1 MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT Consumption and Saving 2 nd edition

12-2 Key Concepts Consumption Saving Caveats

12-3 U.S. Consumption Boom Real GDP growth and Consumption growth move together

12-4 GDP Identity GDP = C + I + G + NX Assume closed economy (NX = 0) Y = C + I + G National saving = current income – current spending S = Y – C – G S = I

12-5 Consumption & Saving Decision of an Individual A person can consume less than current income (saving is positive) A person can consume more than current income (saving is negative) Trade-off between current consumption and future consumption The price of 1 unit of current consumption is 1 + r units of future consumption, where r is the real interest rate real interest rate is an intertemporal price (i.e. price of resources across time) Consumption-smoothing motive: the desire to have a relatively even pattern of consumption over time

12-6 Consumption & Saving Effect of changes in current income Increase in current income: both consumption and saving increase due to consumption smoothing (vice versa for decrease in current income) Marginal propensity to consume (MPC) = fraction of additional current income consumed in current period; between 0 and 1 Aggregate level: When current income (Y) rises, C d rises, but not by as much as Y, so S d rises Effect of changes in expected future income Higher expected future income leads to more consumption today, so saving falls can “afford” to consume more today… consumption smoothing aside: debt => (1) investment payoff (2) consumption smoothing

12-7 Consumption & Saving Effect of changes in wealth Wealth is determined by (1) saving and (2) capital gains Saving rate can be lowered if capital gains is sufficiently large Increase in wealth lowers need for saving and raises current consumption Y has not changed, so saving must fall if consumption increases again, consumption smoothing Example: strong asset prices in the U.S., low saving rate

12-8 Consumption & Saving Effect of changes in real interest rate Increased real interest rate has two opposing effects Substitution effect: Positive effect on saving, since rate of return is higher; greater reward for saving elicits more saving Income effect: (1) For a saver: Negative effect on saving, since it takes less saving to obtain a given amount of wealth in the future (target saving) (2) For a borrower: Positive effect on saving, since the higher real interest rate means a loss of wealth Empirical studies have mixed results; probably a slight increase in aggregate saving

12-9 Caveats Uncertainty about future income Borrowing constraints Demographics Save according to life cycle

12-10 Uncertainty Future income is uncertain The more risk averse people are, the more they will save Rainy day savings: Save because you know your income is going to fall (e.g. retirement) Precautionary savings: Save because you are worried that your income might fall

12-11 Borrowing constraints Model assumes ability to borrow against future income Inability to borrow – borrow less today Consumption is not smoothed as desired

12-12 Demographic Influences Lifecycle of earnings alters savings patterns Typical pattern Borrow when young Save when middle aged Borrow (deplete savings) when old Shift in age profile of nation shifts savings

12-13 Demographic Influences

12-14 Public Sector Fiscal policy Affects desired consumption through changes in current and expected future income Directly affects desired national saving (tax ↑, same gov’t spending) (same tax, gov’t spending ↑)