1. transitory saving may take the form of investment and disinvestment of consumer durables.
2. a tax cut will affect investment rather than consumption as traditionally measured but will still shift the IS curve to the right at a given real exchange rate.
3. a tax cut will leave wealth unchanged.
4. all of the above are true.
Choose the correct option.
The right option is the first one. In the presence of liquidity constraints (an inability to borrow at rates of interest equivalent to those earned on physical capital) individuals can smooth consumption by adding to and running down their durable capital stock (investing and disinvesting directly in consumer durables) rather than lending and borrowing. A tax cut will reduce the amount of disinvestment (or increase the amount of investment) in consumer durables in that particular year. These changes in investment appear as changes in consumption as we usually measure it rather than in the conventional investment aggregate. Wealth may change because the use of tax finance of government expenditures makes it easier for society to smooth consumption.
Consumers base their consumption on permanent income, consuming more than their current income in bad years and less than their current income in good years. This requires that they either sell assets or borrow in bad years. When they are liquidity constrained---that is, cannot borrow at reasonable rates of interest---they can simply "borrow from themselves" by not replacing depreciated durable capital in bad years and restoring their capital in good years. Tax cuts in bad years provide the loans that enable them to maintain consumption without drawing down their stock of durables. Purchases of durables will therefore be greater than otherwise and aggregate demand will be higher.
While these purchases of durables out of the proceeds of the tax cut really represent investment---since consumption is the absorption of the services of these durables with change in their stocks representing investment---we normally measure such purchases as a component of consumption. This stems from the difficulty of properly measuring the consumption of services from durables. For this reason, option 2 is the wrong choice.