Macroeconomics in the World Economy: Theory and Applications Topic 3: Consumption, Saving, and Investment

Macroeconomics in the World Economy: Theory and Applications Topic 3: Consumption, Saving, and Investment Dennis Plott University of Illinois at Chicago Department of Economics http://blackboard.uic.edu Spring 2014 Plott (ECON 221) Spring 2014 1 / 89

Outline 1 Topic 3: Consumption, Saving, and Investment Investment Saving Consumption The Investment-Saving Curve Plott (ECON 221) Spring 2014 2 / 89

Goal: Start Modeling Aggregate Demand (AD) What drives business investment decisions? Does investment theory accurately match the data? What is the role of inventory? What drives household consumption? Does consumption theory accurately match the data? What theories of consumption seem to match the data? What role can the government play in shaping spending? Should a distinction be made between unexpected and expected changes and permanent and temporary changes in income? What is the link between consumption and savings? Plott (ECON 221) Spring 2014 3 / 89

Outline 1 Topic 3: Consumption, Saving, and Investment Investment Saving Consumption The Investment-Saving Curve Plott (ECON 221) Investment Spring 2014 4 / 89

An Introduction to Investment Second major component of spending Includes purchase and construction of capital goods (fixed capital); inventories; residential structures. Two reasons why studying investment is important: 1 Investment matters more for business cycle fluctuations than consumption; i.e. much more volatile than consumption. Investment accounts for one-sixth of GDP, but more than half of the decline in spending during a recession. 2 Determines long-run productive capacity of an economy; i.e. output is higher if capital stock is higher. Plott (ECON 221) Investment Spring 2014 5 / 89

Desired Capital Stock Firms optimize the amount of capital to have (just like they optimize the amount of labor to hire). Remember from Topic 2: For the optimal amount of labor, firms equate the MPN with the real wage (cost of an additional unit of labor). For the optimal amount of capital, firms equate the MPK (per period benefit of one more unit of capital) with the per period cost of an additional unit of capital. How does capital evolve: K t+1 = (1 d)k t + I t i.e. Capital is increased tomorrow by investing today less depreciation (d). So the desired capital stock is determined by future MPK and expected user cost of capital (uc) What is the cost of an additional unit of capital (user cost of capital)? Plott (ECON 221) Investment Spring 2014 6 / 89

User Cost of Capital User Cost of Capital = Expected cost of using an extra unit of capital for a period Capital is long lived so user costs include not only current, but future costs Real Interest Rate (Cost of Funds). Firms usually have to borrow to buy equipment. If you do not borrow and instead use retained earnings, you give up the interest payments you would have received in you invested that money instead of buying new equipment. (Assume borrowing rates = lending rates = r = expected real interest rate). Depreciation Rate on the Capital (how long the capital lasts) (Percent that depreciates, on average, per year) (Symbol = d) Maintenance Rate How much will it cost (per unit price) to maintain the equipment. (Symbol = mm) Real Purchase Price of capital (how much the equipment costs per unit) (Symbol = p K ) User Cost (per period) = uc = r p K + δ p K + mm p K Plott (ECON 221) Investment Spring 2014 7 / 89

Desired Capital Stock (Cont.) First order condition from profit maximization: P MPK f = p K [r + δ + mm] Benefits of investing are more output tomorrow so, it is the future MPK that is important. P is the price of output, p K is the price of capital. If P = p K, then: MPK f = [r + δ + mm] = user cost If User Cost of Capital > MPK f, then MPK f must rise (capital must fall; i.e., investment must be lower today). If User Cost of Capital < MPK f, then MPK f must fall (capital must rise; i.e, investment must increase). Plott (ECON 221) Investment Spring 2014 8 / 89

The Desired Capital Stock Graphical representation of the definition of the desired capital stock. The desired capital stock is affected by changes in future MPK (MPK f ) or the user cost of capital (uc) uc,mpk f uc 0 uc(r, d) K f 0 MPK f (A f,n f ) K f Plott (ECON 221) Investment Spring 2014 9 / 89

Changes in the Desired Capital Stock: A f Increases As (A f ) increases, MPK f shifts rightward, desired future capital stock, K f, increases. uc,mpk f uc 0 uc(r, d) K f 0 MPK f (A f,n f ) K f Plott (ECON 221) Investment Spring 2014 10 / 89

Changes in the Desired Capital Stock: r Increases As r increases (to r 1 > r 0 ), User Cost shifts upward, desired future capital stock, K f, falls. uc,mpk f uc 0 uc(r, d) K f 0 MPK f (A f,n f ) K f Plott (ECON 221) Investment Spring 2014 11 / 89

Changes in the Desired Capital Stock: Tax the Revenues Suppose now the government starts taxing revenues at rate τ k. At optimum: MPK f (1 τ k ) = r + δ + mm Need to Tax Adjust the User Cost, equivalent to User Cost Shifting Up, desired future capital stock, K f, falls. uc,mpk f uc 0 uc(r, d) K f 0 MPK f (A f,n f ) K f Plott (ECON 221) Investment Spring 2014 12 / 89

