Savings Behavior: Update

A quick update on the main topic from class last semester:

The personal savings rate has continued to increase, it's now up to 6.9%, above the average of 6.3% from 1959 to present. For more information check out the CalcRisk posting.

Some Solutions (updated)

Here are some more samples questions and solutions. These are from previous years, so not all of the material is relevant (figuring out what is relevant is a good test!);

• Growth
• One Period Model
• Two Period Models

I also have an accumulation of past final exams with some comments about the solutions. The comments refer to other solutions that may or may not agree with the above solutions. Again, not all of the material is relevant.

• Previous Final Exams

The solutions to the review questions previously posted are somewhere within the material here, with the exception of Keynes. I thought I had some Keynes solutions from last Fall. I'm still looking. If I don't find them and I get some time I will try to post this afternoon.

update: The Keynes Notes have been updated to include the solution to the sample question.

Review Session and Office Hours

Details on Review Session:

• Tuesday, May 5
• 8pm
• Wylie 005

We actually have the room reserved from 7:15-9:15, so you are all welcome to get there early and work together on the board.

Office Hours:

• T: 11:00-12:00; 3:30-4:30
• W: 11:00-12:00; 3:30-4:30

Study hard.

Review Questions for the Final

I have posted some review questions for the final here. Remember that the final is cumulative, including the material covered by Professor Huynh. The review session will be on Tuesday evening at 8pm. I will post the room location sometime later. Study well.

Homework #2

Here is the second homework, due at the start of class on Thursday. It uses the Keynes assumptions from the previous post.

Simple Keynes Model Assumptions

Here are some notes for a simple model of Keynes. Note that is NOT the standard Keynesian model that is in all the textbooks (chapter 12 in Williamson's Third Edition). This model allows aggregate demand to affect the economy. When aggregate demand affects the economy then financial frictions can have real effects on the economy. This is at the heart of Keynes' Theory in The General Theory, not sticky nominal wages. The sticky nominal wages are just an assumption so that the financial frictions and investor psychology can affect the economy. For this last point see the new and very intersting book by Akerlof and Shiller: Animal Spirits. We will be talking about this in class on Tuesday.

Exam One Solutions

Suggested solutions and a general grading algorithm for exam one can be found here.

Homework #1

The first homework, due Thursday is here.

Since we will be going over the homework in class, you have to turn the homework in at the start of class.

Homework and Extra Credit

In order to improve your performance for the rest of the class I am providing you an incentive to work hard the last two weeks of class. There will be two homeworks, one each due on the last two Thursdays of the semester. Each homework will be graded for completion, based upon effort not on whether the answer is correct. For each homework that you successfully complete your exam grade for my portion of the class will be augmented. Your exam grade consists of the weighted average of the two exams. The first exam is worth 40% and the last exam is worth 60%. Therefore your exam grade for my portion of the class is given by

exam grade=0.4*exam 1 % correct+0.6*exam 2 % correct

The exam grade will lie between 0 and 1.

Your exam grade will be augmented by the following algorithm:

• exam grade>0.9: each homework raises exam grade by 0.005
• 0.9> exam grade >0.8: each homework raises exam grade by 0.01
• 0.8> exam grade >0.7: each homework raises exam grade by 0.015
• 0.7> exam grade >0.6: each homework raises exam grade by 0.02
• 0.6> exam grade: each homework raises exam grade by 0.025

If you do two homeworks and the first homework raises your exam to a higher class (such as from 0.79 to 0.810) then the second homework raises your exam grade based upon the new category.

Note that this algorithm provides you some insurance in the case of poor exam performance.

Sample Questions

Here are some sample questions to work on for class on Tuesday and for the exam/quiz on Thursday. The exam will only be two questions and will not take the whole class time, thus I am referring to it as an exam/quiz. Another excellent source are the sample questions in the back of Chapter 8.

Update:

Here are some solutions for the questions.

