Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Chapter 12 Consumption and Saving

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Objectives Evaluate modern theories of consumption which link lifetime consumption to lifetime income Consider consumption under uncertainty Investigate further aspects of consumption behaviour Explain the Barro-Ricardo problem

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Chapter Organisation 12.1The Life-Cycle–Permanent-Income Theory of Consumption and Saving 12.2Consumption under Uncertainty: the Modern Approach 12.3Further Aspects of Consumption Behaviour

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Consumption and Saving Consumption accounts for more than 61% of aggregate demand. A simple model of consumption was outlined in Chapter 7. It assumed that consumption was determined by disposable income in a simple linear relation. (12.1)

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley The Life-Cycle Theory Life-cycle (LC) hypothesis –Individuals plan their consumption and savings behaviour over long periods with the intention of allocating consumption over their entire lifetime. A key assumption is individuals choose to consume at about the same level every period. This implies that the MPC will vary over the life-cycle of the individual.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley The Life-Cycle Theory Modern consumption theories consider the way in which individuals plan and make choices over an extended period of time. Two theories explain consumption patterns: –The life-cycle hypothesis –The permanent income theory. These two models focus on different aspects of consumption planning. Today, these two theories have largely merged.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley The Life-Cycle Theory Example –Assume a person starts work at 20, plans to work until they are 65, expects to die at 80, and earns –$ a year (YL). –The person’s lifetime resources would be YL times working life (WL) or $  (65 – 20) = $1.35m. –Spreading the lifetime resources over the lifespan (NL) gives an annual C of $ –C = (WL/NL)  YL = $1.35m/(80 – 20) = $22 500

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley The Life-Cycle Theory Example –C = (WL/NL)  YL –So the MPC is WL/NL = (65 – 20)/(80 – 20) = 0.75 Consider now a permanent increase in Y of $3000: –The extra Y times 45 working years spread over 60 years of life would increase annual consumption by +$3000  (45/60) = +$2250 –The MPC out of permanent Y would still be: WL/NL = 45/60 = 0.75

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley The Life-Cycle Theory Consider now a transitory increase in Y of $3000 for 1 year only: –The extra Y spread over 60 years would increase annual consumption by +$3000  (1/60) = +$50 –The MPC out of transitory Y would be 1/NL = 1/60 = –The MPC out of permanent Y is large while the MPC out of transitory Y is small.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Permanent-Income Theory The Permanent-Income hypothesis (PIH) claims C is not related to current Y but rather longer-term estimates of Y. Permanent-Income is: –The steady rate of C a person could maintain for the rest of his or her life –Given the present level of wealth and the Y earned now and in the future.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Permanent-Income Theory This implies that consumption is proportional to permanent Y. C = cYP (12.2) Where YP is permanent (disposable) Y. Transitory Y is assumed not to have any substantial affects on consumption.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Chapter Organisation 12.1The Life-Cycle–Permanent-Income Theory of Consumption and Saving 12.2Consumption under Uncertainty: the Modern Approach 12.3Further Aspects of Consumption Behaviour

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Consumption under Uncertainty: the Modern Approach The modern version of the LC-PIH links income uncertainty and changes in consumption. Changes is consumption arises from surprise changes in Y. Without surprises, maximising consumers equate consumption over all periods.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Consumption under Uncertainty: the Modern Approach Any reallocation of consumption from the optimum will reduce total utility. A person enjoys utility u from consumption C in period t: u(Ct). Lifetime utility (LU) is the sum of period-by-period utilities.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Consumption under Uncertainty: the Modern Approach –Starting at period t until the final period T LU = u(C t ) + u(C t + 1 ) + ….. + u(C T - 1 ) + u(C T ) The lifetime budget constraint (LBC) is the sum of the period-by-period consumption LBC= C t + C t ….. + C T C T = wealth +YL t +YL t+1 + …..+YL T - 1 +YL T (12.3)

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Consumption under Uncertainty: the Modern Approach Equation 12.3 states that consumers choose consumption each period: –To maximise lifetime utility –Subject to total lifetime resources. The optimal choice is the C path that equates the marginal utility of C across periods: –MU(C t + 1 ) = MU(C t ) –No reallocation over time can increase total utility.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Consumption under Uncertainty: the Modern Approach Now consider uncertainty. –Future marginal utility is unknown at time t. –The consumer must estimate the expected value of tomorrow’s t + 1 utility: E [MU(C t + 1 )]. –The optimum time path of consumption is where E[MU(C t + 1 )] = MU(C t ). –If the (marginal) utility function is one-to-one with C, then: E (C t + 1 ) = C t.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Consumption under Uncertainty: the Modern Approach Now consider uncertainty. –E (C t + 1 ) = C t –If observed C is expected C with a random surprise  C t + 1 = E (C t + 1 ) +  –Then substituting for the expected value derives a simple random-walk model of consumption C t + 1 = E (C t + 1 ) +  = C t + 

