Macro essay

Household savings in the United Kingdom and the United States rose significantly in 2008, even though the unemployment rate remained reasonably low (below 7%) in both countries. Discuss possible reasons for this trend in the light of theories of consumption

From 2008, household saving grew rapidly in both United Kingdom and the United States, although the unemployment rate had only experienced a relatively small increase. In the UK, for instance, the total household saving jumped from 0 to almost 15,000 million pounds during 2008 or UK households saved 5% more of their disposable income in that year. But the unemployment rate only increased by 1 % (5.5% to about 6.5%). The U.S.A had a similar trend for saving and unemployment rate.

According to the following graphs, household saving rate inclined from 3% to 6.5% during 2008, peaked at even more than 8%, comparing with a 2% unemployment rate increase.

An increase in saving rate must lead to a decrease in consumption or investment, and there are several reasons for this change.

Income uncertainty
It is well-known that 2008 is the first year of the Great Recession. There are negative future uncertainties such as reduction in income or risks of losing jobs for households. For example, in the UK, from the following diagram, the income did drop dramatically in the beginning of 2009 (440 pounds per week to 420 pounds per week).

According to CE-LC-PI model and Permanent Income Hypothesis, an increase in labor income uncertainty can stimulate precautionary saving, that is savings occurs in response to uncertainty regarding future income, to smooth their consumption for the future.

Since households are risk-aversers and utility maximisers, under uncertainties, household would revise the information and determine the optimal consumption profile. In this case, household will revise down the consumption level thanks to the negative income shock. A lower consumption means a higher saving. According to IMF, an increase in income uncertainty by 1 percent is associated with a higher household saving rate by about 1 percentage point.

Subject to
U(c) is utility function,
Beta is the discounted coefficient
Y is income

Using Lagrangian method, the optimal consumption level in current period is lower than that in the second period, unlike the CE-LC-PI model, where consumption in two periods is equal, the difference between CE-LC-PI model and the optimal consumption level is called precautionary savings, and the consumption will fall under income uncertainties.

However, income uncertainty could affect households in different ways. Empirical evidence from IMF shows, young households (under their 40s) will choose to consume in a lower level and save more to ‘buffer’ off the negative shock. Older household could begin to converging to certainty equivalent consumers. Since they have very secure jobs or decent income, income uncertainty becomes less serious.

Capital market uncertainty
In 2008, capital market as well as housing market in the United Kingdom and the United States was becoming unstable. In fact, the crisis had already happened in mid-September 2008, when Lehman’s and some housing agents bankrupted, leaving billions of dollars’ worth of bad debt to banks in the world.

The upcoming instability or even collapse in housing and financial market, especially in the U.S, leaded to a fall in households’ wealth in the near future, more importantly, this instability also caused a fall in confidence level. To smooth consumption, households will choose to save more for future consumption since their expected future wealth will decrease.

As always, households want to maximize overall utility in two periods. In this case, real interest rate (return on savings) is decreasing.

Using the same method as in the income uncertainty, we can conclude that, weather to increase savings or not depends negatively on elasticity of inter-temporal substitution which is

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