Consumption and Savings October 10 2016 1 51 Consumption I The major components I I I I Purchases of non durable goods and services Food clothing education health care financial services Purchases of durable goods Autos computers furniture Consumption is between 60 and 70 of GDP in most countries Relatively stable except for expenditures on durable goods which fluctuate significantly 2 51 GDP vs Consumption 3 51 I I If you know that your wealth will grow in the future will your consumption exceed your income If you cannot borrow 4 51 Key lessons from the data I I I Consumption is not just a constant fraction of income Consumption is strongly correlated with GDP and income Implications I I I Households must use their savings to smooth consumption over time We need to understand the link between consumption and savings Evidence for consumption smoothing through savings across periods 5 51 Saving and Borrowing I Why save or borrow Friedman Modigliani I I I I Life cycle save for retirement Life cycle borrow against future earnings for education Precautionary savings uncertain income save for relative drops in income Time discounting Preferences for consumption today vs tomorrow I Consumers optimal choice is to smooth consumption I Trade off Interest rate on borrowing saving vs preferences for consumption today tomorrow 6 51 A Simplified Model I Assume agents live for only two periods present and future generalizes to 2 periods I y Current income y f Future income c Current consumption cf Future consumption a Assets at the beginning of current period af Assets at the beginning of next period r Real interest rate I I I I I I 7 51 Budget Constraints c af y a I Use wealth and income to consume today save the rest I I I af savings save for tomorrow in some assets e g savings account stocks etc Grows at rate 1 r Consumption tomorrow cf y f 1 r af I Consume all of interest on savings af and income since last period not if 2 periods 8 51 Intertemporal Budget constraint IBC Combine the two budget constraints into an IBC expressed in present value terms c I yf cf a y P V LR 1 r 1 r Present values discounted by 1 r I I 1 For 1 of future consumption need to save 1 r and earn interest 1 r 1 Similarly 1 of future income is like having 1 r today cf I 1 r is the present value of future consumption yf I 1 r is the present value of future income I As before PVLR is the present value of lifetime resources 9 51 Intertemporal Budget constraint IBC I How do we draw the consumer s problem 10 51 Intertemporal Budget constraint IBC I How do we draw the consumer s problem I Let s have current consumption on the x axis and future consumption on the y axis 11 51 Intertemporal Budget constraint IBC I How do we draw the consumer s problem I Let s have current consumption on the x axis and future consumption on the y axis I What are the terminal conditions 12 51 Intertemporal Budget constraint IBC I How do we draw the consumer s problem I Let s have current consumption on the x axis and future consumption on the y axis I What are the terminal conditions I What is the slope of the budget constraint 13 51 Intertemporal Budget constraint IBC I How do we draw the consumer s problem I Let s have current consumption on the x axis and future consumption on the y axis I What are the terminal conditions I What is the slope of the budget constraint I What are the effects of a change in the interest rate 14 51 The effect of an increase in the interest rate I Substitution effect I I Relative price of tomorrow s consumption increases So substitute from today consumption to tomorrow s by saving more Income effect I I If saver Can save less to get same income tomorrow Therefore it tends to reduce savings If borrower Need to save more to get same income tomorrow Therefore it tends to increase S I The effect of real interest rate on aggregate saving is theoretically ambiguous Empirical research suggests that saving increases I The aggregate Saving Curve will be upward sloping 15 51 The Real Interest Rate and the Consumption Saving Decision The real interest rate and the budget line Fig 4 A 6 When the real interest rate rises one point on the old budget line is also on the new budget line the no borrowing no lending point Slope of new budget line is steeper Copyright 2014 Pearson Education Inc All rights reserved 4A 27 Figure 4 A 6 The effect of an increase in the real interest rate on the budget line Copyright 2014 Pearson Education Inc All rights reserved 4A 28 The Real Interest Rate and the Consumption Saving Decision The substitution effect A higher real interest rate makes future consumption cheaper relative to current consumption Increasing future consumption and reducing current consumption increases saving Suppose a person is at the no borrowing no lending point when the real interest rate rises Fig 4 A 7 An increase in the real interest rate unambiguously leads the person to increase future consumption and decrease current consumption The increase in saving equal to the decrease in current consumption represents the substitution effect Copyright 2014 Pearson Education Inc All rights reserved 4A 29 Figure 4 A 7 The substitution effect of an increase in the real interest rate Copyright 2014 Pearson Education Inc All rights reserved 4A 30 The Real Interest Rate and the Consumption Saving Decision The income effect If a person is planning to consume at the noborrowing no lending point then a rise in the real interest rate leads just to a substitution effect But if a person is planning to consume at a different point than the no borrowing no lending point there is also an income effect Copyright 2014 Pearson Education Inc All rights reserved 4A 31 The Real Interest Rate and the Consumption Saving Decision The income effect The intuition of the income effect If the person originally planned to be a lender the rise in the real interest rate gives the person more income in the future period the income effect works in the opposite direction of the substitution effect since more future income increases current consumption If the person originally planned to be a borrower the rise in the real interest rate gives the person less income in the future period the income effect works in the same direction as the substitution effect since less future income reduces current consumption further Copyright 2014 Pearson Education Inc All rights reserved 4A 32 The Real Interest Rate and the Consumption Saving Decision The income and