Consumption, Savings

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Consumption, Savings Investment
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Assumptions for discussion on this topic

• In our class on National Income we saw that
  output
• Y C I G NX
• We shall ignore NX. This means we are assuming
  that our economy is closed.
• In this class we shall focus on C and I.
• G has implications for both C and I. But we shall
  try to limit discussion on G in this class as we
  shall have a full discussion on G in our Fiscal
  Policy class.

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What do C and I imply?

• C indicates the level of consumption. Therefore,
  C also stands for aggregate demand for goods and
  services by the households.
• C also indicates how much is saved by the
  household.
• I stands for investment. This indicates how much
  is spent for producing goods and services to be
  consumed by the households.
• I includes acquisition of capital goods by the
  firms, which actually indicates the productive
  capacity of economy.
• I indicates CAPITAL FORMATION, which is important
  to understand economic growth.

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Consumption and saving

• From our class on National Income recall that
• National savings (S) Private savings Govt.
  saving
• Y (T TR INT) NFP C (T TR INT)
  G
• Y NFP C G
• As our economy is closed NFP in the above
  equation is equal to zero. Therefore, saving in a
  closed economy is equal to Y C G
• We shall start looking at consumption and saving
  at the individual level. Because, individual
  level behavior determines the aggregate level
  behavior.

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Decision of an individual on C and S

• Consumption is about spending during present
  time. Savings is for consuming in the future.
• However, consumption more than current income
  during present time means negative savings for
  future.
• A person can always trade-off current and future
  consumption.
• Economic theories suggest that this trade-off
  depends on the REAL INTERESRT RATE
• Real interest rate is defined as
• Nominal interest rate inflation
• Example A person spends Tk. 100 to consume
  potato today. Nominal interest rate is 10 and
  inflation rate is 5. At present, price of potato
  is Tk. 10/kg. Another person saves Tk. 100 in
  bank account to consume potato one year later.
  How would you compare consumption of these two
  persons?
• The higher the real interest rate, the more
  people will want to save for future consumption.
• However, people generally tend to spread their
  consumption rationally over time. This is called
  consumption smoothing.

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Determinants of C and S

• Some important determinants of economic wellbeing
  of a person are-
• Current income
• Expected future income
• Wealth and
• Real interest rate
• Changes in any of these will affect consumption
  of the individual.
• To see how the effects work let us assume that
  the real interest rate is fixed

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Effect of changes in current income

• A change in the current income works in two ways-
• It may change the individuals current
  consumption
• It may change the individuals future consumption
  by changing savings today
• The decision about how much the consumption today
  changes depending on a change in todays income
  is called marginal propensity to consume (MPC).
  
• MPC indicates the percentage of the increased
  income that is spent for consumption.
• Example If MPC is 0.40, it means that if income
  of an individual increases Tk. 100 today, she
  will spend Tk. 40 of this additional income for
  consumption.
• Note that in this case the person is saving 60
  of her increased income for future consumption.
  This rate of savings is called marginal
  propensity to save.
• MPC MPS is always equal to 1.

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Effect of changes in expected future income

• Depending on the expected future income a
  persons current consumption may also change.
• The consumption smoothing motive will guide the
  person to consume today at least some of the
  expected future income.
• Note that if the person increases her current
  consumption, her current savings will reduce. If
  needed, she might even consume more than her
  current income.
• Example We use credit cards to consume today.
  This is actually consuming by borrowing based on
  the expectation that we shall be able to pay it
  back in future. If a person expects that she will
  be promoted to a higher rank in her office having
  better remuneration, she might actually increase
  the use of her credit card today, before she gets
  the promotion.
• Example We spend on Eid shopping before we get
  Eid bonus.

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Effect of changes in wealth

• Wealth is defined as Assets Liabilities
• Increase in wealth induces current consumption
  and therefore reduces savings.
• A decrease in wealth will do just the opposite.
• Example During stock market boom we tend to
  consume more than normal times. When the market
  crashes we consume less.

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Effect of change in real interest rate

• An increase in the real interest rate means that
  savings will have higher payoff in future.
  Therefore, it increases savings.
• It also means that a targeted future consumption
  level can be reached by saving smaller amounts
  today! This means real interest rate may induce
  current consumption and reduce current savings.
• These two forces work in opposite direction.
• The first phenomenon is known as the substitution
  effect of the real interest rate on saving.
• The second phenomenon is known as the income
  effect of the real interest rate on saving.

