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1. Consumption and Saving14
Consumption and Saving
Learning objectives
Understand that consumption is a large but relatively stable fraction of GDP.
Understand the relationship between changes in the real interest rate and changes in consumption and savings.
Understand the modern theories of consumption behaviour link lifetime consumption to lifetime income.
Understand that empirical evidence suggests that both modern theories and simple “psychological rule-of-thumb” models contribute to explaining consumption.
PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa
Copyright 2005 © McGraw-Hill Ryerson Ltd.

2. The Keynesian Consumption Function
Chapter 14: Consumption and Saving
The Consumption Function:
(1)
See Figure 14.1
As income increases this will increase consumption.
Only for short-run analysis (Large MPC)
No interest rate
Depends only on current consumption
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3. The Keynesian Consumption Function
Figure 14-1: An Estimated Early Consumption Function,
Chapter 14: Consumption and Saving
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4. Intertemporal Choice Maximizing Utility: Indifference Curves
Chapter 14: Consumption and Saving
Indifference Curve: A graphical representation of consumer preferences, showing combinations of current and future consumption for which total utility is constant.
Marginal rate of Substitution: The rate at which a consumer is willing to give up an amount of consumption today in order to receive increased consumption in the next period, holding total utility constant.
Budget Constraint: Is the line that shows the combinations of consumption today and consumption next period that the consumer can choose, given real income and the real interest rate.
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5. Intertemporal Choice Ct + 1 IC2
Figure 14-2: Indifference Curves
Chapter 14: Consumption and Saving
Ct + 1
IC2
The consumer is indifferent between bundles A and bundle B.
IC1
Total utility is higher on IC2 compared to IC1. B
CBt
CBt+1
Future Consumption A
CAt
Cat+1 Ct
Current Consumption
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6. Intertemporal Choice Yt + 1 + (1 + r)Yt Yt + 1 Yt + Yt / (1 + r) Yt
Figure 14-3: The Budget Constraint
Chapter 14: Consumption and Saving
Ct + 1
The budget constraint is the line that shows the combinations of consumption today and consumption next period that the consumer can choose, given real income and real interest rate.
Yt (1 + r)Yt
Future Consumption
Yt + 1 Yt
Yt + Yt / (1 + r) Ct
Current Consumption
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7. Intertemporal Choice
Figure 14-4 (a): Changes in the Budget Constraint
Chapter 14: Consumption and Saving
Y’t + Y’t + 1 / (1 + r)
Y’t (1 + r)Y’t
An increase in income in either period will shift out the budget constraint, increasing the consumption possibilities in both periods.
Yt (1 + r)Yt
Yt + Yt + 1 / (1 + r)
Future Consumption
Current Consumption
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8. Intertemporal Choice Yt + 1 Yt
Figure 14-4 (b): Changes in the Budget Constraint
Chapter 14: Consumption and Saving
Yt + Yt + 1 / (1 + r’)
Yt (1 + r’)Yt
An increase in the real rate of interest will rotate the budget constraint, making the slope steeper.
Yt (1 + r)Yt
Yt + Yt + 1 / (1 + r)
Future Consumption
Yt + 1 Yt
Current Consumption
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9. Intertemporal Choice C*t + 1 C*t Ct + 1 E IC3 IC2 IC1 Ct
Figure 14-5: Choosing Optimum Consumption and Savings
Chapter 14: Consumption and Saving
Ct + 1
Optimum consumption in each period is given by point E. At point E, the slope of the budget constraint equals the slope of the indifference curve. At the marginal rate of substitution equals the real rate of interest.
IC3
IC2
IC1
Future Consumption
C*t + 1
C*t E Ct
Current Consumption
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10. Intertemporal Choice
Chapter 14: Consumption and Saving
Normal Good: A good for which an increase in income causes the demand for the good to increase.
Substitution Effect: All else being equal, an increase in the real rate of interest will cause current consumption to go down and current savings to go up.
