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1MANKIW'S MACROECONOMICS MODULES MANKIW'S MACROECONOMICS MODULESCHAPTER 17ConsumptionA PowerPointTutorialTo AccompanyMACROECONOMICS, 7th. EditionN. Gregory MankiwTutorial written by:Mannig J. Simidian, modified by mebB.A. in Economics with Distinction, Duke UniversityM.P.A., Harvard University Kennedy School of GovernmentM.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management
2and the Consumption Function John Maynard Keynesand the Consumption FunctionThe consumption function was central to Keynes’ theory of economicfluctuations presented in The General Theory in 1936.Keynes conjectured that the marginal propensity to consume— the amount consumed out of an additional dollar of income is betweenzero and one. He claimed that the fundamental law is that out ofevery dollar of earned income, people will consume part of it and savethe rest.Keynes also proposed the average propensity to consume, the ratio of consumption to income falls as income rises.Keynes also held that income is the primary determinant of consumption and that the interest rate does not have an important role.
3The Consumption Function C = C + c Y, C > 0, 0 < c <1Consumptionspending byhouseholdsCYC determines the intercept on the vertical axis. The slope of the consumption function is lower case c, the MPC.C = C + c Ymarginalpropensity toconsume (MPC)disposableincomeautonomousconsumptiondependson
4The Marginal Propensity to Consume To understand the marginal propensity to consume (MPC), consider a shopping scenario. A person who loves to shop probably has a large MPC, let’s say (.99). This means that for every extra dollar he or she earns after tax deductions, he or she spends $.99 of it. The MPC measures the sensitivity of the change in one variable, consumption, with respect to a change in the other variable, income.
5The Average Propensity to Consume The C function exhibits three propertiesthat Keynes conjectured.(1) the marginal propensity toconsume c is between zero and one.(2) the average propensity toconsume falls as income rises.(3) consumption is determined bycurrent income Y. Notice that theinterest rate is not included in thisequation as a determinant of consumption.APC = C/Y = C/Y + cCAPC1CAPC211YWhat Keynes conjectured: at higher values of income, people spend a smaller fraction of their income. So, as Y rises, the average propensity to consume C/Y falls. Pick a point on the consumption function; that point represents a particular combination of consumption and income. Now draw a ray from the origin to that point. The slope of that ray equals the APC at that point. At higher values of Y, the APC (slope of the ray) is smaller.
6Early Empirical Successes: Results from Early Studies Households with higher incomes:consume more MPC > 0save more MPC < 1save 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
7Simon Kuznets, and the Consumption Puzzle Secular Stagnation,Simon Kuznets, and the Consumption PuzzleDuring World War II, on the basis of Keynes’s consumption function,economists predicted that the economy would experience what theycalled secular stagnation—a long depression of infinite duration—unless the government used fiscal policy to stimulate aggregate demand.It turned out that the end of the war did not throw the United Statesinto another depression, but it did suggest that Keynes’s conjecturethat the average propensity to consume would fall as income roseappeared not to hold.Simon Kuznets constructed new aggregate data on consumption andinvestment dating back to His work would later earn him aNobel Prize. Kuznets discovered that the ratio of consumption to incomewas stable over time, despite large increases in income; again, Keynes’sconjecture was called into question.This brings us to the puzzle…
8Consumption PuzzleThe failure of the secular-stagnation hypothesis and the findings ofKuznets both indicated that the average propensity to consume is fairlyconstant over time. This presented a puzzle: Why did Keynes’s conjectures hold up well in the studies of household data (cross-sections) and in the studies of short time-series, but fail when long-time series were examined?Studies of household data and short time-series found a relationship between consumption and income similar to the one Keynes conjectured— this is called the short-run consumption function. But, studies using long time-series found that the APC did not vary systematically with income—this relationship is called the long-run consumption function.CLong-run consumption function (constant APC)Short-run consumptionfunction (falling APC)Y
9Irving Fisher and Intertemporal Choice The economist Irving Fisher developed the model with which economists analyze how rational, forward-looking consumers make intertemporal choices—that is, choices involving different periods of time to maximize lifetime satisfaction. The model illuminates the constraints consumers face, the preferences they have, and how these constraints and preferences together determine their choices about consumption and saving.When consumers are deciding how much to consume today versus how much to consume in the future, they face an intertemporal budget constraint, which measures the total resources available for consumption today and in the future.
