Macroeconomic Analysis

Econ 6022

Lecture 2

Fall, 2021

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 Goals

• In Solow model we assume that saving rate is constant.

• In other words, we have not understood the households
saving behavior.
• In this lecture, we want to study why household save and
why they save that much.
• Introduction to inter-temporal approach
• Foundations for business cycle theories

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 Plan

• What’s consumption?
• How do economists think about consumption? The
inter-temporal approach
• Permanent income theory
• Precautionary savings
• Applications:
- Saving puzzle in China
- The decline of household saving rate in the U.S.

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 Understanding Consumption

• Important part of the GDP: accounts for more than 2/3 of

GDP in the US; even higher part of GDP in developing
countries. (But in China, the consumption share is
relatively smaller, why?)
• Components of aggregate consumption: Food, clothing,
transportation, health care, housing services, cars ...

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 Consumption
• How do people consume and save?
• What key economic forces shape their decisions? The
micro-foundations of consumption
• We really need to think dynamically. why?
• Saving means you give up current consumption for future
consumption
• Inter-temporal approach
• maximize a lifetime utility function that depends on current
and future consumption
• forward looking: people recognize that income in the
future may differ from income today, and such differences
influence consumption today
• choose an optimal consumption path (or consumption at
each period)

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 The Neo-classical consumption model

• We think of time involving “today” and “future”

• People may earn income today and in the future, they
consume today and in the future.
• A key decision they have to make is how much to
consume today versus in the future.
• In your micro class, you learn that people choose a bundle
of Apples and Bananas to maximize their utilities

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 Parts of the model: Utility function

• Replace apples and bananas with “today” and “future”

• Life time utility:
U = u(ctoday ) + β · u(cfuture )
• u(·):u 0 (·)
> 0; u 00 (·) < 0
• β is discount factor, which captures the weight you place
on the future relative to today.
• β < 1: a given flow of utility is worth more when it occurs
today
• β = 1: you treat utility flows today and in the future equally

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 Parts of the model: inter-temporal
budget constraint
• income vs. wealth (flow vs. stock)
• constraint:
consumption + saving = income
• making decision on ctoday or ffuture at the beginning of the
period, where ffuture is the end-of-period wealth.
• today, the constraint:
ctoday = ytoday − (ffuture − ftoday )
• future, the constraint:
cfuture = yfuture + (1 + r ) · ffuture
• Present value of consumption = financial wealth + human
wealth = total wealth
c y
ctoday + future = ftoday + (ytoday + future )
(1 + r ) 1+r
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 Key Assumptions

• Consumption in any given year can be different from the

income
• it is possible to borrow today : consume more than labor
income today
• it is also possible to save today : consume less than labor
income today
• what must be true is that the present value of consumption
equals the present value of lifetime resources

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 Choosing the consumption to maximize utility
maxctoday ,cfuture U = u(ctoday ) + β · u(cfuture )

subject to
cfuture
ctoday + =W
1+r
Let’s transform the problem,

maxctoday U = u(ctoday ) + β · u((1 + r ) · (W − ctoday ))

First Order Condition:

u 0 (ctoday
∗ ) + β · u 0 (cfuture
∗ ) · (1 + r )(−1) = 0

or Euler equation,

u 0 (ctoday
∗ ) = β · (1 + r ) · u 0 (cfuture
∗ )

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The Euler Equation

u 0 (ctoday
∗ ) β · u 0 (cfuture
∗ )
= 1
1 1+r

Or

u 0 (ctoday
∗ ) 1
∗ =
β· u 0 (cfuture ) 1
1+r

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 The Euler equation

• Any other consumption plans (ctoday , cfuture ) are not

optimal.
• Given (ctoday , cfuture ), Euler equation does not hold.
• You can always increase or decrease ctoday (or cfuture ) to
improve your welfare.
• For example, (ctoday , cfuture )
u 0 (ctoday ) < β · (1 + r ) · u 0 (cfuture )
• You can decrease ctoday by one dollar, which increases
your welfare.
• You should keep doing it, until the Euler equation holds
with equality.