Reaching the Desired Capital Stock: Investment Rationale: Investment decisions today have effects on the capital stock tomorrow. It takes time to build, install, train workers, etc. This is especially true with large expenditures (buildings, structures, assembly lines, etc). Recall how capital evolves: K t+1 = (1 d)k t + I t i.e. Capital is increased tomorrow by investing today (less depreciation). Gross investment is I t ; Depreciation is dk t ; Net investment is K t+1 K t Net Investment = Gross Investment Depreciation If K is the desired capital stock then K = (1 d)k t + I t A change in K produces a change in I t. The relationship is 1-to-1. Investment is the means to achieve the optimal capital stock. Plott (ECON 221) Investment Spring 2014 13 / 89

Investment (I) and Real Interest Rates (r) r Investment Demand (ID) ID(A f,n f ) I Key: As r decreases, desired capital stock increases, investment increases. Read: Section 4.2 on investment in Abel, Bernanked, and Croushore. Plott (ECON 221) Investment Spring 2014 14 / 89

Investment: Some Caveats on the Process Investment takes time to plan. Investment tends to be "irreversible" (costly to change if you over/under invest). Investment returns are uncertain (returns are in the future which is unknown). As economic uncertainty increases, investment decisions can become delayed. Firms, like individuals, are forward looking. If interest rates fall today, I may not invest today because I believe interest rates can be even lower tomorrow. Firms, like individuals, may be liquidity constrained. (The role of banks in the economy may be important). Liquidity constrained means that the firm is unable to have access to financial markets or they have access, but the cost of funds is prohibitive. Tax policy can affect investment decisions (investment tax credit... ) Correlation between A and A f (if A changes today and it is only temporary and it was unexpected, then no effect on investment) Plott (ECON 221) Investment Spring 2014 15 / 89

Other Components of Investment We have focused on business fixed investment so far. But Aggregate Investment also includes: Inventories (unsold goods, unfinished goods, raw materials) Residential Structures (new houses, condos, apartment complexes). Same principles apply for the decision of how much inventories to keep or condos to build (i.e. equalize marginal benefit and marginal cost). Note: the following topics will be discussed in Topic 9 on the Financial Crisis: investment and the banking system leverage housing market Plott (ECON 221) Investment Spring 2014 16 / 89

Investment: The Role of Inventories Investment is highly procyclical! (remember procyclical means when Y increases I increases and vice versa). Inventories are the most volatile (and procyclical) component of GDP. Can inventories be a signal of future economic activity? Yes, can predict recessions (a rapid rise in inventories unplanned inventories) Yes, can predict expansions (a smooth rise in inventories planned inventories). Plott (ECON 221) Investment Spring 2014 17 / 89

Outline 1 Topic 3: Consumption, Saving, and Investment Investment Saving Consumption The Investment-Saving Curve Plott (ECON 221) Saving Spring 2014 18 / 89

Measures of Aggregate Saving: Government Government saving = net government income government purchases of goods and services S govt = (T TR INT) G Government saving = government budget surplus = government receipts government outlays Government receipts = tax revenue (T) Government outlays = government purchases of goods and services (G) + transfers (TR) + interest payments on government debt (INT) Government budget deficit = S govt Simplification: count government investment as government purchases, not investment Plott (ECON 221) Saving Spring 2014 19 / 89

Measures of Aggregate Saving: Private and National Saving = current income current spending Saving rate = saving/current income Private saving = private disposable income consumption S pvt = (Y + NFP T + TR + INT) C National saving National saving = private saving + government saving S = S pvt + S govt S = (Y + NFP T + TR + INT C) + (T TR INT G) S = Y + NFP C G S = GNP C G Plott (ECON 221) Saving Spring 2014 20 / 89

Saving and Investment Use the private saving definition and the income-expenditure identity to show the relationship between saving and investment. Note: with a closed economy (which we assume until Topic 8) NX = 0 and NFP = 0. The current account (CA) also equals zero since CA = NFP + NX = 0 S pvt = Y + NFP T + TR + INT C Y = S pvt NFP + T TR INT + C Y = Y S pvt NFP + T TR INT + C = C + I + G + NX S S govt NFP + T TR INT = I + G + NX S (T TR INT G) NFP + T TR INT = I + G + NX S T + TR + INT + G NFP + T TR INT = I + G + NX S = I + NFP + NX S = I + CA S = I Plott (ECON 221) Saving Spring 2014 21 / 89

Saving and Wealth Wealth Household wealth = a household s assets minus its liabilities National wealth = sum of all households, firms, and governments wealth within the nation Saving by individuals, businesses, and government determine wealth Wealth and saving as stock and flow (wealth is a stock, saving is a flow) Flow variables: measured per unit of time (GDP, income, saving, investment) Stock variables: measured at a point in time (quantity of money, value of houses, capital stock) Flow variables often equal rates of change of stock variables Plott (ECON 221) Saving Spring 2014 22 / 89

Saving and Wealth National wealth: domestic physical assets + net foreign assets Country s domestic physical assets (capital goods and land) Country s net foreign assets = foreign assets (foreign stocks, bonds, and capital goods owned by domestic residents) minus foreign liabilities (domestic stocks, bonds, and capital goods owned by foreigners) Wealth matters because the economic well-being of a country depends on it Changes in national wealth Change in value of existing assets and liabilities (change in price of financial assets, or depreciation of capital goods) National saving (S = I + CA) raises wealth Comparison of U.S. saving and investment with other countries The United States is a low-saving country; Japan is a high-saving country U.S. investment exceeds U.S. saving, so we have a negative current-account balance Plott (ECON 221) Saving Spring 2014 23 / 89