Income Effect: The change in consumption due to the fact that the consumer can now reach a higher indifference curve.
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11. Intertemporal Choice Ct + 1 Ct
Figure 14-6: Effects of an increase in Income
Chapter 14: Consumption and Saving
Ct + 1
An increase in income in either period shifts the budget constraint outward.
Future Consumption Ct
Current Consumption
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12. Intertemporal Choice ∆Ct + 1 Yt + 1 Yt ∆Ct
Figure 14-7: Effects of an Increase in the Real Interest Rate.
Chapter 14: Consumption and Saving
If the income effect is smaller than, or in the same direction as, the substitution effect, the net result is lower period t consumption and higher savings.
An increase in the real rate of interest makes the budget line steeper. E’
∆Ct + 1
Future Consumption E
Yt + 1 Yt Ct
∆Ct
Current Consumption
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13. Intertemporal Choice
Figure 14-8: The Savings rate and the Real Interest Rate,
Chapter 14: Consumption and Saving
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14. Life-Cycle-Permanent-Income Theory of Consumption and saving
Chapter 14: Consumption and Saving
Life-cycle Hypothesis: Emphasises choices about how to maintain a stable standard of living in the face of changes in income over the course of a life.
(2)
Permanent-income Theory: Says that people form expectations of their future income and choose how much to consume based on those as well as their current income.
(3)
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15. Life-Cycle-Permanent-Income Theory of Consumption and saving
Figure 14-9: Lifetime Income, Consumption, Saving, and Wealth in the LC Model
Chapter 14: Consumption and Saving
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16. Consumption Under Uncertainty
Chapter 14: Consumption and Saving
Lifetime Utility: The sum of period-by-period utilities.
Lifetime budget constraint: The sum of period-by-period consumption.
Lifetime utility = u(Ct) + u(Ct + 1) + … + u(CT - 1) + u(CT)
Subject to Ct + Ct … + CT CT
= Wealth + YLt + Ylt … + YLT YLT (4)
Marginal lifetime utility of consumption: The increase in utility from a small increase in consumption.
The optimal choice is the consumption path that equates the Marginal lifetime utility of consumption across periods.
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17. Consumption Under Uncertainty
Chapter 14: Consumption and Saving
Random-walk model of consumption: Consumption tomorrow should equal consumption today plus a truly random error.
(5)
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18. Policy in Action Temporary Tax Cuts and the Consumer
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19. Consumption Under Uncertainty
Chapter 14: Consumption and Saving
The LC-PIH: The Traditional Model Strikes Back
Excess sensitivity: Consumption reacts too strongly to predictable changes in income.
Excess smoothness: Consumption responds too little to surprise changes in income.
(6)
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20. Consumption Under Uncertainty
Chapter 14: Consumption and Saving
Liquidity Constraints and Myopia
Liquidity constraints: When a consumer cannot borrow to sustain current consumption in the expectations of higher future consumption.
Myopia: The idea that consumers are not as forward thinking as the LC-PIH suggests.
Uncertainty and Buffer-stock Saving
Buffer-stock: Excess consumer savings used to maintain consumption when income is lower than usual (saving for a rainy day).
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21. Chapter Summary
Chapter 14: Consumption and Saving
Theoretically, if the income effect is outweighed by the substitution effect, an increase in the real rate of interest leads to a decrease in current consumption and an increase in savings.
The life-cycle-permanent-income hypothesis (LC-PIH) predicts that the marginal propensity to consume out of permanent income is large and that the marginal propensity out of transitory income is very small.
Observed consumption is much smoother than the simple Keynesian consumption function predicts.
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22. Chapter Summary (cont’d)
Chapter 14: Consumption and Saving
The LC-PIH is a very attractive theory, but it does not give a complete explanation of consumption behaviour.
The life-cycle hypothesis suggests that the propensities of an individual to consume out of disposable income and out of wealth depend on the person’s age.
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23. The End Chapter 14: Consumption and Saving
Copyright 2005 © McGraw-Hill Ryerson Ltd.