ECON 314:MACROECONOMICS 2 CONSUMPTION AND CONSUMER EXPENDITURE

Transcription

1 ECON 314:MACROECONOMICS 2 CONSUMPTION AND CONSUMER EXPENDITURE

2 CONSUMPTION AND CONSUMER EXPENDITURE Previously, consumption was conjectured to be a function of income, more precisely current income. This is largely attributed to the work of Keynes based on his work from the mid-1930s.

3 CONSUMPTION AND CONSUMER EXPENDITURE More formally, this is specified as: Or in the slightly more realistic form:

4 CONSUMPTION AND CONSUMER EXPENDITURE This function as we have come to recognise, yields the all too familiar MPC:

5 CONSUMPTION AND CONSUMER EXPENDITURE Consumption has important macroeconomic consequences, particularly how the economy behaves over the long-run and short-run. It also has consequences on long-run economic growth, via the effects on savings decisions.

6 Keynes s conjectures 1. 0 < MPC < 1 2. Average propensity to consume (APC ) falls as income rises. (APC = C/Y ) 3. Income is the main determinant of consumption.

7 The Keynesian consumption function C As income rises, consumers save a bigger fraction of their income, so APC falls. C C cy C C APC c Y Y slope = APC Y

8 Last week we noted that three important conclusions had been reached from several cross-sectional data research on the consumption function.

9 Cross-sectional budget studies show s/y increasing and c/y decreasing as y rises, so that in cross-sections of the population, MPC < APC. Business cycle or short-run data show that that c/y ratio is smaller than average during boom periods and greater than average during slumps, so that in the short run, as income fluctuates, MPC < APC. Long-run trend data show no tendency for the c/y ratio to change over the long-run, so that as income grows long trend, MPC = APC.

10 The theories that were developed to explain the observed phenomena (already noted in the first lecture) all have basic foundations in the microeconomic theory of consumer choice. In particular, both approaches/theories developed by Friedman and Modigliani begin with the explicit assumption that observed consumer behaviour is the result of an attempt by rational consumers to maximise utility by allocating a lifetime stream of earnings to an optimum lifetime pattern of consumption.

11 INTER TEMPORAL CHOICE Along with Friedman and Modigliani, and before them Irvin Fisher (who pioneered this approach of inter-temporal consumer choice) we can begin with the case of single consumer with a utility function.

12 Irving Fisher and Inter-temporal Choice The basis for much subsequent work on consumption. Assumes consumer is forward-looking and chooses consumption for the present and future to maximize lifetime satisfaction. Consumer s choices are subject to an intertemporal budget constraint, a measure of the total resources available for present and future consumption.

13 INTER TEMPORAL CHOICE Along with Friedman and Modigliani, and before them Irvin Fisher (who pioneered this approach of inter-temporal consumer choice) we can begin with the case of single consumer with a utility function.

14 INTER TEMPORAL CHOICE Where lifetime utility U is a function of his real consumption in all time periods up to T, the instant before the consumer dies. The objective of the consumer to maximise his/her utility, that is, to obtain the highest level of utility, subject to the budget constraint that the present value of his total consumption in life cannot exceed the present value of his total income in life.

15 INTER TEMPORAL CHOICE Symbolically, this constraint can be written as

16 INTER TEMPORAL CHOICE T is the individual s expected life time. This budget constraint says that the consumer can allocate his income stream to a consumption stream by borrowing and lending, but the present value of consumption is limited by the present value of income.

17 INTER TEMPORAL CHOICE To simplify our lives, we restrict the analysis to a two-period case.

18 The basic two-period model Period 1: the present Period 2: the future Notation Y 1, Y 2 = income in period 1, 2 C 1, C 2 = consumption in period 1, 2 S = Y 1 - C 1 = saving in period 1 (S < 0 if the consumer borrows in period 1)

19 Deriving the intertemporal budget constraint Period 2 budget constraint: Rearrange terms: C 2 Y2 (1 r ) S Y (1 r )( Y C ) (1 r ) C C Y (1 r ) Y Divide through by (1+r ) to get

20 The intertemporal budget constraint C C Y Y 1 r 1 r present value of lifetime consumption present value of lifetime income

21 The intertemporal budget constraint C 2 C C Y Y 1 r 1 r (1 r ) Y Y 1 2 The budget constraint shows all combinations of C 1 and C 2 that just exhaust the consumer s resources. Y 2 Saving Y 1 Consump = income in both periods Borrowing Y Y (1 r ) 1 2 C 1

22 The intertemporal budget constraint The slope of the budget line equals (1+r ) C 2 1 C C Y Y 1 r 1 r (1+r ) Y 2 Y 1 C 1

23 Consumer preferences An indifference curve shows all combinations of C 1 and C 2 that make the consumer equally happy. C 2 Higher indifference curves represent higher levels of happiness. IC 2 IC 1 C 1

24 Consumer preferences Marginal rate of substitution (MRS ): the amount of C 2 the consumer would be willing to substitute for one unit of C 1. C 2 1 MRS The slope of an indifference curve at any point equals the MRS at that point. IC 1 C 1

25 Optimization The optimal (C 1,C 2 ) is where the budget line just touches the highest indifference curve. C 2 O At the optimal point, MRS = 1+r C 1

26 How C responds to changes in Y Results: Provided they are both normal goods, C 1 and C 2 both increase, regardless of whether the income increase occurs in period 1 or period 2. C 2 An increase in Y 1 or Y 2 shifts the budget line outward. C 1

27 Keynes vs. Fisher Keynes: Current consumption depends only on current income. Fisher: Current consumption depends only on the present value of lifetime income. The timing of income is irrelevant because the consumer can borrow or lend between periods.

28 How C responds to changes in r As depicted here, C 1 falls and C 2 rises. However, it could turn out differently C 2 B An increase in r pivots the budget line around the point (Y 1,Y 2 ). A Y 2 Y 1 C 1

29 How C responds to changes in r income effect: If consumer is a saver, the rise in r makes him better off, which tends to increase consumption in both periods. substitution effect: The rise in r increases the opportunity cost of current consumption, which tends to reduce C 1 and increase C 2. Both effects C 2. Whether C 1 rises or falls depends on the relative size of the income & substitution effects.

30 Implications Worth Noting!!! One implication of the forgoing analysis is that current period consumption will vary less than does income. In the two-period case we utilise, an increase in present income would be spread across an increase in both present and future consumption.

31 Implications Worth Noting!!! Thus, if we extend the analysis to many periods, say 25 years, spreading an increase in present income over 25 years of consumption increments would give a present consumption increase that is very small relative to the increase in present income.

32 Implications Worth Noting!!! The relationship between the present value of the income stream and current consumption gives us the first general formulation of the consumption function c f ( PV ); f 0 0 ' 0

33 Implications Worth Noting!!! Where PV 0 is formulated as PV 0 T y (1 0 t r ) t

34 Implications Worth Noting!!! This consumption function c f ( PV ); f 0 0 ' 0 simply says that an individual s consumption in time 0 is an increasing function of the present value of his/her income in time 0.