IU Economics Forum

We had a very educational and quite often entertaining forum on Friday afternoon concerning the current economic crisis. Thanks goes out to Eric Leeper for organizing the forum.

All of the presenters at the forum have graciously allowed me to post their slides:

• Eric Leeper: Introduction
• Gregory F. Udell: "Should We Have Expected More from the Fed"
• George M. von Furstenberg: "Governance Effects of Current US Financial-Crisis Management: Executive Branch to the Rescue"
• Ellis W. Tallman and Elmus R. Wicker: "One More Observation in in 2008: Financial Crises in U.S. History"
• Bill Witte: "The Economic Situation and Outlook"
• Brian Peterson: "The Federal Reserve and the Credit Crisis: Non-Traditional Monetary Policy Responses"
• Eric Leeper: "Fiscal Policy Response: Unprecedented Stimulus"
  

Eating Out and the Fall in Consumption

Calculated Risk is a great blog to check each day to see the latest economics news. Today there was an update about restaurant spending. Check out the figure from the past seven years. Notice how sharp the index in restaurant spending fell around September 2008. Clear evidence of a fall in consumption right when the credit markets started freezing up. In class we argued that this could be explained by consumers thinking that their expected future income would fall.

Later in the class we will also argue that the fall in consumption could be due to an income effect from the fall in the stock market.

Foolish Homework Suggestions for Tuesday

Last class we showed that, using the two-period model of savings with perfect capital markets (also known as efficient markets) that a fall in current income (Y) leads to a fall in savings. However, we know that currently we are seeing a fall in income and a rise in savings. Instead, examine the effects of a fall in future income (Y') on savings.

Also, examine the effect of a permanent fall in income--both Y and Y' falling--on savings. How do your results compare to only Y or Y' falling? For now, keep to analyzing the case of perfect capital markets.

Household Debt leading up the the Credit Crisis

In the first class, we saw how the household savings rate fell from over 10% around 1980 to roughly 0% in 2007, and has risen to roughly 5% in the past seven months. Here we examine what has happened to household debt. The Federal Reserve maintains a balance sheet for the household sector. The balance sheet consists of all of the debts and assets of all of the households of the United States. These contain both financial assets, such as stocks and deposit at banks, as well as real assets such as houses and cars. The data reported here are part of the Flow of Funds put out by the Federal Reserve. For more information check out the Flow of Funds page at the Fed.
Figure One plots (all of the figures are also availble in a pdf) the amount of debt held by households relative to income. People generally feel that the more debt a person has, the worse is their financial position. We can see from figure one that from 1980 to 2006, household debt relative to income rose tremendously. Of particular note is the acceleration in the amount of debt relative to income starting around 2000.
Having debt is not necessarily a bad thing. Debt is important to be able to buy assets that we cannot buy with our current income, but that we can buy using our lifetime income. This is the idea of student loans and using a mortgage to buy a house. Along these lines, a lot of people were arguing that the rise in debt after 1980 would not be a problem because it was accompanied by rising wealth. Figure Two plots the net worth of households relative to income. Net Worth is the value of all assets less the value of debt owed. We can see that after 1980 household net worth was indeed rising, suggesting that the rising debt levels were justified by increases in wealth. A striking feature in figure two are the twin bubbles of the tech stock (around 2000) and the housing market (2006). These large swings in net worth happened at the same time as the explosion of debt around 2000.

FigureThree plots the ratio of debt to assets. This helps us see if the rising debt was backed up by purchases of assets. This picture suggests that not all of the rise in debt was offset by rising assets. Figure four compares debt/income to debt/assets. For both series I have divided them by their level in 1952. Thus, we get a sense for how much each series has moved the last 57 years. From figure 4 we see that debt/income and debt/assets generally move together. However, beginning around 1995, debt/income rose while debt/assets fell. During this time period many experts were arguing that the rising debt/income was not a problem since debt/assets was actually falling. However, we now know that the low level for debt/assets was due to assets being overvalued due to the tech bubble. Once the tech bubble burst in 2001, debt/assets caught up to the debt/income level. Around 2003 debt/income againg took off while debt/assets went flat. Once again many experts, argued that this was not a problem because the rising debt was being offset by a rise in assets values--this time housing assets. We now now what happened: the housing bubble burst in 2007 and debt/assets rose, trying to catch up with debt/income.

