CHAPTER ONE
BEHAVIOURAL FOUNDAIONS: THEORIES OF CONSUMPTON
Now days in the real world economies, from the components of Gross National Product, the
aggregate consumption expenditures take more than 60 percent. Consumption has also played
a key role in macroeconomic analysis ever since. Due to these facts consumption decision got
top priorities by economists. Accordingly, in this part we will discuss the views of four
prominent economists on consumption; namely, Keynesian, Ando-Modigliani’s life cycle
hypothesis, Freidman’s permanent income hypothesis and Irving Fisher’s model of
consumption.
1.1 Keynesian Consumption theory: The absolute income hypothesis (AIH)
The Keynesian consumption theory made consumption function central to his theory of
economic fluctuation. Due to absence of computer and availability of data on consumption
expenditure Keynes made conjectures about the consumption function based on introspection
and casual observation. He further postulates the consumption function based on three
conjectures. These are:
1. The Marginal Propensity to Consume (MPC)—the amount consumed out of an additional
dollar of income—is between zero and one. That is, when a person earns an extra dollar of
earned income, he typically spends some of it and saves some of it.
i.e., 0< MPC <1
2. The ratio of consumption to income, called the Average Propensity to Consume (APC),
falls as income rises. He believed that saving was a luxury, so he expected the rich to
save a higher proportion of their income than the poor. The implication is that on average
the rich spend less of their income than (or saves more than) the poor.
3. Income is the primary determinant of consumption and that the interest rate does not
have an important role. In other words, income is the most important determinant of
consumption. That is the higher the income of a household the higher will be
consumption.
Algebraically, on the basis of these three conjectures, the Keynesian consumption function is
often written as C c y 0 <β<1, ---------------------------------- (1.1)
Where c is consumption, y is disposable income, c is a constant, and β is the marginal
propensity to consume. Notice that this consumption function exhibits the three properties
1|Page
that Keynes posited. It satisfies Keynes’s first property because the marginal propensity to
consume c is between zero and one, so that higher income leads to higher consumption and
also to higher saving. This consumption function satisfies Keynes’s second property because
the average propensity to consume is APC C/y c /yβ.As disposable income (y) rises, the
ratio c/y fall, and so the average propensity to consume
(c/y) go down. And finally, this consumption function satisfies Keynes’s third property
because the interest rate is not included in this equation as a determinant of consumption.
Graphically, the function is shown in Figure 1.1, which plots consumption expenditure ( c ),
against real income ( y ). This function indicates the observation that as income increase
people tend to spend a decreasing percentage of income, or conversely tend to save an
increasing percentage of income(by the second proposition). The slope of the line from the
origin to a point on the consumption function gives the average propensity to consume (APC)
or the c / y ratio at that point.
The slope of the function itself is the Marginal Propensity to Consume (MPC). From the
graph it is clear that the MPC is less than APC. If the ratio of c / y falls as income rises, the
ratio of increment in c ( c ) to the increment in y ( y ), or β (MPC), must be smaller
than c / y . Keynes saw this as the behavior of consumer expenditure in the short-run- over the
duration of a business cycle- reasoning that as income falls relative to the recent levels,
people will protect consumption standards by not cutting consumption proportionally to the
drop in income, and conversely as income rises, consumption will not rise proportionally.
Figure 1.1: Keynes Consumption Function (absolute income hypothesis)
2|Page
The lineOE is the 450 line along which all income is consumed. At income level y1,
consumption is given byOc1, while savings are given by Os1 and represent that amount of
income not spent. The average propensity to consume ( c1 / y1 ) is represented by the slope of
lineOA . The figure also represents APC declines as income increases. Suppose now that income
increased from y1 to y2 . The Average Propensity to Consume (APC) is now given
by the slope of the lineOB , which is less than the slope of OA and hence APC has declined.
MPC (Marginal Propensity to Consume) it refers to the amount consumed out of an
additional dollar of income.
