Econ 309: Savings and Social Security

1. Econ 309: Savings and Social Security

2. Keynesianism: The IS-LM Model • Keynes wrote The General Theory of Employment, Interest, and Money in 1936 • The IS-LM model was developed by John Hicks for the Econometric Conference at Oxford, September, 1936 • One of many attempts to make the General Theory more accessible, formal • Hicks later became disillusioned with IS-LM and was ambivalent about receiving the Nobel Prize for it in 1972

3. Keynesianism: The IS-LM Model P LM • IS curve: Y = C(Y-T) + I(r) + G • LM curve: M/P = L(r, Y) Ymax IS2 IS1 Q

4. Keynesianism: IS-LM curve • IS curve: Y = C(Y-T) + I(r) + G • Assumption: Consumption is a functional of “disposable income” (marginal propensity to consume) and nothing else • Assumption: Investment is a function of interest rates (though it can be exogenously shifted by “animal spirits”) • Government spending does not affect either investment or consumption directly • LM curve: M/P = L(r, Y) • People have a liquidity preference, demanding more money and less

5. Keynesianism: The IS-LM Model • Implications for policy • Fiscal policy: An increase in government spending pushes the IS curve outward and raises GDP (if Y<Ymax) • Monetary policy: An increase in the money supply pushes LM outward and raises GDP • “Crowding out”: expansionary fiscal policy drives up interest rates and causes a fall in investment that partially offsets its effects • Question: What if Y=Ymax?

6. Savings in Keynes • IS curve: Y = C(Y-T) + I(r) + G • Consumption, C, is a function of disposable income, Y-T • Savings is the residual of disposal income after consumption, i.e. S = Y – T - C(Y-T) • Savings behavior does not involve any thought for the future! • What is the effect of a fall in the savings rate? C rises, and GDP rises

7. Basic Monetarism • The equation of exchange: MV=PT, where • M = money supply • V = velocity of money • P = price level • T = volume of real transactions (i.e., real GDP) • If V is constant (a major assumption), then: • Monetary policy (interpreted as raising M) can increase real GDP, but might only increase inflation • No obvious interpretation for fiscal policy • “The triumph of monetarism”: in recent years (until 2009), economists have usually advocated monetary policy rather than fiscal policy

8. The Solow Model of Long-Run Growth y=f(k) • Yt = f(Kt), dY/dK > 0, d2Y/dK2 < 0 • Kt+1 = (1-n-d)Kt + sYt (n+d)k Y sy K

9. Savings in Solow • As in the standard Keynesian model, savings is exogenously fixed • What is the effect of a fall in the savings rate? The long-run growth rate falls • IS-LM plus Solow: Savings are bad in the “short run,” good in the “long run”???

10. Digression: Ethics and discount rates • Economists assume that people “discount the future” • Revealed preference says: • The future really is worth less than the present, if people systematically treat it so • It is not irrational to discount the future • Ordinary people find this view hard to accept • Exponential vs. hyperbolic discounting: • If discounting is exponential, people’s behavior is “time-consistent” • If discounting is hyperbolic, people have time-inconsistent preferences • Given economic growth, is it clear that people really do discount the future?

11. Gokhale: Social Security and Savings • Gokhale’s explanations for the decline in the savings rate: • Government redistribution of income from younger cohorts to older cohorts • A rise in the consumption propensities of older cohorts due to annuitization of incomes

12. The decline in US savings rates • (go to Gokhale, p. 7/320) • Between 1950 and 1995, savings rate dropped from 11.5% to 3.4% • Continued falling after that, to 0% or less, before rising sharply in 2008/09

13. US savings rates, 2000-2009 http://www.bea.gov/briefrm/saving.htm

14. Net national savings rate Savings rate equals one minus consumption rate minus government spending rate