Figure 5 plots the value of houses and the stock market relative to income. For the value of houses, we use home equity. Home equity is the amount of money a household would get if the household sold their house. It represent the value of the house less the value of the mortgage on the house. We can see from figure five that home equity has roughly the same value to households as the value of their stocks. However, we should be careful when we say this, since most the stock held by households is held by the top 5% of the wealthiest households. The bottom 95% hold most of their wealth in the from of bank deposits (not in figure 5) and home equity. Therefore, the large swing in the value of home equity from 1998 to now was most likely felt more by the average American household. Also, note that if a household ignored the housing bubble, that, relative to income, home equity is the same as it was in 1999. A lot of the problems we are facing are that a lot of people thought the increase in home equity was permanent.
Focusing more squarely on the housing market, figure 6 plots the value of mortgage debt relative to income. Here we see a huge surge starting around 2000. Figure 7 plots the value of mortgage debt relative to the value of housing. The higher is the amount of mortgage debt relative to the value of the house, we say that households are more levered in housing. We refer to the amount of debt used to purchase an asset as the amount someone is levered in that asset. For instance, when a house is purchased, a homeowner typically only pays for a part of the house, called the down payment, and borrows the rest. Essentially, the amount borrowed acts as a lever, raising the amount of housing that can be purchased with the cash used for the down payment. The lower the down payment, the higher is the leverage. We can see that from 1995 to 2005 that housing leverage was not increasing even though the amount of mortgage debt was exploding. Of course we all know the result.

Last, figure 8 compares mortage debt/income to housing leverage. Once again, I divide each series by their value in 1952. Here we see mortgage debt rising. However, when mortgage debt rises it takes a while for leverage to also increase. However, in every instance we see that leverage does eventually rise. From 2001 to roughly 2005, we saw mortgage debt take off, while leverage remained constant. Many people were arguing that the rise in debt was not a problem since it was backed up by the rise in home values. These people were ignoring the data before 2000. We can see from figure 8 that a rise in debt eventually leads to an increase in housing leverage--it is just delayed. If we think of the average household as only owning housing, then we can see that the average American household is now more levered than ever. Therefore, as we saw in figure 5 home equity may be back where it was in 1999, but the amount of debt owed for the that home equity, given by the amount of leverage, is at an all time high. The high rates of foreclosure are quite understandable: the real value of houses are not worth more than in 1999 (relative to income) but households have to pay more for them.

The Trainwreck

The picture above is an image an impending trainwreck. The picture plots the savings rate in the United States (produced by the Bureau of Economic Analysis). We can see that between 1959 and 1980 the savings rate was slowly rising from 7% to around 10%. However, beginning in 1980, the savings rate started on a new trajectory, falling from 10% to essentially zero. The last observation in the above picture is for the first quarter of 2008. In hindsight, this clearly looks like a bad situation. Nothing good can probably come out of negative savings. However, arguments were made, such as "Americans invest well," "Americans are actually getting wealthier from the return to their assets." As we will see next class, Americans were getting wealthier from the high return to their savings. However, a large part of the return to their assets was an illusion, the result of a bubble in asset prices. The trajectory of the fall in the savings rate was unsustainable. Negative savings for a country as a whole is most likely not good.

What happened? The next picture adds the last three quarters for 2008 and one observation for January 2009 (the latest release of the data from the BEA can be seen here).


We can clearly see that the trajectory for the savings rate was indeeed an impending trainwreck. We clearly see the collision. In the last seven months, the savings rate has gone from essentially zero to 5%. Whatever was the cause behind the falling savings rate, starting in 1980, is most likely the ultimate cause behind the current crisis.