Macroeconomic Relationships
Lesson 17

Consumption and Savings

1. Definitions

• Disposable Income (DI) - income remaining after taxes are deducted
  • Households spend a portion of income on consumption (C) and save (S) a portion
• Consumption schedule - the amount households in a country spend on goods and services
• Savings schedule - the amount household in a country save
  • Important for savers to deposit savings into banks
  • Banks lend to businesses and households
    • Businesses borrow to invest in capital, such as buildings, machines, and equipment
    • Households borrow for house mortgages, car loans, appliances, etc.
    • A country requires a well developed banking system
      • If the public does not trust the banks, then the people do not deposit their savings into banks and this money is removed from the economy
      • Gov. calls this hoarding
      • Causes poor economic growth
  • Note - a country with high savings and well developed banking system may experience real estate bubbles
  • The bank loans cause rapid rises in real estate prices
• Consumption versus GDP is shown below

2. Economists define two ratios

• Average Propensity to Consume APC) - on average, the proportion a society spends from its disposable income

• Average Propensity to Save (APS) - on average, the proportion a society saves from its disposable income

• Example: A society's total disposable income is $40,000 per year and saves $10,000 of it.
• What are its APC and APS?
  • He consumes $30,000, because DI - S = $40,000 - $10,000 = $30,000

We can derive another relationship. We know disposable income is either spent on consumption or saved, thus

Source: Pasquali, Valentina and Tina Aridas. June 2012. Household Savings Rates. Available from http://www.gfmag.com/tools/global-database/economic-data/12065-household-saving-rates.html#axzz2kt1e9z00

• Marginal is important!
  • For example, a low-income country has a GDP per capita of $5,000 per year
    • People have low savings rate
    • People may have high consumption rate as they consume income on food
    • Banking system may not develop well with low savings rate
  • For example, a high-income country like Qatar has a GDP per capita of $80,000 per year
    • People have high savings rates
    • Qatar can invest its money in developed countries like Europe and United States
• Savings and consumption can be different for different levels of disposable income
• In math, delta, D, means change
• Marginal Propensity to Consume (MPC) - the amount a society increases its consumption if its aggregate disposable income increases by $1

• Marginal Propensity to Save (MPS) - the amount a society increases its savings if its aggregate disposable income increases by $1

Likewise, MPS + MPC = 1, because if disposable income increases, a society either spends it or saves it.

• MPC and MPS are slopes of a line, when C = f(DI) and S = g(DI)
  • As disposable income increases, both the consumption and savings increase.
  • The consumption and savings functions both have positive slopes

What determines consumption and savings?
These factors shift the consumption and savings functions

1. Wealth - households' level of wealth determines consumption and savings
   • wealth - amount of assets held by a household
     • physical - houses, cars, real estate, and land
     • financial - cash, stocks, bonds, pensions, etc.
   • As households become wealthier, their consumption rises
   • Example - 2008 Financial Crisis
     • Stock prices and home values are dropping, people become less wealthy and reduce their consumption
     • Both consumption and savings functions decrease and shift downward.
2. Expectations - households expectations of the future determine consumption and savings levels
   • Example 1 - A person graduated from college and found a high-paying job, he boosts both his consumption and savings
   • Example 2 - 2008 Financial Crisis, people expect the economy to enter a recession; increasing layoffs, foreclosures, and unemployment rates
     • With an uncertain financial future, households will save more
     • Consumption function falles while savings function rises
3. Real Interest Rates - impact household consumption and savings
   • If a household spends income on consumption, it has an opportunity cost. The household could invest that money and earn interest
   • If real interest rates are low, households have low opportunity costs and increase their consumption
     • Consumption function increases while savings function falls
   • If real interest rates are high, households have a high opportunity costs; thus they increase their savings and reduce consumption
     • Consumption function could decrease and savings function could increase
4. Household Debt - households can borrow from future income
   • Households can consume more today by borrowing and increasing their debt
   • Households may save more in the future to pay off this debt
   • If households are burdened with too much debt, then they could reduce their consumptions and savings levels
     • Consumption and savings functions both fall.
5. Taxes
   • If government increases taxes, disposable income decreases
   • Households must reduce their consumption and/or savings
   • Consumption and savings functions could both decrease.

