Macroeconomics II Consumption

Transcription

1 Macroeconomics II Consumption Vahagn Jerbashian Ch. 17 from Mankiw (2010); 16 from Mankiw (2003) Spring 2018

2 Setting up the agenda and course Our classes start on and end on Lectures and practical sessions: Thursday and Friday, 8:30am - 10:00am Lectures and practical sessions: Wednesday, 9:00am - 10:00am

3 Setting up the agenda and course Offi ce hours: By appointment and by default on Wednesday, 4:00pm - 5:00pm, building 696, room #418; vjerbashian@gmail.com and vahagn.jerbashian@ub.edu

4 Setting up the agenda and course Check course web-page for detailed syllabus, exercises, slides, materials, news, info, and discussions vjerbashian.wordpress.com/teaching/macro-ii-18/

5 Setting up the agenda and course - book Main textbooks are "Mankiw, G., N. (2010). Macroeconomics (7th ed). Worth Publishers" and "Mankiw, G., N. (2003). Macroeconomics (5th ed). Worth Publishers" Check our web-page for online supplementary materials and quizzes

6 Setting up the agenda and course - grading There are two evaluation options available: Continuous Evaluation option and Unique Evaluation option You have to choose in the Virtual Campus which one you want to take by March 15 - automatically assigned to continuous! Continuous Evaluation consists of completing in-class exercises, mid-term exams, and home assignments during the semester and an end-of-semester exam Unique Evaluation option consists of an end-of-semester exam which might differ from the exam for Continuous Evaluation option

7 Setting up the agenda and course - Continuous Evaluation Students will complete the following continuous assessment activities during the semester: 6 in-class exercises to be done individually (15% of the final grade) 2 mid-term exams (25% of the final grade) The tentative dates of two of the mid-term exams are March 22 (Thursday) and May 17 (Thursday) Course participation (10% of the final grade)

8 Setting up the agenda and course - Continuous Evaluation At least two tests and 4 in-class practical exercises are required to calculate the continuous assessment grade If a student has less than that s/he will only be eligible for the repeat assessment option The end-term examination covers all topics It is up to 50% of the final grade All exams consist of multiple choice questions, theoretical questions, and problems of numerical and graphical analysis

9 Setting up the agenda and course - Unique Evaluation Students can take an end-term examination based (unique) evaluation worth 100% of the final grade The problems in this exam might be different from the end-term exam of Continuous Evaluation option Those who are unable to meet the continuous assessment requirements can request this option This request is made via Virtual Campus with a deadline by March 15

10 Setting up the agenda and course - Repeat Evaluation Repeat Evaluation consists of a test similar to the end-term exam and is worth 100% of the final grade for all students i.e., irrespective whether they have taken the Continuous Evaluation or Unique Evaluation options All students who fail or do not take the end-term exam can take the Repeat Evaluation exam.

11 Setting up the agenda and course - preparing for exam In order to be well prepared for the exam I strongly recommend attend all lectures and practical sessions read the chapters of the book as we go through them solve manually the problem sets available on our web-page consult with me about your solutions during my offi ce hours

12 Where we are In the previous semester you have got acquainted with the national income accounts, Y = C + I + G + NX. Mankiw - Chapters 1, 2, and 3 During the first two weeks we will have a closer look on consumption (C) and investment (I ) Mankiw (2010) - Chapters 17 and 18; Mankiw (2003) - Chapters 16 and 17 Having a better understanding of C and I we will later construct a model which tries to explain economic fluctuations in the short-run

13 Microeconomics in Macroeconomics Macroeconomics is largely motivated by microeconomics There are issues that are answered in microeconomics and can have aggregate/macroeconomic effects What does affect the households decision of consumption How do households decide how much of income to consume now and how much to save for future?

