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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

Real Consumption versus Real GDP

2. Economists define two ratios

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

The average propensity to consume

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

The average propensity to save

  • 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

The average propensity to consume

The average propensity to save

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

APC + APS = 1

Net Savings Rates for Several Countries
Country

2006
(%)

2012
(%)

Australia 2.4 9.6
Canada 3.5 3.3
France (gross) 14.8 16.1
Germany 10.8 11.0
Japan 1.1 1.9
United Kingdom (gross) 3.1 6.6
United States 2.6 4.3
South Korea 5.2 2.9

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 Consume

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

Marginal Propensity to Save

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

Real Interest Rate versus Real Investment

  • 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

Changes in Real GDP and Real Investment

Blue arrow 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

GDP increases from the multiplier effect

For our example, GDP changes by

GDP increases from the multiplier effect

  • 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:

The Keynesian multiplier

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

The Keynesian multiplier

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

 

Terminology

  • disposable income
  • consumption schedule
  • saving schedule
  • average propensity to consume (APC)
  • average propensity to save (APS)
  • marginal propensity to consume (MPC)
  • marginal propensity to save (MPS)
  • financial intermediaries
  • expected rate of return
  • investment demand curve
  • multiplier effect
 

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