CHAPTER SIXTEEN Consumption

OVERVIEW GDP = final goods expenditures: consumption investment government purchases net exports of goods and services These components represent demands for goods and services by various sectors - households, firms, the government and foreigners. Their sum: aggregate spending or aggregate demand. The 2 most important private elements of aggregate spending: consumption and investment.

This chapter: Households receive income from their labor or their assets holdings and have to decide what to do with it The decision to consume: - the decision not to save The decision to save: - the decision to postpone consumption How do households decide how much of their income to consume today and how much to save for the future? This decision is fundamentally intertemporal: now or later, which is better?

This chapter: In previous chapters, consumption was a function of disposable income: C=C(Y-T) This is too simple to provide a complete explanation of the consumer behavior 4 views on the theory of consumption behavior: - J.M. Keynes - I.Fisher - F.Modigliani - M.Friedman

and the Consumption Function 1. John Maynard Keynes and the Consumption Function The consumption function was central to Keynes’ theory of economic fluctuations presented in The General Theory in 1936. Three main ideas: 1. Keynes conjectured that the marginal propensity to consume-- the amount consumed out of an additional dollar of income-- is between zero and one. He claimed that the fundamental law is that out of every dollar of earned income, people will consume part of it and save the rest. He wrote that “men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income.”

2. Keynes proposed that the average propensity to consume-- the ratio of consumption to income-- falls as income rises. 3. Keynes also held that income is the primary determinant of consumption and that the interest rate does not have an important role. He wrote that “the main conclusion suggested by experience is that the short-period influence of the rate of interest on individual spending out of a given income is secondary and relatively unimportant”.

The Consumption Function Y The slope of the consumption function is the MPC. C = C + c Y C = C + c Y Marginal Propensity to consume (MPC) income consumption spending by households depends on Autonomous consumption

The Average Propensity to Consume This consumption function exhibits three properties that Keynes conjectured. 1. The marginal propensity to consume c is between zero and one. 2. The average propensity to consume falls as income rises. 3. Consumption is determined by current income. APC = C/Y = C/Y + c C APC1 C APC2 1 1 Y As Y rises, C/Y falls, and so the average propensity to consume C/Y falls. Notice that the interest rate is not included in this function.

The 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 (0.99). This means that for every extra dollar he or she earns after tax deductions, he or she spends $0.99 of it. The MPC measures the sensitivity of the change in one variable (C) with respect to a change in the other variable (Y).

The Early Empirical Successes The earliest data indicated that the Keynesian consumption function is a good approximation of how consumers behave. Some studies: researchers surveyed households and collected data on consumption and income Findings: households with higher income consumed more (MPC>0) households with higher income saved more (MPC<1) higher-income households saved a larger fraction of their income (APC falls as income rises)

The Early Empirical Successes Other studies: researchers examined aggregate data on consumption and income for the period between the two world wars Findings: in years when income was very low (i.e. Great Depression), both consumption and saving were low (0<MPC<1) during those years of low income, the ratio of consumption to income was high (APC rises, as income falls) the correlation between income and consumption was very strong, so no other variable appeared to be important for explaining consumption

Simon Kuznets, and the Consumption Puzzle Secular Stagnation, Simon Kuznets, and the Consumption Puzzle But…the Keynesian consumption function soon encountered two anomalies: 1. During World War II, on the basis of Keynes’ consumption function, economists predicted that the economy would experience what they called secular stagnation-- a long depression of infinite duration-- unless fiscal policy was used to stimulate aggregate demand. It turned out that the end of the war did not throw the U.S. into another depression, but it did suggest that Keynes’ conjecture that the average propensity to consume would fall as income rose appeared not to hold.

Simon Kuznets, and the Consumption Puzzle Secular Stagnation, Simon Kuznets, and the Consumption Puzzle 2. Simon Kuznets constructed new aggregate data on consumption and investment dating back to 1869 (he later earned a Nobel Prize). He discovered that the ratio of consumption to income was stable over time, despite large increases in income; again, Keynes’ conjecture was called into question. This brings us to the puzzle…

Long-run consumption function (constant APC) Consumption Puzzle The failure of the secular-stagnation hypothesis and the findings of Kuznets both indicated that the average propensity to consume is fairly constant over time. This presented a puzzle: why did Keynes’ conjectures hold up well in the studies of household data and in the studies of short time-series, but fail when long time series were examined? Long-run consumption function (constant APC) Studies of household data and short time-series:short-run consumption function (the Keynesian consumption function). Studies using long time-series found: long-run consumption function (the APC did not vary systematically with income). C Short-run consumption function (falling APC) Y

Economists needed to explain how these two consumption functions could be consistent with each other. In the 1950s, Franco Modigliani and Milton Friedman each proposed explanations of these contradictory findings (they both later won Nobel prizes). Modigliani - life-cycle hypothesis Friedman - permanent-income hypothesis Both theories rely on the theory of consumer behavior proposed by Irving Fisher.

