Business, Government, and the World Economy Consumption, Saving & Investment

Business, Government, and the World Economy

Consumption, Saving & Investment

Aggregate Demand

The amount that consumers, business and Government wants to purchase.

ConsumptionInvestmentGovernmentIS/LM Model – joint determination of output and interest rates

Consumption

Average or expected income of consumers

Cost and availability of credit

The Decision to save vs. spend

Determinants of Consumption

Disposable IncomeExpected average Disposable IncomeChanges in Tax RatesCost and Availability of CreditDemographic factorsExpected Rate of Return on Investment AssetsChanges in spendable income from asset price fluctuations (not part of DI)Consumer Attitudes

Empirical Evidence

Consumption / Income is constant in long runShort run changes in consumption are not as closely correlated with income

Cons based on average or expected incomeAttitudes shift frequentlyCost of credit changes quickly

Consumption is smoother in short run than income except during recessions

Empirical Evidence

Changes in realized capital gains are not reflected in disposable income, (similarly a reduction in mortgage rates could increase disposable income)Declines in available credit can have a larger influence on consumption than expected.

Variability of Consumption Spending

1990 recession – consumption spending declined .2% over first 5 quarters2001 recession – consumption spending increased by more than 3% (income growth, consumer sentiment both declined)Post 2008 – increase in saving

Quarterly Variability

Changes in disposable income explains less than half of change in consumer spendingChanges in money variables such as yield spread, money supply, stock prices, consumer credit also explain less than half (only 25%)The remainder of the fluctuation is explained by exogenous and random factors – political shocks etc.

Long-term Variability

Over 60% of the one year change can be explained by disposable income, costs, availability of credit and asset pricesFor a 3 year change over 90% of the of the change can be explained by changes in disposable income etc.Managers need to be careful to not over respond to short term shifts.

Quick Review

Linear Regression - Provides line the best describes the relationship between two variablesR2 - Portion of relationship explained by the estimated lineT-Statistic - Confidence in the estimate of the variable (Is is statistically significant?)Standard Error - Confidence Interval

Quarter to Quarter Results

1959-I to 2012 -2Y = % change in Real Personal Consumption Expenditure Quarter to QuarterX= % change in Real Disposable Income Quarter to Quarter

Regression StatisticsMultiple R 0.459396353R Square 0.21104501Adjusted R Square 0.207305886Standard Error 0.006234187Observations 213

Coefficients Standard Error t Stat P-valueIntercept 0.005320664 0.000570322 9.329219465 1.50822E-17DI 0.353144119 0.04700557 7.512814355 1.6173E-12

Yearly Changes

Y = % change in Real Personal Consumption Expenditure Year to YearX= % change in Real Disposable Income Year to Year


Coefficients Standard Error t Stat P-valueIntercept 0.009081583 0.001729541 5.250862 3.7292E-07DI 0.738413613 0.04498014 16.41644 2.1401E-39

Yearly % Change

3 year % Change

1962 - 2011Y = 3 year % change in Real Personal Consumption ExpenditureX = 3 Year % change in Real Personal Disposable Income


Coefficients Standard Error t Stat P-valueIntercept 0.0053786 0.00370 1.45542 0.14712DI 0.9638300 0.03329 28.95360 1.85E-73

3 year % change

The Consumption Function

Basic idea is trying to determine the relationship between consumption and the key inputs.Start with a simple model

Assume that consumption is actually determined by

Disposable income (DI)Marginal propensity to consume (MPC)C = a + (mpc)(DI)

Impact of Consumption

We said before that output in the economy equals income.

C + G + I + NX

Assume no trade so output = C + G + I

Planned Expenditure

Substituting the consumption function into the equation for C produces a + (mpc)Y + G + ILet this equal the amount of planned spending in the economy.mpc will generally be less than 1

Keynesian Cross

Graph Planned expenditure on vertical axis and output (or income) on the horizontal.

Let Y* be the equilibrium level of spending where planned spending equals output (income)

When output is less than Y*

Planned Spending > Output (income)

Inventories decline production increases

When output is greater than y*

Planned Spending < Output (Income)

inventories increase, production increases.

