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Macroeconomics ECO 403

LESSON 39

CONSUMPTION (Continued...)

John Maynard Keynes and the Consumption Function

The 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.

Simon Kuznets and the 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?

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.

· 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. The generalization is:

C1 + r

1+r

= Y1 +

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 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.

The Hypothesis

Most people plan to stop working at about age 65, and they expect their incomes to fall

when they retire, but don't want a drop in standard of living characterized by consumption.

Suppose a consumer expects to live another T years, has wealth of W and expects to earn

income Y until she retires R years from now.

What level of consumption will the consumer choose to have a smooth consumption

over her life?

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Macroeconomics ECO 403

The Life-cycle Consumption Function

The Lifetime resources of consumer for T years are wealth W and lifetime earnings of R x Y

(assuming interest rate to be zero).

To have smoothest consumption over lifetime, she divides such that

C = (W + RY) / T

C = (1 / T)W + (R / T)Y

If she expects T = 50 and R = 30, then the consumption function will be

C = 1 / 50W + 30/50Y or

C = 0.02W + 0.6Y

Generalizing for Aggregate Consumption function of the economy:

C = αW + βY

Where, α = MPC out of Wealth

β = MPC out of Income

Consumption, C

αW

Income, Y

Solving the Consumption Puzzle

According to Life-cycle consumption function,

APC = C/Y = α (W/Y) + β

Because, in short periods, wealth does not vary proportionately with incomes, High incomes

corresponds to Low APC.

But over longer periods, wealth and incomes grow together, resulting in constant W/Y ratio

and hence a constant APC

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Macroeconomics ECO 403

Consumption, C

αW2

αW1

Income, Y

The Upward Shift prevents the APC from falling as income increases. Thus solving Keynes's

puzzle

Consumption, Income and Wealth over Life-cycle

Wealth

Income

Savings

Dissavings

Consumption

Retirement

End of

Begins

Life

Consumption and Saving of Elderly

Research findings show that elderly people do not dissave as much as the life cycle model

predicts.

In other words, the elderly do not run down their wealth as quickly as one would expect if

they were trying to smooth their consumption over their remaining years of life.

Reasons

They are concerned about unpredictable expenses. Additional saving that rises from

uncertainty is called precautionary saving. This may be due to expecting a long life and

to plan for a longer period of retirement.

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Macroeconomics ECO 403

· It is not completely persuasive considering the availability of annuity schemes of

insurance companies and public health insurance plans.

They may want to leave bequests to their children

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.

Y = YP + YT

Permanent Income is the part of income that people expect to persist in the future.

Transitory income is the part of income that people do not expect to persist.

Friedman reasoned that consumption should depend primarily on permanent income

because consumers use savings and borrowings to smooth consumption in response to

transitory changes in income.

Friedman approximation of consumption function is:

C = αYP

While Average propensity to consume is:

APC = C/Y = αYP /Y

When Y > YP, APC Falls

When Y < YP, APC rises

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.

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