VIVEKANANDA COLLEGE

THAKURPUKUR
KOLKATA-700063
NAAC ACCREDITED ‘A’ GRADE

Topic: Consumption
Course Title: CC8
Paper: Macroeconomics
Unit: III
Semester: IV
Name of the Teacher: Dr. Atanu Thakur
Name of the Department: Economics

CONSUMPTION 0
 Here you will learn…
An introduction to the most prominent work on
consumption, including:
◦ John Maynard Keynes: consumption and current income
◦ Irving Fisher: intertemporal choice
◦ Franco Modigliani: the life-cycle hypothesis
◦ Milton Friedman: the permanent income hypothesis
◦ Robert Hall: the random-walk hypothesis
◦ David Laibson: the pull of instant gratification

CONSUMPTION 1
 Keynes’s conjectures
1. 0 < MPC < 1

2. Average propensity to consume (APC )

falls as income rises.
(APC = C/Y )

3. Income is the main determinant of

consumption.

CONSUMPTION 2
The Keynesian consumption function
C

C  C  cY

c c = MPC
= slope of the
1
consumption
C function

Y
CONSUMPTION 3
The Keynesian consumption function
As income rises, consumers save a bigger
C fraction of their income, so APC falls.

C  C  cY

C C
APC    c
Y Y
slope = APC
Y
CONSUMPTION 4
 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

CONSUMPTION 5
 Problems for the
Keynesian consumption function
Based on the Keynesian consumption function, economists predicted
that C would grow more slowly than Y over time.
This prediction did not come true:
◦ As incomes grew, APC did not fall,
and C grew at the same rate as income.
◦ Simon Kuznets showed that C/Y was
very stable in long time series data.

CONSUMPTION 6
The Consumption Puzzle
Consumption function
C from long time series
data (constant APC )

Consumption function
from cross-sectional
household data
(falling APC )

Y
CONSUMPTION 7
Irving Fisher and Intertemporal Choice
The basis for much subsequent work on consumption.
Assumes consumer is forward-looking and chooses consumption for the
present and future to maximize lifetime satisfaction.
Consumer’s choices are subject to an intertemporal budget constraint,
a measure of the total resources available for present and future
consumption.

CONSUMPTION 8
 The basic two-period model
Period 1: the present
Period 2: the future
Notation
Y1, Y2 = income in period 1, 2
C1, C2 = consumption in period 1, 2
S = Y1 - C1 = saving in period 1
(S < 0 if the consumer borrows in period 1)

CONSUMPTION 9
 Deriving the intertemporal
budget constraint
Period 2 budget constraint:
C 2  Y 2  (1  r ) S
 Y 2  (1  r )(Y1 - C 1 )

 Rearrange terms:
(1  r )C 1  C 2  Y 2  (1  r )Y1

 Divide through by (1+r ) to get…

CONSUMPTION 10
The intertemporal budget constraint
C2 Y2
C1   Y1 
1r 1r

present value of present value of

lifetime consumption lifetime income

CONSUMPTION 11
 The intertemporal budget constraint

C2 C2 Y2
C1   Y1 
1r 1r

(1  r )Y1 Y 2
Consump =
Saving income in
The budget
both periods
constraint shows all
combinations Y2
of C1 and C2 that just Borrowing
exhaust the
consumer’s
resources. C1
Y1
Y1 Y 2 (1  r )
CONSUMPTION 12
 The intertemporal budget constraint

C2 C2 Y2
C1   Y1 
1r 1r
The slope of the
budget line
equals
-(1+r ) 1
(1+r )

Y2

C1
Y1

CONSUMPTION 13
 Consumer preferences Higher
C2
An indifference indifference
curve shows curves
all combinations of represent
C1 and C2 higher levels
that make the of happiness.
consumer
equally happy. IC2

IC1
C1

CONSUMPTION 14
 Consumer preferences
C2 The slope of
Marginal rate of an indifference
substitution (MRS ): the curve at any
amount of C2 point equals
the consumer the MRS
would be willing to 1 at that point.
substitute for MRS
one unit of C1.

IC1
C1

CONSUMPTION 15
 Optimization
C2
The optimal (C1,C2) is
At the optimal point,
where the
MRS = 1+r
budget line
just touches
the highest indifference
curve. O

C1

CONSUMPTION 16
 How C responds to changes in Y
C2 An increase
Results: in Y1 or Y2
Provided they are shifts the
both normal goods, budget line
C1 and C2 both outward.
increase,
…regardless of
whether the
income increase
occurs in period 1
or period 2. C1

CONSUMPTION 17
Keynes vs. Fisher
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.

CONSUMPTION 18
 How C responds to changes in r
C2
An increase in r
As depicted here, pivots the budget
C1 falls and C2 rises. line around the
However, it could point (Y1,Y2 ).
turn out differently… B
C2**

A
C2 *

Y2

*
Y1 C1
C1**C1

CONSUMPTION 19
 How C responds to changes in r

income effect: If consumer is a saver,

the rise in r makes him better off, which tends to increase
consumption in both periods.
substitution effect: The rise in r increases
the opportunity cost of current consumption,
which tends to reduce C1 and increase C2.
Both effects  C2.
Whether C1 rises or falls depends on the relative size of the
income & substitution effects.

