SMU Classification: Restricted

Lecture 4
Consumption and Saving
 SMU Classification: Restricted

Consumption and Saving

• The importance of consumption and saving
▪ Desired consumption: consumption amount desired by households
▪ Desired national saving: level of national saving when consumption is at
its desired level:

Sd = Y – Cd – G

• The consumption and saving decision of an individual

▪ A person can consume less than current income (saving is positive)
▪ A person can consume more than current income (saving is negative)
 SMU Classification: Restricted

Consumption and Saving

• Consumer’s current-period budget constraint (individual level):
c + s = y −t
• Consumer’s future-period budget constraint:

c' = y'−t '+(1 + r )s

• Substitute in the current-period budget constraint obtaining lifetime

budget constraint:
c'− y '+t '
s=
1+ r
 SMU Classification: Restricted

Consumption and Saving

• Consumer’s Lifetime Budget Constraint
c' y '−t '
c+ = y −t +
1+ r 1+ r
• Consumer’s Lifetime Income
y '−t '
we = y − t +
1+ r
• Simplified Lifetime Budget Constraint
c'
c+ = we
1+ r
• Simplified Lifetime Budget Constraint:

c' = −(1 + r )c + we(1 + r )

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A Consumer’s Indifference Curves

The consumer’s preferences:

▪ More is always preferred to less.
▪ The consumer likes diversity in his or her
consumption bundle.
▪ Current consumption and future consumption
are normal goods.

MRSc,c’: The marginal rate of substitution of

consumption in the current period for consumption in
the future period

MRSc,c’ at point A is minus the slope of a tangent to

the indifferent curve at point A
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Optimization
• Marginal condition that holds when the consumer is optimizing:
MRS c ,c ' = 1 + r
▪ The MRS of current consumption for future consumption is equal to the relative price of current
consumption in terms of future consumption, 1+r.

• A Consumer Who Is a Lender

▪ The endowment point is at E

▪ The consumer chooses the
consumption bundle at point A,
where (c,c’)= (c*,c’*).
▪ Saving: s=y-t-c*, or the distance BD
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A Consumer Who Is a Borrower

▪ The endowment point is at E

▪ The consumer chooses the

consumption bundle at point A,
where (c,c’)= (c*,c’*).

▪ The quantity the consumer borrows

in the first period is -s=y-t-c*, or the
distance DB.
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Consumption and Saving

• The consumption and saving decision of an individual
▪ Trade-off between current consumption and future
consumption
➢The price of 1 unit of current consumption is 1 + r units of future
consumption, where r is the real interest rate
➢Consumption-smoothing motive: the desire to have a relatively
even pattern of consumption over time
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1. Effect of changes in current income

▪ Increase in current income: both consumption and saving increase (vice versa for
decrease in current income)
▪ Aggregate level: when current income (Y) rises, Cd rises, but not by as much as Y, so Sd
rises

y '−t '
▪ Lifetime wealth increases from we1 = y1 − t +
y '−t ' 1+ r
to we2 = y2 − t +
1+ r
➢ Current income rises from E1 to E2.
➢ Current consumption rises from c1 to c2 (A to B)
➢ Saving increases: ∆s=∆y-∆t-∆c>0
➢ The consumer acts to smooth consumption over time.
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2. Effect of changes in expected future income

▪ Higher expected future income leads to more consumption today, so saving
falls

3. Effect of changes in wealth

▪ Increase in wealth raises current consumption, so lowers current saving
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2. Effect of changes in expected future income

▪ Suppose future income y’ rises fro point A to D

▪ Consumption bundle from A to B (c1 to c2)
▪ No change in current income: ∆y=∆t=0
▪ Savings goes down: ∆c>0, therefore ∆s<0.
▪ The increase in future consumption (AF) is less
than the increase in future income (AD)

➢ The consumer wants to smooth consumption

over time: rather than spend all the increase in
income in the future, the consumer saves less
in the current period so that current
consumption can increase.
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Temporary and Permanent Increases in Income

• As a permanent increase in income (both current and future income) will have a
larger effect on lifetime wealth than a temporary (only current income) increase,
there will be a larger effect on current consumption.

• A consumer will tend to save most of a purely temporary income increase.

• Permanent income theory: a theory that states that consumption depends on the
present value of lifetime resources, with the implication that consumption responds
much less to temporary than to permanent changes in income
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Temporary Versus Permanent Increases in Income

▪ Temporary: an increase in income that occurs only in the

current period (AB to DE)
▪ Permanent: an increase in income occurring in the current
period and the future period. (AB to GF)

• Assume: y’2-y’1= y2-y1

• Temporary:
▪ Consumers choose from H to J, c1 to c2.
▪ y2-y1= HL
▪ c2-c1 <y2-y1
• Permanent:
▪ Consumers choose from H to J and to K, therefore c1 to c3.
▪ y’2-y’1= LM
▪ A larger effect on current consumption
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4. Effect of changes in real interest rate

1
• is the relative price of future consumption goods
1+𝑟
in terms of current consumption goods.

• An increase in the market real interest rate decreases

the relative price of future consumption goods in
terms of current consumption goods – this has income
and substitution effects for the consumer.

• The budget constraint is steeper .

➢ slope is –(1+r)
➢ we(1+r)=(y-t)(1+r)+y’-t’
➢ Wealth: we1 to we2
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An Increase in the Real Interest Rate for a Lender

• The budget constraint pivots around E.

▪ E: endowment point

• Consumer chooses from A to B

➢ Substitution effect: c decreases, c’ increases (A
to D)
➢ Income effect: both c and c’ increase (D to B)
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An Increase in the Real Interest Rate for a Borrower

• Consumer chooses from A to B

➢ Substitution effect: c decreases, c’ increases
(A to D)
➢ Income effect: both c and c’ decrease (D to B)
➢ Savings must rise.
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4. Effect of changes in real interest rate

▪ Increased real interest rate has two opposing effects

✓Substitution effect: Positive effect on saving, since rate of return is
higher; greater reward for saving elicits more saving
✓Income effect
• For a saver: Negative effect on saving, since it takes less saving to obtain a
given amount in the future.
• For a borrower: Positive effect on saving, since the higher real interest rate
means a loss of wealth, borrow less (or save more)

▪ Empirical studies have mixed results; a slight increase in aggregate saving

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Perfect Complements Example

• With perfect complements, the ratio of future consumption to
current consumption is constant.
c' = ac

• The consumer’s budget constraint must hold.

c'
c+ = we
1+ r
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Perfect Complements Example

• With perfect complements we can solve explicitly for current and
future consumption:

we(1 + r )
c=
1+ r + a

awe(1 + r )
c' =
1+ r + a
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Perfect Complements Example

• Substituting for lifetime income gives:

( y − t )(1 + r ) + y '−t '

c=
1+ r + a

 ( y − t )(1 + r ) + y '−t ' 

c' = a  
 1 + r + a 
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Example with Perfect Complements Preferences

• The consumer desires current and future

consumptions in fixed proportions, with
c’=ac.

• The optimal consumption bundle is at

point D on the lifetime budget constraint
AB
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Summary : Determinants of Desired National Saving

 SMU Classification: Restricted

Consumption and Saving

• Aplication: the Idiosyncrasy of Singapore Aggregate Consumption

❖ The average propensity to

consume (APC) in Singapore
(1960–2008)

❖ Marginal propensity to consume

(MPC) = fraction of additional current
income consumed in current period;
between 0 and 1

❖ As a country develops, consumption

ratio should increase or at least
remain stable, but in Singapore the
average propensity to consume has
fallen.
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Consumption and Saving

• Application: The Idiosyncrasy of Singapore Aggregate Consumption

▪ The main explanation was the rise in loans and withdrawals from the Central
Provident Fund to finance housing and car purchases, which affect residents’
wealth accumulation and restrict their disposable income and consumption
capacity over time.

▪ This is cause for policy concern because, in most countries, aggregate consumption
expenditure is a stabilizing component in final aggregate demand.
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Takeaway

• Consumer’s problem in two period model

• Effect of changes in current income
• Effect of changes in future income and wealth
• Effect of changes in real interest rate