ECON 314: MACROECONOMICS II CONSUMPTION AND CONSUMER EXPENDITURE

Transcription

1 ECON 314: MACROECONOMICS II CONSUMPTION AND CONSUMER 1

2 Explaining the observed patterns in data on consumption and income: short-run and cross-sectional data show that MPC < APC, whilst long-run data show MPC = APC. Several explanations put forward to solve the consumption puzzle. 2

3 Franco Modigliani and the Life Cycle Hypothesis (LCH) Key names: Franco Modigliani, Albert Ando and Richard Brumberg The LCH was put forward in a series of papers written in the 1950s 3

4 Modigliani emphasised that income varies systematically over individuals (people s) life time. According to the LCH, the typical individual has an income stream which is relatively low at the beginning and end of his/her life (retirement), when his/her productivity is low, and high during the middle of his/her life. 4

5 The LCH therefore views individuals as planning their consumption and savings behaviour over long periods with the intention of allocating their consumption in the best possible way over their entire lifetimes. Individuals are assumed to maintain a more or less constant, if slightly rising level of consumption throughout their lifetime. 5

6 The constraint to this consumption stream is that the present value of this total consumption does not exceed the present value of total income. This implies that in the early years of a person s life, s/he is a net borrower. In the middle years, s/he saves and repays debt and provides for retirement. In the retirement years, s/he dissaves. 6

7 This pattern of consumption and saving can be illustrated below: Income Y c Net Borrower/Dissaving T t 7

8 This pattern of consumption and saving can be illustrated below: 8

9 Thus, instead of relying on a single value (based on a psychological rule of thumb) for the MPC, the LCH (based on optimizing behaviour) implies different MPCs out of permanent income, transitory income and wealth. 9

10 The key assumption (as noted earlier but stated in other words) is that individuals choose stable lifestyles, not saving furiously in one period for a huge spending spree in the next. 10

11 Remember that if the assumptions made, both about individuals and the population, are stable then we can add up all the individual consumption functions to obtain a stable aggregate function in which the population consumes k percent of the present value of its income stream in each period: 11

12 The aggregate consumption function can be expressed as follows: c k( PV ) 0 0 Where the variables are as previously defined 12

13 The next crucial step is to operationalize the PV 0 term. Ando and Modigliani provided an excellent answer. They noted that income can be divided into income from labour (work) and income from assets and property (wealth) y P y L 13

14 Thus, the PV 0 term can be expressed as: PV 0 T y L T t (1 r) t 0 0 y (1 P t r) t Where 0 is the current period, and t ranges from 0 to the remaining years of life, T. 14

15 Let us now attempt a simplification of this decision-making over a life time. Let us suppose the individual starts life at the age of 20, and plans to work until 65, and will die at

16 Again we can suppose that initial wealth (W), and is income from earnings. is now is now Y, which If the number of years an individual expects to work before retirement, can be defined as R. y L y P 16

17 Then the individual s lifetime resources is made up of initial wealth, W, and lifetime earnings (R x Y). For simplicity we assume that interest rate is zero, although if this were positive then interest on savings will be included. 17

18 The individual s decision now involves ensuring a smooth consumption path over the remaining life, T. The individual is expected to divide his/her lifetime resources (W + RY) equally over the remaining number of years, T. 18

19 C ( W RY) / T The consumption function can be written as C 1 T W R T Y 19

20 Thus with our example, R = 45 and T = 60. The consumption function can be written as W 0. Y C 75 The equation above shows that consumption depends on both wealth and income. 20

21 For the whole economy, the aggregate consumption function can be expressed as: C W Y Where is the MPC out of wealth and is the MPC out of income. 21

22 Implications: For any given wealth, W, the LCH yields a conventional consumption function (we already know). However, the intercept of the consumption function is not fixed, but depends on the level of wealth. See figure on next slide! 22

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24 Implications: The LCH can also solve the puzzle. Given the consumption function, the APC is below: C Y W Y 24

25 Implications: Here is the explanation in respect of the puzzle: Because wealth does not vary proportionately with income from person to person or from year to year, we should expect to find that high income corresponds to low APC when looking at data across individuals or over short periods of time. 25

26 Implications: Nevertheless, over long periods of time, wealth and income grow together resulting in a constant W/Y ratio, and thus a constant APC. Put differently, as wealth increases the consumption function shifts upward. This upward shift prevents the APC from falling as income rises. 26

27 Implications: Once we have a theory of consumption we also have a theory of saving. The LCH also predicts that saving varies over an individual s lifetime. 27