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 The Euler equation

A thought experiment (Approximation): The optimal

∗
consumption is (ctoday ∗
, cfuture ) and you consider deferring
consumption today by a (very) small amount of ∆c.
• the cost of deferring is ∆c · u 0 (ctoday
∗ )
• the benefit of deferring is,
∆c · (1 + r ) · u 0 (cfuture
∗ )·β
• Given the optimal consumption choice, you must be
indifferent between deferring and not deferring
u 0 (ctoday
∗ ) = β · (1 + r ) · u 0 (cfuture
∗ )

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 Example: Log Utility

1
• u(c) = log(c) and u 0 (c) =
c
• the Euler equation reads,
1 1
∗ = β · (1 + r ) · ∗
ctoday cfuture
• rearrange it
∗
cfuture
∗ = β · (1 + r )
ctoday
• consumption profile
• β · (1 + r ) > 1, cfuture
∗ ∗
> ctoday
• β · (1 + r ) = 1, cfuture
∗ ∗
= ctoday

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 Example: β = 1
the Euler equation,
∗
cfuture ∗
= ctoday
1+r
inter-temporal budget constraint,
c∗
∗
ctoday + future = W
1+r
so, the present value of future consumption equals
consumption today
∗ 1
ctoday = ·W
2
and
∗ 1
cfuture = · (1 + r ) · W
2
Or
∗
cfuture 1
= ·W
1+r 2
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 Effects of a rise in r on consumption

∗
• Does ctoday change if r increases?
y
• W = ftoday + (ytoday + future )
1+r
• ctoday decreases in r . It is called wealth effect.
• it works through the total wealth.
• Think about substitution effect and income effect. They
cancel out under log utility.
• Substitution, income and wealth effects. (see the
supplementary note online.)

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 Permanent income hypothesis
• Observation: the consumption today is independent of
the current income
• it is proportional to a consumer’s overall wealth, W
• ... which depends on the present discounted value of
income.
• consumption does not track the current income but is
determined by permanent income.
• In other words: consumption profile is independent of the
income profile
• Keep W the same, change ytoday and yfuture , consumption
profile does not change
• If ytoday is too high (low), relative to yfuture , you save
(borrow).

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 Marginal propensity to consume

• How does ctoday respond to a temporary increase in

income, say 100 HKD?
• Continue the example with log utility and β = 1
• you should consume only 50 HKD, instead of 100 HKD
• you smooth out the windfall over both of the periods
• we call the ratio, 1/2, marginal propensity to consume
• if we increase the number of periods in his life, for example
to 80 periods, where each periods represents a year of life,
then the marginal propensity to consume is approximately
equal to one divided by the number of periods (show it is
true, given β = 1 and r = 0 in problem set 2)

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Income shocks and permanent income theory
• if one expects to live for another 50 years and he gets an
temporary increase in current income, then he only
consumes roughly 2% of the windfall and save almost 98%
of it.
• if one expects to live for another 50 years and he gets an
permanent increase in his income, then he consumes all
the increase.
• suppose one expects to live many periods from now,
• unexpected temporary shocks:
• Announce an increase in y2 at the beginning of Period 2
• Announce an increase in y3 at the beginning of Period 2
• unexpected permanent shocks:
• Announce an increase in income from Period 2 on at the
beginning of Period 2
• Announce an increase in income from Period 3 on at the
beginning of Period 2

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 Borrowing constraint

• A key assumption: borrow and save freely at the market

interest rate r
• For some people, it is not true! examples...
• in this case, we say you are borrowing constrained!
• constrained by the lack of borrowing opportunities
• Suppose you want to borrow today, but you are somehow
borrowing constrained. how much do you consume today?
• What’s your marginal consumption propensity, if you are
borrowing constrained?
• What does your consumption profile look like, if your
income increases over time but you are borrowing
constrained?

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 Saving puzzle in China

• China: a fast growing economy.

• Saving rate on average is high: National saving rate
reached 53% in 2007.
• “Chinese saving puzzle”.

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High National Saving Rate in China

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 High National Saving Rate in China

Source: World Development Indictors (World Bank, 2009)

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Household, Enterprise and Government Saving as
Percentage of GDP, 1992-2007

Source: NBS (1995-2009).

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The URBAN Household Income and Saving

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 Saving Rates by Income Levels, 1988-2007

Source: UHS data, 1988-2007.

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3-year Moving Average Saving Rates by Region,
1988-2007

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Household Saving Rates and Demographic Structure,
1988-2007

Source: UHS data, 1988-2007. 28 / 48

 Cross-Sectional Age-Saving Profiles

• The fact is robust that the urban household’s saving rate

increases.
• Both life-cycle earning and age-saving profiles of
urbane household have changed substantially.

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Age-Saving Profiles by Age of Household Head

Source: UHS data, 1988-2007.

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 Cross-Sectional Age-Saving Profiles

• Age-Saving Profiles in early 90’s

• Age-Saving Profiles in 2007
• Bigger increase in young and old cohorts’ saving rate
• To understand the increase in household saving rate, it is
crucial to explain young and old corhorts saving pattern.
• Due to time constraint, we discuss their explaination of the
increase in saving rate of younger cohorts.

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Cross-Sectional Life-Cycle Earnings Profiles

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Cross-Sectional Life-Cycle Earnings Profiles

• Life-Cycle Earnings Profiles

• Life-cycle earning profiles flattens in China
- Young corhorts enter the labor market with relatively higher
earnings.
- Earning profile becomes less steep.

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Simplified Version

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The Great Famine and Thrift (Chen and Rupelle,
2016)
How people value thrift should be affected by the famine.

• World Value Survey describes a list of ten characteristics

“Independence,” “Hard work,” “Feeling of responsibility,”
“Imagination,” “Tolerance and respect of other people,”
“Thrift, saving money and things,” “Determination and
perseverance,” “Religious faith,” “Unselfishness
(generosity),” “Obedience,” “Self-expression.”
• Pick five qualities that they consider to be especially
important for children to learn at home.
• People who give priority to thrift are more patient and take
more effort to cultivate thrift in children.
• The World Value Survey of 1990, 2001, 2007 and 2012.

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 Quality to teach to a child

Table: Thrif - Linear probability model - Excess death rate, instrumented by province area affected by natural disasters.

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
thrift hard work imagination determination unselfishness religion tolerance responsibilities obedience independence
Excess death rate 0.021** 0.011 -0.004 0.006 0.015 -0.004 0.004 -0.002 0.001 0.001
(0.01) (0.01) (0.01) (0.01) (0.01) (0.00) (0.01) (0.01) (0.00) (0.01)
Age, age squared, gender Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Education Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Party membership Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Has a child Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
City size Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Per capita income (province - log) Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
1956 and 1958 climatic conditions Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
1956 gdp per capita Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
1956 grain production Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
1956 leader Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
2002 leader Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Year dummy Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Observations 5554 5554 5554 5554 5554 5554 5554 5554 5554 5554
Adjusted R-squared 0.0301 0.0439 0.0359 0.0412 -0.0157 -0.00913 0.0268 0.00749 0.0204 0.0377
KP F-stat 10.36 10.36 10.36 10.36 10.36 10.36 10.36 10.36 10.36 10.36

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 Household Saving data

• The 2002 Chinese Household Income Project (CHIP) rural

sample: 9200 households from 961 villages and 122
counties.
• Income: The self-declared income value by households
and disaggregate income items from various sources.
• Expenditures: The value of expenditures that is
aggregated from all the survey items Details .
• We estimate:
log(Y /C)ikj = βFj + ηi Zi + ηk Zk + ηj Zj + ikj

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 The Famine Impact on Current Saving Rate
(1) (2) (3) (4) (5) (6)
Famine survival index -0.290* -0.343** -0.343** -0.320** -0.333**
(0.15) (0.15) (0.16) (0.16) (0.16)
famine X 1 inc. quart. -0.361*
(0.20)
famine X 2 inc. quart. -0.008
(0.15)
famine X 3 inc. quart. 0.159
(0.14)
One child policy index -0.285**
(0.14)
Household basic Yes Yes Yes Yes Yes Yes
Conditions, rain shocks Yes Yes Yes Yes Yes No
Household characteristics No Yes Yes Yes Yes Yes
Growth No No Yes Yes Yes No
Land, income and migration No No No Yes Yes Yes
Observations 6575 6575 6575 6575 6575 6575
Number of villages (FE) 659
Adjusted R-squared 0.0675 0.0788 0.0800 0.308 0.314 0.219
KP F-stat 12.84 12.40 14.36 13.64 14.82 21.05
Hansen J p-value 0.343 0.295 0.339 0.356 0.368 0.185

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 Consumption, Saving and Uncertainty

• So far, we have been working with a model without

uncertainty.
• Uncertainty is important
• How does saving or consumption behaviors respond to
uncertainty in the future?
• Precautionary savings: formalization in a two period model.
• We keep the structure of the previous model without
uncertainty.
• Assume that ytoday = yfuture , permanent income theory
predicts that c1∗ = c2∗ = ytoday , if r = 0 and β = 1

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 Precautionary Savings
• Key difference: Assume that income in the first period,
y1 = ytoday , is certain, but income in the second period, y˜2 ,
is uncertain.
• To compare with the previous model, we assume
E(y˜2 ) = yfuture and (1 + r ) · β = 1

max u(c1 ) + β · E{u(c˜2 )}

c1

s.t.
c˜2 y˜2
c1 + = y1 +
1+r 1+r
The Euler condition is:

u 0 (c1∗∗ ) = E[u 0 (c˜2 ∗∗ )] (1)

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 Taylor Expansion
• We approximate u 0 (c˜2 ∗∗ ) around c¯2 ≡ E{c˜2 ∗∗ },
1
u 0 (c˜2 ∗∗ ) ≈ u 0 (c¯2 ) + u 00 (c¯2 )(c˜2 ∗∗ − c¯2 ) + u 000 (c¯2 )(c˜2 ∗∗ − c¯2 )2
2
• Taylor Expansion: at point x = a

f 0 (a) f 00 (a)
f (x) = f (a) + (x − a) + (x − a)2
1! 2!
• In our case, f (x) = u 0 (x), x = c˜2 and a = c¯2
• Take expectation,
1
E(u 0 (c˜2 ∗∗ )) ≈ u 0 (c¯2 )+u 00 (c¯2 )E(c˜2 ∗∗ −c¯2 )+ u 000 (c¯2 )E(c˜2 ∗∗ −c¯2 )2
2
• Euler equation becomes
1
E(u 0 (c˜2 ∗∗ )) ≈ u 0 (c¯2 ) + u 000 (c¯2 )σc2˜2 ∗∗
2
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 Precautionary Savings

• Euler equation (1) becomes

1
u 0 (c1∗∗ ) = E{u 0 (c˜2 ∗∗ )} ≈ u 0 (c¯2 ) + u 000 (c¯2 )σc2˜2 ∗∗
2
• If u 000 (·) = 0, c1∗∗ = c1∗
• If u 000 (·) 6= 0 , c1∗∗ 6= c1∗
• Is c1∗∗ higher or lower than c1∗ ?
• If c1∗∗ = c1∗ , is it true that c2∗ = c¯2 ?
• u 000 (·) > 0 leads to lower c1∗∗ or extra savings.
• Precautionary savings = c1∗ − c1∗∗

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 Precautionary Savings

• u 000 (·) characterizes Prudence.

• Prudence v.s. Risk aversion
• Convex u 0 (c) v.s. Concave u(c)
• Uncertainty and precautionary savings: A rise in
uncertainty about ỹ2 causes c̃2 to be more variable and
also raises E(u 0 (c̃2 ))
• Wealth and precautionary savings: higher initial wealth
provides a buffer for bad income shock in the future and
leads to lower precautionary savings.
• Uncertainty and precautionary savings: higher uncertainty
in the future income leads to more precautionary savings.
• An example with close form in the online note.

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 Household saving rate in the U.S.
96 PCE / DPI

12
Personal Saving Rate

10
94

Personal Saving Rate

8
92
PCE /DPI

6
90

4
88

2
86

1940 1960 1980 2000

Years

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Consumption as share of GDP in the U.S.

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 Household saving rate in the U.S.

• The household saving rate declined in the period of 1980

to 2000.
• Winter and Chen (2011) develops a theory to explain that.
• Earning risk and precautionary savings motive.
• Deregulation in housing finance market in early 80’s.
• Refinancing became much easier.
• The household portfolio become much more liquid.
• Household choose to cut down liquid asset, savings.

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 Hypothesis: Changes in Housing Finance

Earning Risks and Traditional Mortgage Loan

• If the market is incomplete, households can only self-insure
against adverse income shock with precautionary savings.
• Mortgage payment is not state-contingent.
• Adjusting housing size is costly.
• Mortgage payments amplify the impact of earning risks on
precautionary savings (Committed expenditure risk,
Frattantoni, 2001)

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 Hypothesis: Changes in Housing Finance

Refinancing and Precautionary Savings

• Refinancing allows households to access their home
equity accumulated in the past.
• Housing wealth can be used to smooth bad income
shocks.
• Refinancing allows households to change the payment
steam over time.
• Housing wealth becomes more liquid and the demand for
precautionary saving decreases.
• Implicitly, refinancing becomes an additional risk-sharing
channel for home-owners.

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