2. Irving Fisher and Intertemporal Choice Keynes’s consumption function: relates current consumption to current income. This relationship is incomplete: - when people decide how much to consume and how much to save, they consider both the present and the future. - the more consumption they enjoy today, the less they will be able to enjoy tomorrow Irving Fisher: developed a model with which economists analyze how rational, forward-looking consumers make intertemporal choices-- that is, choices involving different periods of time.

2. Irving Fisher and Intertemporal Choice The model illuminates: the constraints consumers face the preferences they have 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.

The Intertemporal Budget Constraint People consume less than they desire, because their consumption is constrained by their income. Consumers face a limit on how much they can spend - BUDGET CONSTRAINT. THE INTERTEMPORAL BUDGET CONSTRAINT - measures the total resources available for consumption today and in the future.

The Consumer's Budget Constraint Let’s examine the decision facing a consumer who lives for two periods. Period 1 - consumer’s youth Period 2 - consumer’s old age The consumer earns income Y1 and consumes C1 in period 1. The consumer earns income Y2 and consumes C2 in period 2.

The Consumer's Budget Constraint The standard way of expressing the consumer’s intertemporal budget constraint is the following: This equation relates consumption in the two periods to income in the two periods

Interpretation of the consumer’s budget constraint If the interest rate is zero, the budget constraint shows that total consumption in the two periods equals total income in the two periods. If the interest rate is greater than zero, future consumption and future income are discounted by a factor of 1 + r. This discounting arises from the interest earned on savings. Because the consumer earns interest on current income that is saved, future income is worth less than current income. Also, because future consumption is paid for out of savings that have earned interest, future consumption costs less than current consumption. The factor 1/(1+r) is the price of second-period consumption measured in terms of first-period consumption; it is the amount of first-period consumption that the consumer must forgo to obtain 1 unit of second-period consumption.

The Consumer's Budget Constraint Here are the combinations of first-period and second-period consumption the consumer can choose. If he chooses a point between A and B, he consumes less than his income in the first period and saves the rest for the second period. If he chooses between A and C, he consumes more than his income in the first period and borrows to make up the difference. Consumer’s budget constraint consumption Second- period B Saving Vertical intercept is (1+r)Y1 + Y2 A Borrowing Y2 Horizontal intercept is Y1 + Y2/(1+r) C Y1 First-period consumption

Consumer Preferences Indifference curves - The consumer’s preferences regarding consumption in the two periods An indifference curve - the combination of first-period and second-period consumption that makes the consumer equally happy. The slope at any point on the indifference curve - 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.

Consumer Preferences consumption Second- period Y Z IC2 X W IC1 First-period consumption Indifference curves represent the consumer’s preferences over first- period and second-period consumption. An indifference curve gives the combinations of consumption in the two periods that make the consumer equally happy. Higher 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 Z to all the others-- Point Z is on a higher indifference curve and is therefore not equally preferred to W, X and Y.

Optimization consumption Second- period O IC3 IC2 IC1 First-period consumption The consumer achieves his highest (or optimal) level of satisfaction by choosing the point on the budget constraint that is on the highest indifference curve. At the optimum, the indifference curve is tangent to the budget constraint.

How Changes in Income Affect Consumption Second- period O IC2 IC1 First-period consumption An increase in either first-period income or second-period income shifts the budget constraint outward. Consumption smoothing - regardless of whether the increase in income occurs in the first period or the second period, the consumer spreads it over consumption in both periods.

Present Value Present Value of Income: Keynes: a person’s current consumption depends largely on his current income Fisher: consumption is based on the resources the consumer expects over his lifetime

How Changes in the Real Interest Rate Affect Consumption Economists decompose the impact of an increase in the real interest rate on consumption into two effects: an income effect and a substitution effect. The income effect: the change in consumption that results from the movement to a higher indifference curve. The substitution effect: the change in consumption that results from the change in the relative price of consumption in the two periods. An increase in the interest rate rotates the budget constraint around the point C, where C is (Y1, Y2). The higher interest rate reduces first period consumption (move to point A) and raises second-period consumption (move to point B). New budget constraint consumption Second- period B Old budget constraint A C Y2 IC2 IC1 Y1 First-period consumption

Constraints on Borrowing The inability to borrow prevents current consumption from exceeding current income. A constraint on borrowing can therefore be expressed as: C1 < Y1. This inequality states that consumption in period one must be less than or equal to income in period one. This additional constraint on the consumer is called a borrowing constraint, or sometimes, a liquidity constraint.

Constraints on Borrowing Budget constraint Borrowing constraint C1

Constraints on Borrowing The analysis of borrowing leads us to conclude that there are two consumption functions: 1. For some consumers, the borrowing constraint is not binding, and consumption in both periods depends on the present value of lifetime income. 2. For other consumers, the borrowing constraint binds. Hence, for those consumers who would like to borrow but cannot, consumption depends only on current income.

3. Franco Modigliani and the Life-Cycle Hypothesis In the 1950’s, Franco Modigliani, Ando and Brumberg used Fisher’s model of consumer behavior to study the consumption function. One of their goals: to study the consumption puzzle. According to Fisher’s model, consumption depends on a person’s lifetime income. Modigliani 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 those times when income is low. This interpretation of consumer behavior formed the basis of his life-cycle hypothesis.