CONSUMPTION 20
 Constraints on borrowing
In Fisher’s theory, the timing of income is irrelevant:
Consumer can borrow and lend across periods.
Example: If 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 (aka
“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.

CONSUMPTION 21
Constraints on borrowing
C2
The budget line
with no
borrowing
constraints

Y2

Y1 C1

CONSUMPTION 22
 Constraints on borrowing
C2
The borrowing
constraint takes
the form:
The budget
C1  Y1 line with a
borrowing
Y2 constraint

Y1 C1

CONSUMPTION 23
 Consumer optimization when the borrowing
constraint is not binding
C2
The borrowing
constraint is not
binding if the
consumer’s
optimal C1
is less than Y1.

Y1 C1

CONSUMPTION 24
 Consumer optimization when the borrowing
constraint is binding
C2
The optimal choice
is at point D.
But since the
consumer cannot
borrow, the best
he can do is point
E. E
D

Y1 C1

CONSUMPTION 25
The Life-Cycle Hypothesis
due to Franco Modigliani (1950s)
Fisher’s model says that consumption depends on lifetime income, and
people try to achieve smooth consumption.
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.

CONSUMPTION 26
 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

CONSUMPTION 27
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 = a W + 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

CONSUMPTION 28
 Implications of the Life-Cycle Hypothesis
The LCH can solve the consumption puzzle:
◦ The life-cycle consumption function implies
APC = C/Y = a(W/Y ) + b
◦ Across households, income varies more than wealth, so high-income households
should have a lower APC than low-income households.
◦ Over time, aggregate wealth and income grow together, causing APC to remain
stable.

CONSUMPTION 29
 Implications of the Life-Cycle Hypothesis
RS

The LCH implies

that saving Wealth
varies
systematically
over a person’s Income
lifetime.
Saving

Consumption Dissaving

Retirement End
begins of life
CONSUMPTION Time 30
 The Permanent Income Hypothesis
Milton Friedman (1957)
Y = YP + YT
where
Y = current income
YP = permanent income
average income, which people expect to persist into the future
YT = transitory income
temporary deviations from average income

CONSUMPTION 31
The Permanent Income Hypothesis
Consumers use saving & borrowing to smooth consumption in response
to transitory changes in income.
The PIH consumption function:
C = aYP
where a is the fraction of permanent income that people consume per
year.

CONSUMPTION 32
 The Permanent Income Hypothesis
The PIH can solve the consumption puzzle:
◦ The PIH implies
APC = C / Y = a Y P/Y
◦ If high-income households have higher transitory income than low-income
households,
APC is 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.

CONSUMPTION 33
 PIH vs. LCH
Both: people try to smooth their consumption
in the face of changing current income.
LCH: current income changes systematically
as people move through their life cycle.
PIH: current income is subject to random, transitory fluctuations.
Both can explain the consumption puzzle.

CONSUMPTION 34
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.

CONSUMPTION 35
 The Random-Walk Hypothesis
If PIH is correct and consumers have rational expectations,
then consumption should follow a random walk: changes
in consumption should
be unpredictable.
◦ A change in income or wealth that was anticipated has
already been factored into expected permanent income,
so it will not change consumption.
◦ Only unanticipated changes in income or wealth that alter
expected permanent income
will change consumption.

CONSUMPTION 36
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.

CONSUMPTION 37
The Psychology of Instant Gratification
Theories from Fisher to Hall assume that consumers are rational and act
to maximize lifetime utility.
Recent studies by David Laibson and others consider the psychology of
consumers.

CONSUMPTION 38
The Psychology of Instant Gratification
Consumers consider themselves to be imperfect decision-makers.
◦ 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.

CONSUMPTION 39
 Two questions and time inconsistency
1. Would you prefer (A) a candy today, or
(B) two candies tomorrow?
2. Would you prefer (A) a candy in 100 days, or
(B) two candies in 101 days?
In studies, most people answered (A) to 1 and (B) to 2.
A person confronted with question 2 may choose (B).
But in 100 days, when confronted with question 1,
the pull of instant gratification may induce her to change her
answer to (A).

CONSUMPTION 40
 Summing up
Keynes: consumption depends primarily on current
income.
Recent work: consumption also depends on
◦ expected future income
◦ wealth
◦ interest rates

Economists disagree over the relative importance of these

factors, borrowing constraints,
and psychological factors.

CONSUMPTION 41
 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

CONSUMPTION slide
42 42
 Summary
2. Fisher’s theory of intertemporal choice
◦ Consumer chooses current & future consumption to maximize lifetime satisfaction of
subject to an intertemporal budget constraint.
◦ Current consumption depends on lifetime income, not current income, provided
consumer can borrow & save.

CONSUMPTION slide
43 43
 Summary
3. Modigliani’s life-cycle hypothesis
◦ Income varies systematically over a lifetime.
◦ Consumers use saving & borrowing to smooth consumption.
◦ Consumption depends on income & wealth.

CONSUMPTION slide
44 44
 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.

CONSUMPTION slide
45 45
 Summary
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.

CONSUMPTION slide
46 46
 Summary
6. Laibson and the pull of instant gratification
◦ Uses psychology to understand consumer behavior.
◦ The desire for instant gratification causes people to save less than they rationally
know they should.

CONSUMPTION slide
47 47