2. © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Chapter 13
Consumption and Saving
Item
Etc.
McGraw-Hill/Irwin
Macroeconomics, 10e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

3. Introduction Consumption accounts for about 70% of AD
Fluctuations in C are proportionately smaller than the fluctuations in GDP
Consumption is relatively stable
In this chapter we seek to understand consumption and the link between consumption and income
Consumption theory
The debate over different consumption theories = debate over the size of the marginal propensity to consume (MPC)
Keynesian model MPC is high, modern theories MPC is low

4. Introduction
Figure 13-2 plots changes in per capita consumption and changes in per capita disposable income
Consumption follows income swings that last 5-10 years
Consumption does not respond to spikes in income
[Insert Figure 13-1 here]
Long term changes in income
generate changes in consumption,
but short term changes in income
do not.

5. Introduction
Figure 13-2 compares consumption this quarter to the previous quarter:
Consumption is almost perfectly predicted by previous consumption
This relationship is an outcome of the link between current consumption and expected future consumption
Used in the modern theories of consumption
[Insert Figure 13-2 here]

6. Introduction
Early Keynesian theories explained consumption as a function of current disposable income (Figure 13-3)
No separation for temporary and permanent income
This consumption function is of the form: (1), where c is the MPC and is on the [0,1] range
Modern consumption theories incorporate intertemporal dynamics
[Insert Figure 13-3 here]

7. Life Cycle Theory
The life cycle hypothesis views individuals as planning their consumption and savings behavior over long periods with the intention of allocating their consumption in the best possible way over their entire lifetimes
Different MPC out of permanent income, transitory income, and wealth compared to the Keynesian theory with a single MPC
Key assumption: most people choose stable lifestyles, or smooth out consumption over their lifetime
Individuals do not like consumption to change dramatically from year to year
The simplest form of this assumption is to consume the same amount in every year

8. Life Cycle Theory Suppose an individual: Starts life at age 20
Plans to work until age 65
Will die at age 80
Has annual labor income of YL = $30,000
Lifetime resources are $30,000 x 45 = $1,350,000
Spreading lifetime resources over the number of years of life (80-20 = 60) allows for C = $1,350,000/60 = $22,500
The general formula is
The marginal propensity to consume is

9. Life Cycle Theory
Once we have a theory of consumption, we have a theory of savings (savings is income less consumption)
Figure 13-4 traces out the path of consumption and saving using the life cycle theory
Wealth peaks at retirement
Wealth is zero at death
Accumulate savings in working years, but dissave through retirement
Income is positive in working years, and zero in retirement
[Insert Figure 13-4 here]

10. Life Cycle Theory
Continuing with the example, can compute different marginal propensities to consume for various measures of income: permanent and transitory income
Suppose income increases permanently by $3,000:
The extra $3,000 for each 45 years spread out over 60 years of life increases consumption by
The marginal propensity to consume out of permanent income is
Suppose income increased by $3,000 for only one year:
The extra $3,000 over 60 years would increase consumption by
The MPC out of transitory income is

11. Life Cycle Theory The MPC out of permanent income is large
The MPC out of transitory income is small and fairly close to zero
The life-cycle theory implies that the MPC out of wealth should equal the MPC out of transitory income
WHY?
Spending out of wealth is spread out over remaining years of life
The MPC out of wealth is used to link changes in the value of assets to current consumption

12. Permanent Income Theory
Permanent income theory of consumption is like the life cycle hypothesis in that current consumption is not dependent upon current income, but on a longer-term estimate of income
Milton Friedman called this permanent income
Permanent income is the steady rate of expenditure a person could maintain for the rest of his/her life, given the present level of wealth and the income earned now and in the future
The consumption function is then: (2), where YP is permanent disposable income
Life cycle hypothesis and permanent income hypothesis are very
similar, and are often combined as the PILCH.

13. Consumption Under Uncertainty
If permanent income were known, according the PILCH, consumption would never change
The modern version of PILCH emphasizes the link between income uncertainty and changes in consumption and takes a more formal approach to consumer maximization
Under this newer version of consumption theory, changes in consumption arise from surprise changes in income
Absent such surprises, consumption this period is the same as last period and is the same as next period
Consumption can be modeled as: , where consumption tomorrow is equal to consumption today plus a truly random error (Robert Hall)

14. Liquidity Constraints and Myopia
Why might the PILCH miss explaining close to half of consumption behavior?
Two explanations include:
Liquidity constraints: consumer unable to borrow to sustain current consumption in the expectation of higher future income
When permanent income is higher than current income, consumers are unable to borrow to consume at the higher level predicted by PILCH
Consumption more closely linked to current income
Myopia:
Consumers simply are not as forward looking as the PILCH suggests
Difficult to differentiate between the two, but both imply current consumption
dependent upon current disposable income, rather than future levels.

15. Uncertainty and Buffer Stock Saving
Life cycle hypothesis is that people save to finance retirement
Additional saving goals also matter, especially with the presence of uncertainty
Research suggests that some save to leave bequests to children
Different motives for bequests: altruistic motive and strategic motive
Some saving is precautionary  undertaken to guard against unexpected events (ex. Health care costs)
Saving is used as a buffer stock  added to when times are good in order to maintain consumption when times are bad
One piece of evidence for these other motives is that older people rarely dissave, or draw down their wealth, but live off of income (Ex. Interest and dividends from wealth)