Wollo University, Department of Economics
Chapter Two: Aggregate Consumption & Saving
2.1 Consumption under Certainty: The Life Cycle/Permanent Income
Hypothesis
This topic and the next investigate households’ consumption choices and firm’s investment
decisions in more detail. Consumption & investment are important to both growth &
fluctuations. With regard to growth, the division of the society’s resource between current
consumption & various investment (physical capital, human capital and R & D is central to the
standard of living in the long run. With regard to fluctuation, consumption and investment make
up the vast majority of demand for goods /national income. (Consumption only takes 1
3 of the
GDP).
There are two other reasons for studying consumption & investment.
They introduce some important issues involving in financial market.
Most empirical work in macroeconomics has been concerned with consumption and
investment.
Assumptions
The utility is certain /actual but not expected.
Interest rate & discount rates are zero.
Assuming that an individual lives for T periods, his lifetime utility is:-
T
U U (C t )
t 1
Given his initial wealth of A0 and labor incomes of y1 , y2 , ... yT thus the individual’s budget
constraint is
T T
U Ct A0 Yt
t 1 t 1
Since the margin of utility of consumption is always positive, the individual satisfies the budget
constraint with equality. So the lagrangian for his maximum problem is
T T T
L U (Ct ) A0 Yt Ct
t 1 t 1 t 1
Lecture Notes: Advanced Macroeconomics By: Addisu Molla (PhD)
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Wollo University, Department of Economics
The first order condition for C1 is U 1 (C t ) . Thus, the marginal utility of consumption is
constant so that consumption levels in different period are the same, C1 C2 .... CT . As a
result the individual’s total lifetime resources (initial wealth + lifetime income) will be equally
distributed among each period his life.
T
1
Ct A0 Y2
T T 1
Implications
The individual’s consumption in a given period is determined not by income at that period, (i.e,
current income), but by income over his entire lifetime (i.e, permanent income which is
represented by the right hand side of above equation). The difference between the current and
permanent income is transitory income (e.g lottery, remittance/income transfer).
Saving
Saving is future consumption. In other words, saving is used for consumption of parents &
children later in life. Decision about division of income between consumption and saving is
driven by preferences between present and future consumption. Based on the above analysis the
time pattern of income is not important to consumption (e.g. Consumption is smooth out over
periods). But it is critical to saving. The individual’s saving in period t is the difference between
income & consumption:
S Yt Ct
T
1 1
Yt
T
Y T A
Z 1
t 0
Income Percent income Average wealth
/average
Saving is high when current income is higher than average /permanent income, that is when
transitory income is high and vice versa. (N.B= Current Y Y P Y T )
Lecture Notes: Advanced Macroeconomics By: Addisu Molla (PhD)
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Wollo University, Department of Economics
Empirical Application: Estimated Consumption Function
Regression of consumption on current income
C1 a bYt e1
The estimated value of the coefficient b is given as the ratio of covariance of independent &
dependent variables to variance of independent variable.
bˆ Cov (Y , C ) / Var (Y )
Similarly the estimated value of the constant /intercept a is given by:
C aˆ bˆY , Y Y P Y T Yt (Current Income)
aˆ C bY
aˆ Y p b(Y p Y T ) , Consumption equals permanent income.
aˆ (1 bˆ)Y p , the mean of transitory income is zero.
In connection with this we can see different forms of the relationship between current income
and consumption.
Lecture Notes: Advanced Macroeconomics By: Addisu Molla (PhD)
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Wollo University, Department of Economics
Figure 2.1 Relationship between current income and consumption
While the individual consumption is determined by current disposable income, aggregate
consumption is proportionate to aggregate income. With regard to consumption across groups,
the slope of whites and blacks consumption is similar but the intercept is higher to whites. It is
important to note that in this section due to the unavailability of information the future
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Wollo University, Department of Economics
consumption is unpredictable so that the prediction is based on expectations on the future
consumption which in turn is based on making some random hypothesis such as Ct 1 Ct .
