MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT 11/19/2018 MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT 2nd edition Consumption PowerPoint by Beth Ingram University of Iowa Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

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

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

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

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

GDP Identity GDP Income = C G I X-IM T C PS =

I + G + X – IM = PS + T I = PS + (IM – X) + (G – T) C I G C PS T = Investment = Savings + Net Imports + Government Surplus I = PS + (IM – X) + (G – T)

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

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

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

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?)

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

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

The Multiplier, 1 1 - b 1 1 - b 1 1 - MPC = 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

Keynesian Model Y C + I + G = A + bY + I + G Output Income A + G + I 450 Income

Keynesian Model Y C + I + G Output Income Increase in unplanned inventories A + G + I 450 Y0 Income

Keynesian Model Y C + I + G Output Income Decrease in unplanned inventories A + G + I Y0 Income

Increase in G Y C + I + G Output A + G + I 450 Y1 Y0 Income

Permanent Income Model People consider lifetime income in determining spending patterns What is lifetime income? 2002 C2002 + S2002 = Y2002 {first year of work} 2003 C2003 = Y2003 + (1+r)S2002 {second year of work} C2002 + C2003/(1+r) = Y2002 + Y2003/(1+r)

Lifetime Spending C2002 + C2003/(1+r) = Y2002 + Y2003/(1+r) Consumption is fungible (between years) Increase in Y generates increase in C Increase in Y2002  increase in C2002 and C2003 Increase in Y2003  increase in C2002 and C2003 Income increases are spread over lifetime

Lifetime Preferences Feasible C2003 Y2002 x (1 + r) + Y2003 C2002 Y2002 + Y2003/(1 + r)

Representation of Preferences Lifetime Preferences C2003 Representation of Preferences Y2002 x (1 + r) + Y2003 C2002 Y2002 + Y2003/(1 + r)

Lifetime Preferences C2003 Y2002 x (1 + r) + Y2003 C2002 Y2002 + Y2003/(1 + r)

Increase in income C2003 Increase in lifetime income produces increase in consumption in both periods Y2002 x (1 + r) + Y2003 C2002 Y2002 + Y2003/(1 + r)

Savings is more volatile 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

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

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

What should happen to US savings rates? Is this good? 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?

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

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

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

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 NOTE: Debtors have I high MPC but creditors low

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

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

Behavior of a First-Year Saver C2003 Y2002 x (1 + r) + Y2003 Consumption plan Income point, Y2002 and Y2003 C2002 Y2002 + Y2003/(1 + r)

Behavior of a First-Year Saver C2003 Increase in interest rate Y2002 x (1 + r) + Y2003 C2002 Y2002 + Y2003/(1 + r)

Behavior of a First-Year Saver C2003 Increase in interest rate implies Decrease in 2002 consumption Increase in 2003 consumption (substitution effect dominates) Y2002 x (1 + r) + Y2003 C2002 Y2002 + Y2003/(1 + r)

Behavior of a First-Year Borrower C2003 Increase in interest rate Income point, Y2002 and Y2003 Y2002 x (1 + r) + Y2003 Consumption plan C2002 Y2002 + Y2003/(1 + r)

Behavior of a First-Year Borrower C2003 Increase in interest rate Y2002 x (1 + r) + Y2003 C2002 Y2002 + Y2003/(1 + r)

Behavior of a First-Year Borrower C2003 Increase in interest rate Decrease in 2002 consumption Increase in 2003 consumption Assumes substitution effect > income effect Y2002 x (1 + r) + Y2003 C2002 Y2002 + Y2003/(1 + r)

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)

IS Curve Interest Rate IS Curve Equilibrium Output

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

Corrected Savings Rate

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

Three different lifetime income patterns Consumption Three different lifetime income patterns Lifetime 3

Summary An understanding of consumption is critical Key feature of business cycle Integral to savings behavior Keynesian model Convenient to explain cyclical behavior of consumption Provides benchmark for multiplier effect Permanent income model Emphasizes role of lifetime income Provides explanation for changes in consumption Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained therein.