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Summary Determinants of Savings
An increase in Causes savings to Reason
Current income Rise Part of the extra income is saved
Expected future income Fall Anticipation of increased future income induces current consumption
Wealth Fall New stock of wealth secures future consumption level and makes more of current income free for consumption.
Expected real interest rate Not clear. Probably rise. Increased rate produces higher pay-offs in future and thus may make savings more attractive.
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Investment

• Investment is putting money into something to get
  some return or avoid loss.
• Investment is related to savings.
• We study investment so that we can assess the
  long-run productive capacity of economy by
  looking at investment

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Determining the level of investment

• We need to determine the desired capital stock of
  the firms to determine the level of investment.
• If the marginal product of capital (MPK) is
  greater than the marginal cost of capital then
  firms will use more capital. Marginal cost of
  capital is sometimes referred to as user cost of
  capital.
• Recall that a firms profit is maximized at the
  point where MC MR. Similarly, the desired
  capital stock of the firm will be at the point
  where MPK user cost of capital.
• If the MPK has the property of diminishing return
  then the curve of MPK will slope downward.
• On the other hand, the user cost of capital will
  generally be fixed and therefore the curve of
  user cost of capital will be a straight
  horizontal line. For example when we borrow from
  bank, bank charges us fixed interest rate. If the
  interest rate were variable, user cost of fund
  would not be horizontal straight line.

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Desired level of capital stock

• Like the profit maximizing level of employment
  (where MPN is equal to wage), profit maximizing
  level of capital is where user cost of capital
  and MPK are equal.
• On the left of K there is still room for the
  firm to use capital to get more return than cost
  of the capital.
• On the right of K use of capital is no more
  profitable.
• Desired level of capital changes when MPK or user
  cost of capital change.

MPK and uc
uc
MPK
K
K
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From capital stock to investment

•  

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From capital stock to investment

• Rearranging equation 1 we get
• Equation 2 has two parts
• The net increase in capital stock during the year
  and
• Investment needed to replace the worn-out capital
  stock.

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Goods market equilibrium

• An important question is how do we know that the
  goods and services that the consumers and
  investors want to buy will be the same as the
  amount that the producers are willing to provide?
  
• The real interest rate is a key element that
  whose adjustment helps to find the answer.
• If the goods market is in equilibrium, the supply
  of goods will match with the demand for goods.
• The national income identity for a closed economy
  is
• Y C I G
• The left hand side indicates the amount of output
  supplied by the producers.
• The right hand side indicates the amount of goods
  and services demanded by the consumers, investors
  and the government.
• Therefore, the national income identity can also
  be perceived as the goods market equilibrium
  condition.

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Goods market equilibrium

• Rearranging the national income identity we get
• Y C G I
• S I
• This means that the goods market will be in
  equilibrium when savings will be equal to
  investment.
• This is another way of expressing the goods
  market equilibrium.
• Both savings and investment are affected by real
  interest rate.
• If real interest rate increases, savings
  increases and investment decreases and vice versa.

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Goods market equilibrium

• Goods market equilibrium is at E.
• Any deviation from point E will not sustain and
  will come back to it again.
• For example when the real interest rate is lower
  than the equilibrium rate, then the investors
  will want to invest more than the savers want to
  lend.
• Note that at the equilibrium point total output
  of the economy will be equal to the sum of
  consumption, investment and government purchases.
  

Real interest rate
S
I
E
A
B
S, I
D
C
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Savings and investment in open economy

• Goods market equilibrium in open economy will be
  established when
• S I NX NFP
• But NX NFP current account balance (CA)
• Therefore the equilibrium condition for open
  economy will be
• S I CA
• This means that when savings is more than
  investment, the economy will have more idle money
  to lend to foreigners. The amount of idle money
  that can be lent to the foreigners will be equal
  to CA. In this case the current account balance
  will be positive.
• Conversely, if savings is less than investment
  that means the economy is using more money for
  investment purposes than it has. The extra money
  comes by borrowing from the foreigners. In this
  case the current account balance is negative.

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Savings and investment in open economy

• Alternatively we can also state the open economy
  goods market equilibrium as
• Y C I G NX
• NX Y (C I G)
• This means that the economys net export will be
  equal to the amount of goods that the economy
  will not absorb. The size of absorption is equal
  to (C I G).
• When we consider open economy condition for a
  small economy, the goods market equilibrium will
  depend on the world real interest rate, not on
  the domestic interest rate. However, if the
  country is large domestic interest rate may
  affect the world interest rate.

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Question When does the goods market equilibrium
shift?