1. 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.

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

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

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

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

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

7. 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)

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

9. 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)

10. 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

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

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

14. 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

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

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

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

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

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

20. 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

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

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

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

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

25. 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

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

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

28. 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?

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

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

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

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
NOTE: Debtors have I high MPC but creditors low

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

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

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

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

37. 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
Y Y2003/(1 + r)

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

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

40. 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
Y Y2003/(1 + r)

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)

42. IS Curve
Interest Rate
IS Curve
Equilibrium Output

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

44. Corrected Savings Rate

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

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

47. 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.