Determinants of Consumption and Saving:

A crucial issue before a  household  is to decide on how much to allocate  towards current consumption  out  of its  current income. Apart from  the level of  income  another  factor influencing  the level of saving  is  the rate of  interest,  that  is, higher the  interest  rate higher is  the saving.

We know that when we save money (in the form of bank deposits or in bonds) we receive interest. Thus when we look beyond  the current period we expect a flow of income  over different time  periods. Thus  expected  future  income  plays  an  important   role in our  decision  on consumption  and saving  in  the  current  period as well as  in  future  time periods. Based upon the  simple  framework discussed above there  are quite  a few inter- temporal  consumption  models, which we will discuss  in Block  4.

A  second  issue  is  the determination of  aggregate  consumption  and saving  for  the economy as  a whole. What we have  explained above  is  the  behavior of households. It  is  true that all  households  have different income levels  and MPC, which  pose certain  complexities.

It is  usually seen  that young  adults  have a low MPC largely  to  lesser  responsibilities compared to old  people. Economic models that stress  the presence  of old and young households  are  referred  to as  'overlapping generations model'. You may have observed  that saving rate varies across economies  and over  time. In India, for example saving rate was around 10  per cent of GDP  during 1950s  while it  is around  25 percent of GDP at present. There  has  been a three-fold increase  in per capita income during  1950-5 1  and 2004-2005. However, higher per capita  income  does not translate  into  higher  saving  rate   always. We observe that among developed economies saving  rate  is not uniform. For  example, saving  rate is much higher in Japan  (about  30 per cent)  compared  to the United States  (about 14  percent). Thus there  may  be certain other  factors  apart from  income, which influence consumption and  saving  decision. However,  in cross-country  analysis we see  that there  is  a   positive and  strong  correlation  between saving rate and per capita  income. Thus we can say  that the consumption function at aggregate level would also depict the same features as the household consumption  function.