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12-2 Key Concepts Marginal Propensity to Consume and the Multiplier The Budget Constraint and Utility Permanent Income Precautionary Savings Borrowing Constraints Life Cycle Issues Determinants of Savings The role of the interest rate

12-3 Consumption Spending Spending on goods and services by private individuals Importance Significant fraction of output Relationship to savings and investment

12-4 U.S. Consumption Boom Real GDP growth and Consumption growth move together

12-5 U.S. Savings Bust Year Savings Ratio (% of Income)

12-6 GDP Identity GDP CGI X-IM Income TCPS = =

12-7 I + G + X – IM = PS + T CGITCPS = Investment = Savings + Net Imports + Government Surplus I = PS + (IM – X) + (G – T)

12-8 Keynesian Consumption \$1 Disposable Income 80% to Consumption 20% to Savings % of extra \$ of Income used for Consumption is Marginal Propensity to Consume % of extra \$ of Income used for Consumption is Marginal Propensity to Consume

12-9 Why is the MPC important? Government spends \$100 on road repair Cumulative Increase in GDP (MPC = 0.8) Cumulative Increase in Savings (MPS = 0.2) \$100 Road contractors spend \$80 and save \$20 \$180 \$20 Retailers spend \$80*0.8=\$64 and save \$16 \$244 \$36 …

12-10 Total impact of \$100 … After all rounds are complete Change in GDP = \$500 Change in Savings = \$100 Total Impact = \$100/(1-MPC) = \$100/0.2 = \$500 Total Impact = \$100/(1-MPC) = \$100/0.2 = \$500

12-11 Reality Check US multiplier is about 1.8 – 2.2 depending on kind of spending Simplistic, but gives benchmark Expansions (why do we monitor consumer spending?) – think about CNN report Recessions (why is consumer spending an indicator of recession?)

12-12 Keynesian Model Consumption = A + b x Disposable Income Consumption Income A Slope is b

12-13 Keynesian Model Y = C + G + I Y = A + bY + G + I Y = A + G + I 1 - b

12-14 The Multiplier, 1 1 - b 1 1 - MPC 1 1 - b = Increase in MPC means increase in multiplier Example MPC = 0.8 yields multiplier of 5 Extra \$100 in government spending produces an extra \$500 in total spending

12-15 Keynesian Model Output Income A + G + I C + I + G = A + bY + I + G Y 45 0 Y = C + I + G

12-16 Keynesian Model Output Income A + G + I C + I + G Y 45 0 Y0Y0 Increase in unplanned inventories

12-17 Keynesian Model Output Income A + G + I C + I + G Y Y0Y0 Decrease in unplanned inventories

12-18 Increase in G Output Income A + G + I C + I + G Y 45 0 Y0Y0 Y1Y1

12-19 Permanent Income Model People consider lifetime income in determining spending patterns What is lifetime income? 2002C 2002 + S 2002 = Y 2002 {first year of work} 2003C 2003 = Y 2003 + (1+r)S 2002 {second year of work} C 2002 + C 2003 /(1+r) = Y 2002 + Y 2003 /(1+r)

12-20 Lifetime Spending Consumption is fungible (between years) Increase in Y generates increase in C Increase in Y 2002  increase in C 2002 and C 2003 Increase in Y 2003  increase in C 2002 and C 2003 Income increases are spread over lifetime C 2002 + C 2003 /(1+r) = Y 2002 + Y 2003 /(1+r)

12-21 Feasible Lifetime Preferences C 2002 C 2003 Y 2002 + Y 2003 /(1 + r) Y 2002 x (1 + r) + Y 2003

12-22 Lifetime Preferences C 2002 C 2003 Y 2002 + Y 2003 /(1 + r) Y 2002 x (1 + r) + Y 2003 Representation of Preferences

12-23 Lifetime Preferences C 2002 C 2003 Y 2002 + Y 2003 /(1 + r) Y 2002 x (1 + r) + Y 2003

12-24 Increase in income C 2002 C 2003 Y 2002 + Y 2003 /(1 + r) Y 2002 x (1 + r) + Y 2003 Increase in lifetime income produces increase in consumption in both periods

12-25 Implications Consumption doesn’t vary as much as income Doesn’t fall as much in recessions Doesn’t rise as much during booms Savings is more volatile than Income Savings is more volatile than Income

12-26 Implications Temporary income changes have less impact on spending than permanent income changes Temporary tax cuts vs. Permanent tax cuts Temporary tax cuts vs. Permanent tax cuts

12-27 Implications Expectations about future income may change spending patterns today What happens during periods of economic uncertainty?

12-28 Implications Savings rates will be lower when expectation is that future income will be higher Savings can be negative What should happen to US savings rates? Is this good? What about Japan? What should happen to US savings rates? Is this good? What about Japan?

12-29 Caveats People must be able to anticipate future income Uncertainty  Higher Savings People must be able to borrow Lack of borrowing opportunities  Higher Consumption

12-30 Precautionary Savings 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 Precautionary savings: Save because you are worried that your income might fall

12-31 Borrowing constraints Model assumes ability to borrow against future income Inability to borrow – borrow less today Current consumption is higher than it would otherwise be

12-32 Role of Interest Rates Suppose interest rate rises Saving becomes more lucrative, consumption becomes more expensive Current consumption should fall Future consumption should rise Savers expect higher future income Current and Future consumption rises Debtors expect lower future income Current and Future consumption falls

12-33 Income effect As income rises, buy more of all goods Increase consumption in all periods of life

12-34 Substitution Effect As price of a good rises, buy less of that good As price of a good falls, buy more of that good As relative price of two goods change, buy more of one and less of the other

12-35 Behavior of a First-Year Saver C 2002 C 2003 Y 2002 + Y 2003 /(1 + r) Y 2002 x (1 + r) + Y 2003 Consumption plan Income point, Y 2002 and Y 2003

12-36 Behavior of a First-Year Saver C 2002 C 2003 Y 2002 + Y 2003 /(1 + r) Y 2002 x (1 + r) + Y 2003 Increase in interest rate

12-37 Behavior of a First-Year Saver C 2002 C 2003 Y 2002 + Y 2003 /(1 + r) Y 2002 x (1 + r) + Y 2003 Increase in interest rate implies Decrease in 2002 consumption Increase in 2003 consumption (substitution effect dominates)

12-38 Behavior of a First-Year Borrower C 2002 C 2003 Y 2002 + Y 2003 /(1 + r) Y 2002 x (1 + r) + Y 2003 Increase in interest rate Consumption plan Income point, Y 2002 and Y 2003

12-39 Behavior of a First-Year Borrower C 2002 C 2003 Y 2002 + Y 2003 /(1 + r) Y 2002 x (1 + r) + Y 2003 Increase in interest rate

12-40 Behavior of a First-Year Borrower C 2002 C 2003 Y 2002 + Y 2003 /(1 + r) Y 2002 x (1 + r) + Y 2003 Increase in interest rate Decrease in 2002 consumption Increase in 2003 consumption Assumes substitution effect > income effect

12-41 IS curve Relation of planned expenditure to interest rate Increase in interest rate Decline in investment spending Decline in current consumption spending (substitution effect dominates)

12-42 IS Curve Interest Rate Equilibrium Output IS Curve

12-43 Capital Gains Savings calculations include only currently- produced income Capital gains arise from housing sales, stock price increases, etc. Savings picture changes when capital gains are taken into account

12-44 Savings Rate Corrected Savings Corrected Savings Rate

12-45 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