APC (Average Propensity to Consume) refers to the ratio of consumption to income
The acceptance of the theory that MPC APC ; so that as income rises c / y falls led to the
formulation of stagflation thesis around 1940. It was observed that if consumption follows
this pattern, the ratio of consumption demand to income would decrease as income rises. The
problem for fiscal policy that the stagflation thesis poses can be seen as follows. If
y c i g or 1=c / y +i/ y + g/ y ……………………………………………………………..1.2
is the condition for equilibrium growth of real output ( y ), and there is no reason to assume
that the ratio of private investment to income (i / y ) will rise as economy grows, then
government expenditure to income ( g / y ) must rise to balance the consumer expenditure to
income ( c / y ) drops to maintain full-employment demand as y grows.
1.2. The early empirical successes
Soon after Keynes proposed the consumption function, economists began collecting and
examining data to test his conjectures. The earliest studies indicated that the Keynesian
consumption function was a good approximation of how consumers behave. In some of these
studies, researchers surveyed households and collected data on consumption and income. They
found that households with higher income consumed more, which confirms that the marginal
propensity to consume is greater than zero. They also found that households with higher income
saved more, which confirms that the marginal propensity to consume is less than one. In
addition, these researchers found that higher-income households saved a larger
fraction of their income, which confirms that the average propensity to
consume falls as income rises. Thus, these data verified Keynes’s
conjectures about the marginal and average propensities to consume. In
other studies, researchers examined aggregate data on consumption and
3|Page
income for the period between the two world wars. These data also
supported the Keynesian consumption function. In years when income was
unusually low, such as during the depths of the Great Depression in 1932
and 1933, both consumption and saving were low, indicating that the
marginal propensity to consume is between zero and one. In addition, during
those years of low income, the ratio of consumption to income was high,
confirming Keynes’s second conjecture. Finally, because the correlation
between income and consumption was so strong, no other variable appeared
to be important for explaining consumption. Thus, the data also confirmed
Keynes’s third conjecture that income is the primary determinant of how
much people choose to consume and that the interest rate plays a minor
role.
1.3. secular Stagnation, Simon Kuznets and the consumption puzzle
Simon Kuznets made a study on consumption and saving behavior in USA. Kuznets’ data
pointed out two important things about consumption behavior. First, it appeared that on
average over the long-run the ratio of consumer expenditure to income ( c / y ) or APC,
showed no downward trend, so the MPC equaled the APC as income grew along trend. This
meant that along trend the c c(y) function was a straight line passing through the origin as
shown in Figure 1.2
Figure 1.2: Long-run and short-run consumption functions
4|Page
Second, Kuznets’ study suggest that years when the c / y ratio was below the long-run
average occurred during boom periods, and with c / y ratio above the average occurred
during periods economic slump (recession). This meant that the c / y ratio varied inversely
with income during cyclical fluctuation, so that for the short period corresponding to a
business cycle empirical studies would show consumption as a function of income to have a
slope like that of the short-run functions of Figure 1.2 rather than the long-run functions.
Thus, by the late 1940s it was clear that there were three observed phenomena, which the
consumption function must account for
1. Cross-section budget studies show s / y increasing as y rises, so that in cross-section
of the population MPC APC
2. Business cycle, or short-run data show that the c / y ratio is smaller than average
during boom periods and greater than average during slumps, and hence in the shortrun,
as income fluctuates, MPC APC
3. Long-run trend data show no tendency for the to change over the long-run, so that as
income grows along trend, MPC APC
In addition, the theory of consumption should be able to explain the apparent effect of liquid
assets on consumption. Therefore, the failure of Keynesian consumption function to explain
long-run behavior of consumption in cross-section studies and the effect of liquid assets on
consumption has motivated to the emergence of alternative consumption theories in 1950s.
Unlike Keynes, the theories that were developed by Fisher, Ando-Modigliani, and Friedman
have basic foundation in the microeconomics theory of consumer intertemporal choice to
explain these phenomena. In particular, Modigliani and Friedman begin with the explicit
common assumption that observed consumer behavior is the result of an attempt by rational
consumers to maximize utility by allocating a lifetime stream of earning to an optimum
lifetime pattern of consumption. Thus, we begin the discussion of these three theories at their
common points of departure in the theory of consumer behavior and follow them individually
as they diverge.
