Econ 309: Savings and Social Security

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Econ 309: Savings and Social Security. Keynesianism: The IS-LM Model. Keynes wrote The General Theory of Employment, Interest, and Money in 1936 The IS-LM model was developed by John Hicks for the Econometric Conference at Oxford, September, 1936

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### Econ 309: Savings and Social Security

Keynesianism: The IS-LM Model
• Keynes wrote The General Theory of Employment, Interest, and Money in 1936
• The IS-LM model was developed by John Hicks for the Econometric Conference at Oxford, September, 1936
• One of many attempts to make the General Theory more accessible, formal
• Hicks later became disillusioned with IS-LM and was ambivalent about receiving the Nobel Prize for it in 1972
Keynesianism: The IS-LM Model

P

LM

• IS curve: Y = C(Y-T) + I(r) + G
• LM curve: M/P = L(r, Y)

Ymax

IS2

IS1

Q

Keynesianism: IS-LM curve
• IS curve: Y = C(Y-T) + I(r) + G
• Assumption: Consumption is a functional of “disposable income” (marginal propensity to consume) and nothing else
• Assumption: Investment is a function of interest rates (though it can be exogenously shifted by “animal spirits”)
• Government spending does not affect either investment or consumption directly
• LM curve: M/P = L(r, Y)
• People have a liquidity preference, demanding more money and less
Keynesianism: The IS-LM Model
• Implications for policy
• Fiscal policy: An increase in government spending pushes the IS curve outward and raises GDP (if Y<Ymax)
• Monetary policy: An increase in the money supply pushes LM outward and raises GDP
• “Crowding out”: expansionary fiscal policy drives up interest rates and causes a fall in investment that partially offsets its effects
• Question: What if Y=Ymax?
Savings in Keynes
• IS curve: Y = C(Y-T) + I(r) + G
• Consumption, C, is a function of disposable income, Y-T
• Savings is the residual of disposal income after consumption, i.e. S = Y – T - C(Y-T)
• Savings behavior does not involve any thought for the future!
• What is the effect of a fall in the savings rate? C rises, and GDP rises
Basic Monetarism
• The equation of exchange: MV=PT, where
• M = money supply
• V = velocity of money
• P = price level
• T = volume of real transactions (i.e., real GDP)
• If V is constant (a major assumption), then:
• Monetary policy (interpreted as raising M) can increase real GDP, but might only increase inflation
• No obvious interpretation for fiscal policy
• “The triumph of monetarism”: in recent years (until 2009), economists have usually advocated monetary policy rather than fiscal policy
The Solow Model of Long-Run Growth

y=f(k)

• Yt = f(Kt), dY/dK > 0, d2Y/dK2 < 0
• Kt+1 = (1-n-d)Kt + sYt

(n+d)k

Y

sy

K

Savings in Solow
• As in the standard Keynesian model, savings is exogenously fixed
• What is the effect of a fall in the savings rate? The long-run growth rate falls
• IS-LM plus Solow: Savings are bad in the “short run,” good in the “long run”???
Digression: Ethics and discount rates
• Economists assume that people “discount the future”
• Revealed preference says:
• The future really is worth less than the present, if people systematically treat it so
• It is not irrational to discount the future
• Ordinary people find this view hard to accept
• Exponential vs. hyperbolic discounting:
• If discounting is exponential, people’s behavior is “time-consistent”
• If discounting is hyperbolic, people have time-inconsistent preferences
• Given economic growth, is it clear that people really do discount the future?
Gokhale: Social Security and Savings
• Gokhale’s explanations for the decline in the savings rate:
• Government redistribution of income from younger cohorts to older cohorts
• A rise in the consumption propensities of older cohorts due to annuitization of incomes
The decline in US savings rates
• (go to Gokhale, p. 7/320)
• Between 1950 and 1995, savings rate dropped from 11.5% to 3.4%
• Continued falling after that, to 0% or less, before rising sharply in 2008/09
US savings rates, 2000-2009

http://www.bea.gov/briefrm/saving.htm

Net national savings rate

Savings rate equals one minus consumption rate minus government spending rate