14 Why is consumption so important? In Macroeconomics we try to answer those questions since consumption is around 2/3 of total output (GDP) in Spain and in the US in short time horizon (short-run) the fluctuations in consumption and/or savings can cause fluctuations in GDP in long time horizon (long-run) consumption and savings can determine the steady-state wealth (and the rate of growth) e.g., in the Solow Model savings are a constant fraction of output (whatever is left after consumption) and determine the steady-state level of per capita output in the economy

15 GDP, consumption, and investment in Spain

16 GDP, consumption, and investment in the US

17 Different theories for consumption There are several alternative explanations behind the observed patterns of aggregate consumption (in chronological order) John Maynard Keynes s (Keynesian) Consumption Function Irving Fisher s Model of Inter-temporal Choice Franco Modigliani s Life Cycle Hypothesis Milton Friedman s Permanent Income Hypothesis Robert Hall s Random Walk Hypothesis Although these views have rather different explanations, they all agree that the marginal propensity to consume is from 0 to 1; and none of them has hard empirical support

18 Keynesian Consumption Function Keynes did not have data that would support his conjectures. He based his conjectures on casual observations and logic 1. The marginal propensity to consume (MPC) is from 0 to 1 MPC is the amount consumed out of an additional EUR 2. The average propensity to consume (APC) falls as income increases APC is the ratio of consumption to income (APC = C /Y ) Keynes argued that the savings are luxury good - thus, the rich would invest bigger fraction of their income 3. The key determinant of consumption is the current income, and the interest rate does not play big role

19 Keynesian Consumption Function - formally Formally and in the most basic case, Keynesian consumption function can be written as C = C + cy, C > 0, 0 < c < 1

20 Empirical evidence - positive In individual households data (cross section) Those with higher income consume more (MPC > 0) and save more (MPC < 1). They also save a larger fraction of their income (Y APC ) Aggregated data on consumption and income (time series) In years of high/low income the consumption and savings are high/low [MPC (0, 1)] and Y C is low/high in short time horizon (Y APC )

21 Empirical evidence - negative Regarding the negative relation between APC and Y Simon Kuznets was the first who complied long time series of aggregate data on income (Y ) and consumption. His data revealed that Y rises over time though APC does not decline, but it is stable This is one of the motivations of modern growth theories Regarding the hypothesis that only current income matters Those that study (invest their time) forgo an opportunity to work and increase their consumption for the opportunity to consume more in future. Thus, the future income may matter for today s consumption

22 Irving Fisher s Model of Inter-temporal Choice The main idea behind this model is that saving and borrowing are instruments for transferring income over time In contrast to Keynes s model this one incorporates time dimension and a trade-off between current and future consumption

23 2 period model of inter-temporal choice at t = 1 the person earns income Y 1 (given) and consumes C 1 (choice) at t = 2 the person earns income Y 2 (given) (let Y 2 < Y 1 ) and consumes C 2 (choice) opportunity to borrow/save at interest rate r

24 Inter-temporal choice At any point of time when we decide the level of consumption we take into account our potential income (as well as consumption) in different time periods In order to decide then, we have to make everything comparable In order to make them comparable we have to convert the future units to present units For that, we discount the future units by 1 + r, where r is the real interest rate

25 Inter-temporal choice C 1 + C r }{{} PDV of consumption = Y 1 + Y r }{{} PDV of income

26 Inter-temporal budget constraint (BC) Budget constraint says that the amount a person can spend is constrained by his income C 1 + S = Y 1 C 2 = Y 2 + (1 + r)s where S is the saving (S > 0) or the borrowing (S < 0)

27 Inter-temporal optimal choice C 1, C 2 and S are determined from households optimization problem The household faces a trade-off between consumption today and tomorrow (e.g., less today more tomorrow) From microeconomics we know that the household will choose to consume as much as possible C 1 and C 2 upon the marginal rate of substitution (MRS) MRS shows the minimal addition to C 2 that households will accept in order to sacrifice 1 unit of C 1 MRS = 1 + r, since in optimum household s indifference curve (between C 1 and C 2 ) is tangent to budget constraint

