ECNS 303 Ch. 16: Consumption

ECNS 303 Ch. 16: Consumption

Micro foundations of Macro: Consumption Q. How do households decide how much of their income to consume today and how much to save for the future? Micro question with macro consequences We have modeled consumption as a function of disposable income (i.e. Y T) Allowed us to develop simple models for LR and SR analyses, but is a simple explanation of consumption behavior Let s think about consumption in a more detailed fashion Work our way through the models of consumption that have been developed and subsequently improved upon

Keynes and the Consumption Fnc. First, Keynes conjectured the marginal propensity to consume Second, he posited that the ratio of consumption to income, called the average propensity to consume, falls as income rises He believed that saving was a luxury, so he expected the rich to save a higher proportion of their income than the poor Third, Keynes thought that income is the primary determinant of consumption and that the interest rate plays a less important role

Keynes and the Consumption Fnc. Based on these three conjectures, the Keynesian Consumption Function is written as C = C + cy where C > 0, 0 < c < 1 C is consumption, Y is disposable income, C is a constant, and c is the MPC [show graphically]

Keynes and the Consumption Fnc. This consumption function exhibits the three properties Keynes posited 1.) it satisfies his first property bc the MPC, c, is b/w 0 and 1, so that higher income leads to higher consumption and also higher savings 2.) It satisfies the second property b/c the ave. propensity to consume is APC = C/Y = C /Y + c as Y rises, the first term falls and, hence, so does the APC 3.) Satisfies third property b/c the interest rate is not included in this equation as a determinant of consumption

Keynes and the Consumption Fnc. Early empirical success Early studies indicated the Keynesian Consumption Function was a good approximation of how consumers behave However, other studies using newly constructed income and consumption data found that higher incomes did not necessarily translate to large decreases in the rate of consumption For household data and for short time series, the Keynesian Consumption Function appeared to work well Yet, for longer time series, the consumption function did not have the properties Keynes predicted Two economists (Modigliani and Friedman) tried to solve this puzzle. Before discussing their work, we must first discuss Irving Fisher s contribution to consumption theor

Irving Fisher and Intertemporal Choice Consumers face a limit on how much they can spend: budget constraint When deciding how much to consume today vs. how much to save for the future, people face an intertemporal budget constraint [insert two period model and derive intertemporal budget constraint. Provide graphical treatment.]

Irving Fisher and Intertemporal Choice Consumer Preferences Consumer s preferences regarding consumption in the first two periods can be represented by indifference curves illustrating combos of 1 st period and 2 nd period consumption that make the consumer equally happy. [insert graph with ICs] Optimization Consumer wants to end up with best possible combo of C 1 and C 2, but is budget constrained Point of tangency is the best the consumer can do [insert graph and describe condition that holds at point of optimization]

Irving Fisher and Intertemporal Choice Changes in Income Q. An increase in Y 1 or Y 2 does what to the budget constraint? Ans. Shifts it out Consumer responds by choosing more consumption in both periods Implication is that regardless of whether the increase in Y comes from pd. 1 or pd. 2, the consumer spreads it over consumption in both periods called consumption smoothing. Take away: consumption depends on the present value of current and future income, which can be expressed as PV of income = Y 1 + Y 2 /(1+r) Quite different than conclusion reached by Keynes Keynes posited that a person s current consumption depends on current income Fisher s model says, instead, that consumption is based on the income the consumer expects over his entire lifetime

Irving Fisher and Intertemporal Choice How changes in the real interest rate affect consumption Two changes to consider 1.) The case where consumer is initially saving 2.) The case where consumer is initially borrowing We will consider case 1.) work through case 2.) on your own [insert graphical treatment]

Irving Fisher and Intertemporal Choice Constraints on Borrowing C 1 > Y 1 is our borrowing condition Many people face constraints, however, where borrowing is not possible An inability to borrow prevents current consumption from exceeding current income C 1 Y 1 a borrowing constraint [insert graph and explain how borrowing constraint impacts consumption decision] [insert example problem]

Modigliani and the Life Cycle Hypothesis Modigliani used Fisher s model of consumer behavior to study the consumption function Emphasized that income varies systematically over people s lives and that saving allows consumers to move income from those times in life when income is high to times when it is low This interpretation of consumer behavior became known as the lifecycle hypothesis One important reason income varies over a person s life is retirement Consumption after retirement requires saving

Modigliani and the Life Cycle Hypothesis Consider a consumer who expects to live another T years, has wealth W, and expects to earn income Y until she retires R years from now. Q. What level of consumption will she choose if she wishes to maintain a smooth level of consumption over her life? Lifetime resources are composed of initial wealth W and lifetime earnings RY (for simplicity, assume r = 0) Consumer can divide up lifetime resources among T remaining years of life Assuming she wishes to smooth her consumption, she divides this total equally among the T years: C = (W + RY)/T => C = (1/T)W + (R/T)Y

Modigliani and the Life Cycle Hypothesis So, e.g., if the consumer expects to live 50 more years and work 30 of them, then T = 50 and R = 30: C =.02W +.6Y and this says consumption depends on both wealth and income Aggregating over the entire economy, we write C = αw + βy where α is the MPC out of wealth and β is the MPC out of income [insert graph]

Modigliani and the Life Cycle Hypothesis According to the life-cycle consumption function, the APC is C/Y = α(w/y) + β Because wealth does not vary proportionally with income from person to person or from year to year, we should find that high income corresponds to a low APC when looking at data across individuals or over short periods of time But, over long periods of time, wealth and income grow together, resulting in a constant ratio W/Y and thus a constant APC This addresses the Keynesian consumption puzzle: The LR Keynesian Consumption Function did not match the data well.

Friedman and the Permanent Income Hypothesis Complements Modigliani s life-cycle model Also uses Fisher s theory to argue that consumption should not depend on current income alone Hypothesis Friedman suggested we separate Y into two parts (permanent and transitory) Y = Y P + Y T Permanent income: the part people expect to persist into the future (= average income). For example, the higher income earned from having a professional degree Transitory income: not expected to persist (= random deviation from the average). For example, an orange grower in FL earned less this year due to an unexpected freeze.

Friedman and the Permanent Income Hypothesis Friedman argued that consumption should depend primarily on permanent income, because consumers use saving and borrowing to smooth consumption in response to transitory changes in income He argued we should view the consumption function as C = αy P where α is a constant measuring the fraction of income consumed. Consumption is proportional to permanent income Implications Suggest the standard Keynesian Consumption Function uses the wrong variable According the PIH, consumption depends on permanent income; yet many studies tried to relate consumption to current income

Friedman and the Permanent Income Hypothesis PIH has implications for APC APC = C/Y = α(y P /Y) = α(y P /Y P +Y T ) Thus, the APC depends on the ratio of permanent income to current income -when current income temporarily rises above permanent income, the APC temporarily falls Consider studies that use household data HHs with high permanent income have proportionately higher consumption If all variation in current income comes from permanent income, the APC would be the same across HHs

Friedman and the Permanent Income Hypothesis But, some of the variation in come comes from the transitory component, and HHs with high transitory income do not have higher consumption Therefore, researchers find that high-income HHs have, on average, lower average propensities to consume (consistent with Keynes) But, now consider studies of time-series data. Friedman reasoned that year-to-year fluctuations are dominated by transitory income So, years of high income should be years of low APCs But, over long periods of time the variation in income comes form the permanent component. Hence, in long time-series data, one should observe a constant APC APC = α(y P /Y P +Y T ) where Y T is less important over a long time span