Savings Prof. Michael Smitka Washington and Lee University

Savings What determines savings? Motives –Present vs future consumption But no specific reason to believe we really trade off consumption today against more goodies tomorrow Need more precise motives! –Precautionary motive Rainy day needs are constant? Surely not huge… –Until you get into a severe recession

“Sticky Behavior” How do we plan our consumption behavior? –Look at those around us … Hence we look backward at how others did? OR: –Project current income into the future … Hence we look backward at how others did? –But all with the aim of providing for the future With sticky behavior, an unanticipated rise in income thus tends to be saved In particular, growth raises savings rates –but this is ad hoc / makes light of efforts to optimize

Lifetime or Permanent Income Sticky behavior assumes we can’t see what’s happening around us, and that non-precautionary savings is unplanned Alternatively, we deliberately choose to save using (rational?) expectations about the future –We want steady consumption over our lifetime Though we can jazz the model up to reflect family formation –But income is low when young and old, then: We dissave ( or would like to! ) when (i) young or (ii) retired We save otherwise.

Income vs. Consumption (death!) Income (rises then falls) Consumption (steady) Savings Dissavings Retirement...

$ age Income is red line consumption is blue line saving Temp income decline or consumption spurt ===> savings is the margin over which we adjust Dissaving

Implications Savings rise: –When the core savings age bracket is rising as a share of the population –When there are unexpected increases in income –Due for example to a short-term tax rebate –Or when economic growth lifts retirement targets –When (expected) longevity increases Private savings fall with “social security” –Total savings likely shifts far less

Other interpretations Another approach is to posit target consumption over the course of a lifetime These might include: –Buying a house –Funding children’s education –Paying for their wedding –Retirement In effect, a variation of the “lifetime” model

Advantages of a “target” Individual targets can shift independent of other movements (income, etc) It helps in particular to model the impact of changes in asset prices –A rise in housing prices lowers savings if most of the population already owns a house –A fall in the stock market boosts savings It also seems to fit how people actually plan

Present vs. Future Consumption Do interest rates matter? We trade off in financial markets –S today becomes (1+i)S tomorrow (i=interest) –When “i” rises real wealth rises: we can consume the same amount today and more tomorrow! From micro theory: –A change in “i” thus has an income effect: we don’t need to save as much to make (say) a down payment. –It also has a substitution effect: the better “price” makes us save more by making future consumption cheaper. Empirically they cancel: “i” doesn’t affect S

Interest rates: addendum However, consumption of durables is sensitive to interest rates in the US –Lots of people borrow / buy and then save Repaying a loan means consumption is less than income Hence you save to repay a loan –But when interest rates are high, the monthly payment on a mortgage rises steeply People are priced out of the market –If no one is borrowing, consumption is lower and S  Alternatively, only those repaying loans are left, so S 

Japan These various approaches successfully predict Japan’s rising savings rate during the high growth era of The “target” approach helps us understand why savings didn’t fall in : inflation eroded assets so families had to redouble their efforts The “target” approach helps us understand the bubble, too...

Realism: Addenda We can always add complexity: sample data

This and the previous chart are from Mark Aguiar and Erik Hurst (2008). “Deconstructing Lifecycle Expenditure.” University of Michigan Retirement Research Center, Working Paper WP