28 Inter-temporal optimal choice - illustration The opimal choices can be illustrated graphically in the following manner (IC: indifference curve)

29 Inter-temporal choice: The effect of income and interest rate The increase in income shifts the budget constraint outward If C 1 and C 2 are normal goods, then they both increase (even if only Y 1 changes) We can observe also consumption smoothing when the household prefers the average days to the sequence of good and bad days regardless when consumer experiences increase in income, he spreads it over consumption in both periods Implication: consumption is based on resources the consumer expects over his lifetime

30 Inter-temporal choice: The effect of income The increase in income shifts the budget constraint outward

31 Inter-temporal choice: The effect of income and interest rate The interest rate matters since today it indicates the relative price of tomorrow s consumption There are two effects when r increases 1. Substitution effect: tomorrow s consumption becomes less expensive today so the household may consume less today and invest more 2. Income effect: the budget constraint rotates around the point (Y 1, Y 2 ) thus the indifference curve can change The combination of these two effects depends on the (shape) of preferences

32 Inter-temporal choice: The effect of interest rate The increase in interest rate rotates budget constraint

33 Franco Modigliani s Life Cycle Hypothesis This hypothesis consists of two general points Income varies systematically over life time People can save their income from good (high-income) periods for bad (low-income) periods

34 Example for the Life Cycle Hypothesis A person with current wealth W expects to live T more years: R working and earning Y, T R in retirement with no earnings Assume the person tries to smooth consumption over life time (tries to have the same consumption every year), then C = W + RY T = 1 T W + R T Y. If T = 50 and R = 30 C = 0.02W + 0.6Y Formally: C = αw + βy, where α and β are the MPCs out of wealth and out of income, respectively

35 Implications of the Life Cycle Hypothesis This hypothesis delivers an interesting explanation for APC "paradox" APC = C Y = αw Y + β in short-run: W is roughly constant (APC Y ) in long-run: W and Y grow at the same rate (APC = const)

36 Implications of the Life Cycle Hypothesis Another implication is savings vary across person s lifetime - young, who are working, save, whereas the old, who are retired, dissave

37 Implications of the Life Cycle Hypothesis These implications seem to be intuitive although they still confront the data Elderly do not dissave as much as the model predicts The reasons could be - expect longer life, leave bequests to their children, etc.

38 Milton Friedman s Permanent Income Hypothesis (PIH) This hypothesis consist of several points 1. There are two types of income 1.1 Y P - expected life-time income (permanent income) 1.2 Y T - short-term (transitory) income that does not affect the expected income Y = Y P + Y T 2. The main determinant of consumption is permanent income, Y P 3. Saving (and borrowing) is used in response to the short term changes in income for consumption smoothing Formally: C = αy P

39 The implications of the Permanent Income Hypothesis This hypothesis can deliver an explanation to APC paradox by fluctuation of Y around Y P In household surveys APC = C Y = α Y P Y If the increase in Y comes from Y P, households proportionally increase their consumption (APC = const) If the increase in Y comes from Y T, households do not change their consumption (Y APC ) In time series short-run: changes determined by Y T - APC changes long-run: changes determined by Y P - APC = const

40 Robert Hall s Random Walk Hypothesis The Random Walk Hypothesis, in addition to PIH, assumes that people have rational expectations It follows then that the consumption follows a random walk (fluctuations are unpredictable) Explanation The random walk is a trajectory that consists of taking successive random steps PIH states that the consumers try to smooth their consumption in response to transitory changes Rational consumers use all available information to calculate the expected income; thus, only unpredictable shocks are reflected by changes in consumption

41 The implications of Random Walk Hypothesis 1. Only unexpected policy changes can affect the consumption 2. In order to change it permanently, these policies have to affect the expectations The problems: This hypothesis is not supported by data. It turns out that the fluctuations of consumption are predictable A reason could be the rather irrational behavior of consumers