Investment and Savings

• Financial intermediaries - institutions that link savers to investors
  • banks - accepts deposits from savers and lends
    • savers earn interest
    • bank grants loans to businesses
    • businesses pay interest to the bank
    • bank earns profits by earning more interest than what it pays to savers
  • banks - extremely important for an economy
• Businesses invest in structures, machines, and equipment
  • Greater productivity
  • Higher production level
  • The reason - more profits
    • Businesses only invest if they expect greater profits
  • Marginal analysis - changing the amount of capital
• Expected rate of return - a profit as a percentage given the investment has future cash flows and costs
  • More complicated - investment creates future cash flows
  • Expected - profit is a future event; it may occur or not occur
    • investment has risk
• Business invests in project in two ways
  1. Issues more stock or bonds- investors buy stock or bonds allowing the corporation to raise more money
     • Opportunity cost - investors expect a higher return from the stock or bonds as opposed to earning interest at a bank
  2. Bank loans - interest is the cost of borrowing
• Analysis removes impact of inflation - every thing is converted to real terms
  • Businesses will invest if real expected return > real interest rate
  • Businesses will not invest if real interest rate > real expected rate of return
  • Example
    • Will a business invest if businesses expects a real rate of return of 10%, the nominal interest rate is 20% and inflation is 15%?
    • real interest rate is, r = 20% - 15% = 5%
    • Yes, the rate of return is greater, so business will invest
• Investment Demand Function - businesses demand investment funding
  • Real interest rate is the price
    • As real interest rate rises, businesses lower their quantity demanded for investment funds
    • A higher interest rate implies the future project has a higher expected return
    • Business may have fewer capital investments with high expected returns
    • Relationship between real interest rate and investment is below

• Investment Demand Function can shift
  1. Future project costs
     • All factors cause Investment Demand to decrease
       • New capital become more expensive over time
       • Higher costs to operate capital
       • Higher taxes
       • Higher energy costs
       • Higher labor costs
       • Higher maintenance
  2. Technological advances
     • Businesses increase their investment demand function
       • Increases productivity
       • Could increase quality or quantity given the same resource inputs
       • Increases efficiency such as using less electricity
  3. Company's capital level
     • If a company is using 75% of its capital, then it may reduce its investment demand
       • Company has plenty of excess capital and does not need to invest in more
     • During recessions, businesses reduce their production levels
       • Have excess capital
       • Businesses reduce their investments
  4. Expectations
     • Businesses increase their investment demands
       • Optimistic about the future
       • Economy is growing
       • Country changed its legal structure, becoming more capitalistic
     • Businesses decrease their investment demands
       • Pessimistic about the future
       • Recession, wars, political instability