Outline 1 Topic 3: Consumption, Saving, and Investment Investment Saving Consumption The Investment-Saving Curve Plott (ECON 221) Consumption Spring 2014 24 / 89

University of Michigan: Consumer Sentiment 1978M1 2013M7 Plott (ECON 221) Consumption Spring 2014 25 / 89

Animal Spirits & Irrational Exuberance Fluctuations with contagious swings of optimism and pessimism, called "animal spirits" by Keynes and "irrational exuberance" by former Fed chairman Alan Greenspan. Plott (ECON 221) Consumption Spring 2014 26 / 89

An Introduction to Consumption Major component of spending (approximately 70% of U.S. GDP). Includes purchases of goods and services by individuals. Two reasons why studying consumption is important: 1 It is the largest component of demand for goods and services in the U.S. 2 Deciding how much to consume is linked to how much to save. C d = desired consumption; S d = desired saving. Assume income is all disposable (Y d = Y ), Y C d G = S d Plott (ECON 221) Consumption Spring 2014 27 / 89

Old School Consumption? Keynesian Consumers (named after a theory of John Maynard Keynes) C = C + MPC Y d (ignoring Taxes and Transfers: Y d = Y ) C = "subsistence" level of Consumption ("wolf point") MPC = marginal propensity to consume Key: Consumption is based solely on current income. Based on cross-country and long-run time series data: C 0 and MPC = C Y 0.90 Problem: In Micro Data (household data) over short term, MPC << 0.90 Using household data researchers find the MPC 0.40 The Keynesian consumption function does not seem to match short-run (household) data. It does match long-run (country level) data. Plott (ECON 221) Consumption Spring 2014 28 / 89

John Maynard Keynes (canes) In 1936 Keynes published The General Theory of Employment, Interest, and Money establishing Keynesian economics as a major alternative to the Classical model. Keynes questioned the classical view that economies moved quickly to their long-run equilibriums. Stating that "in the long-run, we are all dead", Keynes argued that the primary focus of macroeconomists should be the short-run. Plott (ECON 221) Consumption Spring 2014 29 / 89

Old School Consumption? Drawbacks to Keynesian Consumption Functions (aside from not matching data): Does not result from optimizing household behavior Does not allow for the role of interest rates Does not distinguish between different types of income (one-time increase vs. permanent increase) Does not include expectations Is there another theory which allows us to look at household consumption behavior? Yes Fisher Life-Cycle Hypothesis (Modigliani) Permanent Income Hypothesis (Friedman) Plott (ECON 221) Consumption Spring 2014 30 / 89

A Model of Consumption: Fisher s Model Fisher s model of consumption allows us to look at individual/household consumption behavior. Based on the intuition that in your consumption-saving decision you face a trade off. Consuming more today means less saving today. Less saving today means that your resources for future consumption tomorrow are going to be lower. Call r the real interest rate (given). The intertemporal price of 1 extra unit of consumption today is (1 + r) less units of consumption tomorrow. If we understand this simple point we are already half way through! Plott (ECON 221) Consumption Spring 2014 31 / 89

Set up of the Fisher s Model of Consumption Let s study the decision of an individual (i.e. representative consumer or household) that lives for two periods; e.g., think of them during their working age and retirement. r given. Current and future income given, wealth given (exogenous). Define: y = current income i.e.current wage y f = future income i.e. future wage a = initial assets i.e. wealth c = current consumption c f = future consumption Objective: determining the choice of (c,c f ) Plott (ECON 221) Consumption Spring 2014 32 / 89

Relationship between Current and Future Resources We call the relationship between current and future resources the (intertemporal) budget constraint. Key: The amount of c chosen will determine the amount available for c f y + a c are the leftover resources that you carry to period 2 (the future). Particularly if you put those resources in a bank you will get (y + a c)(1 + r) Assume that at period 2 you consume everything. It s the last period. We have c f = (y + a c)(1 + r) + y f This is the budget constraint. Let s look at it in the (c,c f ) space Plott (ECON 221) Consumption Spring 2014 33 / 89

Intertemporal budget constraint Slopes downward. There is a trade off between current and future consumption. c f Intertemporal Budget Constraint c f = (y + a c)(1 + r) + y f c Plott (ECON 221) Consumption Spring 2014 34 / 89

Present Value of Lifetime Resources (PVLR) An additional concept: how much are all your resources (current and future) worth today? We just need to add the resources up, appropriately discounted. We call it the present value of lifetime resources = PVLR = y + a + 1 + r You can check that this is also equal to present value of lifetime cf consumption (PVLC = c + ) (nobody is getting away with 1 + r consuming more that he can and nobody wastes resources that go unconsumed). PVLR is also the maximum level of consumption that you can get in the current period. yf Plott (ECON 221) Consumption Spring 2014 35 / 89

Intertemporal Budget Constraint Note the PVLR on the horizontal axis. c f yf PVLR = y + a + 1 = r c f = (y + a c)(1 + r) + y f PVLR c Plott (ECON 221) Consumption Spring 2014 36 / 89

