1 CONSUMPTION AND SAVING Macroeconomics II Pascasarjana Ilmu Ekonomi Hermanto Siregar, Ph.D. & Rina Oktaviani, Ph.D.

2 Introduction  Consumption: makes up the largest portion of GDP is relatively stable at that portion

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8  What drives C? How is dynamic link between C and Y?  Consumption theory.  Debate about different consumption theories  debate over whether MPC is large or small. Traditional Keynesian theory  MPC is high  the multiplier [1/(1-MPC)] also large Modern theory based on rational consumer decisions  MPC is low.  MPC out of permanent income is high  MPC out of transitory income is close to 0.

9  Simple consumption function (for a person living for 100 years, aiming at maintaining a constant standard of living): C = (Y now + 99 Y later ) / 100 If income were to rise $1000 for now, C would rise by $10/year. Short run MPC would be only 0.01 because the remainder of the extra income would be saved to support future C. But if income were to rise $1000 now and forever, C would rise by $1000 and long run MPC would be 1.

10  Example of the traditional consumption function: C = C 0 + c Y D 0 < c < 1  In the US, the equation is: C = Y D indicating that MPC is 0.94 (very high). LIFE-CYCLE THEORY (Modigliani)  Unlike the equation above, LC theory views individuals as planning their C and S behavior over long run periods with the intention of allocating their C in the best possible way over their entire lifetimes.

11  LC theory implies different MPC out of permanent income, transitory income, and wealth.  Its key assumption: most people choose stable lifestyles, consuming at about the same level in every period. In practice it is at the same level of C, with the formula: C = (WL / NL)  YL WL = working life, NL number of years of life, and YL annual labor income.

12 Consumption function: C=aWR+cYL WR=real wealth YL=labor income NL=expect for live (years) WL=work and earn income (years) Retirement = (NL-WL) years Live time income=YLxWL Live time consumption=live time income or CxNL=YLxWL Consumption per year: C=WL/NLxYL Saving: S=YL-C=YLxNL-WL NL

13 Lifetime Income, Consumption, Saving, and the Wealth in the LC Model Time WR max WLNL Dissaving Saving Assets YL C C is constant throughout lifetime. During the working life, lasting WL years, the individuals saves, accumulating assets. At the end of the working life, the individual begins to live off these assets, dissaving for the remaining years such that assets equal zero at the end of life.

14 Example  A person starts working at age 20, plans to work until 65, and will dies at 80. His annual labor income (YL) $30,000. Thus, WL = = 45 and lifetime resources 30,000  45 = $ 1,350,000. Spreading lifetime resources over the number of years of (productive) life (NL = = 60), the annual consumption (C) is $ 1,350,000 / 60 = $22,500.  Suppose income were to rise permanently by $3000 p.a. The extra income would increase C by $3000  (45/60) = $2250. So MPC out of permanent income would be WL/NL = 45/60=  But if the $3000 were to rise but only in 1 year. Spreading it over 60 years would increase C by 3000 / 60 = $50. So MPC out of transitory income would be 1/NL = 1/60 

15  MPC of wealth should equal the MPC out of transitory income, which is very small. MPC out of wealth is used to link changes in the value of assets to current consumption. Wealthier people have a somewhat lower MPC out of income. This is one of the ways that there is a link from income distribution back to macro policy  shifting income to less wealthy families will increase overall C and stimulate the economy.

16 PERMANENT INCOME THEORY (Friedman)  Consumption is related not to current income but to a longer-term estimate of income, which is called by Friedman as permanent income (Y P ).  Permanent income is the steady rate of expenditure a person could maintain for the rest of his or her life, given the present level of wealth and the income earned now and in the future. C = c Y P  According to LC-PIH, consumption should be smoother than income because spending out of transitory income is spread over many years (Fig. 13-1).

17 CONSUMPTION UNDER UNCERTAIN- TY: THE MODERN APPROACH  If permanent income were known exactly, then according to the LC-PIH, C would never change.  The modern version of the LC-PIH emphasizes the link b/w income uncertainty and changes in C and takes a more formal approach to consumer maximization. According to this version, changes in C arise from “surprise” changes in income. So absent income surprise, C this period should be the same as C last period (Fig. 13-2).

18  Campbell and Mankiw combine the LC-PIH and the traditional consumption function. According to the LC-PIH, the change in C equals the surprise element  so C LC-PIH = . According to the traditional theory, C = C 0 + c Y D so C TRAD = c Y D. If is percent of population behaves in accordance with the traditional model and the remaining (1- ) follows the LC-PIH, the total change in C is: C = C TRAD + (1-) C LC-PIH = c Y D + (1-) . Empirically, the equation is: C = Y D suggesting that around half of C is explained by current income rather than permanent income.

19 LIQUIDITY CONSTRAINTS AND MYOPIA.  These are factors missing in the LC-PIH theory. A liquidity constraint exists when a consumer cannot borrow to sustain current C in the expectation of higher future income. Myopia is hard to distinguish in practice from the liquidity constraint hypothesis. Wilcox showed that the announcement of an increase in social security benefits doesn’t lead to a change in C until the benefit increase is actually paid  once paid, the recipients do adjust spending, particularly durables.

20  once paid, the recipients do adjust spending, particularly durables, the delay because:  Recipients do not have assets to enable them to adjust spending before receiving higher payments (liquidity constraint), or  They fail to pay attention to the announcement (myopia), or perhaps  They do not believe the announcement.

21  Uncertainty and Buffer-Stock Saving. The LC hypothesis: people save largely to finance retirement. Additional saving goals also matter:  Some saving is precautionary  savings are used as a “buffer stock”  to enable maintaining C when times are bad  Old people rarely actually dissave  finance their live with interest and dividens.  Further aspects of C behavior (Read!!)