1. MANKIW'S MACROECONOMICS MODULES
MANKIW'S MACROECONOMICS MODULES
CHAPTER 17
Consumption
A PowerPointTutorial
To Accompany
MACROECONOMICS, 7th. Edition
N. Gregory Mankiw
Tutorial written by:
Mannig J. Simidian, modified by meb
B.A. in Economics with Distinction, Duke University
M.P.A., Harvard University Kennedy School of Government
M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management

2. and the Consumption Function
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.
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.
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.

3. The Consumption Function
C = C + c Y, C > 0, 0 < c <1
Consumption
spending by
households C Y
C determines the intercept on the vertical axis. The slope of the consumption function is lower case c, the MPC.
C = C + c Y
marginal
propensity to
consume (MPC)
disposable
income
autonomous
consumption
depends on

4. 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 (.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.

5. The Average Propensity to Consume
The C 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 Y. Notice that the
interest rate is not included in this
equation as a determinant of consumption.
APC = C/Y = C/Y + c C
APC1 C
APC2 1 1 Y
What 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.

6. 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

7. Simon Kuznets, and the Consumption Puzzle
Secular Stagnation,
Simon Kuznets, and the Consumption Puzzle
During World War II, on the basis of Keynes’s consumption function,
economists predicted that the economy would experience what they
called 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 States
into another depression, but it did suggest that Keynes’s conjecture
that the average propensity to consume would fall as income rose
appeared not to hold.
Simon Kuznets constructed new aggregate data on consumption and
investment dating back to His work would later earn him a
Nobel Prize. Kuznets discovered that the ratio of consumption to income
was stable over time, despite large increases in income; again, Keynes’s
conjecture was called into question.
This brings us to the puzzle…

8. 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’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. C
Long-run consumption function (constant APC)
Short-run consumption
function (falling APC) Y

9. Irving 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.

10. 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)

11. Deriving the intertemporal budget constraint
Period 2 budget constraint:
Rearrange:
Explain the intuition/interpretation of the period 2 budget constraint.
Finally, divide by (1+r ):

12. The consumer’s intertemporal budget constraint
present value of lifetime consumption
present value of lifetime income
If your students are not familiar with the present value concept, it is explained in an FYI box in the text.

13. Here is an interpretation of the consumer’s budget constraint:
The consumer’s budget constraint implies that if the interest
rate is zero, the budget constraint shows that total
consumption in the two periods equals total income
in the two periods. In the usual case in which 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.

14. 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 that
his income in the first period and borrows to make up the difference.
Consumer’s (intertemporal) budget constraint
showing all combinations of C1 and C2
that are feasible. The slope equals –(1+r) C2 B
Saving 1
Vertical intercept is
(1+r)Y1 + Y2
(1+r ) A
Borrowing
Horizontal intercept is
Y1 + Y2/(1+r) Y2 C Y1
The slope of the budget line equals -(1+r):
to increase C1 by one unit,
the consumer must sacrifice
(1+r) units of C2. C1

15. Consumer Preferences
The 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.

16. Consumer Preferences Y Z IC2 X W IC1
Second-period
consumption Y Z
IC2 X W
IC1
First-period consumption
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 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.

17. Consumer Preferences
The 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.

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

19. Optimization
Second-period
consumption 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. Here the slope of the indifference curve
equals the slope of the budget line. At the optimum, the indifference
curve is tangent to the budget constraint. The slope of the indifference
curve is the marginal rate of substitution MRS, and the slope of the
budget line is 1 + the real interest rate. At point O, MRS = 1 + r.

20. How Changes in Income Affect Consumption
Second-period
consumption O
IC2
IC1
First-period consumption
An increase in either first-period income or second-period income
shifts the budget constraint outward. If consumption in period one and
consumption in period two are both normal goods - those that are
demanded more as income rises, this increase in income raises
consumption in both periods.

21. Keynes vs. Fisher about income
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.

22. 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:
- a substitution effect , the change in consumption that results from the
change in the relative price of consumption in the two periods;
an income effect , the change in consumption that results from the
movement 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…….. ! C2
New budget
constraint B
Old budget constraint A Y
IC2 Y2
IC1 Y1 C1

23. How 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.

24. An 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.

25. Keynes 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.

26. Constraints on Borrowing
In Fisher’s theory, the timing of income is less important because the
consumer 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 borrowing
in the current period.
However, if consumer faces borrowing constraints
(or 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
The inability to borrow prevents current consumption from exceeding
current income. A constraint on borrowing can therefore be expressed
as C1 < Y1.

27. Constraints on borrowing
The budget line with no borrowing constraints Y2 Y1

28. Constraints on borrowing
The budget line with a borrowing constraint
The borrowing constraint takes the form:
C1  Y1 Y2 Y1
The area under the blue line satisfies both budget and borrowing constraints

29. Consumer 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. C1 C2
In this case, the consumer would not have borrowed anyway, so his inability to borrow has no impact on consumption choices. Y1

30. Consumer 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. C1 C2
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.
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 constraint
Then 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. E D Y1

31. 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 constraint
Then 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.

32. Europa: 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).

33. Franco Modigliani and the Life-Cycle Hypothesis
In the 1950s, Franco Modigliani, Albert Ando, and Richard Brumberg
used Fisher’s model of consumer behavior to study
the consumption function. One of their goals was 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.

34. The 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.

35. 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 initial wealth could be zero, or could be a gift from parents to help the consumer get started on her own.

36. 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

37. 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 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 Keynes
Over time, aggregate wealth and income grow together, causing APC to remain stable  Simon Kuznets puzzle solved.

38. Implications of the Life-Cycle Hypothesis€
Wealth
The LCH implies that saving varies systematically over a person’s lifetime.
Income
Saving
Consumption
Dissaving
Retirement begins
End of life

39. Milton Friedman and the Permanent-Income Hypothesis
In 1957, Milton Friedman proposed the permanent-income hypothesis
to explain consumer behavior. Its essence is that 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. But unlike the life-cycle hypothesis,
which 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.
Friedman suggested that we view current income Y as the sum of two
components, permanent income YP and transitory income YT.

40. 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)

41. The 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 P
where a is the fraction of permanent income that people consume per year.

42. 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 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.

43. PIH vs. LCH
In 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.

44. Robert Hall and the Random-Walk Hypothesis
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.

45. The Random-Walk Hypothesis
due to Robert Hall (1978)
based on Fisher’s model & PIH, in which forward-looking consumers base consumption on expected future income
Hall 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.

46. Implication 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.

47. David Laibson and the Pull of Instant Gratification
Recently, economists have turned to psychology for further explanations
of consumer behavior. They have suggested that consumption decisions
are not made completely rationally. This new subfield infusing
psychology into economics is called behavioural economics. Harvard’s
David Laibson notes that many consumers judge themselves to be
Imperfect decisionmakers. Consumers’ preferences may be time-
inconsistent: they may alter their decisions simply because time passes.
Pull of Instant
Gratification

48. The 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.

49. The 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.

50. Two 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.

51. Summing up
Keynes suggested that consumption depends primarily on current income.
More 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.

52. 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

53. 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.

54. 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.
5. Hall’s Random-Walk Hypothesis
Combines PIH with rational expectations.
Main result: changes in consumption are unpredictable, occur only in response to unanticipated changes in expected permanent income.

55. Chapter 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.

56. Key Concepts of Chapter 17
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