macro CHAPTER FIFTEEN

Consumption

macroeconomics
 Chapter overview
This chapter surveys the most prominent work
on consumption:
 John Maynard Keynes: consumption and
current income
 Irving Fisher and Intertemporal Choice
 Franco Modigliani: the Life-Cycle Hypothesis
 Milton Friedman: the Permanent Income
Hypothesis
 Keynes’s Conjectures
1. 0 < MPC < 1
2. APC falls as income rises
where APC
= average propensity to consume
= C/Y
3. Income is the main determinant of
consumption.
The Keynesian Consumption Function
A consumption function with the
C properties Keynes conjectured:

C  C  cY

c c = MPC
= slope of the
1
consumption
C function

Y
The Keynesian Consumption Function
As income rises, the APC falls (consumers
C save a bigger fraction of their income).

C  C  cY

C C
APC    c
Y Y

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

Consumption function
C from long time series
data (constant APC )

Consumption function
from cross-sectional
household data
(falling APC )

Y
Irving Fisher and Intertemporal 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
 The basic two-period model
 Period 1: the present
 Period 2: the future
 Notation
Y1 is income in period 1
Y2 is income in period 2
C1 is consumption in period 1
C2 is consumption in period 2
S = Y1 - C1 is saving in period 1
(S < 0 if the consumer borrows in period 1)
Deriving the
intertemporal budget constraint
 Period 2 budget constraint:
C 2  Y 2  (1  r ) S
 Y 2  (1  r ) (Y1 - C 1 )

 Rearrange to put C terms on one side

 Finally, divide through by (1+r ):

C2 Y2
C1   Y1 
1r 1r

present value of present value of

C2 C2 Y2
C1   Y1 
1r 1r
The budget
constraint
(1  r )Y1 Y 2
shows all Consump =
combinations Saving income in
of C1 and C2 both periods
that just
exhaust the Y2
consumer’s Borrowing
resources.
C1
Y1
Y1 Y 2 (1  r )
The intertemporal budget constraint

C2 C2 Y2
C1   Y1 
The slope of 1r 1r
the budget
line equals
-(1+r ) 1
(1+r )

Y2

C1
Y1
 Consumer preferences

An indifference C2 Higher
curve shows all indifference
combinations of curves
C1 and C2 that represent
make the higher levels
consumer of happiness.
equally happy.
IC2

IC1
C1
 Consumer preferences

C2 The slope of
an indifference
Marginal rate of curve at any
substitution (MRS ): point equals
the amount of C2 the MRS
1 at that point.
consumer would be
MRS
willing to substitute
for one unit of C1.
IC1
C1
 Optimization

C2
The optimal (C1,C2) At the
is where the budget optimal point,
line just touches the MRS = 1+r
highest indifference
curve.
O

C1
 How C responds to changes in Y

C2 An increase in Y1 or Y2
Results: shifts the budget line
Provided they are outward.
both normal goods,
C1 and C2 both
increase,
…regardless of
whether the
income increase
occurs in period 1
or period 2. C1
 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.
 How C responds to changes in r
C2
An increase in r
pivots the budget
line around the
point (Y1,Y2 ).
B

As depicted here, A
C1 falls and C2 rises.
Y2
However, it could
turn out differently… C1
Y1
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 C1
and increase C2.
 Both effects  C2.
Whether C1 rises or falls depends on the
relative size of the income & substitution
effects.
 Constraints on borrowing
 In Fisher’s theory, the timing of income is irrelevant
because the consumer can borrow and lend across
periods.
 Example: If consumer learns that her future income
will increase, she can spread the extra consumption
over both periods by borrowing in the current period.
 However, if consumer faces borrowing constraints
(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 & forward-looking
Constraints on borrowing

C2

The budget
line with no
borrowing
constraints
Y2

Y1 C1
 Constraints on borrowing

The borrowing C2
constraint takes
the form:
The budget
C1  Y1 line with a
borrowing
constraint
Y2

Y1 C1
 Consumer optimization when the
borrowing constraint is not binding
C2

The borrowing
constraint is not
binding if the
consumer’s
optimal C1
is less than Y1.

