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Keynes’s conjectures

1. 0 < MPC < 1

Chapter 17: Consumption
2. Average propensity to consume (APC )
falls as income rises.
(APC = C/Y )
3. Income is the main determinant of
consumption.

CHAPTER 17 Consumption 0 CHAPTER 17 Consumption 1

The Keynesian consumption function The Keynesian consumption function

As income rises, consumers save a bigger

C C fraction of their income, so APC falls.

C  C  cY C  C  cY

c c = MPC
= slope of the
1
consumption C C
APC   c
C function Y Y
slope = APC
Y Y
CHAPTER 17 Consumption 2 CHAPTER 17 Consumption 3

Early empirical successes: Problems for the

Results from early studies Keynesian consumption function
 Households with higher incomes:  Based on the Keynesian consumption function,
 consume more,  MPC > 0 economists predicted that C would grow more
 save more,  MPC < 1 slowly than Y over time.
 save a larger fraction of their income,  This prediction did not come true:
 APC  as Y   As incomes grew, APC did not fall,
 Very strong correlation between income and and C grew at the same rate as income.
consumption:  Simon Kuznets showed that C/Y was
 income seemed to be the main very stable in long time series data.
determinant of consumption

CHAPTER 17 Consumption 4 CHAPTER 17 Consumption 5

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The Consumption Puzzle Irving Fisher and Intertemporal Choice

 The basis for much subsequent work on

Consumption function consumption.
C from long time series
data (constant APC )  Assumes consumer is forward-looking and
chooses consumption for the present and future
to maximize lifetime satisfaction
satisfaction.
Consumption function  Consumer’s choices are subject to an
from cross-sectional
intertemporal budget constraint,
household data
a measure of the total resources available for
(falling APC )
present and future consumption.
Y
CHAPTER 17 Consumption 6 CHAPTER 17 Consumption 7

The basic two-period model Deriving the intertemporal

budget constraint
 Period 1: the present
 Period 2 budget constraint:
 Period 2: the future
C 2  Y 2  (1  r ) S
 Notation
 Y 2  (1  r ) (Y1  C 1 )
Y1, Y2 = income
i iin period
i d11, 2
C1, C2 = consumption in period 1, 2  Rearrange terms:
S = Y1  C1 = saving in period 1 (1  r ) C 1  C 2  Y 2  (1  r )Y1
(S < 0 if the consumer borrows in period 1)
 Divide through by (1+r ) to get…

CHAPTER 17 Consumption 8 CHAPTER 17 Consumption 9

The intertemporal budget constraint The intertemporal budget constraint

C2 C2 Y2
C1   Y1 
C2 Y2 1r 1r
C1   Y1 
1r 1r
(1  r )Y1 Y 2
Consump =
Saving income in
present value
l off present value
l off The budget both periods
lifetime consumption lifetime income constraint shows
all combinations Y2
of C1 and C2 that Borrowing
just exhaust the
consumer’s C1
Y1
resources.
Y1 Y 2 (1  r )
CHAPTER 17 Consumption 10 CHAPTER 17 Consumption 11

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The intertemporal budget constraint Consumer preferences

C2 Y2 Higher
C2 C1   Y1  C2
1r 1r An indifference indifference
The slope of curve shows curves
the budget all combinations represent
line equals 1 of C1 and C2 higher levels
(1+r
(1+ ) (1 r )
(1+ that make the off happiness.
h i
consumer
Y2 equally happy. IC2

IC1
C1 C1
Y1

CHAPTER 17 Consumption 12 CHAPTER 17 Consumption 13

Consumer preferences Optimization

C2 The slope of C2
Marginal rate of an indifference The optimal (C1,C2)
substitution (MRS ): At the optimal point,
curve at any is where the
the amount of C2 MRS = 1+r
point equals budget line
the consumer the MRS jjust touches
would be willing to 1 at that point. the highest
substitute for MRS
indifference curve. O
one unit of C1.

