Consumption & Saving

- Output (Y) = Consumption (C) + Investment (I) + Government (G)

-

National Saving = Private Saving (S private) + Public Saving (S public)

- Saving by the private - Saving by the

sector government
- Consumers’ - Government
disposable income revenues minus the
minus their government spending
consumption - Budget surplus (A
budget deficit ->
public dissaving)

- Private saving is income that is not consumed.

Saving(private) = Y – T – C
- Public saving is amount of taxes the government has left over after it makes it purchases.
Saving(public) = T – G

- In the US economy, a large percentage of their GDP comes from private saving. National
saving is very often below private saving. As for government saving, it is always negative, this
signifies that the government is running a budget deficit.

The reasons why a government is running a budget deficit is numerous; but according to the
Keynesian Model, the government only runs a deficit during a recession. The Keynesian
Model especially would advocate for deficit spending on labor-intensive infrastructure
projects to stimulate employment and stabilize wages during economic downturns.

- What is consumption smoothing?

The desire to have relatively even pattern of consumption over time, rather than to have a
lot of consumption in one period but very little consumption in another period.
- Trade off between current and future consumption occurs in interest rate.

Interest rate is the opportunity cost of current consumption, consuming current income
means that I forgo the opportunity of saving it with growth in interest rate that is expected.

Therefore,
Price of 1 unit of current consumption = 1 + r units of future consumption

- What is intertemporal choice?

 The backbone of the consumption maximization model is assumptions relating to
intertemporal choice, which simply means choices made over time. The key assumption
is that consumers are forward looking, and they choose consumption for the present
and future to maximize lifetime satisfaction. When people decide how much to
consume and how much to save, they consider both the present and the future.
 [Constrained consumption maximization model]
With the consumption maximization model, it comes with a constraint: intertemporal
budget constraint. This simply means budget constraint over time, due to say changing
income. The intertemporal budget constraint is a measure of the total resources
available for present and future consumption.

- What is the Life-Cycle Model?

 Derived from Milton Friedman’s permanent income hypothesis.
 The hypothesis is a model in the field of economics to explain the formation of
consumption patterns. It suggests consumption patterns are formed from future
expectations and consumption smoothing.
- What is the consumer’s consumption-saving decision about?
 It introduces a 2-period model that looks at studying saving and investment in the goods
market, which is otherwise unachievable using the one-period model

- What can a 2-period model show?

 Representative consumer/worker
 Supplies labour in the current period labour market [Maximize Utility]
 Demands consumption goods in the current period goods market [Spend]
 Saves the remainder of income [Save]
 Representative firm
 Demands labour in the current period
 Supplies goods in the current period
 Demands investment goods in the current period (as they become capital stock in
the next period)
 In a 2-period model,
 Lower case: denotes individual’s variables
 Upper case: denotes aggregate variables
 All variables are measured in real terms (in units of output), no dollar signs!

- How to derive intertemporal budget constraint (without tax yet)?

1) First, pen down Period 1’s budget constraint, which is equal to Saving = Income –
Consumption in Period 1.
2) Next, pen down Period 2’s budget constraint, which is equal to
Saving in Period 1 x (1+r) = Income – Consumption in Period 2
 Why multiply Period 1 saving with (1+r)?
 We are trying to compound the present value forward in time to the future. Future
consumption is paid for out of savings that have earned interest or future income,
future consumption thus costs less than current consumption too.

If we want to move a future value backward in time to the present, we discount it.
Meaning, we divide it by (1+r). For example, if we want to find out how much does
Consumption in Period 2 is equivalent to Period 1’s value, we divide the
Consumption in Period 2 by (1+r).

3) Then substitute 1) into 2) to express the intertemporal budget constraint as a

function of C1.

 Why is it expressed as a function of C1 and not C2?

This is because this is a 2-period model. In period 1, consumer chooses C1 and thus
S1. And in period 2, C2 must come from any income in Period 2 AND accumulated
savings from Period 1.

So, C2 is not a choice variable once C1 has been chosen. C2 is very dependent on C1
and is hence not chosen.

- How to convert Present Value $X to the Future Value of the same $X in T years?

- How to convert $X today with interest rate r to its future value in T years?
- How to derive the marginal rate of substitution for the model on consumer’s consumption-
saving decision?
 What it means? The amount of C2 a consumer is willing to substitute for one unit of C1.

- What does discount factor, beta refer to?

 Discount factor is always between the number 0 and 1 (because the value of today’s
dollar will intrinsically be worth less in the future due to inflation and other factors)
 It measures how the level of patience in a consumer, and alternatively the importance of
future rewards.
 A higher discount factor also means that the consumer is more patient now, this means
that he will pull off current consumption and consume more in the future because he
sees that the future utility is worth more today.
 If discount factor is more than 1, action values may diverge??
 If discount factor is 0, this means that consumer is short sighted and only considers
current rewards.
 If discount factor approaches 1, consumer is striving for a long-term high reward.

- Presenting intertemporal utility maximization workings:

 Always write down the maximization problem and its budget constraint first. Then,
express C2 as a function of C1, afterwards convert the constrained maximization
problem into a one variable unconstrained one.
- Explaining the relationship between U(C1), U’(C1), r and p:

 P here stands for the rate of time preference. And is derived by:
B = 1/(1+p)

 Meaning behind the economic intuitions of the image above: