Global Economics: PGP

Session 2: Consumption, Savings

and the Capital Market

Shekhar Tomar

June 4, 2019 GLEC: Session 2 1

Players in the Capital Market
Households Firms and Govt
•Firms:
Receive Income,
Issue Debt and Equity
Consume, and Save:
•Governments:
Buy Debt and Equity
Issue Debt
(Supply “funds”)
(Demand “funds”)

Savings Investment
Capital Market:
Determines rates of return
Supply of savings =
Demand for savings
(investment in new capital)
Intermediaries (Banks)
June 4, 2019 GLEC: Session 2 2
Background and Assumptions

• Understand the savings and investment dynamics

• The income-expenditure identity:

Y=C+I+G+NX

• Assumptions:
• G – exogenously given (determined by political process)
• Closed economy: NX=0

• This leaves C and I to be determined

• Affects the production decisions

June 4, 2019 GLEC: Session 2 3

HH side: Savings and Consumptions

• In equilibrium, Savings S = Investment I

• Savings and consumption are two parts of the same coin:

S= Y – C - G

• Consumption, C, is the large part of Y

• Savings rate differ by country

June 4, 2019 GLEC: Session 2 4

Measures of Saving

• Saving of any economic entity is its current income minus its

spending on current needs. It is simplest to think of households
doing all the saving and firms doing all the investment in machinery,
factories, etc.

• Private (household + business) saving:

Spvt = Private disposable income – Consumption

June 4, 2019 GLEC: Session 2 5

Saving Measures (more general)

• Government (federal + state + local) saving:

Sgovt = T - (G + TR + INT)
• T: Taxes, G: Govt. purchases, TR: Transfers, INT: Interest
on debt
• Sgovt < 0, if budget deficit
• National saving:
S = Y + NFP – C – G
=(C+I+G+NX)+NFP-C-G
= I + (NX + NFP) = I + CA

June 4, 2019 GLEC: Session 2 6

Destiny of Savings

• CA: Current Account

• S = Spvt + Sgovt = I + CA

• Therefore, Spvt = I + CA – Sgovt

• Private Savings finance I or CA or Government Deficits

• Closed economy: CA = 0 & S = I

June 4, 2019 GLEC: Session 2 7

Why Save?

• Consumption Smoothing:
• Depends on present value of income (present plus future income
stream)
• Save when income is high (mid-age), borrow when income is low
(young or old)

• Precautionary motive:
• Saving for rainy day

June 4, 2019 GLEC: Session 2 8

Consumption is smoother than income

June 4, 2019 GLEC: Session 2 9

Consumption over the life cycle
• Wealth accumulation is entirely driven by life-cycle motives

Income/
Income
Consumption

S>0
Consumption
S<0 S<0

Borrow Save Dissave

t
Also see: http://piketty.pse.ens.fr/fichiers/enseig/ecoineg/EcoIneg_fichiers/ModiglianiNobelLecture1985%28AER1986%29.pdf

June 4, 2019 GLEC: Session 2 10

The inter-temporal choice

• Consume versus save today  trade off present vs future

consumption
• Depends on consumer impatience and real rate of interest

• Impatience- deep parameter (given)

• Real Rate of interest, r - market determined

June 4, 2019 GLEC: Session 2 11

How ‘r’ impacts saving S?

↑ in ‘r’ can have two effects

• Substitution effect: Opportunity cost of consumption today goes up.

Substitute today’s consumption with tomorrow’s. Savings ↑.

• Income effect: Can save less to derive same consumption tomorrow.

Savings ↓.

• Ambiguous effect. For a large set of cases, substitution effect dominates.

June 4, 2019 GLEC: Session 2 12

Savings Curve
r (real interest
rate)

S (savings)

• ↑ in ‘r’ makes household savings ↑

June 4, 2019 GLEC: Session 2 13

How G impacts saving S?

Fiscal Policy: Temporary ↑ in ‘G’

• Higher G financed by higher taxes → reduces after-tax income → reduces

Consumption

• Even if taxes levied in the future, consumers will cut consumption today

• Since C declines less than rise in G, savings still decline: S = Y-C-G

• Govt. purchase reduce both C and S

June 4, 2019 GLEC: Session 2 14

Tax rate and saving
Tax cut where govt. does not cut its spending (financing by debt)

• Ricardian equivalence proposition

• If future income loss exactly offsets current income gain, no change in consumption

• Tax change affects only the timing of taxes, not their ultimate amount (present value)

• In practice, people may not see that future taxes will rise if taxes are cut today;
then a tax cut leads to increased desired consumption and reduced desired
national saving

June 4, 2019 GLEC: Session 2 15

How consumers react to tax rebates?
• The US government provided tax rebates in recessions of 2001 and 2008-09 to
stimulate the economy

Agarwal, Liu and Souleles (2007)

“We use a new panel data set of credit card accounts to analyze how consumers
responded to the 2001 federal income tax rebates. We estimate the monthly
response of credit card payments, spending, and debt, exploiting the unique,
randomized timing of the rebate disbursement. We find that, on average,
consumers initially saved some of the rebate, by increasing their credit card
payments and thereby paying down debt. But soon afterward their spending
increased, counter to the permanent income model.”

June 4, 2019 GLEC: Session 2 16

Investment

• Why is investment important?