1.4 Irving Fisher’s Model of Consumption ( Intertemporal Choice)
Keynes consumption function relates current consumption to current income. This
relationship, however, is incomplete at best. When people decide how much to consume and
how much to save, they consider both the present and the future. The more consumption they
5|Page
enjoy today, the less they will be able to enjoy tomorrow. In making this tradeoff, households
must look ahead to the income they expect to receive in the future and to
the consumption of
goods and services they hope to be able to afford. Irving Fisher, therefore,
developed the
model with which economists analyze how rational, forward-looking consumers make
intertemporal choices that is, choices involving different periods of time. Fisher’s model
illuminates the constraints consumers face, the preferences they have, and how these
constraints and preferences together determine their choices about consumption and saving.
He assumes that household’s utility depends upon its lifetime profile of consumption. Hence,
he began his explanation with a single rational consumer utility maximization behavior as
U f (c0 ,...,ct ,...,cT ) --------------------------------------------- (1.3)
Where, lifetime utility U is a function of the individual’s real consumption c in all time
period up to timeT , the instance before he/she dies. The consumer will try to maximize
his/her utility, that is obtain the highest level of utility, subject to the constraint that the
present value ( PV ) of his/her total consumption cannot exceed the present value of his/her
total income in life. That is
Where, T is the individual’s expected life time. The constraint says that the individual can
allocate his/her income stream to a consumption stream by borrowing or lending, but the present
value of consumption is limited by the present value of income. We thus have an individual with
an expected stream of lifetime income who will want to spread that income over a consumption
pattern in an optimum way. We might imagine that his/her expected income stream begins and
ends low, with a rise in the middle, and he wants to smooth it out into a more even consumption
pattern. To keep the analysis as simple as possible and formulate the problem in a workable
manner he assumed that the individual lives only for two periods: today; period zero and
tomorrow;
period 1 (intertemporal choice). The two-period case utility of the household for is thus
given as:
6|Page
U u(c0 ,c1) -------------------------------------- (1.5)
Second, the household is assumed to maximize lifetime utility subject to
the borrowinglending constraint imposed by its real wealth, where
wealth is defined as the present value
of all future income streams. In a two-period model this is simply:
Where, A0 represents the household’s expected real wealth measured in terms of current
period (period 0); y0 is this period’s real income; and y 1 is next period income discounted by
the real rate of interest, r.
Third, it is also assumed that the agent knows with certainty the expected future rate of
interest and that capital market is perfectly competitive. This means that the household can
either lend or borrow money as much as it wants at the going rate of interest without
affecting the rate. Forth, transaction cost is also assumed to be zero. Since this is a twoperiod model and
consumption is the sole determinant of economic growth (GDP), it follows
that lifetime wealth will be the constraint of lifetime consumption. Thus at equilibrium,
equation (1.6) can be
Figure 1.3 shows the structure of intertemporal model. The vertical axis measures income
and consumption in period 1 while the horizontal axis measures income and consumption in
the current period (or period zero).
7|Page
Figure 1.3: Two-period consumption case: utility maximization
added
The budget constraint (BC) in the above graph indicates the maximum amount of lifetime
consumption. If the household is to consume its entire lifetime income stream in period zero
by borrowing against period 1, then the maximum amount that can be consumed can be
y1
yo + which is the intercept of the budget line in period zero axis, point C .
1+ r
Conversely, if the household decides to consume nothing in period zero, delaying or
postponing all consumptions until period 1, then the maximum it can consume in period 1 is
y0 1( r) y1 , which is given by point B on period 1 axis. The slope of the budget constraint
(line) is given by differentiating the wealth constraint for a given level of interest rate, which
is
Point A in figure 1.3 shows that the amount of income the household will earn in period zero,
y0 and the amount of income he/she will earn in period 1, y1. The household has also
indifference map, representing preference for consumption in both periods and given by
lines U 0 andU1. The subscripts of U denote increasing level of utility.
