MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT

1. MACROECONOMICSAND THE GLOBAL BUSINESS ENVIRONMENT 2nd edition Consumption and Saving

2. Key Concepts • Consumption • Saving • Caveats

3. U.S. Consumption Boom Real GDP growth and Consumption growth move together

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

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 • 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

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

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

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

9. Caveats • Uncertainty about future income • Borrowing constraints • Demographics • Save according to life cycle

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

11. Borrowing constraints • Model assumes ability to borrow against future income • Inability to borrow – borrow less today • Consumption is not smoothed as desired

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

13. Demographic Influences

14. Public Sector Fiscal policy • Affects desired consumption through changes in current and expected future income • Directly affects desired national saving (tax ↑, same gov’t spending) (same tax, gov’t spending ↑)