Instability of the Investment Function -investment function is always changing

1. Durability - some capital goods can have a long life
   • Petroleum industry - pipes, tanks, and other equipment can last for decades
   • Car manufacturing - factories can have machines several decades old
   • During recession - businesses may fix older machines and equipment instead of buying new stuff
2. Innovation - innovation occurs irregular
   • As economy adopts technology on a wide scale - causes a surge in investment
     • Railroads
     • Electricity
     • Automobiles
     • Computers
     • Advance communications
3. Profits - a businesses' expectations of future profits
   • An industry expects future profitability - firms may increase current investment
     • Example - economy switched to flatscreen TVs, so TV manufacturers are investing in capital that make them
   • An industry expects future losses - firms decrease current investment
     • Example - steel industry, U.S. automobile industry, tube T.V. industry, etc. expect future losses, these firms should use up their capital stock
4. Government intervention
   • Government can change regulatory structure, alter tax structure, or subsidize investment
   • Example: U.S. government wants biofuels to penetrate transportation fuels market
     • Biodiesel substitutes for diesel, U.S. government offers $1 per gallon subsidy for biodiesel from agricultural sources
     • Ethanol substitutes for gasoline, U.S. government offers a $0.51 per gallon subsidy
     • Encouraged the building of biofuels industry
   • State and local government offers tax breaks and/or partnerships
     • Attract new companies to their area and company invests in new capital
   • People's expectations of government intervention
     • Example: The U.S. government's $700 billion bailout package for the financial system in 2008
     • Pros
       • May slow down the collapse of large financial institutions
       • Provide national and international confidence in the U.S. financial markets
       • Financial sector is important sector of economy
         • Links savers to borrowers
       • Many households have pension plans, savings, etc. that are linked to the financial market's performance
     • Cons
       • Markets for motgages may be already saturated
         • Cannot force borrowers to take out new loans
       • Rewards the financial industry for bad decision making
       • Granting mortgages to anyone who wanted one
       • Allows investors who did not get out in time to "cash" out their investments
       • Businesses and banks are hoarding the cash and not granting loans
       • Could cause inflation, as "money" is injected into the financial system
       • Could cause further weakening of the U.S. dollar
       • U.S. government gains ownership in financial industry
         • Bureaucrats make poor decisions
         • If U.S. economy enters a long recession like Japan, then U.S. government accumulates losses from holding financial assets

• Below is growth in GDP and investments

Did you notice that investment has larger swings than GDP?

The Multiplier Effect

Multiplier Effect - the impact on the economy (or GDP) when spending or investment changes in the economy

• Example - HP is building a new manufacturing plant in Conway, AR.
  • Direct Impact - HP invested $28 million building the facility and hiring employees
    • New employees and construction companies earned money
      • 1200 HP workers and $50 million payroll
      • Does not include construction workers, but they earn money too!
    • With more income, the employees and construction workers spend more
      • New houses
      • New cars
      • Clothing, restaurants, cinemas, etc.
  • These businesses have more customers and earn more profits and income
    • These businesses hire more workers
    • Work workers longer
    • These employees have higher income and increase their spending and savings
  • The process continues indefinitely
  • The $28 million investment in Conway, AR could result in more than $28 million in incomes
  • Other benefits
    • White collar employment - encourage more people to gain computer skills
    • More income increases government's tax revenue
    • Government can increase its spending and provide more services to the community

• The Multiplier Effect can work in reverse
  • A large firm or plant shuts down
    • Workers are laid off
    • They have less income and decrease their spending and savings
    • Other businesses experience a slow down
    • They reduce their workforce
  • The process continues indefinitely
• Note - Less income means government collects less tax revenue
  • Usually government increases or expands taxes
• Example
  • Flint, MI - GM shut down manufacturing
  • Gary, IN - U.S. steel industry severely contracted with competition from Japan during 1980s
    • Jobs left, then the workers, the poor were left behind, crime and drugs became rampant

• Investment or changes in government spending, taxes, net exports, and consumption drive the multiplier
  • Example: Investment increases by $100
    • MPC = 0.9 and MPS = 0.1
  • Round 1: Income increases by $100    Savings is $10 and consumption is $90
  • Round 2: Income increases by $90      Savings is $9 and consumption is $81
  • Round 3: Income increases by $81      Savings is $8.10 and consumption is $72.90

   

  • Infinity     Total savings is $100 and total consumption is $1,000

   

  • This is an infinite sequence

For our example, GDP changes by

• Note - Savers deposit their money into the financial institutions, and in turn, they grant loans to businesses for new investment. That is where the money came from!
  • If people hide their money in their mattresses, then banks do not have money to lend out for new investment
• We can also calculate the multiplier in two ways.
  • First way we know MPS (or MPC), then the multiplier is:

• Second, if we knew how GDP changed when investment changed, then we use algebra to rearrange the equation to get:

• Note - things other than investment can cause the multiplier effect. Government can decrease taxes or increase government spending to stimulate the economy, or consumers get extra money.
  • Example - President Bush gave tax payers anywhere from $300 to $600
    • Consumers will spend this money and help the economy expand

Economic advisors for the U.S. President estimate the multiplier effect to be approximately 2

Terminology