Consumption, Saving, and Investment Notes

Chapter 4: Consumption, Saving, and Investment

This chapter shifts focus from production (supply) to the demand side of the economy, specifically how total production is used. Aggregate demand includes consumption (households), investment (firms & new homes), government purchases, and net exports. For simplicity, government purchases are treated as a given, and the economy is initially assumed to be closed (net exports = 0), leaving consumption and investment as the main components to analyze.

4.1 Consumption and Saving

Household consumption is the most significant part of aggregate demand. Consumption and saving decisions are two sides of the same coin. Higher consumption means less saving, and vice versa, given disposable income.

Desired Consumption and National Saving

Desired consumption ($C^d$) represents the total goods/services households want to consume, based on income and economic conditions. Desired national saving ($S^d$) is the level of national saving that corresponds to the desired level of aggregate consumption.

National saving ($S$) is defined as $S = Y - C - G$, where:

• $Y$ is the output,

• $C$ is consumption,

• $G$ is government purchases.

Desired national saving is therefore:

$S^d = Y - C^d - G$ $(4.1)$

Individual Consumption and Saving Decisions

Individuals balance current vs. future consumption. Saving allows future consumption to exceed future income, such as during retirement. Prudence, earning $60,000 annually, can consume less and save, or borrow to consume more than her income. This involves a trade-off between current and future consumption.

The real interest rate ($r$) dictates the trade-off between current and future consumption. Saving $1 today yields$1 + r$in future consumption. Borrowing$1 requires repaying $1 + r$ in the future. Therefore, $r$ is the relative price of current consumption.

Consumption Smoothing

People prefer a stable consumption pattern over time, known as the consumption-smoothing motive. Individuals avoid large consumption swings and try to maintain a consistent level of spending.

Changes in Current Income

Suppose Prudence receives a \$6,000 bonus. She can spend it all, save it all, or a combination of both. The marginal propensity to consume (MPC) is the fraction of extra income used for consumption. If Prudence's MPC is 0.4, she spends 0.4 \times 6000 = $2400 and saves $6000 - $2400 = $3600. MPC is between zero and one ( 0 < MPC < 1 ).

The same principle applies to income declines. Aggregate income and consumption patterns reflect these individual decisions at a macroeconomic level. An increase in aggregate output ($Y$) leads to an increase in aggregate desired consumption ($C^d$), but by less than the increase in Y. Desired national saving ($S^d$) also rises when Y rises.

Changes in Expected Future Income

Consumption depends not only on current income but also on expected future income. If Prudence anticipates a \$6,000 bonus next year, she might increase current consumption by reducing current saving. A \$1,000 increase in current consumption reduces next year's resources by $1000 \times (1 + r)$. Overall, she can use the bonus to increase consumption both now and later.

An increase in expected future income increases current consumption and decreases current saving. Macroeconomically, if people expect higher future income, current desired consumption ($C^d$) increases and desired national saving ($S^d$) decreases.

Application: The Idiosyncrasy of Singapore’s Aggregate Consumption

Singapore challenges conventional understanding, with average propensity to consume (APC) falling from 0.80 in 1960 to 0.41 in 2000, despite economic growth. Loans/withdrawals from the Central Provident Fund (CPF) for housing/car purchases constrain disposable income. High housing/car costs reduce consumption capacity over time. The CPF is a compulsory social security savings scheme where both employees and employers contribute part of their salaries to the fund until retirement.

Econometric modeling attributes this to the use of CPF funds for housing and car purchases. Rising housing prices combined with diminished CPF savings adversely affect consumption. Singapore's unique car ownership system requires bidding for licenses, adding to financial strain. The falling APC is a policy concern. Aggregate consumption expenditure is a stabilizing component in final aggregate demand. More variable components in aggregate demand such as investment and exports become dominant in cyclical fluctuations and result in more volatile GDP growth.

Changes in Wealth

Wealth (assets minus liabilities) also affects consumption and saving. If Prudence discovers a \$6,000 stock certificate, this increases her wealth, leading to increased current consumption and decreased current saving. Stock market fluctuations significantly impact wealth and, consequently, consumption.

Changes in the Real Interest Rate

The real interest rate ($r$) is the price of current consumption relative to future consumption. Higher $r$ has two opposing effects:

• Substitution effect: Higher $r$ encourages saving to take advantage of higher future consumption, leading to reduced current consumption.

• Income effect: For savers, higher $r$ increases wealth, leading to increased current consumption. For borrowers, higher $r$ reduces wealth, decreasing current consumption.

The net effect on national saving is theoretically ambiguous, as savers and borrowers respond differently. Empirically, a higher $r$ may slightly reduce consumption and increase saving, but the effect is weak.

Taxes and the Real Return to Saving

Interest earnings are taxed, reducing the real return. The after-tax real interest rate ($r<em>{a-t}$) is: $r</em>{a-t} = (1 - t)i - \pi^e$ (4.2), where:

• $i$ is the nominal interest rate,

• $t$ is the tax rate on interest income,

• $\pi^e$ is the expected inflation rate.

Lowering taxes on interest income can increase saving by increasing the real return. Tax-advantaged savings accounts (e.g., IRAs) aim to stimulate saving.

Fiscal Policy

Government spending and taxes affect consumption and saving. Increased taxes decrease consumption, while policies affecting future tax expectations also impact consumption. For a given output ($Y$), fiscal policy affects desired national saving ($S^d = Y - C^d - G$). Higher government purchases ($G$) directly lower $S^d$. Fiscal changes affect consumption by affecting households’ current and expected future incomes.

For example, an increase in government purchases by \$10 billion, financed by raising current taxes by \$10 billion, decreases after-tax incomes, causing consumers to reduce consumption (e.g., by \$6 billion). If taxes aren't raised, the government will have to borrow the money, implying that future taxes will have to rise. Households' expected future (after-tax) income will fall, and they will reduce desired consumption. Because the decline in desired consumption can be expected to be less than the initial increase in government purchases, a temporary increase in government purchases will lower desired national saving.