MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT

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MACROECONOMICSAND THE GLOBAL BUSINESS ENVIRONMENT
2nd edition

• Consumption and Saving

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Key Concepts

• Consumption
• Saving
• Caveats

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U.S. Consumption Boom
Real GDP growth and Consumption growth move
together
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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

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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

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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,
  Cd rises, but not by as much as Y, so Sd 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 gt (1) investment payoff (2)
  consumption smoothing

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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

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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

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Caveats

• Uncertainty about future income
• Borrowing constraints
• Demographics
• Save according to life cycle

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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

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Borrowing constraints

• Model assumes ability to borrow against future
  income
• Inability to borrow borrow less today
• Consumption is not smoothed as desired

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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

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Demographic Influences
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Public Sector

• Fiscal policy
• Affects desired consumption through changes in
  current and expected future income
• Directly affects desired national saving

(tax ?, same govt spending)
(same tax, govt spending ?)