Saving, Consumption, and Wealth

1. 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 Spvt = Y + NFP + TR + INT - T - C where GNP = Y + NPF • Government saving Sgvt = T - TR - G - INT also called government surplus

5. Total Saving • S = Spvt + Sgvt • 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 • Spvt + Sgvt = I + int’l lending • Spvt = I + int’l lending - Sgvt • Spvt = 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 • Spvt = I + int’l lending + budget deficit • I = Spvt + int’l borrowing + budget surplus • I = Spvt + 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) = c0 + cY*Y • cY 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. 1997 1998 1996 Labor income = $30,000 Labor income = $30,000 Labor income = $30,000 LOTTERY!! = $1 million Example of wealth effect Income=$30,000 Income=$1,030,000 Income=$30,000 Wealth=$0 Wealth=$801,000 Wealth=$1000 C=$29,000 C=$230,000 C=$100,000 S=$1,000 S=$800,000 S= -$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 = Spvt + Sgvt = 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 = Spvt + Sgvt = 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 = Spvt + Sgvt = 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 = Spvt + Sgvt = 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. $ Income Saving Consumption Dissaving Dissaving 18 65 85 age Life Cycle Model

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)