Last Piece: Individual Preferences Our individual consumer, Bender, has utility U(c,c f ) Ignore his (immense) dependence on leisure for this example makes it simpler. (Realistically) Bender likes consumption (both in the present and future) Assume c, c f are normal goods (if your income increases you want to consume more). (Realistically) Bender likes if the level of consumption (c, c f ) remains smooth over time (consumption smoothing, more on this later). No large drops or jumps. So Bender has regular indifference curves (curves representing the (c,c f ) pairs that yield the same utility). Plott (ECON 221) Consumption Spring 2014 37 / 89

An Indifference Curve for Standard Preferences c f c Plott (ECON 221) Consumption Spring 2014 38 / 89

Optimal Choice of Consumption (Current and Future) Borrower vs. Lender/Saver c f c Plott (ECON 221) Consumption Spring 2014 39 / 89

Fisher s Model of Consumption Objective: determining the choice of (c,c f ) We just did it graphically! It is the point of tangency we just found. (where the intertemporal rate of substitution equals 1 + r). (From Micro, some more details in an example coming up) This simple set up is good enough for start thinking at consumption and saving. Saving = s = y c Plott (ECON 221) Consumption Spring 2014 40 / 89

Permanent Income Hypothesis (PIH) & Life-Cycle Hypothesis (LCH) Milton Friedman and Franco Modigliani: Consumers like smooth Consumption Optimize "lifetime" utility (over consumption). Pretty much the Fisher model. Today, you plan your consumption based upon what you observe today and what you expect to happen tomorrow. Constraint: PVLC = PVLR (PVLC = present value of lifetime consumption). They like to smooth "marginal utility" across seasons, business cycles and life cycles. Think about it: Retirement, Job Loss, Summer Vacations, etc. Does much better at matching data although not perfect. Plott (ECON 221) Consumption Spring 2014 41 / 89

Franco Modigliani (mo-deel-yah-nee) 1918 2003 Awarded Nobel Prize in Economics in 1985 Work Life-Cycle Hypothesis (LCH) Modigliani-Miller Theorem: under particular assumptions, it makes no difference whether a firm finances itself with debt or equity. Plott (ECON 221) Consumption Spring 2014 42 / 89

Milton Friedman Awarded Nobel Prize in Economics in 1976 "the most influential economist of the second half of the 20th century... possibly of all of it." The Economist http://miltonfriedman.blogspot.com Plott (ECON 221) Consumption Spring 2014 43 / 89

From Micro: An Example of Solving the Model Again assume households (Bender) maximize U(c,c f ) in a two period model (current = period 1, future = period 2) U(c,c f ) = ln(c) + βln(c f ) (log utility for simplification, β = Discount Factor i.e., how much you like eating today versus tomorrow) c f = (y + a c)(1 + r) + yf or c + (Budget Constraint; a = Initial Wealth) cf 1 + r = a + y + yf 1 + r (I just re-wrote the above constraint PVLC = PVLR) Do some simple constrained optimization: Maximize U(c,c f ) with respect to (c,c f ) subject to intertemporal budget constraint. Plott (ECON 221) Consumption Spring 2014 44 / 89

An Example (Continued) For our example, assume that β = 1 and r = 0 (for simplicity, not realism). Solution: c = c f (Households want equal levels of consumption each period). Suppose: y = 1, y f = 9, a = 0: What are the optimal (c,c f )? We know that c is smoothed over time (optimizing behavior). We also know that c f = (a + y c)(1 + r) + y f ( budget constraint). Solving we get c = (a + y + yf ) 2 = PVLR LL = 5 ; where LL = length of life. Plott (ECON 221) Consumption Spring 2014 45 / 89

An Example (Continued) Period 1 2 Income 1 9 Consumption 5 5 Savings 4 4 Note: expected income increases are already included in today s consumption plan: Only news today (about today or the future) affect our consumption plan! The fact that income rises from 1 to 9 between periods 1 and 2 is already included in my consumption plan! Unexpected news about income, life spans, etc. WILL effect consumption decisions. Plott (ECON 221) Consumption Spring 2014 46 / 89

Unexpected Transitory Increase in Current Income Example: Suppose today I find out that my current income increases by = $2. What is the new consumption plan associated with this transitory (temporary) increase in y? c = c f = 6 (still smooth consumption across periods) s = 3,s f = 3 Consumption increases by a little today (and in the future), saving increases today! Saving increases today so consumption tomorrow will be higher (transfer some of the transitory income shock towards the future) MPC = c today = 1 = (in this example) = 0.5 y today LL Plott (ECON 221) Consumption Spring 2014 47 / 89

Unexpected Transitory Increase in Current Income Increase in current income (y + = y > y). Pure income effect. Increasing income increases both current and future consumption (both normal goods). Bender is a lender here. Note that current saving (y c ) also goes up when y increases. The level of c f increases for this reason. c f c Plott (ECON 221) Consumption Spring 2014 48 / 89

Transitory Increase in Future Income Increase in future income (y f + (1 + r) > y f ). Pure income effect. I know now that in period 2 I have (1 + r) more. Increasing future income increases both current and future consumption (both normal goods). Note that current saving (y c ) goes down when future income increases! c f c Plott (ECON 221) Consumption Spring 2014 49 / 89