2.2 Consumption under Uncertainty: The Random Walk Hypothesis
Individual Behavior
The analysis for uncertainty also continues to assume that both interest rate and discount rate are
zero but the consumption function is quadratic but not linear as in the case of certainty analysis.
Thus, the individual maximizes:
T a 2
E (U ) E Ct Ct
t 1 2
The budget constraint is again given by
T T
Ct A0 Yt
t 1 t 1
Since it is the case of uncertainty the consumption and thus the utility at a given period is an
expected value based on the information available. If an individual optimizes his utility the
marginal utility of consumption, say in period 1, (must be equals to its expected value i.e,
U1' E1 (U ' )
1 aC1 E1 (1 aCt )
Since E1 (1 aCt ) equals 1 aE1 (Ct )
1 aC1 1 aEt (Ct )
C1 E1 (Ct ) for t 2, 3, ..., T , Thus, C1 E1 (C2 )
Implications
C1 E1 (C2 ) The expected period 2 consumption equals period 1 consumption. More
generally, the expected next period consumption equals the current period consumption.
i.e, E (Ct 1 ) Ct or Ct E (Ct 1 )
In regression= Ct Ct 1 et E (Ct 1 ) Ct 1
Lecture Notes: Advanced Macroeconomics By: Addisu Molla (PhD)
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Wollo University, Department of Economics
With regard to smoothing of consumption overtime, individual’s consumption period 1, C1, is
equals to expected lifetime resources
T
0 E1 (Yt ) divided by his lifetime, T.
A
t 1
T
1
C1 A0 E1 (Yt )
T t 1
To investigate the change in consumption between period 1 and period 2 (i.e, between current
period & next period) we need to derive period 2 consumption, C2. This consumption equals to
expected remaining lifetime resource divided by the remaining lifetime.
T
1
C2 A1 E2 (Yt )
T 1 t 2
Since A1 A0 Y1 C1
T
1
C2 A0 Y1 C1 E 2 (Yt )
T 1 t 2
T
Since the expectation as of period 2 of income, E (Y )
t 2
2 t equals to the expectation as of period
T T T
1, E1 (Yt ) , plus the information learned between period 1 & period 2,
t 2
E2 (Yt ) E1 (Yt ) ,
t 2 t 2
thus the above equation can be rewrite as
T
1 T T
C2 A0 Y1 C1 E1 (Yt ) E2 (Yt ) E1 (Yt )
T 1 t 2 t 2 t 2
T
Since A0 Y1 E1 (Yt ) TC , Consumption at period 1 X T.
t 2
1 T T
C2 TC1 C1 E2 (Yt ) E1 (Yt )
T 1 t 2 t 2
1 T T
C2 C
1
T 1
(T 1)
t 2
E 2 (Yt )
t 2
E1 (Yt )
1 T T
C 2 C1 E 2 (Yt ) E1 (Yt )
T 1 t 2 t 2
1 T T
C 2 C1 E 2 (Yt ) E1 (Yt )
T 1 t 2 t 2
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Wollo University, Department of Economics
The change in consumption between period 1 and period 2 equals the change in individual’s
estimate of his lifetime resource between the two periods divided by his remaining lifetime. Note
that the empirical test of Cambell & Mankiws on a random walk hypothesis aims to test whether
change in income has a significant effect on change in consumption.
2.3 The Interest Rate and Saving
In the case consumption under certainty zero interest rate is prevailed, however, now we can
extend the case by allowing a non-zero interest rate. Thus, the constraint function become:-
T T
1 1
t 2 (1 r )
t
C t A0
t 1 (1 r )
Y)
t t
The present value of lifetime consumption cannot exceed initial wealth plus present value of
lifetime labor income. When we allow a non-zero interest rate (interest rate of saving or
borrowing to smooth out consumption overtime), it is also useful to allow a non-zero discount
rate (discounting the future consumption expectation & income to the present period).