IC1
C1 C1

CHAPTER 17 Consumption 14 CHAPTER 17 Consumption 15

How C responds to changes in Y Keynes vs. Fisher

C2 An increase
 Keynes:
Results: Current consumption depends only on
in Y1 or Y2
Provided they are current income.
shifts the
both normal goods,
C1 and C2 both
budget line  Fisher:
outward.
increase, Current consumption depends only on
…regardless of the present value of lifetime income.
whether the The timing of income is irrelevant
income increase because the consumer can borrow or lend
occurs in period 1 between periods.
or period 2. C1

CHAPTER 17 Consumption 16 CHAPTER 17 Consumption 17

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How C responds to changes in r How C responds to changes in r

C2  income effect: If consumer is a saver,
An increase in r
As depicted here, the rise in r makes him better off, which tends to
pivots the budget
C1 falls and C2 rises. increase consumption in both periods.
line around the
However, it could point (Y1,Y2 ).  substitution effect: The rise in r increases
turn out differently…
y B the opportunity cost of current consumption
consumption,
which tends to reduce C1 and increase C2.
A
 Both effects  C2.
Y2 Whether C1 rises or falls depends on the relative
C1 size of the income & substitution effects.
Y1

CHAPTER 17 Consumption 18 CHAPTER 17 Consumption 19

Constraints on borrowing Constraints on borrowing

 In Fisher’s theory, the timing of income is irrelevant:
Consumer can borrow and lend across periods. C2
The budget
 Example: If consumer learns that her future income line with no
will increase, she can spread the extra consumption borrowing
over both pperiods by
y borrowing
g in the current p
period. constraints
 However, if consumer faces borrowing constraints
Y2
(aka “liquidity constraints”), then she may not be
able to increase current consumption
…and her consumption may behave as in the
Keynesian theory even though she is rational & Y1 C1
forward-looking.
CHAPTER 17 Consumption 20 CHAPTER 17 Consumption 21

Consumer optimization when the

Constraints on borrowing
borrowing constraint is not binding
C2 C2
The borrowing The borrowing
constraint takes constraint is not
the form: The budget binding if the
line with a
C1  Y1 consumer’s
consumer s
borrowing
optimal C1
Y2 constraint
is less than Y1.

Y1 C1 Y1 C1

CHAPTER 17 Consumption 22 CHAPTER 17 Consumption 23

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Consumer optimization when the

The Life-Cycle Hypothesis
borrowing constraint is binding
C2
 due to Franco Modigliani (1950s)
The optimal
choice is at
 Fisher’s model says that consumption depends
point D. on lifetime income, and people try to achieve
smooth consumption.
But since the
consumer  The LCH says that income varies systematically
cannot borrow, E over the phases of the consumer’s “life cycle,”
the best he can D and saving allows the consumer to achieve
do is point E.
smooth consumption.
Y1 C1

CHAPTER 17 Consumption 24 CHAPTER 17 Consumption 25

The Life-Cycle Hypothesis The Life-Cycle Hypothesis

 The basic model:  Lifetime resources = W + RY
W = initial wealth  To achieve smooth consumption,
Y = annual income until retirement consumer divides her resources equally over time:
(assumed constant) C = (W + RY )/T , or
R = number of years until retirement C = W +  Y
T = lifetime in years where
 Assumptions:  = (1/T ) is the marginal propensity to
 zero real interest rate (for simplicity) consume out of wealth
 consumption-smoothing is optimal  = (R/T ) is the marginal propensity to consume
out of income
CHAPTER 17 Consumption 26 CHAPTER 17 Consumption 27

Implications of the Life-Cycle Hypothesis Implications of the Life-Cycle Hypothesis

$
The LCH can solve the consumption puzzle:
 The life-cycle consumption function implies The LCH
APC = C/Y = (W/Y ) +  implies that
Wealth

 Across households, income varies more than saving varies

wealth, so high-income households should have systematically Income
a lower APC than low-income households. over a
person’s Saving
 Over time, aggregate wealth and income grow lifetime.
Consumption Dissaving
together, causing APC to remain stable.
Retirement End
begins of life
CHAPTER 17 Consumption 28 CHAPTER 17 Consumption 29

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The Permanent Income Hypothesis The Permanent Income Hypothesis

 due to Milton Friedman (1957)  Consumers use saving & borrowing to smooth
consumption in response to transitory changes
 Y = YP + YT
in income.
where
Y = current income
 The PIH consumption function:
Y P = permanent income C = YP
average income, which people expect to where  is the fraction of permanent income
persist into the future
that people consume per year.
Y T = transitory income
temporary deviations from average income

CHAPTER 17 Consumption 30 CHAPTER 17 Consumption 31

The Permanent Income Hypothesis PIH vs. LCH

The PIH can solve the consumption puzzle:  Both: people try to smooth their consumption
 The PIH implies in the face of changing current income.
APC = C/Y =  Y P/Y  LCH: current income changes systematically
 If high-income
g households have higher
g transitory
y as p
people
p move through
g their life cycle.
y
income than low-income households,
APC is lower in high-income households.  PIH: current income is subject to random,
transitory fluctuations.
 Over the long run, income variation is due mainly
(if not solely) to variation in permanent income,  Both can explain the consumption puzzle.
which implies a stable APC.