Unexpected Increase in Permanent Income Example: Suppose today I find out that my income will permanently increase by $2 (in both period 1 and period 2). What is the new consumption plan associated with this permanent increase in y and y f? c = c f = 7 s = 4,s f = 4 Consumption increases more today (and in future) than compared with the case of a transitory income shock, and saving remains constant! MPC = C(today) Y (today) = 1 = (in all examples) = 2 2 = 1 With permanent changes in income, consumption and income move 1 for 1. Plott (ECON 221) Consumption Spring 2014 50 / 89

Unexpected Increase in Wealth Example: Suppose today I find out that my wealth increased by $2 prior to period 1 (a one-time unexpected stock market gain). What is the new consumption plan associated with this unexpected increase in a? c = a + y + yf = c f = 6 2 s = 5(= y c),s f = 3 (increase in PVLR due to wealth = 2) Consumption increases today (and in future), and saving falls. One time increases in wealth are identical to one time (transitory) changes in current income. Different effect on saving though. Plott (ECON 221) Consumption Spring 2014 51 / 89

Unexpected Increase in Wealth Increase in initial wealth (a + = a > a). Pure income effect. Increasing wealth increases both current and future consumption (both normal goods). Note however that current saving (y c ) goes down when a increases! c f c Plott (ECON 221) Consumption Spring 2014 52 / 89

Some Evidence Consistent with PIH Behavior Business Cycles are likely to be associated with temporary shocks to income. We find consumption to be more stable than income over the business cycle. And the saving rate is generally procyclical. So, C does not move 1-for-1 with Y. Micro Studies find the MPC out of income changes to be much less than 0.9 (C does not track Y one for one). Micro Studies find a MPC out of changes in wealth of about 0.05. (Unexpected capital gains in housing/securities are like one time increases in income). Household consumption responds more to permanent shocks to income than to temporary shocks. Plott (ECON 221) Consumption Spring 2014 53 / 89

However... In contrast to the predictions of the PIH, consumption does vary too much with temporary income changes. Suppose a household earns $60,000 (on average) over 40 working years. Total earnings over working years = $2.4 million (do not worry about discounting) Suppose in a recession, that household loses their job for 1 year and because of transfers (unemployment insurance, severance) only earns $20,000 that year. That household s lifetime income only declined by 0.166% (less than one fifth of one percent)... ($40,000/$2.4 million) because of recession. Being unemployed even for one full year out of a lifetime does not effect lifetime income all that much! According to the PIH, consumption should not respond that much... (household should spread that $40,000 over 40 years. Consumption should, at most, decline only $1,000/year). If you prepared for the possibility of job loss, consumption really shouldn t change at all (just draw down savings). If the PIH theory is true, consumption of the economy should not respond that much during recessions 1 recessions have little effect on our lifetime incomes and 2 we should prepare for recessions and as a result, have savings to buffer our low income). Plott (ECON 221) Consumption Spring 2014 54 / 89

Consumption During Recessions But Consumption falls during recessions Not a prediction of the standard permanent income hypothesis (PIH). If households were smoothing consumption, they should realize that their lifetime income has not changed that much because of job loss. Furthermore, they should have saved to prepare for a recession (we all know that recessions sometimes happen)! During recessions, aggregate consumption behavior looks more Keynesian than PIH... Why do I say this? Well, Keynesian behavior says C is a function of only current Y ; i.e., C = C + MPC Y d As current Y falls (as in a recession), current C falls. However, data shows that C falls only by about 40% of the Y fall. That implies MPC is 0.40. But, this doesn t match long term response of consumption to income changes (too high). Plott (ECON 221) Consumption Spring 2014 55 / 89

Refinements to Consumption Theory These are refinements to consumption theory that we will not spend much time on (there is a whole consumption literature modeling consumption behavior more thoroughly to match the data). Liquidity Constraints (borrowing constraints maybe consumers cannot smooth income!) Uncertainty (Precautionary Savings) Little is known about preferences (time preference rates β and risk aversion). Bequests explain a large portion of wealth accumulation Portfolio Choice makes a difference Large variation in wealth accumulations across individuals Life Cycle Shocks Home production (including shopping for bargains) Plott (ECON 221) Consumption Spring 2014 56 / 89

Refinement of PIH Theory (part 1): Liquidity Constraints Liquidity Constraints refer to the fact that sometimes a household (or a firm) optimally wants to borrow to smooth consumption (or for investment), but lenders are unwilling to lend to that household against future streams of income. Why will lenders refuse to lend? Lender may not believe that the household will pay them back. Lender cannot distinguish between households who want to borrow to smooth consumption from borrowers who want to borrow and then default. In recessions, in order to smooth consumption, households who receive a negative income shock either have to draw down saving or borrow. If they are prevented from borrowing, household will have no choice but to cut their consumption. As a result, C will fall during recessions. Liquidity constraints make households look Keynesian when income falls (C falls when Y falls for those with no saving and who cannot borrow). However, when Y is high, households look like PIH households nothing prevents them from saving. If Y is temporarily high, households would want to save some of that income. Liquidity constraints prevent borrowing NOT saving... Plott (ECON 221) Consumption Spring 2014 57 / 89

Liquidity Constraints Desired consumption is C d. Note: current and future consumption are constrained. c f c Plott (ECON 221) Consumption Spring 2014 58 / 89

