15-1Consumption, Saving, and Investment, Part 15-2Agenda• Consumption and Saving• Determinants of National Saving• Investment5-3Consumption and Saving• Consumption and saving decisions :¾ Desired consumption is the consumption amount desired by households¾ Desired national saving is the level of national saving when consumption is at its desired level:Sd= Y – Cd–G5-4Consumption and Saving• Consumption and saving decisions:¾ A person can consume less than current income, i.e., saving is positive.¾ A person can consume more than current income, i.e., saving is negative.25-5Consumption and Saving• Consumption and saving decisions:¾ There is a trade-off between current 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.• Consumption-smoothing motive: the desire to have a relatively even pattern of consumption over time.5-6Consumption and Saving• Effect of changes in current income:¾ Increases in current income increase both consumption andsaving.• Because the marginal propensity to consume—the fraction of additional income consumed—is less than 1.¾ When current income (Y) rises, Cdrises, but not by as much as Y, so Sdalso rises.5-7Consumption and Saving• Effect of changes in expected future income:¾ Higher expected future income raises current consumption even at the same current income level, so current saving declines.5-8Consumption and Saving• Effect of changes in wealth:¾ Increase in wealth raises current consumption even at the same current income level, so current saving declines.35-9Consumption and Saving• Effect of changes in the real interest rate:¾ A higher real interest rate has 2 effects.• The Substitution effect on saving is positive because a higher rate of return is a greater reward for saving.• The Income effect on saving is mixed:– It is negative for a net saver because it takes less saving to achieve a given amount in the future (target saving).– It is positivefor a net borrower because a higher real interest rate represents a loss of wealth.5-10Consumption and Saving• Effect of changes in the real interest rate:¾ Taxes and the real return to saving.• The expected after-tax real interest rate is given by:ra-t=(1 –t)i –πe5-11Consumption and Saving• Effect of changes in fiscal policy:¾ Changes in fiscal policy affects desired consumption through changes in both current andexpected future income.¾ They directly affect desired national saving:Sd= Y – Cd–G5-12Consumption and Saving• Effect of changes in fiscal policy:¾ Government purchases:• Higher G financed by higher current taxes reduces after-tax income, lowering desired consumption.• Higher G financed by higher futuretaxes also lowers desired consumption ifpeople realize that future after-tax income will be lower.45-13Consumption and Saving• Effect of changes in fiscal policy:¾ Government purchases:• However Cddeclines by less than G rises because the marginal propensity to consume is less than 1. • Consequently, national saving (Sd= Y – Cd– G) declines.• An increase in government purchases reduce both desired consumption and desired national saving if it is financed by higher (current or expected future) taxes.5-14Consumption and Saving• Effect of changes in fiscal policy:¾ Taxes:• A reduction in current taxes will increase current (disposable) income and desired consumption.• However, consumers may realize that a tax cut today will result in higher taxes in the future, which will reduce future expected income.5-15Consumption and Saving• Effect of changes in fiscal policy:¾ Taxes—3 possible situations:• If the decline in future expected income is less than the increase in current income, desired consumption will rise.5-16Consumption and Saving• Effect of changes in fiscal policy:¾ Taxes—3 possible situations:• If the decline in future expected income is more than the increase in current income, desired consumption will fall.55-17Consumption and Saving• Effect of changes in fiscal policy:¾ Taxes—3 possible situations:• If the decline in future expected income exactly offsetsthe increase in current income, desired consumption will not change.– This is an example of Ricardian equivalence.– The tax change affects only the timing of taxes, not their ultimate (present value) amount.5-18Consumption and Saving• Effect of changes in fiscal policy:¾ Taxes:• In practice, people do not fully see that future taxes will rise if taxes are cut today.• Consequently, a tax cut today leads to increased desired consumption and reduced desired national saving.5-19Application: A Ricardian Tax Cut?• The Economic Growth and Tax Relief Reconstruction Act (EGTRRA) of 2001 gave rebate checks to taxpayers and cut tax rates substantially.¾ From 2001 Q1 to 2001 Q3:• Government saving fell $277 billion (at an annual rate).• Private saving increased $180 billion (at an annual rate).• National saving declined $97 billion (at an annual rate).– About 2/3 of the tax cut was saved.5-20Application: A Ricardian Tax Cut?• Results of the tax rebates:¾ Most consumers saved their tax rebates and did not spend them.¾ As a result, the tax rebate and tax cut did not stimulate much additional spending by households.65-21Determinants of Desired National Saving• Desired national saving will:¾ Increase with a rise in current income because part of the extra income is saved.¾ Decrease with an increase in expected future income because a higher expected future income raises current desired consumption and reduces current desired saving.5-22Determinants of Desired National Saving• Desired national saving will:¾ Decrease with an increase in wealth because some of the extra wealth is consumed, which reduces saving for a given current income.¾ Probably increase with an increase in expected (after-tax) real interest rates because the increased return to savings probably outweighs that less must be saved to reach a savings target.5-23Determinants of Desired National Saving• Desired national saving will:¾ Decrease with an increase in government purchases, G, because higher G directly lowers desired national saving.¾ Probably rise with an increase in taxes, T, because consumers don’t take full account for future taxes and so reduce current consumption. • But saving won’t change if consumers fully account for a offsetting