8|Page
The optimal consumption position for the household is thus given by indifference curve
labeled U1. From point E it is clear that the household saves in period zero for c0 y0 and
dissaves in period 1 asc1 y1. That is the unspent income (saving) in period 0:
S0 = y0 - c0 Money lent --------------------------------- (1.9)
By lending this amount, the individual will receive in period 1 an amount equal to the ratio of
consumption to income s0 1( r) , so that his/her consumption in period 1 can exceed his/her
income by that amount, which is his/her period 1 dissaving, s1
Since the slope of the indifference curve (IC), U1 is equal to the slope of the budget line at
point E , the marginal utility of consumption (MUC) in period 0,U / c0 to that in
period1,U / c1 , is exactly equal to (1 r) . That is the MRS between
consumption in
period 0 and consumption in period 1 is ( 1 r) .
Furthermore, if the indifference curves (ICs) are homogenous of degree zero, then the slope
of all ICs are identical along the straight line passing through the origin. This implies that the
MRS of c0 and c1 depends only on the ratio of c0 / c1 and not on the absolute size of c0 and c1 .
This assumption has an important implication if consumption is not an inferior good, one
with negative income/wealth effect, then whenever a consumer received an extra Birr worth
of resource he/she would allocate it between c0 and c1 in exactly the same proportion as he/she
allocated his/her original resource. That is, as income or wealth rises, with a constant rate of
interest, the budget line shifts out parallel to BC , as shown in figure 1.4, leaving the
c0 / c1 ratio unchanged no matter whatever the size of the wealth.
9|Page
Figure 1.4: The effect of rise in wealth for a given interest rate
Though not discussed for it is beyond the scope of this course the c0 / c1 ratio also depends on
the rate of interest r and the slope of the indifference map.
1.5 The Ando-Modigliani approach: The Life-cycle Hypothesis of Consumption
Franco Modigliani and his collaborators Albert Ando and Richard Brumberg used Fisher’s
model of consumer behavior as bench mark to study the consumption function. One of their
goals was to solve the consumption puzzle—that is, to explain the apparently conflicting
pieces of evidence that came to light when Keynes’s consumption function was brought to
the data. Fisher’s model assumes that, consumption depends on a person’s lifetime income.
Modigliani emphasized that income varies systematically over people’s lives and that saving
allows consumers to move income from those times in life when income is high to those
times when it is low. This interpretation of consumer behavior formed the basis for his lifecycle
hypothesis.
The Hypothesis of the Model
The model hypothesized that retirement is one of the reasons why income varies over a
person’s life. Most people plan to stop working at about age 65, and they expect their
incomes to fall when they retire; therefore to maintain consumption after retirement, people
must save during their working age. To analyze the model, let us consider a consumer who
expects to live other T years, has wealth of w, and expect to earn income Y until he/she retires R
years from now. The basic question that we have to ask is "What level of consumption will the
10 | P a g e
consumer choose if he/she wishes to maintain a smooth level of consumption over his/her life " ?
The consumer’s lifetime resource are composed of initial wealth W and life time earnings of R x
Y , (here for simplicity, we are assuming an interest rate of zero r=o) The consumer can divide
up his/her lifetime resources among his/her T remaining years of life and if we further assume
that the consumer wishes to achieve the smoothest possible path of consumption over his/her
lifetime , therefore, the consumer divides the total of W+RY equally among the T years and each
year consumes:
We can write this person’s consumption function as
------------------------------------------------------- 1.12
For example, if the consumer expects to live for 50 years more and work for 30 of them then
T = 50 & R = 30, so the consumer’s consumption function is given by:
C= 0.02W + 0.6Y and the coefficients of this equation can be interpreted as:
An extra Birr 1 of income per year raises consumption by Birr 0.6 per
year,and
an extra Birr 1 of wealth raises consumption by Birr 0.02 per year
Note that if every individual in the economy plans consumption like this, then the aggregate
consumption function is much the same as the individual one. In particular, aggregate
consumption depends on both wealth and income. That is, the economy’s consumption
function is C = W + Y
11 | P a g e
Where the parameter is the marginal propensity to consume out of wealth, and the
parameter is the marginal propensity to consume out of income. Implication of this
hypothesis can be depicted (shown) by the following diagram:
Figure 1.5 The Life-Cycle Consumption Function
As shown by the diagram, for any given level of wealth W, the model yields a conventional
consumption function similar to the Keynes’s consumption functions. However, the vertical
intercept of this consumption function is not fixed value; instead, the intercept here is W
and, thus, depends on the level of wealth.