Refinement of PIH Theory (Part 2): Grasshoppers and Ants Perhaps the economy is made up of both Keynesian and PIH consumers: "It was wintertime, the ants store of grain had got wet and they were laying it out to dry dry. A hungry grasshopper asked them to give it something to eat. "Why did you not gather food in the summer like us?" the ants asked. "I hadn t time", it replied. "I was too busy making sweet music." The ants laughed at the grasshopper. "Very well", they said. "Since you piped in the summer, now dance in the winter." An Aesop Fable The fable is a a story about consumption (eating), saving (storing food) and retirement (winter)... Suppose the population is made up of both economic grasshoppers (Keynesian consumers) and ants (PIH consumers). The ants in the parable were forward looking (like PIH theory suggests they know retirement is coming and prepare for it). The grasshoppers eat their current income and do little saving. They behave as if retirement does not exist. When retirement comes, they do not have enough resources to sustain their consumption. (we can also think of winter as a recession... the grasshoppers do not prepare for recessions) As a result, the consumption of grasshoppers will respond to predictable changes in income (recessions, retirement, etc.) Plott (ECON 221) Consumption Spring 2014 59 / 89

Grasshoppers and Ants: Evidence About 20% of households behave according to Keynesian theories (increasing consumption with income without regard for future states of the world). A full 1/3 of the baby boom generation is "ill prepared" to sustain consumption through retirement (Bill Gale, Brookings). Over 20% of households do not own a checking/saving account (40% have less than $5k in liquid assets). Observe "Grasshopper" behavior among households in the population (consumption responds to both predictable income increases and predictable income declines). These same households are ill prepared for retirement. Pseudo-Keynesian behavior important for policy! Keynesian s will have large current response to temporary tax cuts. PIH households (who are not liquidity constrained) will have very small response to temporary tax cuts. Plott (ECON 221) Consumption Spring 2014 60 / 89

Refinement of PIH Theory (Part 3): Home Production We measure consumption (as with most macro variables) in dollars. Expenditure may not be a good measure of consumption when the value of time changes. When the value of time is low (unemployment like in recessions) or retirement, individuals can take action to reduce their expenditure (holding consumption constant). Clip coupons Search for bargains across stores Make your lunch at home instead of buying it at a cafeteria. If home production/search is important, we would expect EXPENDITURE to fall during a recession. However, CONSUMPTION may remain unchanged! Strong evidence for the home production/search theory of consumption expenditures. The decline in expenditure during recessions does not mean people are consuming less. Plott (ECON 221) Consumption Spring 2014 61 / 89

LCH Diagram & an Empirical Problem Many economists have studied the consumption and saving of the elderly. Their findings present a problem for the life-cycle model. It appears that the elderly do not dis-save as much as the model predicts. In other words, the elderly do not run down their wealth as quickly as one would expect if they were trying to smooth their consumption over their remaining years of life. Plott (ECON 221) Consumption Spring 2014 62 / 89

Refinement of LCH Theory (Part 1): Precautionary Saving & Bequests There are two chief explanations for why the elderly do not dis-save to the extent that the model predicts. The first explanation is that the elderly are concerned about unpredictable expenses. Additional saving that arises from uncertainty is called precautionary saving. One reason for precautionary saving by the elderly is the possibility of living longer than expected and thus having to provide for a longer than average span of retirement. Another reason is the possibility of illness and large medical bills. The elderly may respond to this uncertainty by saving more in order to be better prepared for these contingencies. The precautionary-saving explanation is not completely persuasive because the elderly can largely insure against these risks. To protect against uncertainty regarding life span, they can buy annuities from insurance companies. For a fixed fee, annuities offer a stream of income that lasts as long as the recipient lives. Uncertainty about medical expenses should be largely eliminated by Medicare, the government s health insurance plan for the elderly, and by private insurance plans. The second explanation for the failure of the elderly to dis-save is that they may want to leave bequests to their children. Economists have proposed various theories of the parent-child relationship and the bequest motive. Plott (ECON 221) Consumption Spring 2014 63 / 89

Consumption and Interest Rates So far we have focused at changes in income and wealth. Now let s analyze what are the consequences of changes in prices. 1+the real interest rate is the price of today s consumption relative to future consumption. You forgo 1 + r dollars of future consumption to consume 1 dollar today. An increase in the real interest rate produces an increase of the price of today s consumption relative to future consumption. Plott (ECON 221) Consumption Spring 2014 64 / 89

Consumption and Interest Rates Increase in real interest rate (r > r): Example of income effect dominating (Saver/Lender). New intertemporal budget constraint. c f c Plott (ECON 221) Consumption Spring 2014 65 / 89

Substitution and Income Effects: Intuition Assume current and future consumption are normal goods. 1+the real interest rate is the price of today s consumption relative to future consumption: You forgo 1 + r dollars of future consumption to consume 1 dollar today. An increase in the real interest rate means an increase of the price of today s consumption relative to future consumption. The fact that you shift away from current consumption (i.e. you increase your saving) as a consequence of this change in price is the substitution effect. Cheaper future consumption produces an incentive to consume less today and save more. But an increase in r also affects income (hence an income effect): 1 An increase in the real interest rate increases interest receipts for a lender. This produces an incentive to consume more today and save less. 2 An increase in the real interest rate increases interest payments for a borrower. This produces an incentive to consume less today and save more. Plott (ECON 221) Consumption Spring 2014 66 / 89