28 Implications: If an individual begins working life, s/he will accumulate wealth during the working years, and then run down their wealth during retirement years. Thus, the young who are working save, whilst the old who are retired dissave. 28

29 Milton Friedman s Permanent-Income Hypothesis The Permanent-Income Hypothesis (PIC) is based on a book written in The Permanent-Income theory of consumption argues that consumption is related not to current income but to a longerterm estimate of income: what Friedman termed permanent-income. 29

30 Milton Friedman s Permanent-Income Hypothesis The P-I theory complements Modigliani s LCH. But unlike the LCH which argues that income follows a regular pattern over an individual s lifetime, the P-IH emphasises that individuals experience random and temporary changes in their incomes from year to year. 30

31 Milton Friedman s Permanent-Income Hypothesis Permanent income is the steady rate of consumption an individual could maintain for the rest of his/her life, given the present level of wealth and income earned now and in the future. 31

32 Milton Friedman s Permanent-Income Hypothesis Friedman s model of consumption begins with the assumption of individual consumer utility maximisation. This gives us the consumption function between an individual s consumption and present value. 32

33 Milton Friedman s Permanent-Income c i f i Hypothesis ( PV ); f This is the consumption function for a representative individual, i, over time. i Only note that Friedman s treatment of PV is different from Ando-Modigliani s. i 0 33

34 Milton Friedman s Permanent-Income Hypothesis The present value of the total income stream is the current asset value of the income stream. Multiplying this asset value by the rate of return, r, yields Friedman s permanent income from that asset value: i P y r. PV i 34

35 Milton Friedman s Permanent-Income Hypothesis But as with Ando-Modigliani, Friedman assumes that the consumer wants to smooth his/her actual income stream into a more or less flat consumption pattern. This gives a level of permanent consumption, i that is proportional to. y P i c P 35

36 Milton Friedman s Permanent-Income Hypothesis This may be stated as follows: i i P c k i y k is the ratio of permanent consumption to permanent income, this depends on the interest rate, individual tastes, and the variability of expected income. i P 36

37 Milton Friedman s Permanent-Income Hypothesis Aggregating over the entire population and generalising, we have a simple form of the equation: C cyp Where YP is permanent (disposable) income. 37

38 Milton Friedman s Permanent-Income Hypothesis Friedman also suggested we view current income as the sum of two components: permanent income and transitory income. Y Y P Y T 38

39 Milton Friedman s Permanent-Income Hypothesis How can we think about the measurement of permanent income? We know that an individual has a current level of income, and forms some idea of the level of consumption s/he can maintain for the rest of his/her life. 39

40 Milton Friedman s Permanent-Income Hypothesis But suppose income goes up! Then the individual has to decide whether the increase is permanent or merely transitory/temporary! Permanent income is that part of income that individuals expect to persist into the future. Transitory income is that which individuals do not expect to persist. 40

41 Milton Friedman s Permanent-Income Hypothesis Nevertheless, in any particular case, an individual may know whether an increase is permanent or transitory. But in general an individual is not likely to be so sure whether a change is permanent or transitory. 41

42 Milton Friedman s Permanent-Income Hypothesis Implications: Regarding the consumption puzzle, the P-IH argues that the Keynesian consumption function uses the wrong variable; that is, current income instead of permanent income. Relating current income to consumption results in what Friedman termed errors in variables problem. 42

43 Milton Friedman s Permanent-Income Implications: Hypothesis According to the P-IH, the APC depends on the ratio of permanent income to current income. C cyp Y P APC Y Y Y 43

44 Milton Friedman s Permanent-Income Implications: Hypothesis When current income temporarily rises above permanent income, the APC temporarily falls. When current income temporarily falls below permanent income, the APC temporarily rises. 44

45 Milton Friedman s Permanent-Income Hypothesis Implications: Regarding studies using household data, Friedman reasoned that these data reflect a combination of permanent and transitory income. Households with high permanent income, have proportionately high consumption. And if all variations in income came from permanent income, then the APC will be the same for all households. 45

46 Milton Friedman s Permanent-Income Implications: Hypothesis However, some of the variations are the results of transitory income, and households with high transitory income do not have higher consumption. Therefore, the evidence from the data tend to show that households with high-income, have on average lower APC. 46

47 Milton Friedman s Permanent-Income Implications: Hypothesis Regarding time series data, Friedman argued that year-to-year fluctuations in income are dominated by transitory income. Therefore, years of high income should be years of low APC. 47

