Saving, Consumption, and Wealth

2 National Wealth Sum of wealth of all households, firms and the government Accumulation of past saving Stock variable

3 Saving A flow variable Current income minus current spending

4 National Saving Private saving S pvt = Y + NFP + TR + INT - T - C where GNP = Y + NPF Government saving S gvt = T - TR - G - INT also called government surplus

5 Total Saving S = S pvt + S gvt S = Y+NFP+TR+INT-T-C+T-TR-INT-G S = Y + NFP - C - G total income - total spending for current needs

6 Developing Uses of Saving Identity S = Y + NFP - C - G substituting in Y = C + I + G + (X - M) yields S = C + I + G + (X - M) + NFP - C - G S = I + (X - M + NFP) = I + current account

7 A short digression: the current account Current account is roughly the trade balance Current account is equal to the amount of lending we do abroad If we export to other countries, we can use that currency to lend abroad More details in a future lesson

8 Uses of Saving Identity S = I + current account = I + int’l lending S pvt + S gvt = I + int’l lending S pvt = I + int’l lending - S gvt S pvt = I + int’l lending + budget deficit

9 Figure 2.1 The uses-of-saving identity in the United States, 1980–1996

10 Sources of Investment Funds S pvt = I + int’l lending + budget deficit I = S pvt + int’l borrowing + budget surplus I = S pvt + trade deficit + budget surplus

11 Trade Deficit: Good or Bad? US had a trade deficit for most years between 1982 and 1992 This allows us to consume more than we produce This allows us to invest more than we save However, it is not wise to borrow from abroad for consumption goods

12 Private Saving

13 Consumption and Saving Only one decision is made by the household If consumption rises, saving must fall – Only exception is a rise in disposable income If saving rises, consumption must fall – Only exception is a rise in disposable income

14 Determinants of consumption Income – Increase in income increases both consumption and saving – Keynesian consumption function C = f(Y) = c 0 + c Y *Y c Y is called the marginal propensity to consume (MPC) – What additional consumption is generated by an additional dollar of income? – Its value is between 0 and 1

15 Determinants of consumption Expected Future Income – Also called consumer confidence or consumer sentiment – If you expect a raise next month consume more today save less today – If you expect to be unemployed next month consume less today save more today

16 Determinants of consumption Wealth – Increases in wealth raise current consumption – Increases in wealth lower current saving Distinguish wealth from income Stock market movements provide large changes in wealth

17 Example of wealth effect 1996 Labor income = $30, Labor income = $30, Labor income = $30,000 LOTTERY!! = $1 million Income=$30,000Income=$1,030,000Income=$30,000 Wealth=$0 Wealth=$1000 Wealth=$801,000 C=$29,000C=$230,000C=$100,000 S=$1,000S=$800,000S= -$70,000

18 Determinants of consumption Expected real interest rate – Two opposing effects Greater reward for saving – Save more Don’t need as much saving to reach a target amount of wealth in the future – Save less – Empirical studies Increases in real interest rates lead to small increases in saving, small decreases in consumption

19 Determinants of consumption Taxes on interest earned on savings – If tax rate rises Real after tax interest rate declines Savings declines – Empirical evidence IRA accounts Increases in certain types of savings vehicles

20 Determinants of consumption Government purchases – Increase in G financed by taxation Disposable income falls Consumption falls Private saving falls – Increase in G financed by borrowing Higher future taxes (lower future income) Consumption falls Private saving rises

21 Effect of government spending (financed by bonds) on national saving S = S pvt + S gvt = Y + NFP - C - G Private saving rises (as expected future income falls) Government saving falls Increase in private saving is less than fall in government saving Equivalently, decrease in consumption is less than rise in government spending

22 Effect of government spending (financed by bonds) on national saving S = S pvt + S gvt = Y + NFP - C - G If G rises, total saving falls

23 Determinants of Consumption Taxes – A tax cut raises disposable income today Consumption increases, saving increases – Future expected taxes are higher Consumption decreases, saving increases

24 Ricardian Equivalence S = S pvt + S gvt = Y + NFP - C - G – If two effects offset each other and C doesn’t rise, then national saving is unchanged Called Ricardian Equivalence

25 Problems with Ricardian Equivalence Future and current taxes may not be equal (uncertainty) Credit constraints May avoid the future taxes Current tax cut and future tax increase may not be imposed on the same people How forward looking are consumers?

26 Effect of taxes on national saving S = S pvt + S gvt = Y + NFP - C - G If taxes are cut, Consumption rises National saving falls

27 Life-cycle model of consumption Enriches our understanding of consumption behavior Looks at consumption and saving as lifetime decisions Allows us to compare consumption in countries with different demographic patterns

28 Dissaving Saving Life Cycle Model $ age Income Consumption

29 Implications of the life-cycle model People at different ages will have different marginal propensities to consume and save National demographics matter for national saving – Baby boom just turned 50; we expect to see an increase in saving in the near future – The Japanese have long life expectancies, long retirements, and fast growing income. These factors help explain high saving in Japan (Hayashi)