers do not take into account expected future tax changes, however, the Ricardian equivalence proposition will not hold and a tax cut is likely to raise desired consumption and lower desired national saving. The desired capital stock is the level of capital that maximizes expected profits. At the desired capital stock, the expected future marginal product of capital equals the user cost of capital. The user cost of capital is the expected real cost of using a unit of capital for a period of time; it is the sum of the depreciation cost ( the loss in value because the capital wears out ) and the interest cost ( the interest rate times the price of the capital good).

Any change that reduces the user cost of capital or increases the expected future marginal product of capital increases the desired capital stock. A reduction in the taxation of capital, as measured by the effective tax rate, also increases the desired capital stock. Gross investment is spending on new capital goods. Gross investment minus depreciation (wornout or scrapped capital) equals net investment, or the change in the capital stock. Firms invest so as to achieve their desired level of capital stock; when the desired capital stock increases, firms invest more. The goods market is in equilibrium when the aggregate quantity of goods supplied equals the aggregate quantity of goods demanded, which (in a closed economy) is the sum of desired consumption, desired investment, and government purchases of goods and services. Equivalently, the goods market is in equilibrium when desired national saving equals desired investment. For any given level of output, the goods market is brought into equilibrium by changes in the real interest rate. The determination of goods market equilibrium, for any fixed supply of output, Y, is represented graphically by the saving-investment diagram. The saving curve slopes upward because empirical evidence suggests that a higher real interest rate raises desired saving. the investment curve slopes downward because a higher real interest rate raises the user cost of capital, which lowers firms desired capital stocks and thus the amount of investment they do. Changes in variables that affect desired saving or investment shift the saving or investment curves and change the real interest rate that clears the goods market. Vocabulary 1.Consumption-smoothing motive: preference of most people for a relatively constant or stable pattern of consumption over time, as opposed to having high consumption at some times and low consumption at others. 2.Desired capital stock: amount of capital that allows a firm to earn the highest possible possible expected profit 3.Effective tax rate: a single measure of the tax burden on capital that summarizes the many provisions of the tax code that affect investment 4.Expected after-tax real interest rate: nominal after-tax rate of return (equal to the nominal interest rate times 1 minus the tax rate) minus the expected rate of inflation; equals the expected increase in the real value of an asset after payment of taxes on interest income 5.Gross investment: total purchase or construction of new capital goods 6.Income effect of the real interest rate on saving: the tendency of savers to consume more and save less in response to an increase in the real interest rate because they are made wealthier; the tendency of borrowers to consume less and save more in response to an increase in the real interest rate because they are made less wealthy 7.Marginal propensity to consume: MPC - the amount by which desired consumption rises when current income rises by one unit 8.Net investment: the change in the capital stock over the year, equal to gross investment minus depreciation of existing capital 9.Ricardian equivalence proposition: the proposition that changes in the government budget deficit caused entirely by changes in (lump-sum) tax collections have no effect on the economy 10.Substitution effect of the real interest rate on saving: the tendency of consumers to save more, and thereby substitute future consumption for current consumption, in response to a higher reward for saving 11.Tax-adjusted user cost of capital: indicates how large the before-tax expected future marginal product of capital must be to make a proposed investment profitable; equivalently, the (unadjusted) user cost of capital divided by 1 minus the effective tax rate 12.User cost of capital: the expected real cost of using a unit of capital for a specified period of time; equal to the depreciation cost plus the interest cost