“Old” interpretation

Given that the data supports that low income workers are dissaving and high income workers are saving:Can it be said that:

The personal saving rate increases as income increases? (Keynes)

Total GDP can be increased by transferring wealthIncreases in income is accompanied by increases in saving that is not fully invested – need to increase G relative to everything else

Assuming Old Interpretation is Correct

The following outcomes which are not supported by data would occur if the old interpretation is correct

Consumption would not rise as fast as income and savings would increase over time (as real income as increased)Consumption would be a function of only income – not financial variables such as interest rates and creditThe saving rate would decline in recessionSaving rates would be higher for “richer” individuals

PIH

Consumption is based on expected or permanent income, not just current income.

Permanent Income Hypothesis

Those at the high end of the income scale have income above their long term expected income (permanent income) – therefore they are saving (not because they have high permanent income)Those at the low end of the income scale have income below their long term expected income (permanent Income) – therefore they borrow (not because they have low permanent income).

PIH (two periods)

You can save a portion of your income. Let labor income = Y then there is savings available in year 2 equal to (1+r)(Y1-C1)

The total amount available to spend in year 2 is then C2 = Y2+ (1+r)(Y1-C1)

C2 = Y2+ (1+r)(Y1-C1)

RearrangeC2 (1+r)(C1) = Y2+ (1+r)(Y1)

Divide by 1+rC1 + C2/(1+r) = Y1+Y2/(1+r)

The PV of consumption must equal the PV of income -- in other words the key constraint on consumption is your lifetime income.

Intertemporal Budget Constraint

Graph period 2 consumption on vertical axis (max value = Y1(1+r) + Y2)

Graph period 1 consumption on horizontal axis (Max value = Y1+Y2/(1+r))

Combine budget constraint with indifference curves (combinations of consumption with same utility)

An Increase in Income

Assume that future income (Y2) increases by $50,000.Assume that current income increases by $50,000In either case consumption increases in both periodsBasic Perm Income model sets consumption equal in both periods.

PIH and MPC

You still have the choice between saving and consuming – the marginal propensity to consume still plays a key role.In both the Keynesian model and the intertemporal model an increase in permenant income will cause a large increase in current consumption

Precautionary Saving

In reality future income is uncertain. The choice to save or consume is then in part based on precautionary saving (insurance against future uncertainty)This impacts the marginal propensity to consume.

Credit

Given the intertemporal nature of the consumption decision, the amount of credit available and the cost of credit play key role in the decision to save or consume.

Current Consumption Theory

Life Cycle Model of Saving and Consumption)

People will attempt to borrow and save to keep the purchase of goods and services more stable than income. Everyone will act “rationally” to maximize their own self interest by:

Interpreting and Weighing InformationAppropriately Balancing & Evaluating ChoicesMaking Informed Decisions

Life Cycle Model

Age

Income

Consumption

Saving

BorrowingDissaving

RetirementEntrance to Workforce

Implications of Life Cycle ModelSaving Decisions

Individuals understand the need to save for retirement and can estimate the amount they need to save.In other words consumers:

Understand the impact time has on the value of their money.Make informed decisions about their investment choices and actively respond to changes in the economic environment.Act in a manner that maximizes their investment income.Can accurately plan for a retirement age.

Life Cycle Implications

Individuals attempt to “smooth” consumption

If income drops due to short term layoff – the expectation is that consumption would not decrease as much as income.If income drop is viewed as “permanent” consumption may drop by the same amount as income.

Extension

Individuals at the high end of income scale - should have current income higher than their long term expected income - they should saveIndividuals at the low end of the income scale – should have current income less than their long term expected income – they should dissave (borrow)

*Empoyee Benefit Research Instiute (EBRI) www.ebri.org

Some real world dataIs PIH correct?

Only 42% of workers have calculated how much they need for retirement. (EBRI* 2006).30% of US workers have not saved anything for retirement (EBRI 2006).Consumption patterns indicates that US workers experience an unexpected drop in standard of living after retirement. (Bernheim et. al 2001)

Consumption, Saving,and Investment

An increase in consumption may not increase aggregate demand if consumers substitute consumption for saving. A decrease in saving decreases business investment.

Volatility of Investment

Investment is more volatile than output. Investment tends to cluster in certain years, but can have a long term impact.Cooper, Haltwinger, and Power AER 1999 – Sample of firms - 17% of investment over a 20 year span takes place in the “heaviest” year, next heaviest year less than 12%.Investment tends to correspond with peak spending years.