10The basic two-period model Period 1: the presentPeriod 2: the futureNotationY1 is income in period 1Y2 is income in period 2C1 is consumption in period 1C2 is consumption in period 2S = Y1 - C1 is saving in period 1(S < 0 if the consumer borrows in period 1)
11Deriving the intertemporal budget constraint Period 2 budget constraint:Rearrange:Explain the intuition/interpretation of the period 2 budget constraint.Finally, divide by (1+r ):
12The consumer’s intertemporal budget constraint present value of lifetime consumptionpresent value of lifetime incomeIf your students are not familiar with the present value concept, it is explained in an FYI box in the text.
13Here is an interpretation of the consumer’s budget constraint: The consumer’s budget constraint implies that if the interestrate is zero, the budget constraint shows that totalconsumption in the two periods equals total incomein the two periods. In the usual case in which theinterest rate is greater than zero, future consumption and future incomeare discounted by a factor of 1 + r. This discounting arises from theinterest earned on savings. Because the consumer earns interest oncurrent income that is saved, future income is worth less than currentincome. Also, because future consumption is paid for out of savingsthat have earned interest, future consumption costs less than currentconsumption. The factor 1/(1+r) is the price of second-periodconsumption measured in terms of first-period consumption; it is theamount of first-period consumption that the consumer must forgo toobtain 1 unit of second-period consumption.
14The Consumer's Budget Constraint Here are the combinations of first-period and second-period consumptionthe consumer can choose. If he chooses a point between A and B, heconsumes less than his income in the first period and saves the rest forthe second period. If he chooses between A and C, he consumes more thathis income in the first period and borrows to make up the difference.Consumer’s (intertemporal) budget constraintshowing all combinations of C1 and C2that are feasible. The slope equals –(1+r)C2BSaving1Vertical intercept is(1+r)Y1 + Y2(1+r )ABorrowingHorizontal intercept isY1 + Y2/(1+r)Y2CY1The slope of the budget line equals -(1+r):to increase C1 by one unit,the consumer must sacrifice(1+r) units of C2.C1
15Consumer PreferencesThe consumer’s preferences regarding consumption in the two periods can be represented by indifference curves. An indifference curve shows the combination of first-period and second-period consumption, C1 and C2, that makes the consumer equally happy.
16Consumer Preferences Y Z IC2 X W IC1 Second-periodconsumptionYZIC2XWIC1First-period consumptionHigher indifferences curves such as IC2 are preferred to lower ones such as IC1. The consumer is equally happy at points W, X, and Y, but prefers point Z to all the others. Point Z is on a higher indifference curve and is therefore not equally preferred to W, X, and Y.
17Consumer PreferencesThe slope at any point on the indifference curve shows how much second-period consumption the consumer requires in order to be compensated for a 1-unit reduction in first-period consumption. This slope is the marginal rate of substitution between first-period consumption and second-period consumption. It tells us the rate at which the consumer is willing to substitute second-period consumption for first-period consumption.
18Consumer preferencesC1C2The slope of an indifference curve at any point equals the MRS at that point.IC1Marginal rate of substitution (MRS ): the amount of C2 consumer would be willing to substitute for one unit of C1.1MRS
19OptimizationSecond-periodconsumptionOIC3IC2IC1First-period consumptionThe consumer achieves his highest (or optimal) level of satisfactionby choosing the point on the budget constraint that is on the highestindifference curve. Here the slope of the indifference curveequals the slope of the budget line. At the optimum, the indifferencecurve is tangent to the budget constraint. The slope of the indifferencecurve is the marginal rate of substitution MRS, and the slope of thebudget line is 1 + the real interest rate. At point O, MRS = 1 + r.
20How Changes in Income Affect Consumption Second-periodconsumptionOIC2IC1First-period consumptionAn increase in either first-period income or second-period incomeshifts the budget constraint outward. If consumption in period one andconsumption in period two are both normal goods - those that aredemanded more as income rises, this increase in income raisesconsumption in both periods.
21Keynes vs. Fisher about income Keynes: current consumption depends only on current incomeFisher: 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.
