When I teach grad macro, I use a very old schematic on the first night of class showing three sectors -- household, firms, and government -- and a flow of income to each sector, including transfers between them. The last five lines of the schematic are savings, capital expenditures, budget constraints, financing constraints, and a private balance sheet identity:


where W is private sector wealth, M and V are public sector debt in non-interest-bearing (money) and interest-bearing (bond) form, and K is private sector capital. The = represents this as an identity. (The source is a textbook I liked in graduate school, Monetary Macroeconomics by Havrilesky and Boorman.)

I'm thinking with that model in mind as I read Tyler Cowen yesterday:

The fundamental problem in the American economy is that, for years, people treated rising asset prices as a substitute for personal savings. The thinking went something like this: As long as your home�s value rose every year, you didn�t have to set aside so much from your paycheck. If your stocks went up, too, so much the better; don�t forget that the Dow Jones industrial average stood in the 800 range in 1982 and seemed to rise almost nonstop for many years.

Of course, asset prices haven�t been rising much lately, so many people will need more savings for their retirement or for possible emergencies.

And I think, well, why wouldn't they? We model them to think in just that way: A rise in private wealth through a change in the value of K (via a rise in the relative price of capital goods Pk to consumer goods P, with capital broadly considered) should produce the same effect as an increase in money -- assuming you consider money to be "outside". The only difficulty with this story is that we don't think the wealth effect is altogether that large, though if the shock to Pk/P is sufficiently large you might not need a large wealth effect. (Read this interview with Martin Feldstein, particularly at the subhead "The Return on Savings".) I am not sure why Cowen thinks that is a "fundamental" problem. It may just be that rising capital goods prices have driven up consumption and masked more serious weaknesses, but then you'd have to explain why rising productivity doesn't lead to higher living standards.

The broader point is that stock adjustments -- in this case an adjustment of current wealth to one's optimized lifetime path -- can lead to changes in flows of consumption and savings, just as we have always thought, and always taught.

Labels: economics