This life-cycle model of consumer behavior can also solve the consumption puzzle.
According to the life-cycle consumption function, the average propensity to consume is
C/Y = (W/Y ) ……………………………(1.13)
Because wealth does not vary proportionately with income from person to person or from
year to year, we should find that high income corresponds to a low average propensity to
consume when looking at data across individuals or over short periods of time. But, over long
periods of time, wealth and income grow together, resulting in a constant
ratio W/Y and thus a
constant average propensity to consume.
To make the same point somewhat differently, consider how the
consumption function
changes over time. As Figure 1.5 shows, for any given level of wealth, the
life-cycle
consumption function looks like the one Keynes suggested. But this function
holds only in
the short run when wealth is constant. In the long run, as wealth increases,
12 | P a g e
the consumption
function shifts upward, as in Figure 1.6. This upward shift prevents the
average propensity to
consume from falling as income increases.
Figure 1.6 How Changes in Wealth Shift the Consumption Function?
In this way, Modigliani resolved the consumption puzzle posed by Simon Kuznets’s data.
The other important implication of the model is that it predicts that saving varies over a
person's life time. If a person begins adulthood with no wealth, he/she will accumulate wealth
during his/her working years and then run down his/her wealth during his/her retirement
years as the following table illustrates it.
13 | P a g e
Figure1.7 Consumption, Income, and Wealth over the Life Cycle
The figure illustrates the consumer’s income, consumption, and wealth over her adult life.
According to the life-cycle hypothesis, because people want to smooth consumption over
their lives, the young who are working save, while the old who are retired dissave.
N.B:
The consumer saves and accumulates wealth during his/her working years and
dissaves and run down his/her wealth during retirement. According to this hypothesis
because people want to smooth consumption over their lives, young people are
savers, while the old are retired dissevers.
If the consumer smoothes consumption over his/her life (as indicated by the
horizontal consumption line of figure 1.7),he/ she will save and accumulate wealth
during her working years and then dissave and run down her wealth during
retirement.
The Consumption and Saving of the Elderly
Many studies conducted show that the elderly do not dissave as much as the model predicts.
First, elderly are concerned about unpredictable expenses. Additional saving that arises from
uncertainty known as precautionary saving. One reason for precautionary saving is the
possibility of living longer than expected and thus having to provide for a loner than the
average span of retirement. The other reason is the possibility of illness and medical
expenses. Secondly, the elderly may want to leave bequests to their children. Overall,
research on the elderly suggests that the simplest life-cycle model cannot fully explain
consumer behavior. There is no doubt that providing for retirement is an important motive for
saving, but other motives, such as precautionary saving and bequests appear important as
well.
1.6 The Friedman’s Permanent Income Hypothesis
Let us now turn to Friedman’s model of consumption. Friedman also begins with the
assumption of individual consumer utility maximization which gives us the relation between
an individual’s consumption and present value. He proposed the permanent
income
hypothesis to explain consumer behavior. His permanent income hypothesis
complements
14 | P a g e
Modigliani’s life-cycle hypothesis: both use Irving Fisher’s theory of the
consumer to argue
that consumption should not depend on current income alone.
But unlike the life-cycle hypothesis, which emphasizes that income follows a regular pattern
over a person’s lifetime,
the Permanent-income hypothesis emphasizes that people experience random and temporary
changes in their incomes from year to year. Friedman hypothesized that we view current income
Y as the sum of two components, permanent income (YP) and transitory income (YT).