T
1 Ct1
That is, the utility function is also given by U , Where discount rate and
t 1 (1 )t 1
consumption variation (coefficient of relative risk) due to difference in r & . eg. As
increases current consumption increases and as r increases future consumption increases and
consumption is rising over time if r > and falling if r< .
The Interest Rate and Saving in Two Period Case
The increase in r (saving) motivates an individual to save more and thereby raises future
consumption. For illustration, we can take a case where the individual lives for only two periods
and assume that he has no initial wealth. When r rises, the second period consumption increases.
That is giving up 1 unit of 1 st period consumption allows the individual to increase 2 nd period
consumption by (1+r).
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Y2
C2’
C2
Y1 C1’ C1 C1
Figure 2.2 Utility maximization and saving
Figure 2.2 has shown the interaction of budget constraint line and indifference curve of utility.
Accordingly, the budget constraint becomes steeper when r rises. As a result, first period
consumption decreases from C1 to C1’ and second period consumption increases from C2 to C2’.
So that saving increases.
2.4 Consumption and Risky Assets
Individuals want to invest in many assets which all have uncertain returns so that these assets are
called risky assets. But by considering the expected return on assets (r) individuals invest on
asset (say asset i) and investment optimization requires.
1
U ' (Ct )
1
Et (1 rt'1 ).U ' (Ct 1 )
1
The marginal utility from consumption period t equals to times the expected value of the
1
product of return on asset at period t+1 and marginal utility at period t+1. Such expectation is
made by discounting t+1 values in to current period t values.
Instead of estimating the return on risky assets individual also used the payoff/return on risk free
assets to make decision on investing /buying a new risky asset. That is an individual invests on a
new risky asset if the expected return on risky asset at least equals to the rate of return on risk
free asset. If this is so the consumption level also increased in proportionate to expected return
Lecture Notes: Advanced Macroeconomics By: Addisu Molla (PhD)
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Wollo University, Department of Economics
on risky asset. Such model of determination of expected asset return is known as the
consumption capital asset pricing model, or consumption CAPM.
2.5 Alternative Views of Consumption
In permanent income hypothesis discussed so far consumption is determined by permanent
income and this hypothesis also describes many features of relationship between current income
and consumption. But there are also important features of consumption that appear inconsistence
with the permanent income hypothesis. Thus, there are theories that are alternative to the
permanent income hypothesis.
Precautionary Saving and Growth of Consumption
In permanent income hypothesis the utility function is quadratic and the marginal utility falls as
consumption rises so that the second derivative equals to zero. However, in this alternative
theory the function is cubic and the marginal utility falls slowly as consumption rises, that is the
third derivative of utility is probably positive rather than zero. The combination of such positive
third derivative of the utility function and uncertainty about future income reduces current
consumption, and thus raising saving. This saving is known as precaution saving. The precaution
saving has an impact on expected consumption growth.
The impact of precautionary saving on expected consumption growth [E(gc] depicted on variance
of consumption growth [var(gc)] and the coefficient of relative risk aversion ( ) and the
equation is given by
1
E(g c ) ( 1) var( g c )
2
If both are substantial, the precautionary saving can have a large effect on expected consumption
growth. For example, if =4 and the standard deviation of his uncertainty about their
consumption a year ahead is 0.1, thus the precautionary saving raises expected consumption
growth by
1
E(g c ) ( 4 1) (0.1) 2 2.5 Percentage points
2
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Wollo University, Department of Economics
Liquidity Constraints
If individuals face high interest rate for borrowing, they may choose not to borrow to smooth
their consumption when their current resource are low or when they faced liquidity constraints.
Thus liquidity constraint (i.e, low level of current resource) causes the current income to be more
important to consumption than it is predicted by the permanent income hypothesis. The presence
of liquidity constraint causes individuals to save as insurance against the effects of future falls in
incomes. As a result of increase in saving the current consumption falls.
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