Lags and Investment

It makes sense that investment is more volatile. There are time lags with investment – it takes time to build new plants and equipment

Investment and GDPQuarterly % Change

Desired Capital Stock

The desired capital stock is the equilibrium level of capital spending (it maximizes profit for firms).The level of the capital stock is determined in part by the marginal product of capital – The additional benefit of adding one more unit of capital.However there is a lag in the investment in capital and its impact on productivity – so we are actually looking at the expected future Marginal Product of Capital

Finance 101

When will a firm invest in new capital?When the marginal product of capital exceeds the user cost of capital (think IRR>WACC)The same type of principles apply here.

Marginal Product of Capital

As the capital stock increases each unit has a lower benefit. In other words there are diminishing marginal productivity of capital.


Capital Stock

Expect

ed F

utu

re M

arg

inal Pro

du

ct o

f C

apit

al

User Cost of Capital

The user cost of capital is the cost of using a unit of capital for a specified period of time

Interest cost (the real interest rate x price of capital goods)Depreciation costs (the depreciation rate x the price of capital goods)


Capital Stock

Expect

ed F

utu

re M

arg

inal Pro

du

ct o

f C

apit

al

User Cost of Capital

A

B

Desired Capital Stock

At A in the previous slide MPKf > uc it makes sense for the firm to add to its capital stockAt B in the previous slide MPKf < uc the firm should decrease its desired capital stock The tax rate also impacts the relationship – The after tax MPK should be compared to the after tax uc.

Changes in Desired Capital Stock

The equilibrium level of capital stock will change based on:

Price of capitalReal rate of interestMarginal productivity of capital

Increased MPKf causes Increased Desired Capital Stock

Capital Stock

Expect

ed F

utu

re M

arg

inal Pro

du

ct o

f C

apit

al

User Cost of CapitalA B

Tobin’s q

The value of the stock market plays a role in consumers willingness to spend and save.Similarly changes in the value of the stock market may impact the desire of a firm to invest (a wealth effect).Therefore an increase in the value of the firm should cause an increase in the desire to invest.

Tobin’s q

The rate of investment depnds upon the ratio of the capital’s market value (V) to its replacement cost (Price of capital x capital stock)

Kp

V q sTobin'

k

q and when to Invest

If q is greater than one, it implies that the market is placing a higher value on the firms assets than the cost of replacing the assets – the firm should investIf q is less than one the market is valuing the firm’s assets at a price less than the cost of replacing the assets – the firms should start selling off assets

q and Fin 101 (IRR >WACC)

The return on investment can be measured by the return on investment in new capital (basically the ROC)

The required rate of return to shareholders can provide a measure of the cost investing (ROE)

Capital ofCost t Replacemen

Profits

Firm of ValueMarket Stock

Profits


The ratio of the return on investing to the cost should be greater than 1 (the return above the cost) for the firm to invest


Profits


Profits



Profits

Profit



Firm of ValueMarket q

Determinants of q

The same three factors in the original model impact q

If MPKf increases future earnings increase causing Firm Value to increase and qIf the real rate of interest decreases – consumers substitute low yielding investment for higher yielding investments – increasing value and q A decrease in purchase price of capital increases q

Stock Prices and Investment

S&P 500 and Investment

The aggregate data does not show a strong link between stock prices and investment.Implications / Reasons

Firms do not find short term shifts in stock market values to be informative ORFirms concentrate too much on the short term Intangible assts are also part of investment but are not measured well. Internal funds are major source of financing – current cash flow (not future productivity) has an impact

Desired Capital Stock and Investment

It= Gross investment in goods and servicesKt = Capital Stock at the beginning of the

yearKt+1 = Capital stock end of the year

d = depreciation

Net invest = Gross Invest – depreciationKt+1-Kt= It – dKt

Gross Invest = Net Invest + DepreciationIt = Kt+1-Kt + dKt

Replace K with Desired Capital Stock K*

It = K*-Kt + dKt

Desired Net Increase in Capital StockReal Interest RateFuture Marginal Productivity of CapitalPurchase price of CapitalTax Rates

Goods Market Equilibrium

We stated that in a closed economy (no trade) in other words that income and spending were always equal

Y = C + I + GLet Y be the quantity of goods and services supplied by firmsNow on the RHS Substitute desired consumption and desired investment (Cd

& Id) for C and I

Y = Cd + Id + G

Y = Quantity of goods suppliedCd + Id + G = quantity of goods demanded

Unlike the GDP equation on the previous slide this will not always be in equilibrium

For example, If firms produce too much output, inventories increase I this case production exceeds desired spending. The market will react to bring the goods market back to equilibrium