THE HYPOTHESIS Consider a consumer who expects to live T years from now, has wealth of W, and expects to earn income Y until she retires, R years from now Question: What level of consumption will the consumer choose if she wishes to maintain a smooth level of consumption over her life?

THE HYPOTHESIS Aggregate consumption function will be much the same as the individual one: α is the marginal propensity to consume out of wealth β is the marginal propensity to consume out of income

The Life-Cycle consumption function: consumption depends on wealth as well as on income the intercept of the consumption function depends on wealth C β 1 Y

IMPLICATIONS The life-cycle model of consumer behavior can solve the consumption puzzle. The average propensity to consume is: Data across individuals of over short periods of time: high income corresponds to a low APC, since wealth does not vary proportionately with income from person to person or from year to year Data over long periods of time: wealth and income grow together, resulting in a constant APC

How changes in wealth shift the consumption function: - in the long run, as wealth increases, the consumption function shifts upward - this upward shift prevents the APC from falling as income increases C β 1 Y

Other predictions: Saving varies over a person’s lifetime - people want to smooth consumption over their lives, therefore the young who are working save, while the old who are retired dissave $ Wealth Income Saving Consumption Dissaving Retirement begins End of life

The Consumption and Saving of Elderly The consumption and saving of the elderly present a problem for the life-cycle model: it appears that the elderly do not dissave as much as the model predicts Two explanations for this: 1. Elderly are concerned about unpredictable expenses -additional expenses from uncertainty: precautionary saving 2. The elderly may want to leave bequests to their children Research on the elderly suggests that the simplest life-cycle model cannot fully explain the consumer behavior.

4.Milton Friedman and the Permanent-Income Hypothesis The permanent-income hypothesis (Friedman, 1957)- current consumption is proportional to permanent income. Friedman’s permanent-income hypothesis complements Modigliani’s life-cycle hypothesis: both use Fisher’s theory of the consumer to argue that consumption should not depend on current income alone. The life-cycle hypothesis - emphasizes that income follows a regular pattern over a person’s lifetime. The permanent-income hypothesis - emphasizes that people experience random and temporary changes in their incomes from year to year.

The Hypothesis Friedman suggested that we view current income Y as the sum of two components, permanent income YP and transitory income YT: Permanent income = the part of income that people expect to persist in the future (average income) Transitory income = the part of income that people do not expect to persist (random deviations from the average)

Examples Maria, who has a law degree, earned more this year than John, who is a high-school dropout. Maria’s higher income resulted from higher permanent income, because her education will continue to provide her a higher salary Sue, a Florida orange grower, earned less than usual this year because a freeze destroyed her crop. Bill, a California orange grower, earned more than usual because the freeze in Florida drove up the price of oranges. Bill’s higher income resulted from higher transitory income

Friedman reasoned: consumption should depend primarily on permanent income; consumers use saving and borrowing to smooth consumption in response to transitory changes in income The permanent-income hypothesis: consumption is proportional to permanent income. α is a constant that measures the fraction of permanent income consumed

Implications The PIH solves the consumption puzzle: it suggests that the standard Keynesian consumption function uses the wrong variable. According to PIH, consumption depends on permanent income, but many studies of consumption try to relate consumption to current income (errors-in-variables problem)

Implications Studies of household data: - they reflect a combination of permanent and transitory income Studies of time-series: - over long periods of time the variation in income comes from the permanent component

Rational Expectations and Random-Walk Consumption Fisher’s model of intertemporal choice - forward-looking consumers base their consumption decisions not only on their current income but also on the income that they expect to receive in the future. PIH - consumption depends on people’s expectations Rational expectations assumption: people use all available information to make optimal forecasts about the future.

Rational Expectations and Random-Walk Consumption Robert Hall was first to derive the implications of rational expectations for consumption. He showed that if the permanent-income hypothesis is correct, and if consumers have rational expectations, then changes in consumption over time should be unpredictable. When changes in a variable are unpredictable, the variable is said to follow a random walk. According to Hall, the combination of the permanent-income hypothesis and rational expectations implies that consumption follows a random walk.

Rational Expectations and Random-Walk Consumption Hall’s reasoning: - changes in consumption reflect “surprises” about lifetime income - if consumers are optimally using all available information, then they should be surprised only by events that were entirely unpredictable - therefore, changes in their consumption should be unpredictable as well Implications for the analysis of economic policies: if consumers obey the PIH hypothesis and have rational expectations, then only unexpected policy changes influence consumption. These policy changes take effect when they change expectations.

Summary Keynes suggested a consumption function of the form: Consumption=f(Current Income) Recent work suggests instead that: Consumption=f(Current Income, Wealth, Expected Future Income, Interest Rate) Economists continue to debate the relative importance of these determinants of consumption.

Key Concepts of Ch. 16 Marginal propensity to consume Average propensity to consume Intertemporal budget constraint Discounting Indifference curves Marginal rate of substitution Normal good Income effect Substitution effect Borrowing constraint Life-cycle hypothesis Precautionary saving Permanent-income hypothesis Permanent income Transitory income Random walk