Intertemporal Substitution in Consumption Increase in real interest rate: Example of income effect dominating (Saver/Lender). Step 1: Trace Substitution effect (allow original choice at new prices). c f c Plott (ECON 221) Consumption Spring 2014 67 / 89

Intertemporal Substitution in Consumption Increase in real interest rate: Example of income effect dominating. Step 2: Now increase income to new level. Both current and future c increase. Note: current saving decreases. See Abel, Bernanke, Croushore textbook for an example where substitution effect dominates (saving increase). c f c Plott (ECON 221) Consumption Spring 2014 68 / 89

Intertemporal Substitution in Consumption Increase in real interest rate: Example of the problem for a Borrower. c decreases. Note: for a borrower Income and Substitution effects go in the same direction. When r increases, saving increases. c f c Plott (ECON 221) Consumption Spring 2014 69 / 89

Recap Consumption and Interest Rates Assume households are net lenders. Substitution effect: higher r lowers c. Think of people saving more to reap the higher return, or people borrowing less because it is more expensive. Higher interest rate today, makes saving more beneficial (price of future consumption falls). Households will switch away from consumption today (i.e., c today falls, c f tomorrow increases, and s today increases) Income effect: higher r raises c today. For every dollar saved, you get higher income (if you are a net saver). When richer, you buy more of the things you like. What do you like? Consumption today and consumption tomorrow. As a result, you can save less and get more of both. (c today increases, c f tomorrow increases, and s today falls) Evidence: some studies find the substitution effect stronger, others find they are the same. My intuition is that higher r has little, if any, effect on current consumption (i.e. substitution effect equals income effect). What if households are net borrowers? Income effect is opposite as lender/saver. Higher interest rates make households poorer (they have to pay higher interest payments). Income effect will say that c today will fall, c f tomorrow will fall and s today will increase. Plott (ECON 221) Consumption Spring 2014 70 / 89

Full Recap of the Fisher/PIH model Assume current and future consumption are normal goods. An increase in current income increases current and future consumption and increases saving. An increase in future income or wealth increases current and future consumption but decreases saving. An increase in the real interest rate decreases current consumption but increases future consumption and saving for a lender, if the substitution effect dominates. An increase in the real interest rate increases current and future consumption but decreases saving for a lender, if the income effect dominates. An increase in the real interest rate decreases current consumption and increases saving for a borrower. May increase or decrease future consumption. Plott (ECON 221) Consumption Spring 2014 71 / 89

Laibson s Pull of Instant Gratification Keynes called the consumption function a "fundamental psychological law". Yet, as we have seen, psychology has played little role in the subsequent study of consumption. Most economists assume that consumers are rational maximizers of utility who are always evaluating their opportunities and plans in order to obtain the highest lifetime satisfaction. More recently, economists have started to return to psychology. They have suggested that consumption decisions are not made by the ultra-rational Homo economicus but by real human beings whose behavior can be far from rational. This new sub-field infusing psychology into economics is called behavioral economics. The most prominent behavioral economist studying consumption is Harvard professor David Laibson. Laibson notes that many consumers judge themselves to be imperfect decision makers. In one survey of the American public, 76 percent said they were not saving enough for retirement. In another survey of the baby-boom generation, respondents were asked the percentage of income that they save and the percentage that they thought they should save. The saving shortfall averaged 11 percentage points. Plott (ECON 221) Consumption Spring 2014 72 / 89

Two Questions and Time Inconsistency 1 Would you prefer (A) a candy today, or (B) two candies tomorrow? 2 Would you prefer (A) a candy in 100 days, or (B) two candies in 101 days? In studies, most people answered (A) to 1 and (B) to 2. A person confronted with question 2 may choose (B). But in 100 days, when confronted with question 1, the pull of instant gratification may induce her to change her answer to (A). http://www.nobelprize.org/nobel_prizes/economic-sciences/ laureates/2002/kahneman-lecture.html Plott (ECON 221) Consumption Spring 2014 73 / 89

Summary: What Effects Consumption Current Income (Both PIH and Keynesian Theories) Expectations of Future Income (Only PIH theory) Wealth Temporary vs. Permanent Changes Tax Policy Interest rates (slightly) Preferences The magnitude of the results depend on whether consumers follow Keynesian or PIH consumption rules and whether or not liquidity constraints exist! In our Government Policy Lecture, we will talk about Social Security Systems and consumer s expectations of tax changes Plott (ECON 221) Consumption Spring 2014 74 / 89

Conclusion: Getting Closer to Modeling Demand C today = C(y, y f, wealth, taxes, liquidity constraints, consumption rules, expectations) C today = C(PVLR, taxes, liquidity constraints, consumption rules, expectations) We will assume that r does affect C only through the substitution effect. You can extend the model to account for substitution and income effects. I today = I(r, A f, MPK f expectations, investment taxes) We are moving towards a model of Aggregate Demand: Y d = C d ( ) + I d ( ) + G + NX We will get to G & NX later in the course Plott (ECON 221) Consumption Spring 2014 75 / 89