Desired Saving and Desired Investment

Starting with Y = Cd + Id + G and rearranging you get

Y - Cd –G = Id

Or Desired Saving = Desired Investment

Goods Market Equilibrium

The real interest rate will move the goods market toward equilibrium

Saving Decisions

Keeping everything else constant, if individuals are rewarded with a higher return on their investment, they will save more. This implies a direct relationship between saving and the quantity of dollars supplied (As r increases s increases)

Graphing the Saving (Supply of Funds) Function

RealInteres

t Rates

Level ofSaving

S

Saving Decisions

Last class we how a consumer decided to spend (consume or save) Saving Decision - An Individual’s decision to save or consume at a given level of interest rates will depend upon two main things:

Marginal Rate of Time PreferenceTrading current consumption for future consumptionIncome and wealth effectsGenerally higher income – save more

A change in these variable will cause the level of saving at each level of interest rates to change.


RealInteres

t Rates

Level ofSaving

An increase in the level of wealthS0 S1

* Abel and Bernanke MAcroeconomics

Saving Decisions Summary*

An increase in Saving will

Why?

Current Output Rise Saved for Fut Consumption

Expect Fut Output

Fall Fut Income rises, save less today

Wealth Fall Some wealth is consumed, S decreases at given Y

Expt Real Int Rate

Prob Rise Opportunity cost of capital

Government Pur Fall Higher G Lowers S

TaxesUnchanged or Rise

If taxes in fut are expected to fall no change in saving, If tax increase is perm S rises

Investment Decisions

The reward for saving comes from business being willing to pay interest for the funds they borrow.Keeping everything else constant, if business is required to pay a higher level of interest rates on its borrowing, it will borrow (and invest) less. This implies an inverse relationship between the demand for funds by business and the level of interest rates.

Graphing the Investment (Demand for Funds) Function

RealInteres

t Rates

Saving / Investment

I

Determinants of Investment

An increase in Investment

will Why

Real Interest Rate

FallUser cost of capital increases, desired capital stock decreases

Expected MPKf Rise

Each unit of capital provides more output, at same cost, desired capital stock increases

Effective Tax Rate

FallTax adjusted user cost increases, desired capital stock falls

Note:

The availability of credit plays a role in both consumption and investment (the yield spread can serve as an indicator for this)

In part reflected by expected future real interest ratesIncreased borrowing may increase the user cost of capital, even if the market rate does not changeIPOs and venture capital play a key role in small firms access to funds

Graphing the Investment (Demand for Funds) Function

RealInteres

t Rates

Saving / Investment

An increase in the Marginal Productivity of Capital

D0 D1

Equilibrium

The level of interest rates will then be determined by the intersection of the saving (supply of funds) and investment (demand for funds) functions. At this intersection the demand for funds equals the supply of funds. If demand does not equal supply, the level of interest rates will adjust.


RealInteres

t Rate

Level ofSaving /Investment

S

I

r

S=I

Changes in Equilibrium

A change in the economy that causes a shift in either the saving or investment function will cause a change in the general level of interest rates.For example: What if new technology increases the productivity of capital?

The demand for funds will be higher at each level of interest rates. At the original r, Investment > Savings so real interest rates will increase as firms compete to attract funds.

Note:

So far we have not included international trade. The equilibrium will be impacted by foreign savers and the ability for Domestic consumers to save abroad. (we will cover this soon)

Measuring Investment

NIPA tablesEconomic Indicators

Factory OrdersBusiness InventoriesCapacity Utilization and Industrial Production

The IS CurveEquilibrium in the Goods Market

The goods market is in Equilibrium whenAggregate Supply = Aggregate Demand

Or in a closed economy (see Investment Notes)

Starting from Y = Cd + Id +G and rearranging

Id= Y - Cd – G Desired National Investment is equal to Desired National Saving (Id = Sd)

Review Saving = Investment

Real In

tere

st R

ate

, r

Investment and Saving, Id,Sd

DesiredSaving

Id,Sd

DesiredInvestment

Saving Decisions

Earlier we showed how a consumer decided to use income (consume or save) Saving Decision - An Individual’s decision to save or consume at a given level of interest rates will depend upon two main things:

Marginal Rate of Time PreferenceTrading current consumption for future consumptionIncome and wealth effectsGenerally higher income – save more

A change in these variable will cause the level of saving at each level of interest rates to change.


RealInteres

t Rates

Level of Saving

An Increase in the Level of Output

Old DesiredSaving, S0

New DesiredSaving,S1

* Abel and Bernanke Macroeconomics

Saving Decisions Summary*

An increase in Saving will

Why?