CHAPTER 17 Consumption 32 CHAPTER 17 Consumption 33

The Random-Walk Hypothesis The Random-Walk Hypothesis

 due to Robert Hall (1978)  If PIH is correct and consumers have rational
expectations, then consumption should follow a
 based on Fisher’s model & PIH,
random walk: changes in consumption should
in which forward-looking consumers base
be unpredictable.
consumption on expected future income
 A change in income or wealth that was
 Hall adds the assumption of anticipated has already been factored into
rational expectations, expected permanent income,
that people use all available information so it will not change consumption.
to forecast future variables like income.  Only unanticipated changes in income or wealth
that alter expected permanent income
will change consumption.
CHAPTER 17 Consumption 34 CHAPTER 17 Consumption 35

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Implication of the R-W Hypothesis The Psychology of Instant Gratification

 Theories from Fisher to Hall assume that

consumers are rational and act to maximize
If consumers obey the PIH lifetime utility.

and have rational expectations,  Recent studies by David Laibson and others
consider the psychology of consumers
consumers.
then policy changes
will affect consumption
only if they are unanticipated.

CHAPTER 17 Consumption 36 CHAPTER 17 Consumption 37

The Psychology of Instant Gratification Two questions and time inconsistency

 Consumers consider themselves to be imperfect 1. Would you prefer (A) a candy today, or
decision-makers. (B) two candies tomorrow?
 In one survey, 76% said they were not saving 2. Would you prefer (A) a candy in 100 days, or
enough for retirement. (B) two candies in 101 days?

 Laibson:
L ib Th
The ““pullll off iinstant
t t gratification”
tifi ti ” In studies,
studies most people answered (A) to 1 and (B) to 2
2.
explains why people don’t save as much as a A person confronted with question 2 may choose (B).
perfectly rational lifetime utility maximizer would But in 100 days, when confronted with question 1,
save. the pull of instant gratification may induce her to
change her answer to (A).

CHAPTER 17 Consumption 38 CHAPTER 17 Consumption 39

Summing up Chapter Summary

 Keynes: consumption depends primarily on 1. Keynesian consumption theory
current income.  Keynes’ conjectures
 Recent work: consumption also depends on  MPC is between 0 and 1
 expected future income  APC falls as income rises
 current income is the main determinant of
 wealth
current consumption
 interest rates  Empirical studies
 Economists disagree over the relative  in household data & short time series:
importance of these factors, borrowing confirmation of Keynes’ conjectures
constraints, and psychological factors.  in long-time series data:
APC does not fall as income rises
CHAPTER 17 Consumption 40

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Chapter Summary Chapter Summary

2. Fisher’s theory of intertemporal choice 3. Modigliani’s life-cycle hypothesis
 Consumer chooses current & future  Income varies systematically over a lifetime.
consumption to maximize lifetime satisfaction  Consumers use saving & borrowing to
of subject to an intertemporal budget smooth consumption.
constraint.
constraint
 Consumption depends on income & wealth.
 Current consumption depends on lifetime
income, not current income, provided
consumer can borrow & save.

Chapter Summary Chapter Summary

4. Friedman’s permanent-income hypothesis 5. Hall’s random-walk hypothesis
 Consumption depends mainly on permanent  Combines PIH with rational expectations.
income.  Main result: changes in consumption are
 Consumers use saving & borrowing to unpredictable, occur only in response to
smoothth consumption
ti in
i the
th face
f off transitory
t it unanticipated
ti i t d changes
h iin expected
t d
fluctuations in income. permanent income.

Chapter Summary
6. Laibson and the pull of instant gratification
 Uses psychology to understand consumer
behavior.
 The desire for instant gratification causes
people
l to
t save less
l than
th they
th rationally
ti ll know
k
they should.