48 Milton Friedman s Permanent-Income Implications: Hypothesis But over long periods of time, say from decade to decade, variations in income are the result of permanent income. Therefore, in long time series one should observe a constant APC. 48

49 Consumption Under Uncertainty: Robert Hall s Random-Walk Hypothesis The Random-Walk Hypothesis combines Irvin Fisher s assumptions on forward-looking consumers with rational expectations. Rational expectations assumes that individuals use all available information to make optimal forecasts about the future. 49

50 Consumption Under Uncertainty: Robert Hall s Random-Walk Hypothesis From our knowledge of the P-IH, we know that if permanent income were known exactly, then consumption will never change. 50

51 Consumption Under Uncertainty: Robert Hall s Random-Walk Hypothesis However with the RWH, there is a link between income uncertainty and changes in consumption. Changes in consumption therefore arise from surprise changes in income. 51

52 Consumption Under Uncertainty: Robert Hall s Random-Walk Hypothesis According to the rational expectations theory, the surprise must be truly random and unpredictable. Thus the combination of permanent-income hypothesis and rational expectations implies that consumption follows a random walk. Robert Hall s famous random walk model is specified as: 52

53 Consumption Under Uncertainty: Robert Hall s Random-Walk Hypothesis Ct 1 C t This states that consumption tomorrow should equal consumption today plus a truly random error, C C t 1 t 53

54 Consumption Under Uncertainty: Robert Hall s Random-Walk Hypothesis Implications: This approach to consumption has implications for the analysis of economic policies. If consumers are believed to follow this approach, then only unexpected policy changes influence consumption. These policy changes become effective when they change expectations. 54

55 Consumption Under Uncertainty: Robert Hall s Random-Walk Hypothesis Implications: Essentially, the effectiveness of a policy is dependent on how the policy announcement affects expectations. If expectations are unaffected, the policy is ineffective. Thus, policy makers influence the economy not only through their actions but also through the public s expectation of their actions. 55

56 Liquidity Constraints and Myopia It is worth noting that the LCH and P-IH do not explain all of consumption behaviour. Why might this be so? Two explanations are liquidity constraints and myopia. The first argues that when permanent income is higher than current income, consumers are unable to borrow to consume at the higher level predicted by the LCH and P-IH. 56

57 Liquidity Constraints and Myopia The second suggests that consumers simply aren t as forward-looking the theories argue. A liquidity constraint exists when a consumer cannot borrow to sustain current consumption in the expectation of higher future income. This condition is faced by most students, and those who are unable to borrow when their incomes drop temporarily. 57

58 Liquidity Constraints and Myopia Fisher s model suggests that individuals can borrow and save. The ability to borrow allows current consumption to exceed current income. But with a liquidity constraint, current consumption cannot exceed current income. A borrowing constraint exists when C Y

59 Liquidity Constraints and Myopia The figure below illustrates how the borrowing constraint restricts the consumer s set of choices. In these circumstances, the consumer s choice must satisfy both the inter-temporal budget constraint and borrowing constraint. 59

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61 Liquidity Constraints and Myopia The shaded area represents the combinations of the first-period consumption and second-period consumption that satisfy both constraints. In the next figure we show two possibilities. In (a) the consumer wishes to consume less in period one than s/he earns. Hence the liquidity constraint is not binding. 61

62 Liquidity Constraints and Myopia In (b) the consumer will like to consume at point D, where s/he will consume more in period one than s/he earns, but the liquidity constraint prevents this outcome. The best outcome is for the individual to consume all of his/her period one income. The foregoing analysis suggests that there are two consumption functions, one for those facing liquidity constraints and one for those who are unconstrained by borrowing. 62

63 the shad CONSUMPTION AND CONSUMER 63

64 Liquidity Constraints and Myopia For such students who face the liquidity constraint, when they complete their education and get jobs, their incomes will rise and their consumption too will rise. But according to the LCH (and PIH), consumption should not rise much when income rises, so long as the increase in income was expected. 64

65 Liquidity Constraints and Myopia Because liquidity constraint is relieved, consumption will rise a lot when income rises. This implies that consumption will be more closely related to current income than is implied by the LCH and PIH. The explanation for myopia is hard to distinguish in practice from the liquidity constraints hypothesis. That is any expectation of a rise in income does not change consumption until the actual increase takes place. 65

66 David Laibson and the Pull of Instant Gratification Laibson argues that consumers judge themselves to be imperfect decision-makers. Consumption decisions are influenced by psychological factors, in contrast to the rational utility maximisation presumption. This raises the possibility that consumers preferences are time-inconsistent. 66