Outline 1 Topic 3: Consumption, Saving, and Investment Investment Saving Consumption The Investment-Saving Curve Plott (ECON 221) The Investment-Saving Curve Spring 2014 76 / 89

From Our Previous Work to Goods Market Equilibrium In Topic 2 we defined Aggregate Production. Up to this point in Topic 3 we defined two main components of Aggregate Spending: Consumption and Investment. More specifically desired levels of Consumption (C d ) and Investment (I d ). We now consider the Equilibrium: aggregate quantity of goods & services demanded equals goods & services supplied (Y ). Plott (ECON 221) The Investment-Saving Curve Spring 2014 77 / 89

Goods Market Equilibrium Goods Market equilibrium condition: Y = C d + I d + G + NX (1) C d is a function of PVLR (Y, Y f, a), tax policy, expectations, r, etc. I d is a function of r, A f, K, and investment tax policy. G is a function of government policy. NX we will model later in the course Let us take Y (supply) as given. Let us postpone studying G in detail to later. NX in future lectures. Plott (ECON 221) The Investment-Saving Curve Spring 2014 78 / 89

Goods Market Equilibrium (Continued) For given Y, we can re-express (1) as: S d = Y C d G = I d (2) when NX = 0 Desired Saving = Desired Investment Equilibrium: the resources not consumed by private households or the government are channeled to firms that use them to finance investment. So what links S d to I d? The real interest rate, r. In equilibrium S = I. We defined I as negative function of r earlier in Topic 3 by looking at MPKf = uc f. r I d. We also considered saving and consumption decisions as a function of r. Assume now substitution effect dominates (true empirically). r S d Plott (ECON 221) The Investment-Saving Curve Spring 2014 79 / 89

Goods Market Equilibrium (Continued) r S d r 0 I 0 = S 0 I d I,S Plott (ECON 221) The Investment-Saving Curve Spring 2014 80 / 89

Goods Market Equilibrium (Continued) r S d r 0 r I 0 = S 0 I d I,S At r desired investment is higher than desired saving, hence the price of saving (i.e. r) is going to increase converging to equilibrium. If investors want to borrow (I ) more than savers are willing to lend (S ), this will be bid up the price of saving (r). Plott (ECON 221) The Investment-Saving Curve Spring 2014 81 / 89

Example: Increase in output (Y > Y ) r S d = Y C d G S d = Y C d G r 0 r 1 I d I 0 = S 0 I 1 = S 1 I,S Plott (ECON 221) The Investment-Saving Curve Spring 2014 82 / 89

The Investment-Saving (IS) Curve The IS curve is named as such because it shows the relationship between saving and investment (holding NX constant to 0). The IS curve relates Y to r. For any level of output Y the IS curve shows the value of r for which the goods market is in equilibrium. How do interest rates relate to Y? As Y increases, desired saving increases, decreasing the real interest rate that clears the goods market. Alternatively think of IS as: Y = C(r) + I(r) + G where C and I are negative in r. IS curve is downward sloping in {r,y } space. The IS curve represents demand side of the economy. Why IS? Because the demand side of the economy can be boiled down to I = S (when NX is zero). Plott (ECON 221) The Investment-Saving Curve Spring 2014 83 / 89

Building the IS Curve Plott (ECON 221) The Investment-Saving Curve Spring 2014 84 / 89

Demand Side Analysis (IS Curve) r r 0 IS Y 0 Y Suppose r is set by the Fed (U.S. central bank) at the level of r 0 (we will explore this in depth later in the course). For a given r, we can solve for the level of output desired by the demand side of the economy. Plott (ECON 221) The Investment-Saving Curve Spring 2014 85 / 89

Some Thoughts on the IS Curve What shifts the IS curve? Anything that causes desired C, I or G to change (or NX when we model it). What shifts IS curve to the right? (i.e., makes Y higher on the demand side of the economy). Increase in consumer confidence (expectations of future PVLR). Permanent increase in stock market wealth, bonds, and the like. A permanent reduction in income taxes (if households are PIH or Keynesian). A temporary reduction in income taxes (if households are Keynesian or Liquidity Constrained PIH). An expected future increase in TFP (stimulates investment demand). Anything shifting MPK up. An increase in government spending (e.g. war). Changes in r will NOT cause the IS curve to shift (causes movement along IS curve). Plott (ECON 221) The Investment-Saving Curve Spring 2014 86 / 89

Example 1: Suppose Consumer Confidence Falls Suppose consumer confidence falls. Desired saving increases, decreasing the real interest rate that clears the goods market at any Y. The IS curve will shift leftward. r r 0 IS Y 0 Y Plott (ECON 221) The Investment-Saving Curve Spring 2014 87 / 89

Example 2: Suppose Future TFP Increases Suppose future TFP increases. Desired investment increases (MPK goes up), increasing the real interest rate that clears the goods market at any Y. The IS curve will shift rightward. r r 0 IS Y 0 Y Plott (ECON 221) The Investment-Saving Curve Spring 2014 88 / 89

Example 3: Suppose Population Increases (N goes up next period) Suppose N f goes up. Desired investment increases (MPK goes up), increasing the real interest rate that clears the goods market at any Y. The IS curve will shift rightward. r r 0 IS Y 0 Y Plott (ECON 221) The Investment-Saving Curve Spring 2014 89 / 89