Current Output Rise Saved for Fut Consumption

Expect Fut Output

Fall Fut Income rises, save less today

Wealth Fall Some wealth is consumed, S decreases at given Y

Expt Real Int Rate

Prob Rise Opportunity cost of capital

Government Pur Fall Higher G Lowers S

TaxesUnchanged or Rise

If taxes in fut are expected to fall no change in saving, If tax increase is perm S rises

The IS curve

The level of saving at each level of real interest rate increases with the level of output (national income).The IS curve is found by graphing the combinations of Y and r – In other words for a series of output levels, Y, find the corresponding equilibrium level of real interest rates r and then graph the combinations of Y and r (Y,r)

Example

Assume that at a level of output equal to 8000 the level of real interest rates is 7%If the level of output increases to 9000 you can find the equilibrium level of real interest rates from the Saving Investment diagram, lets say the new level of rates is 6%

Equilibrium in Goods MarketAt Various Output Levels

Real In

tere

st R

ate

Level of Saving

An Increase in the Level of Output

Desired Saving, Y0=8000

Desired Saving,Y1=9000r0=7%

r1=6%

Id

Deriving the IS curveR

eal In

tere

st R

ate

, r

Id,Sd

Id

S0(Y=8000)

S1(Y=9000)

8000 9000

7%

6% 6%

7%

IS

Y

Notes on IS

At each point on the IS curve Desired Investment = Desired SavingThis is the same point where Aggregate goods supplied equals Aggregate Goods Demanded (Closed Economy)The level of Interest Rates where Id =Sd is also the place where

Id=Y - C – G or Y =C + Id + G

Intuition

Assume that the economy was initially at Y0= 8000 and the level of output increased to Y1 = 9000.At the new level of output consumption and investment both increaseAt the old level of rates 7% the amount of saving is greater than the amount of investment, the real level of rates will decrease.

Shifts in IS Curve

The IS curve shows the level of interest rates needed for goods market equilibrium at each level of output.Keeping Output Constant – Any decrease in Desired Saving relative to Desired Investment will cause the IS curve to shift up and vice versa.

Intuition

A decrease in the supply of funds (Saving) with the same demand for funds (Investment) has caused a higher level of real interest rate at each level of output.There is a shortage of funds compared to the demand for funds so the level of real interest rates increases (assuming the same investment function).

Example: An Increase in Government Spending

We showed in the investment notes that an increase in government spending will cause a decline in the amount of saving at each level of output.

Id=Y – C- G()This would decrease the level of saving at

each level of real interest rates

Equilibrium in Goods MarketAn Increase in Government Spending

Real In

tere

st R

ate

Level of Saving

S1(Y0) S0(Y0)

r1

r0

Id

Adjustment to Equilibrium

At the original real level of interest rates Sd<Id

To bring the market back to equilibrium the level of interest rates increasesAs the level of rates increases the amount of investment declines along the Id curve until new equilibrium is reached

Equilibrium in Goods MarketAn Increase in Government Spending

Real In

tere

st R

ate

Level of Saving

S1(Y0) S0(Y0)

r1

r0

Id

Sd < IdS*=I*

A Shift in the IS CurveIncreased Government Spending

Real In

tere

st R

ate

, r

Id,Sd

Id

S1(Y0)

S0(Y0)

Y0

r1

r0 r0

r1

IS0

IS1

S*=I* S0=I0

Another Interpretation

Our model above showed that the IS shifted up at each level of output. Alternatively you could have said that the IS curve shifted right at each level of interest rates. This implies that the change increased the level of aggregate demand.

Y = Cd + Id + G()

Notes

Our example is based on the intuition in the loanable funds market. You can arrive at the same function in several different ways. The book assumes an exogenous change in interest rates that impacts both the Investment and Saving Functions but by different amounts – still graphing the relationship between Y and r.

Shifts in IS

An Increase in

Shifts IS Reason

Expect Fut Y Up (Right) Desired Saving Falls (C)

Wealth Up (Right) Desired Saving Falls (C)

Gov’t Spending Up (Right) Desired Saving Falls (C)

Taxes No Change orDown (Left)

No Change, if consumers expect future tax cut

Down if consumers C causing S

Marginal Prod Cap

Up (Right) Id causing r to increase

Effect Tax on Cap

Down (Left) Id causing r to decrease

Bus Sentiment Up (Right) Id causing r to increase

Documents

Business, Government, and the World Economy Consumption, Saving & Investment