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CONSUMPTION (Continued…):The Life-cycle Consumption Function

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Macroeconomics ECO 403
VU
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:
C2
Y2
C1 + r
+
1+r
= Y1 +
1
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
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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
or
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
β
1
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
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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
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· 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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Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand