Chapter 4: Consumption, Saving and investment

Question 1

Recall the equation for savings

Answer 1

Sd=Y-Cd-G, where Sd = desired savings and Cd= desired consumption

Question 2

Why do consumers save?

Answer 2

Because consumers tend to “smooth” their consumption, or maintain a steady level of consumption in spite of potential fluctuations in their income.

Question 3

What is the effect of a current change in income on consumption and savings?

Answer 3

A one-time increase or decrease in income will increase savings and consumption or decrease savings and consumption respectively.

Question 4

What is the effect of an expected change in future income on consumption and savings?

Answer 4

An individual expecting an increase in future income would, according to the consumption smoothing motive, increase current as well as future consumption. However, since the individual’s current income remains unchanged, he will have to save less in order to consume more in the present: therefore, if expected future income increases, current consumption increases and current savings decreases. Vice versa for a decrease in expected future income, which would prompt the individual to save more in order to maintain the same level of consumption in the future.