Question

Describe how the savings decision can be thought of as a trade-off between current and future consumption. In that context, the price of future consumption is one over one plus the interest rate. Using this logic, explain why savings might rise when the interest rate rises. What is the precautionary model of savings? How might that model predict the opposite effect on savings when interest rates rise.

Answer 1

Savings are the part of disposable income that is not consumed.

When faced with a decission to consume and save, a consumer has two choices: consume less today and save for future consumption or consume more today and save less for future consumption

This means savings done today are like opportunity cost of consumption today. This makes savings decission as a tradeoff between current and future consumption.

This means future consumption is nothing but present value of current savings made at Interest rate 'r'

This means future consumption = savings = 1/(1+r)¹

This means there exists a positive relationship between savings and Interest rates. This is because savings are done in order to receive interest income in future. In case of higher interest rate, consumers will have higher future income and thus prefer to save more in order to receive this future income.

Precautionary model of savings states that people prefer saving today more instead of consuming more, as the future is uncertain and people must save today in order to prepare themselves for an unforeseeable future.

This model predicts the opposite effect on savings when interest rates rise because it states that if interest rates are lower than time preference rate, then savings must Decrease, making the relationship between the two variables positive.