• Investment fluctuates sharply over the business cycle, so

we need to understand investment to understand the
business cycle

• Investment plays a crucial role in economic growth

June 4, 2019 GLEC: Session 2 17

Firm Side: Investment

• Evaluate the cost and benefit of additional capital

• Competitive firm, that uses labor and capital for production

• In equilibrium:
• Marginal product of labor, MPL = W/P = w
• Marginal product of capital, MPK = R/P

• So the firm employs capital till the MPK equals real rental
rate

June 4, 2019 GLEC: Session 2 18

Capital demand to investment

• The demand for new capital or investment I:

Desired I = (Desired K – Current K) + Depreciation

• As desired K goes ↑, I goes ↑

• Note: K is a stock variable, I is a flow

June 4, 2019 GLEC: Session 2 19

Cost of Capital/Investment

• Intuitive to think of the real interest rate, r, as connected

to the cost of capital

• If a firm borrows to finance its investment, this is the

cost of the loan

• Why is the interest rate the cost of capital even when

the firm invests out of retained earnings?

June 4, 2019 GLEC: Session 2 20

Cost of Capital/Investment
• The no-arbitrage condition:
r = MPK – d
determines the desired capital stock. Or,
MPK = r + d

• Technically, should write MPKe (Kt+1) since the capital is

productive only next period

• The production firm’s profit maximizing condition is: MPK =

R/P. Put together to get: MPK = R/P = (r+d)

• “r” enters cost of investment in new capital. Hence a

downward sloping I(r) curve

June 4, 2019 GLEC: Session 2 21

Capital Demand to Investment Demand

MPK is Capital Demand r (real

R/P(real interest
rental rate)
rate)

Kd K I

• Desired K and I move one-to-one

June 4, 2019 GLEC: Session 2 22

Capital Market Equilibrium

• Match demand with supply:

• Desired savings=desired investment
• Supply of funds=demand of funds

• For closed economy: Y = C + I + G

• Savings, S = investment, I

• The real rate of interest adjusts till the above market clears
• Equilibrium r is given by intersection of savings and
investment curves

June 4, 2019 GLEC: Session 2 23

Capital Market Equilibrium

r
S (Supply by
households)

r*

I (Demand by firms)

S, I
S* = I*

June 4, 2019 GLEC: Session 2 24

Capital Market Equilibrium

r
S (Supply by
households)
Extra savings
by hh

r1

r*

I (Demand by firms)

S, I
S* = I*

June 4, 2019 GLEC: Session 2 25

Capital Market Equilibrium

r
S (Supply by
households)

r*
r2 I (Demand by firms)
Extra demand
by firms
S, I
S* = I*

June 4, 2019 GLEC: Session 2 26

Shocks to the capital market

• The equilibrium can shift, if the two curves shift

• Savings curve can shift:

• Change in govt. expenditure, G

• Investment curve can also shift:

• Technological innovation increases MPK

June 4, 2019 GLEC: Session 2 27

Change in G
• G goes up from G → G’
• S=Y-C-G → S’ = Y – C – G’

S’
r
S

r*’
r*

S*’ = I*’ S* = I* S, I

June 4, 2019 GLEC: Session 2 28

Technological shock
Capital Market

S
MPK r

A2>A1

R/P r*’
A2 I’
r*
A1 I
S* = I* S*’ = I*’
K I

• For any rental rate, desired K ↑ and hence I ↑

June 4, 2019 GLEC: Session 2 29

Supply-side Economics
• MPK is the return to capital (ignore depreciation temporarily).
Corporate income tax rate of t, effectively decreases return to (1-
t)MPK

• Shifts investment curve down and suppresses equilibrium

investment and economic activity

• Supply-side economists want to keep corporate tax rates low.

Argue that increased economic activity and tax base would still
yield enough tax revenues.

June 4, 2019 GLEC: Session 2 30

The Laffer Curve
Tax
Revenue

0 t0 t1 t2 Tax rate

• Very high or low tax rate do not yield maximum tax revenue

June 4, 2019 GLEC: Session 2 31

Time trend for savings

Source: http://mofapp.nic.in:8080/economicsurvey/pdf/043-054_Chapter_03_ENGLISH_Vol_01_2017-18.pdf

• What is the share of household savings?

June 4, 2019 GLEC: Session 2 32

Other Issues: Crowding Out

June 4, 2019 GLEC: Session 2 33

Tobin’s q and investment

• Firms change investment in the same direction as the stock market:

Tobin’s q theory of investment

• If market value > replacement cost, then firm should invest more

• Tobin’s q = capital’s market value divided by its replacement cost

q = V/(pKK),

• If q < 1, don’t invest

• If q > 1, invest more

• Stock market boom raises V, causing q to rise, increasing investment

June 4, 2019 GLEC: Session 2 34

Tobin’s q and investment, 1987-2012

Source ABC: Investment from authors’

calculations based on real
nonfinancial fixed investment
quantity index at bea.gov/iTable and
real nonfinancial fixed investment in
2005 dollars from St. Louis Fed
Web site at
research.stlouisfed.org/fred2/series/PNFI
C1; Tobin’s q from Federal Reserve
Flow of Funds Accounts, Table
B.102, for nonfarm nonfinancial
corporate business, market value
plus liabilities divided by assets.

June 4, 2019 GLEC: Session 2 35