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Consumption under Uncertainty: the Modern Approach The random walk model suggests that changes in consumption should not be predictable. Consumption is assumed to be based on future expected income as well as current income. The predictions of the random walk model appear to be fairly accurate.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley LC–PIH: The Traditional Model Strikes Back Empirical evidence suggests: –Both the simple consumption function and the LC–PIH help explain consumption behaviour. –Campbell and Mankiw (1989) found that 1/3 of household consumption can be explained by current Y rather than permanent Y. –Consumption behaviour exhibits excess sensitivity (C responds strongly to predictable changes in Y) and excess smoothness (C responds sluggishly to surprise changes in Y).

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Liquidity Constraints and Myopia Why doesn’t LC–PIH fully explain consumption behaviour? Three reasons may account for this shortfall: –Liquidity constraints –Myopia –Uncertainty and buffer stock saving.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Liquidity Constraints and Myopia Liquidity constraints –Represent constraints on borrowing –A consumer may not be able to borrow to sustain current consumption in the expectation of higher future Y –Example: Students cannot obtain a large loan now merely on the basis of expected higher future Y.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Liquidity Constraints and Myopia Myopia –Consumers may not be as forward looking as suggested by the LC–PIH –They take a short-sighted approach –Example: An announcement that social security benefits will be increased in 6 weeks' time –Doesn’t increase consumption (until benefits are paid) because the recipients do not have the available assets to increase consumption (liquidity constraint), or –They do not pay attention to the announcement (myopia), or they don’t believe it.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Uncertainty and Buffer-Stock Saving Some saving is precautionary (buffer-stocks) to guard against times when income is low. –Y fluctuations create considerable risk for the consumer. –The pain caused by a large drop in spending is greater than the pleasure caused by an equal-size increase in spending. –Consumers may avoid having to cut C sharply in bad times if they have a buffer-stock.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Chapter Organisation 12.1The Life-Cycle-Permanent-Income Theory of Consumption and Saving 12.2Consumption under Uncertainty: the Modern Approach 12.3Further Aspects of Consumption Behaviour

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Further Aspects of Consumption Behaviour The Barro-Ricardo Problem (Ricardian equivalence) –Claims that a reduction in taxes does not increase consumption. –Households save the additional disposable income, with unchanged consumption spending. –Debt financing of the budget deficit by bond issue will require future increases in taxes. –So households increase their savings now to pay for the future tax increase.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley Further Aspects of Consumption Behaviour Objections to the Ricardian equivalence –People have finite lives, so later generations pay for the debt that the present generation enjoys. –For a given tax cut now, people increase their consumption now, as the tax cut eases their liquidity constraints. –They do not save now for the future increase in taxes as their liquidity constraints imply they are consuming less now then their optimal consumption level.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley International Differences in Savings Rates Gross national savings –The sum of private sector and public sector savings. Public sector savings –Includes total government saving and savings of public sector enterprises and financial institutions. Private sector savings –Includes personal (household) and business savings.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley International Differences in Savings Rates

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley International Differences in Savings Rates From Figure 12.5: –Significant declines in both private and public sector savings in the early 1990s contributed to national savings reaching a post-war low of around 15.5% of GDP in late –Since then, national savings has increased to 18.9% of GDP. –This has been entirely due to increased public savings. –Private savings have continued to decline.

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley International Differences in Savings Rates

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley International Differences in Savings Rates Table 12.1 shows that Australia had an average gross national savings rate in the 1990s of 18.5%. This rate is similar to Canada’s (17.5%). This rate is higher than the rates for the US (16.5%) and the UK (15.7%). However, national saving is considerably lower than Japan’s (31%).

Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley International Differences in Savings Rates What underlies the trend of savings in Australia and internationally? –Large budget deficits imply reduced saving in the public sector. –Changing demographics (such as a larger senior citizen population) account for some of the changes in saving rates over time. –Australia and other OECD economies find it easier to borrow than most other nations.