22How Changes in the Real Interest Rate Affect Consumption Economists decompose the impact of an increase in the real interestrate on consumption into two effects:- a substitution effect , the change in consumption that results from thechange in the relative price of consumption in the two periods;an income effect , the change in consumption that results from themovement to a higher indifference curve.Suppose the consumer is a saver (his choice is point A). An increase in r (increase in the slope) rotates the budget constraint around the point C, where C is (Y1, Y2). As depicted here, the saver goes from A to B, reducing first-period consumption and raising second-period consumption.But for a saver it could turn out differently…….. !C2New budgetconstraintBOld budget constraintAYIC2Y2IC1Y1C1
23How C responds to changes in r substitution effect The rise in r increases the opportunity cost of current consumption, which tends to reduce C1 and increase C2.income effect If the consumer is a saver, the rise in r makes him better off, which tends to increase consumption in both periods.Both effects C2.But whether C1 rises or falls depends on the relative size of the income & substitution effects.Note: Keynes conjectured that the interest rate matters for consumption only in theory. In Fisher’s theory, the interest rate doesn’t affect current consumption if the income and substitution effects are of equal magnitude.After you have shown and explained this slide, it would be useful to pause for a moment and ask your students to do the analysis of an increase in the interest rate on the consumption choices of a borrower. In that case, the income effect tends to reduce both current and future consumption, because the interest rate hike makes the borrower worse off. The substitution effect still tends to increase future consumption while reducing current consumption. In the end, current consumption falls unambiguously; future consumption falls if the income effect dominates the substitution effect, and rises if the reverse occurs.
24An answer/exercise for you: do the analysis of an increase in the interest rate on the consumption choices of a borrower…..Hint: in that case, the income effect tends to reduce both current and future consumption, because the interest rate hike makes the borrower worse off. The substitution effect still tends to increase future consumption while reducing current consumption. In the end, current consumption falls unambiguously; future consumption falls if the income effect dominates the substitution effect, and rises if the reverse occurs.
25Keynes vs. Fisher about interest rate Keynes conjectured that the interest rate matters for consumption only in theory.In Fisher’s theory, the interest rate doesn’t affect current consumption if the income and substitution effects are of equal magnitude.
26Constraints on Borrowing In Fisher’s theory, the timing of income is less important because theconsumer can borrow and lend across periods.Example: If a consumer learns that her future income will increase,she can spread the extra consumption over both periods by borrowingin the current period.However, if consumer faces borrowing constraints(or liquidity constraints), then she may not be able to increasecurrent consumption and her consumption may behaveas in the Keynesian theoryeven though she is rational & forward-lookingThe inability to borrow prevents current consumption from exceedingcurrent income. A constraint on borrowing can therefore be expressedas C1 < Y1.
27Constraints on borrowing The budget line with no borrowing constraintsY2Y1
28Constraints on borrowing The budget line with a borrowing constraintThe borrowing constraint takes the form:C1 Y1Y2Y1The area under the blue line satisfies both budget and borrowing constraints
29Consumer optimization when the borrowing constraint is not binding The borrowing constraint is not binding if the consumer’s optimal C1 is less than Y1.In this case, the consumer would not have borrowed anyway, so his inability to borrow has no impact on consumption choices.C1C2In this case, the consumer would not have borrowed anyway, so his inability to borrow has no impact on consumption choices.Y1
30Consumer optimization when the borrowing constraint is binding The optimal choice is at point D. But since the consumer cannot borrow, the best he can do is point E.In this case, the consumer would like to borrow to achieve his optimal consumption at point D. If he faces a borrowing constraint, though, then the best he can achieve is the consumption plan of point E.C1C2In this case, the consumer would like to borrow to achieve his optimal consumption at point D. If he faces a borrowing constraint, though, then the best he can achieve is the consumption plan of point E.If you have a few minutes of class time available, have your students do the following experiment:(This is especially useful if you have recently covered Chapter 15 on Government Debt)Suppose Y1 is increased by €1000 while Y2 is reduced by €1000(1+r), so that the present value of lifetime income is unchanged. Determine the impact on C1- when consumer does not face a binding borrowing constraint - when consumer does face a binding borrowing constraintThen relate the results to the discussion of Ricardian Equivalence from Chapter 15.Note that the intertemporal redistribution of income in this exercise could be achieved by a debt-financed tax cut in period 1, followed by a tax increase in period 2 that is just sufficient to retire the debt.The text contains a case study on the high Japanese saving rate that relates to the material on borrowing constraints just covered.EDY1
31If you have a few minutes of class time available, have your students do the following experiment: (This is especially useful if you have recently covered Chapter 15 on Government Debt)Suppose Y1 is increased by €1000 while Y2 is reduced by €1000(1+r), so that the present value of lifetime income is unchanged. Determine the impact on C1- when consumer does not face a binding borrowing constraint - when consumer does face a binding borrowing constraintThen relate the results to the discussion of Ricardian Equivalence from Chapter 15.Note that the intertemporal redistribution of income in this exercise could be achieved by a debt-financed tax cut in period 1, followed by a tax increase in period 2 that is just sufficient to retire the debt.The text contains a case study on the high Japanese saving rate that relates to the material on borrowing constraints just covered.
