4. consumption, investment and saving

4. consumption, investment and saving - Consumption,...

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Consumption, Saving, and Investment 16 September 2010 1 Reading Chapter 4 of Abel/Bernanke/Croushore 2 Consumption and Saving Summing individual households’ choices of consumption, we have the level of desired aggregate consumption, C d . Recall that S = GNP C G. Assuming a closed economy for now, so that GNP = Y, whereby NFP =0 . Write C d for C ,wehave S d = Y C d G, the level of desired national saving. An increase in Y . C d increases but the increase is less than one—for—one, so that S d rises too. If the income increase is expected to be short—lived, much of it would be saved, and that the MPC is likely to be a small fraction. Conversely if the increase in Y is expected to be permanent, much of the increase would be used to increase current consumption, with very little being set aside for saving. There is a MPC close to one. An increase in expected future income . The desire to smooth consumption over time implies that C d would increase immediately. With Y in the current period not changing, there is a decline in S d . An increase in non—labor income (wealth) . The increase in C d with Y not changing, once again, implies a decline in S d . The ups and downs in the stock market are important sources of f uctuations in non—labor income. 1
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Figure 1: Consumption and the stock market 3 Stock market and consumption Consumption and the 1987 crash: When the stock market crashed in 1987, wealth fell by about 1 trillion dollars. Consumption should fall but by less than the trillion dollar decline because households would spread the losses over a long period of time by consumption smoothing. If the planning horizon is about 25 years, the annual decline should be about 40 billion dollars. But if households expect that the stock market crash would lead to a recession from which income falls further, they may cut consumption a bit more. It turned out that the actual decline was much less than 40 billion, and there was no recession to follow. Consumption and the rise in stock market wealth in the 1990s. Stock prices more than tripled in real terms over the decade. But consumption was not strongly a f ected by the runup in stock prices. From 1995 to 1998, stock prices increased signi f cantly, but the ratio of consumption to GDP fell. Consumption and the decline in stock prices in early 2000s. In the early 2000, stock market wealth declined by about 5 trillion dollars. But consumption as a ratio of GDP rose. 2
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4T h e e f ect of changes in the interest rate The e f ect of changes in the real interest rate. There is a positive income e f ect on consumption for savers and a negative e f ect for borrowers. For the economy as a whole, and if asset holding is positive, the e f ect is positive. There is also a negative substitution e f ect on consumption for everyone. Empirical evidence suggests a somewhat negative e f ect on consumption, and thus a slight positive e f ect on saving. Important to remember that it is the expected real interest rate, the nominal interest rate minus expected in
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4. consumption, investment and saving - Consumption,...

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