According to a recent Brookings article, the personal savings rate peaked in April 2020 at its highest level in recorded history of 34%. This is to say that collectively people saved 34% of their disposable income in that month. Prior to the pandemic, this rate hovered around 7-8%. Since the peak, this savings rate has fallen, but still remains historically high, for example this number was 17.8% in July 2020. 

A.    Using the aggregate expenditure model and AD/AS model, explain why this is problematic for the economy during the pandemic period?

B.     The government passed the CARES Act and are currently in discussion of passing a second bill that would offer economic relief and stimulus to the economy. Why would it be important for policymakers to consider the current savings rate behavior of people in the economy in crafting an economic stimulus/relief package? Specifically, what components of these packages and their effectiveness will likely be impacted by the savings rate behavior?

 

A. According to the aggregate expenditure(AE) model, AE=C+I+G+NX, in the USA should be less than investment, but increasing savings would reduce the planned investment as the expected demand for new businesses is low during a pandemic and, hence, savings will not be able to boost investment, so the aggregate expenditure and the consumption will fall as savings increases. 

The graph is attached below.

Using the AD-AS model. It can be stated that  during recession the real purchasing power of people will be reduced and thus the expected demand is low. Therefore, investment will not be improved by increased savings. The consumption will also be lower for increase in savings. Hence, the AD curve will shift to the left.

The graph is attached below.

B. If the current savings rate persists in the economy, the objective to stimulate the economy will not be successful. The inflation will cancel out the effect of increased savings rate. Hence, the policymakers should be careful about the savings rate and craft relief package accordingly which will be beneficial for the US economy.

The output and consumption components like the marginal propensity to consume, output, and money multiplier will get affected by the high savings rate. Because the high savings rate will reduce the planned consumption and investment by increasing the current account deficit.        

Step-by-step explanation

It is given that in a Brooking article, the personal savings rate in the USA peaked at 34% and which implies that people in that month saved 34% of their disposable income. But before pandemic the savings rate was around 7-8%. Although the 34% savings rate has now declined to 17.8% in July, it is still high enough.

A. The aggregate expenditure(AE) refers to the current value of all finished goods and services produced in a given period of time.AE model takes planned investment and consumption under consideration and the model includes consumption, investment, government expenditure and net export and import. AE=C+I+G+NX

The investment equals the savings which includes total savings by households, business and government saving plus the net foreing saving(Current account deficit). So, for the USA, Investment=Savings of the USA+current account deficit. 

Given the above circumstances of the economy with the high personal savings rate, the increased savings rate will not be beneficial for the economy. Due to a rise in savings the consumption will fall because income can either be saved or be consumed. Due to increase in savings the consumption will fall. As the income in this pandemic is already low, thus, the fall in income and a rise in saving rate have a dual negative impact on consumption.The increased savings will be covered in terms of investment or in terms of reduced current account deficit. The USA is a country which generally runs current account deficit during the pandemic and a country with a deficit should save less and invest more. As the savings is higher during a pandemic, that would increase the gap between investment and savings and, therefore, will end up by increasing the current account deficit even more than before. Another part is that by increasing investment during a pandemic the USA will not be able to improve the economy because in developed countries investment depends not only capital, but also on the expected demand. As the expected demand in the USA during a pandemic is very low, so all businesses will be closed and investment will not be profitable. Therefore, the planned investment will be low So, altogether the current account deficit will rise and investment will fall both have a negative impact on the aggregate expenditure.  

The graph of the AE model showing the effect of higher savings rate is attached below.

Initially, equilibrium was at point E0 and GDP was Y0, but after increased savings rate, the equilibrium has moved to point E1, and GDP has reduced to Y1.  

AD-AS model: AD-AS model explains the changes in price and output levels using the aggregate demand (AD)and aggregate supply(AS) of the economy for a given time period. During this pandemic, the price is high, and output is low, so the economy is experiencing inflation and stagnant output or stagflation. In this situation, if the savings rate gets higher, and  investment will not increase as investing in any business will not be profitable during a pandemic because the aggregate demand is low. Consumption will also decrease as people have saved more hence by low consumption and investment aggregate demand will also fall. As AD will fall , the AD curve will shift to the left, and output will reduce. Hence, the economy will not be able to stimulate. 

The graph is attached below.

Initially, the price was P0 and output was Y0 but due to rise in savings and fall in aggregate demand the AD curve will shift to the left and the output has reduced to Y1. 

B.  

The CARES act was introduced by the government of the USA by president Trump to combat pandemic. It was a direct assistance on behalf of the government to the families, small businesses and providing jobs. The objective was to protect public health as well as the economy.   

Now, the government wants to boost the economy and therefore wants to introduce a second bill for economic stimulation. For issuing an economic stimulation relief package, the current savings rate should be considered by the policy maker because the economy will be experiencing recession and thus inflation will exist and due to inflation the increased savings rate will not be realized as the real purchasing power of the saving will reduce for inflation and, therefore, savings will not be able to improve the economy rather  it might make the economic condition worse in future.Therefore the policymakers should address the current savings rate and craft the relief package according to that. 

If the current savings rate persists in the economy while crafting the relief package to boost the economy, then the economy will be in more trouble as the higher savings rate will cause more current account deficit along with that investment will not increase for reasons as discussed above. The main problem that will arise is that the money paid by the government to increase the AD is actually being saved rather than consumed. The multiplier effect which was expected to be seen would not be seen. Therefore, the consumption will be affected and the investment components will be affected if the current savings rate persists in the economy. If the savings rate remains high,  then people will save most of the reliefs provided by the government and, thus, the marginal propensity to consume(MPC) will fall. Therefore, output and money multiplier will fall as output is getting reduced. Hence, all these barriers will prevent the economic stimulation, and equilibrium will not be achieved to combat recession. 

Please see the attached file for the complete solution