32Europa: Austria,Belgio,Danimarca, Finlandia, Francia, Germania, Grecia,Irlanda, Italia, Norvegia, Olanda,Portogallo, UK,Spagna,Svezia, Svizzera. (OECD, IMF,Eurostat).Per alcuni l’elevata crescita del Giappone nel dopoguerra deriva dall’elevato tasso di risparmio (nel modello di crescita di Solow vedremo che il risparmio determina il livello di reddito di stato stazionario). Per altri la lunga recessione degli anni’90 è causata dall’elevato tasso di risparmio (basso consumo e bassa domanda aggregata).
33Franco Modigliani and the Life-Cycle Hypothesis In the 1950s, Franco Modigliani, Albert Ando, and Richard Brumbergused Fisher’s model of consumer behavior to studythe consumption function. One of their goals was to studythe consumption puzzle. According to Fisher’s model,consumption depends on a person’s lifetime income. Modigliani emphasized that income varies systematically over people’slives and that saving allows consumers to move income from thosetimes in life when income is high to those times when income is low.This interpretation of consumer behavior formed the basis of hislife-cycle hypothesis.
34The Life-Cycle Hypothesis due to Franco Modigliani (1950s)Fisher’s model says that consumption depends on lifetime income, and people try to achieve a smooth consumption pattern.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.
35The Life-Cycle Hypothesis The basic model:W = initial wealthY = annual income until retirement (assumed constant)R = number of years until retirementT = lifetime in yearsAssumptions:zero real interest rate (for simplicity)consumption-smoothing is optimalThe initial wealth could be zero, or could be a gift from parents to help the consumer get started on her own.
36The Life-Cycle Hypothesis Lifetime resources = W + RYTo achieve smooth consumption, consumer divides her resources equally over time:C = (W + RY )/T , orC = aW + bYwherea = (1/T ) is the marginal propensity to consume out of wealthb = (R/T ) is the marginal propensity to consume out of income
37Implications 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 ) + bAcross households or in the short-run, wealth does not vary as much as income, so high income households should have a lower APC than low income households similar to KeynesOver time, aggregate wealth and income grow together, causing APC to remain stable Simon Kuznets puzzle solved.
38Implications of the Life-Cycle Hypothesis €WealthThe LCH implies that saving varies systematically over a person’s lifetime.IncomeSavingConsumptionDissavingRetirement beginsEnd of life
39Milton Friedman and the Permanent-Income Hypothesis In 1957, Milton Friedman proposed the permanent-income hypothesisto explain consumer behavior. Its essence is that current consumption isproportional to permanent income. Friedman’s permanent-incomehypothesis complements Modigliani’s life-cycle hypothesis: both useFisher’s theory of the consumer to argue that consumption should notdepend on current income alone. But unlike the life-cycle hypothesis,which emphasizes that income follows a regular pattern over a person’slifetime, the permanent-income hypothesis emphasizes that peopleexperience random and temporary changes in their incomes from yearto year.Friedman suggested that we view current income Y as the sum of twocomponents, permanent income YP and transitory income YT.
40The 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)
41The Permanent Income Hypothesis Consumers use saving & borrowing to smooth consumption in response to transitory changes in income Y T.The PIH consumption function:C = aY Pwhere a is the fraction of permanent income that people consume per year.
42The Permanent Income Hypothesis The PIH can solve the consumption puzzle:The PIH implies APC = C/Y = aY P/YTo the extent that high income households have on average a 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. policy changes will affect consumption only if they are permanent.
43PIH vs. LCHIn both cases, 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.
