MACROECONOMICS
AND THE GLOBAL BUSINESS ENVIRONMENT
2nd edition
Consumption and Saving
1
12-2
Key Concepts
 Consumption
 Saving
 Caveats
12-3
U.S. Consumption Boom
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8
7
6
5
4
3
2
1
0
-1
-2
-3
60
62
64
66
68
70
72
74
76
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80
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90
92
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96
98
00
GDP growth (% p.a.)
Consumption growth (% p.a.)
S ource: E coWin
Real GDP growth and Consumption growth move together
12-4
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
12-5
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
Future Consumption
Present Consumption =
1 r
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
12-6
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 => (1) investment payoff (2) consumption smoothing
12-7
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
12-8
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
12-9
Caveats
 Uncertainty about future income
 Borrowing constraints
 Demographics

Save according to life cycle
12-10
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
12-11
Borrowing constraints
 Model assumes ability to borrow against
future income
 Inability to borrow – borrow less today
 Consumption is not smoothed as desired
12-12
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
12-13
Demographic Influences
12-14
Public Sector
Fiscal policy
 Affects desired consumption through changes
in current and expected future income
 Directly affects desired national saving
 S Y  C G
(tax ↑, same gov’t spending)
 S Y C  G
(same tax, gov’t spending ↑)
d
d
d
d