That is
Y= YP + YT……………………(1.14)
Permanent income is the part of income that people expect to persist into the future.
Transitory income is the part of income that people do not expect to persist.
Put differently, permanent income is average income, and transitory income is the
random deviation from that average.
To see how we might separate income into these two parts, consider these examples
Marartu, who has a law degree, earned more this year than Jobir, who is a highschool
dropout. Marartu’s higher income resulted from higher permanent income,
because her education will continue to provide her a higher salary.
Jalene, a Gibe orange grower, earned less than usual this year because a freeze
destroyed her crop. Biya, an Awash orange grower, earned more than usual because
the freeze in Gibe drove up the price of oranges. Biya’s higher income resulted from
higher transitory income, because he is no more likely than Jalene to have good
weather next year.
These examples show that different forms of income have different degrees of persistence. A
good education provides a permanently higher income, whereas good weather provides only
transitorily higher income. Although one can imagine intermediate cases, it is useful to keep
things simple by supposing that there are only two kinds of income: permanent and
transitory. Friedman reasoned that consumption should depend primarily on permanent
income, because consumers use saving and borrowing to smooth consumption in response to
transitory changes in income. For example, if a person received a permanent raise of $10,000
per year, his consumption would rise by about as much. Yet if a person won $10,000 in a
15 | P a g e
lottery, he would not consume it all in one year. Instead, he would spread the extra
consumption over the rest of his life. Assuming an interest rate of zero and a remaining life
span of 50 years, consumption would rise by only $200 per year in response
to the $10,000
prize. Thus, consumers spend their permanent income, but they save rather than spend most
of their transitory income. Friedman concluded that we should view the consumption
function as approximately
C = YP, ………………………….. (1.15)
Where is a constant that measures the fraction of permanent income consumed.
The permanent-income hypothesis, as expressed by this equation, states that consumption is
proportional to permanent income. The implication of permanent-income hypothesis is that it
solves the consumption puzzle by suggesting that the standard Keynesian consumption function
uses the wrong variable. According to the permanent-income hypothesis, consumption depends
on permanent income; yet many studies of the consumption function try to relate consumption to
current income. Friedman argued that this errors-in-variables problem explains the seemingly
contradictory findings.
let’s see what Friedman’s hypothesis implies for the average propensity to
consume. Divide both sides of his consumption function by Y to obtain
APC =C/Y = YP/Y…………………… (1.16)
According to the permanent-income hypothesis, the average propensity to consume (APC)
depends on the ratio of permanent income to current income. When current income
temporarily rises above permanent income, the average propensity to consume temporarily falls;
when current income temporarily falls below permanent income, the average propensity
to consume temporarily rises.
Now consider the studies of household data. Friedman reasoned that these data reflect a
combination of permanent and transitory income. Households with high permanent income
have proportionately higher consumption. If all variation in current income came from the
permanent component, the average propensity to consume would be the same in all
households. But some of the variation in income comes from the transitory component, and
households with high transitory income do not have higher consumption. Therefore,
16 | P a g e
researchers find that high-income households have, on average, lower average propensities to
consume.
Similarly, consider the studies of time-series data. Friedman reasoned that
year-to-year
fluctuations in income are dominated by transitory income. Therefore, years
of high income
should be years of low average propensities to consume. But over long
periods of time—say,
from decade to decade the variation in income comes from the permanent component.
Hence, in long time-series, one should observe a constant average propensity to consume, as
in fact Kuznets found.
Distinguishing features of the lifecycle and permanent income hypotheses
Similarities
I. The two models are similar in the starting point of the analysis in the consumption
present value relationship given in equation 1.2. In other words, both hypotheses have
micro foundation. Thus, they argued that an individual have different income stream of
income in life and smooth out consumption overtime
II. Both concentrate on the structural relationship between expected lifetime income and
current consumption.
III. Both the LCH and PIH treated the wealth effect on consumption.
Differences: The two theories differ in the empirical implementation of the theory
I. The LCH model exhibit smaller MPC than PIH because the former also includes a
wealth variable whereas in the latter the wealth effect is included in permanent
income.