44Robert Hall and the Random-Walk Hypothesis Robert Hall was first to derive the implications of rational expectationsfor consumption. He showed that if the permanent-income hypothesisis correct, and if consumers have rational expectations, then changesin consumption over time should be unpredictable. When changes in avariable are unpredictable, the variable is said to follow a random walk.According to Hall, the combination of the permanent-incomehypothesis and rational expectations implies that consumption followsa random walk.
45The Random-Walk Hypothesis due to Robert Hall (1978)based on Fisher’s model & PIH, in which forward-looking consumers base consumption on expected future incomeHall adds the assumption of rational expectations, that people use all available information to forecast future variables like income.Rational expectations: people make forecasting errors, but these errors are not systematic or predictable.
46Implication of the R-W Hypothesis If consumers obey the PIH and have rational expectations, then policy changes will affect consumption only if they are unanticipated.This result is important because many policies affect the economy by influencing consumption and saving. For example, a tax cut to stimulate aggregate demand only works if consumers respond to the tax cut by increasing spending. The R-W Hypothesis implies that consumption will respond only if consumers had not anticipated the tax cut.This result also implies that consumption will respond immediately to news about future changes in income. Students connect with the following example: Suppose a student is job-hunting in her senior year for a job that will begin after graduation. If the student secures a job with a higher salary than she had expected, she is likely to start spending more now in anticipation of the higher-than-expected permanent income.
47David Laibson and the Pull of Instant Gratification Recently, economists have turned to psychology for further explanationsof consumer behavior. They have suggested that consumption decisionsare not made completely rationally. This new subfield infusingpsychology into economics is called behavioural economics. Harvard’sDavid Laibson notes that many consumers judge themselves to beImperfect decisionmakers. Consumers’ preferences may be time-inconsistent: they may alter their decisions simply because time passes.Pull of InstantGratification
48The Psychology of Instant Gratification Theories from Fisher to Hall assumes that consumers are rational and act to maximize lifetime utility.recent studies by David Laibson and others consider the psychology of consumers.
49The Psychology of Instant Gratification Consumers consider themselves to be imperfect decision-makers.e.g., in one survey, 76% said they were not saving enough for retirement.Laibson: The “pull of instant gratification” explains why people don’t save as much as a perfectly rational lifetime utility maximizer would save.
50Two Questions and Time Inconsistency 1. Would you prefer (A) a chocolate bar today, or (B) two chocolate bars tomorrow?2. Would you prefer (A) a chocolate bar in 100 days, or (B) two chocolate bars in 101 days?In studies, most people answered A to question 1, and B to question 2.A person confronted with question 2 may choose B days later, when he is confronted with question 1, the pull of instant gratification may induce him to change his mind and to select A. People are more patient in the long-run than in the short-run. Time inconsistency.The text discusses time inconsistency in this context. Time inconsistency was introduced and defined in chapter 14.
51Summing upKeynes suggested that consumption depends primarily on current income.More recent work suggests instead that consumption depends oncurrent incomeexpected future incomewealthinterest ratesEconomists disagree over the relative importance of these factors and of borrowing constraints and psychological factors.
52Chapter summary 1. Keynesian consumption theory Keynes’ conjectures MPC is between 0 and 1APC falls as income risescurrent income is the main determinant of current consumptionEmpirical studiesin household data & short time series: confirmation of Keynes’ conjecturesin long time series data: APC does not fall as income rises
53Chapter 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 HypothesisIncome varies systematically over a lifetime.Consumers use saving & borrowing to smooth consumption.Consumption depends on income & wealth.
54Chapter 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.5. Hall’s Random-Walk HypothesisCombines PIH with rational expectations.Main result: changes in consumption are unpredictable, occur only in response to unanticipated changes in expected permanent income.
55Chapter summary 6. Laibson and the pull of instant gratification Uses psychology to understand consumer behaviour.The desire for instant gratification causes people to save less than they rationally know they should.
56Key Concepts of Chapter 17 Marginal propensity to consumeAverage propensity to consumeIntertemporal budget constraintDiscountingIndifference curvesMarginal rate of substitutionNormal goodIncome effectSubstitution effectBorrowing constraintLife-cycle hypothesisPrecautionary savingPermanent-income hypothesisPermanent incomeTransitory incomeRandom walk