Consumption , saving and investment

Consumption

Household’s demand for goods and services

Investment

Firm’s demand for new capital goods

Government

Government purchases of goods and services

Net exports

The net demand for domestic goods by foreigners

Income expenditure identity in a closed economy

Y = C + I + G

Why do people save

Retirement savings

Precautionary savings

Saving for down payment

Parental altruism

Savings means sacrifice of current consumption

Two period model

A consumer’s consumption -savings decision involving a trade off between current and future consumption

Saving- the consumer is giving up some consumption in the current period in exchange for more consumption in the future period

Borrowing - the consumer is giving up some consumption in the future period in exchange for more consumption in the current period

Current period

Real income = y

Real lump sum tax= t

Real disposable income = y-t

Current consumption = c

Saving / borrowing = s

Future period

Real income = y’

Real lump sum tax = t’

Real disposable income = y’-t’

Future consumption =c ‘

No saving or borrowing

Budget constraint in the current period

C+s= y-t

C= current consumption

S=savings

Y= current real income

T = lump sum tax

Two period model

S> 0 means that the consumer is spending less than her disposable income.

The consumer is saving and we assume they have put all their savings in the bank

S<0 means that the consumer is spending more than her disposable income

This means the consumer is borrowing

Two period model 2

To induce people to deposit money, the bank will have to offer a positive return rate of return to the depositors

The rate of return is called the interest rate or lending rate

On the other hand , the bank will charger an interest rate on loans. This interest rate is called the borrowing rate

There is a difference between real interest rate and nominal interest rate

Real vs nominal interest rate

When inflation rate > nominal interest rate , the purchasing power of assets will decrease over time

When inflation rate < nominal interest rate , the purchasing power of asset will increase over time

Nominal interest rate does not reveal how the value of assets changes in purchasing power terms because it does not take into account the inflation rate

Real vs nominal interest rate

Real interest rate is the rate at which the real value or purchasing power of an asset changes over time

Real interest rate = nominal rate - inflation rate

Two period model 3

Assume that borrowing rate = lending rate = r

By saving one unit of good in the current period the consumer can get back 1 +r units of goods in the future period

The variable r is the real interest rate

Likewise by borrowing one unit of good in the current period , the consumer will have to repay 1+r units of goods in the future period

Two period model 4

If the consumer saves s units of goods in the current period then he receives interest and principal on this savings which is (1+r)s in the future period

If the consumer borrows s units of goods in the current period then he has to pay the interest and principal on his loans. The amount of repayment is (1+r)s

The total amount of resources available for future consumption is y’-t’+(1+r)s

Budget constraint in the future period

C’=y’-t’ +(1+r)s

C’= future consumption

Y’= future real income

T’= future lump sum tax

S’= savings(or borrowings) in the current period

R = real interest rate

Consumption smoothing motive

Refers to the tendency to

-spread consumption spending more or less evenly over time

-avoid sharp fluctuations in consumption

Increase in current income

When there is an increase in current income

-both current consumption and future consumption will increase

-this is also related to the consumption -smoothing motive

-since there is no change in future income , the increase in future consumption must be supported by an increase in savings.

Thus an increase in current income causes an increase in current consumption , future consumption and savings

Marginal propensity to consume

Defined as the fraction of additional current income that a consumer spends in the current period

Increase in future income

When there is an increase in future income

-both current consumption and future consumption will increase

The consume foresees a higher income in the future so he starts spending more today

Since there is no change in current income , the increase in current consumption would lead to a decline in savings

Increase in real interest rate

Any changes in r will change the relative price

An increase in real interest will generate two opposing effects on savings

-income effect

-sub effect