II. Friedman’s consumption model/function is somewhat less satisfactory than
Modigliani in that assets are only implicitly taken into account as determinants of
permanent income. In short, he did not clearly distinguishes between permanent
income (YP) and 0 (which is considered as a shift factor) as did by Ando-Modigliani ,
and
17 | P a g e
III. Friedman relies on the unobservable concepts of income (i.e., permanent income and
transitory incomes) while Ando-Modigliani relies on the observable income (i.e.,
income from labour and income from assets/property or the value of assets)
1.7 Hall’s Random Walk model
The permanent-income hypothesis is built on the insight that forward-looking consumers base
their consumption decisions not only on their current income but also on their expected future
income. Thus, the permanent-income hypothesis highlights the idea that consumption depends
on people’s expectations. Subsequent research on consumption combined this view of the
consumer with the assumption of rational expectations. The rational-expectations assumption
states that people use all available information to make optimal forecasts about the future.
The Hypothesis The economist Robert Hall was the first to derive the implications of rational
expectations for consumption. He showed that if the permanent-income hypothesis is correct,
and if consumers have rational expectations, then changes in consumption over time should be
unpredictable. When changes in a variable are unpredictable, the variable is said to follow a
random walk.
According to Hall, the combination of the permanent-income hypothesis and rational
expectations implies that consumption follows a random walk. Hall reasoned as follows.
According to the permanent-income hypothesis, consumers face fluctuating income and try their
best to smooth their consumption over time. At any moment, consumers choose consumption
based on their current expectations of their lifetime incomes.
Over time, they change their consumption because they receive news that causes them to revise
their expectations. For example, a person getting an unexpected promotion increases
consumption, whereas a person getting an unexpected demotion decreases consumption. In other
words, changes in consumption reflect “surprises” about lifetime income. If consumers are
optimally using all available information, they should be surprised only by events that were
unpredictable. Therefore, changes in their consumption should be unpredictable as well.
A. Rational Expectations (Muth, 1961; Lucas, 1972)
An approach that assumes that people optimally use all available information including
information about current and prospective policies to forecast the future
Economic agents form expectations using:
All available relevant information
18 | P a g e
The correct economic model (or their best understanding of it)
In the Consumption Context
Consumers estimate permanent income using optimal forecasting techniques.
They instantly incorporate all new information.
This is the foundation of Hall's random walk result.
B. Adaptive Expectations (Cagan, 1956; Friedman)
An approach that assumes that people form their expectation of a variable based on recently
observed values of the variable.
Expectations are updated based on past forecast errors.
"Learning from mistakes" but in a backward-looking way.
Common in early consumption functions (Friedman's PIH initially used this).
Properties
Systematic Errors Possible: Can persistently under- or over-predict in trending data
"Error-Correction" Mechanism: Gradually adjusts toward actual values
Weighted Average of Past Values: More weight on recent observations
Economic Implications
Creates sluggish adjustment in consumption to income changes.
Can generate consumption cycles.
Inconsistent with optimizing behavior if the true process is known.
C. Naïve Expectations
Refer to a simple and straightforward way people predict the future based on the assumption that
the future will be the same as the present or the most recent past.
The simplest possible forecast: "Tomorrow will be like today."
Special case of adaptive expectations
When Might This Be "Rational"?
When the variable follows a random walk:
In high-inflation environments where past is best guide
When information is extremely costly to process
19 | P a g e
Comparative Analysis
Rational Naïve
Feature Adaptive Expectations
Expectations Expectations
Only past values of
Information Use All available + model Only current value
variable
Forecast Errors Unpredictable Serially correlated Serially correlated
Suboptimal (unless
Optimality Statistically efficient Very suboptimal
AR(1))
Adjustment Speed Instantaneous Gradual (depends on λ) One-period lag
Can exploit systematic
Policy Implications Lucas Critique applies Easily exploited
errors
Consumption
Random walk Smooth adjustment Simple Keynesian
Behavior
“End”
20 | P a g e