Consumption and Savings

Macroeconomics I

ECON222

Fall 2017

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 1 / 22

Key questions

How do changes in current and future income aect consumption?

How do changes in interest rates to aect consumption and savings?

What are the interactions between consumption/savings choices and

scal policy?

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 2 / 22

Some denitions for a closed economy

Desired consumption, C d : aggregate quantity of goods and services

that households want to consume, given income and other factors

Desired saving, S d : level of national saving that occurs when

aggregate consumption = C d :

S d = Spd + Sg = Y Cd G

,! where Spd = desired private saving

,! simplication: NFP = 0

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 3 / 22

The consumption-saving decision

Savers earn and borrowers pay, a real interest rate of r per year.
,! the cost of $1 of consumption now is $(1 + r ) of consumption next
period

The consumption-smoothing motive is the desire to have a

relatively even pattern of consumption over time
,! a one-time income bonus is likely to be saved and the income earned
on that saving spread over time.

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 4 / 22

A simple model

Two periods: today (1) and "the future" (2)

Perfect capital markets

,! no borrowing constraints
,! interest on savings = interest on borrowing

Households preferences are represented by indierence curves

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 5 / 22

 C2

Increasing
Utility

C1
Figure: Indierence Curves

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 6 / 22

Budget constraint

Savings:
Sp = V + Y1 C1
Future consumption:

C2 = (1 + r )Sp + Y2

Substitute out Sp to get the intertemporal budget constraint:

C2 Y2
C1 + = V + Y1 + W
1+r 1+r
,! note that 1 + r is the relative price of current consumption
,! simplication: let V = 0

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 7 / 22

 C2

(1+r)Y1+Y2
Endowment
Point
Y2

-(1+r) C1
Y1 Y1+ Y2
1+r
Figure: Budget Constraint
Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 8 / 22
 C2

(1+r)Y1+Y2 Optimal
consumption
d

Y2

-(1+r) C1
Y1 Y1+ Y2
1+r
Figure: Optimal Consumption - Saver
Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 9 / 22
 C2

(1+r)Y1+Y2

Optimal
Y2 consumption
d

-(1+r) C1
Y1 Y1+ Y2
1+r
Figure: Optimal Consumption Borrower
Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 10 / 22
Changes in current income

Marginal propensity to consume (MPC) is the fraction of

additional current income that is consumed in the current period

When Y1 rises by $1:

,! C1d rises by less than 1
,! Spd rises by the fraction of 1 not spent on consumption.

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 11 / 22

 C2

b
a
Y2

C1
Y1
Figure: Increase in Current Income, Y1 Saver

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 12 / 22

Changes in income and wealth

Current consumption, C1d , tends to increase and savings, Spd , decrease

when:
,! expected future income, Y2 , increases, due to the smoothing motive
,! nancial wealth, V , increases: no need to save as much for the future

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 13 / 22

Changes in the real interest rate

For a saver an increase in r has two opposite eects:

,! increases the opportunity cost of C1d and thus increases Spd
(substitution eect);
,! increases current income from wealth which increases C1d and Spd
(income eect)

For a borrower, when r increases the substitution and income eects

both result in increased Spd

Empirical evidence: an increase in r reduces C1d and increases Spd , but

the eect is not very strong.

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 14 / 22

 C2

b
a

C1

Figure: Interest Rate Increase Saver

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 15 / 22

 C2

a
b

C1

Figure: Interest Rate Increase Borrower

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 16 / 22

Eects of scal Policy

How does scal policy aect household consumption choices?

,! important policy question

How does an increase in G aect consumption and saving?

Does it matter whether the government nances its expenditures

through taxes or debt?

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 17 / 22

Two-period model again
Suppose government borrows/lends at the same rate r as households

Government saving
Sg = T1 G1
Government spending in period 2

G2 = (1 + r )Sg + T2

,! assumes that the governments scal policy is sustainable

Intertemporal government budget constraint

G2 T2
G1 + = T1 +
1+r 1+r

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 18 / 22

Household after-tax budget constraint

Incorporating taxes (with V = 0) we get

C2 Y2 T2
C1 + = Y1 T1 +
1+r 1+r

Substituting out the taxes using the government budget constraint

C2 Y2 G2
C1 + = Y1 G1 +
1+r 1+r

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 19 / 22

Government purchases

When the government increases G1 by raising T1 :

,! Sg is unchanged
,! C1d and Spd decrease due to lower after-tax income today.

When the government increases G1 by borrowing:

,! C1d falls and Spd increases due to lower after-tax income in future.
,! But Sg falls, because G1 increases

In both cases , the net eect on desired national savings,

S d = Spd + Sg , is a decline

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 20 / 22

Taxes

A government tax cut without a reduction of current spending should:

,! increase current disposable income
,! raise expectations of lower after-tax income in the future

According to the Ricardian equivalence proposition the positive

and the negative eects of the tax cut on C1d should exactly cancel.

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 21 / 22

Why doesnt Ricardian Equivalence hold exactly in
practice?

Shifting the tax burden to future generations

Government borrows at dierent rate than households

Distortionary taxes

Credit constrained consumers

BUT
,! the osetting eect is still an important constraint on scal policy

Macroeconomics I (ECON222) Consumption, Savings & Investment Fall 2017 22 / 22