Consumption and Savings Notes

Introduction to Consumption and Savings

• Growth is Driven by Productivity:
  • Productivity leads to economic growth; influenced by investments.
• Investment and Saving Relationship:
  • Investment closely tied to saving habits.
• Key Concepts to Discuss:
  1. Consumption, Saving, and Income
  2. Micro Foundations of Consumption
  3. Macroeconomics of Consumption
  4. Factors Affecting Consumption
  5. Saving

Consumption Defined

• Consumption: Household expenditure on final goods and services.
  • Largest component of Gross Domestic Product (GDP).

Determinants of Consumption

• Income as Main Determinant:
  • Positive correlation between income and consumption; higher income leads to increased consumption.
  • Example: Consumption per capita in the U.S. is higher than in Canada, partially due to higher GDP per capita.

Marginal Propensity to Consume (MPC)

• Definition: Fraction of each additional dollar of income spent on consumption.
  • Formula: MPC = rac{Change ext{ in consumption}}{Change ext{ in income}}
  • Ranges between 0 and 1.
  • Examples:
  • Spending all extra income: MPC = 1
  • Spending part of the extra income: MPC = 0.6
• Slope of the Consumption Function:
  • Determined by the marginal propensity to consume.

Saving Explained

• Saving: Portion of income not spent; calculated as:
  • Formula: Savings = Income - Consumption
• Dissaving: Spending exceeds income in a specific period, leading to withdrawal from savings or borrowing.
  • Example: Taking out a loan to cover living expenses.

Perspectives on Saving

• Microeconomic View:
  • Savings enhance personal wealth, leading to future consumption potential.
• Macroeconomic View:
  • Savings provide necessary funds to the financial sector for investment purposes.

Micro Foundations of Consumption

• Decision-Making Factors:
  • Interdependence Principle: Future choices depend on current spending decisions; excessive spending leads to repayment issues.
  • Marginal Principle: Evaluates decisions in terms of small incremental choices.
  • Cost-Benefit Principle: Assesses if the benefit of an additional dollar spent exceeds its cost.
  • Opportunity Cost Principle: Considers what could be gained by saving instead of spending.
• Rational Rule for Consumers:
  • Spend today if the marginal benefit of today’s consumption is greater than the future benefits after interest.

Consumption Smoothing

• Maintaining steady consumption over time despite fluctuations in income.
• Reasoning: Diminishing marginal benefit; money spent during poverty has a higher marginal benefit.

Permanent Income Hypothesis

• Suggests consumption is mainly influenced by long-term income estimates rather than current income.
• Macroeconomic Insight: Economic fluctuations impact consumption only if they change perceived long-term income.

Macroeconomics of Consumption

• Responding to Income Changes:
  1. Temporary income change affects consumption marginally.
  2. Permanent income change results in significant consumption change.
  3. Anticipated income changes typically do not affect current consumption.
  4. Learning about future income changes can prompt adjustments in consumption.

Factors Leading to Shifts in Consumption

1. Real Interest Rates: Higher rates = higher savings; can either decrease current consumption or increase for lenders.
2. Expectations: Optimism about economic growth can increase consumption.
3. Taxes: Reductions increase disposable income, leading to higher consumption.
4. Wealth Accumulation: Higher stock of wealth typically leads to increased consumption.

Savings Determinants

1. Income Fluctuations: Save during high-income periods for smoother consumption.
2. Changing Needs: Saving patterns change with age (needs increase during certain life stages).
3. Bequests: Saving with the intent to pass wealth to future generations.
4. Precautionary Saving: Preparing for unexpected events such as job loss or health crises.

Conclusion

• Understanding the nuances of consumption and saving can lead to better financial decisions and economic policies.