Personal Finance and Macroeconomics

Lesson 3: Personal Savings and Macroeconomic Factors

1. Personal Saving, Disposable Income, and Breakeven Point

  • Personal saving is the portion of disposable income not spent on consumption. It’s what remains after covering basic needs and discretionary expenses.
  • Disposable income (DI) is the income remaining after taxes are deducted, available for spending and saving. DI = Income – Taxes
  • Breakeven point is when income equals expenditures, preventing savings. Any additional income must be saved or spent.

2. Determinants of Consumption

Consumption depends on:

  • Current disposable income: Higher disposable income generally leads to increased consumption.
  • Permanent disposable income: Consumption is often based on long-term income expectations (Friedman’s Permanent Income Hypothesis).
  • Net wealth: Wealthier individuals tend to spend more.
  • Interest rate: Higher rates may discourage consumption as saving becomes more attractive, and borrowing costs rise.
  • Human wealth: Expected future income from labor/skills influences current consumption.
  • Non-human wealth: Financial assets (stocks, bonds, property) positively influence consumption.
  • Life cycle: Individuals plan consumption/saving over their lifetime (Life-Cycle Hypothesis). Young people may borrow, while older individuals save for retirement.

3. Determinants of Investment

Investment decisions are influenced by:

  • Interest rate: Lower rates reduce borrowing costs, encouraging investment.
  • Revenue and profits: Firms invest anticipating future profits. Higher current profits provide internal funds.
  • Costs: Production costs (wages, energy, materials) affect investment decisions.

Lesson 4: Fiscal Policy

1. Components of Fiscal Policy

  • Taxes: Government revenue; higher taxes can reduce disposable income, impacting consumption and investment.
  • Government expenditure: Spending on goods/services (infrastructure, education, defense); directly increases aggregate demand.

2. Budgetary Concepts

  • Budget deficit: Expenditures exceed revenues, often financed by borrowing.
  • Budget surplus: Revenues exceed expenditures, enabling debt reduction.
  • Debt: Accumulated past deficits; high levels may increase borrowing costs.
  • Risk premium: Higher government debt may increase risk premiums as investors demand higher returns.

3. Types of Fiscal Policy

  • Expansionary: Increased spending or decreased taxes to stimulate the economy during recessions.
  • Contractionary: Decreased spending or increased taxes to slow the economy and control inflation.

4. Fiscal Policy Approaches

  • Discretionary: Deliberate changes in taxes or spending (e.g., stimulus package).
  • Non-discretionary: Automatic changes without direct intervention (e.g., unemployment benefits).

Lesson 5: Economic Equilibrium and the Multiplier Effect

1. Savings-Investment Imbalance

Consequences:

  1. Inflation/deflation: Excess investment can cause inflation; excess savings can lead to deflation.
  2. Unemployment: High savings can decrease demand, leading to job losses.
  3. Interest rate changes: Imbalances force interest rate adjustments.
  4. Slower economic growth: Persistent imbalance hinders long-term prosperity.

2. Production-Expenditure Imbalance

Consequences:

  1. Over/underproduction: Expenditure below production leads to unsold inventory.
  2. Unemployment: Overproduction causes cutbacks and layoffs.
  3. Price adjustments: Imbalances affect price levels.
  4. Macroeconomic instability: Persistent imbalances create volatility.

3. The Multiplier Effect

  1. Amplification: Initial spending changes lead to larger overall economic changes.
  2. Sequential process: Works through successive spending rounds.
  3. MPC dependence: Higher marginal propensity to consume (MPC) increases the effect.
  4. Time lag: Full effect takes time.
  5. Cumulative: Accumulates as spending flows through the economy.

4. Factors Decreasing the Multiplier Effect

  • High savings rate: Reduced spending diminishes the effect.
  • Imports: Spending on foreign goods leaks from the domestic economy.
  • Taxes: Reduced disposable income dampens the effect.
  • Debt repayment: Using extra income for debt repayment doesn’t stimulate consumption.

5. Government and the Multiplier: Crowding-Out Effect

  • Crowding out: Government borrowing increases interest rates, potentially offsetting the impact of government spending.

6. Fiscal Policy Implementation Problems

  • Time lags: Recognition, decision, and implementation lags delay effects.
  • Ricardian equivalence: Consumers may increase savings in anticipation of future tax increases to repay government debt, offsetting stimulus.