Y1 C1
 Consumer optimization when the
borrowing constraint is binding

The optimal C2
choice is at
point D.
But since the
consumer
cannot borrow,
the best he can E
do is point E. D

Y1 C1
 The Life-Cycle Hypothesis
 due to Franco Modigliani (1950s)
 Fisher’s model says that consumption depends
on lifetime income, and people try to achieve
smooth consumption.
 The LCH says that income varies
systematically over the phases of the
consumer’s “life cycle,”
and saving allows the consumer to achieve
smooth consumption.
 The Life-Cycle Hypothesis
 The basic model:
W = initial wealth
Y = annual income until retirement
(assumed constant)
R = number of years until retirement
T = lifetime in years
 Assumptions:
– zero real interest rate (for simplicity)
– consumption-smoothing is optimal
 The Life-Cycle Hypothesis
 Lifetime resources = W + RY
 To achieve smooth consumption, consumer
divides her resources equally over time:
C = (W + RY )/T , or
C = aW + bY
where
a = (1/T ) is the marginal propensity to
consume out of wealth
b = (R/T ) is the marginal propensity to
consume out of income
Implications of the Life-Cycle Hypothesis
The Life-Cycle Hypothesis can solve the
consumption puzzle:
 The APC implied by the life-cycle
consumption function is
C/Y = a(W/Y ) + b
 Across households, wealth does not vary as
much as income, so high income households
should have a lower APC than low income
households.
 Over time, aggregate wealth and income
grow together, causing APC to remain stable.
 Implications of the Life-Cycle Hypothesis
$
The LCH
implies that
saving varies Wealth
systematically
over a
person’s Income
lifetime. Saving

Consumption Dissaving

Retirement End
begins of life
The Permanent Income Hypothesis
 due to Milton Friedman (1957)
 The PIH views current income Y as the sum
of two components:
permanent income Y P
(average income, which people expect to
persist into the future)
transitory income Y T
(temporary deviations from average
income)
The Permanent Income Hypothesis
 Consumers use saving & borrowing to
smooth consumption in response to
transitory changes in income.
 The PIH consumption function:
C = aY P
where a is the fraction of permanent
income that people consume per year.
The Permanent Income Hypothesis
The PIH can solve the consumption puzzle:
 The PIH implies
APC = C/Y = aY P/Y
 To the extent that high income households
have higher transitory income than low
income households, the APC will be lower in
high income households.
 Over the long run, income variation is due
mainly if not solely to variation in permanent
income, which implies a stable APC.
 PIH vs. LCH
 In both, people try to achieve smooth
consumption in the face of changing current
income.
 In the LCH, current income changes
systematically as people move through their
life cycle.
 In the PIH, current income is subject to
random, transitory fluctuations.
 Both hypotheses can explain the consumption
puzzle.
 Summing up
 Keynes suggested that consumption depends
primarily on current income.
 Recent work suggests instead that consumption
depends on
– current income
– expected future income
– wealth
– interest rates
 Economists disagree over the relative
importance of these factors and of borrowing
constraints and psychological factors.
 Chapter summary
1. Keynesian consumption theory
 Keynes’ conjectures
 MPC is between 0 and 1
 APC falls as income rises
 current income is the main determinant of
current consumption
 Empirical studies
 in household data & short time series:
confirmation of Keynes’ conjectures
 in long time series data:
APC does not fall as income rises
 Chapter summary
2. Fisher’s theory of intertemporal choice
 Consumer chooses current & future
consumption to maximize lifetime satisfaction
subject to an intertemporal budget constraint.
 Current consumption depends on lifetime
income, not current income, provided consumer
can borrow & save.
3. Modigliani’s Life-Cycle Hypothesis
 Income varies systematically over a lifetime.
 Consumers use saving & borrowing to smooth
consumption.
 Consumption depends on income & wealth.
 Chapter summary
4. Friedman’s Permanent-Income Hypothesis
 Consumption depends mainly on permanent
income.
 Consumers use saving & borrowing to smooth
consumption in the face of transitory
fluctuations in income.