ECON 314: MACROECONOMICS II
CONSUMPTION AND CONSUMER EXPENDITURE
Macroeconomics II Lecture Notes Prepared 1 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • Explaining the observed patterns in data on consumption and income: short-run and cross-sectional data show that MPC < APC, whilst long-run data show MPC = APC.
• Several explanations put forward to solve the consumption puzzle.
Macroeconomics II Lecture Notes Prepared 2 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE Franco Modigliani and the Life Cycle Hypothesis (LCH)
• Key names: Franco Modigliani, Albert Ando and Richard Brumberg
• The LCH was put forward in a series of papers written in the 1950s
Macroeconomics II Lecture Notes Prepared 3 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • Modigliani emphasised that income varies systematically over individuals’ (people’s) life time.
• According to the LCH, the typical individual has an income stream which is relatively low at the beginning and end of his/her life (retirement), when his/her productivity is low, and high during the middle of his/her life. Macroeconomics II Lecture Notes Prepared 4 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • The LCH therefore views individuals as planning their consumption and savings behaviour over long periods with the intention of allocating their consumption in the best possible way over their entire lifetimes.
• Individuals are assumed to maintain a more or less constant, if slightly rising level of consumption throughout their lifetime.
Macroeconomics II Lecture Notes Prepared 5 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • The constraint to this consumption stream is that the present value of this total consumption does not exceed the present value of total income.
• This implies that in the early years of a person’s life, s/he is a net borrower. In the middle years, s/he saves and repays debt and provides for retirement. In the retirement years, s/he
Macroeconomics II Lecture Notes Prepared dissaves. 6 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • This pattern of consumption and saving can be illustrated below: Income
Y c
Net Borrower/Dissaving
T t Macroeconomics II Lecture Notes Prepared 7 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • This pattern of consumption and saving can be illustrated below:
Macroeconomics II Lecture Notes Prepared 8 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • Thus, instead of relying on a single value (based on a psychological rule of thumb) for the MPC, the LCH (based on optimizing behaviour) implies different MPCs out of permanent income, transitory income and wealth.
Macroeconomics II Lecture Notes Prepared 9 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE
• The key assumption (as noted earlier but stated in other words) is that individuals choose stable lifestyles, not saving furiously in one period for a huge spending spree in the next.
Macroeconomics II Lecture Notes Prepared 10 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • Remember that if the assumptions made, both about individuals and the population, are stable then we can add up all the individual consumption functions to obtain a stable aggregate function in which the population consumes k percent of the present value of its income stream in each period:
Macroeconomics II Lecture Notes Prepared 11 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • The aggregate consumption function can be expressed as follows:
c0 k(PV0 )
• Where the variables are as previously defined
Macroeconomics II Lecture Notes Prepared 12 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • The next crucial step is to operationalize the
PV0 term.
• Ando and Modigliani provided an excellent answer. They noted that income can be divided into income from labour (work) y L and income from assets and property (wealth) y P
Macroeconomics II Lecture Notes Prepared 13 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE
• Thus, the PV0 term can be expressed as:
T L T P yt yt PV0 t t 0 (1 r) 0 (1 r)
• Where 0 is the current period, and t ranges from 0 to the remaining years of life, T.
Macroeconomics II Lecture Notes Prepared 14 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • Let us now attempt a simplification of this decision-making over a life time.
• Let us suppose the individual starts life at the age of 20, and plans to work until 65, and will die at 80.
Macroeconomics II Lecture Notes Prepared 15 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE
P • Again we can suppose that y is now initial wealth (W), and y L is now Y, which is income from earnings.
• If the number of years an individual expects to work before retirement, can be defined as R.
Macroeconomics II Lecture Notes Prepared 16 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE
• Then the individual’s lifetime resources is made up of initial wealth, W, and lifetime earnings (R x Y).
• For simplicity we assume that interest rate is zero, although if this were positive then interest on savings will be included.
Macroeconomics II Lecture Notes Prepared 17 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • The individual’s decision now involves ensuring a smooth consumption path over the remaining life, T.
• The individual is expected to divide his/her lifetime resources (W + RY) equally over the remaining number of years, T.
Macroeconomics II Lecture Notes Prepared 18 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE
C (W RY)/T
• The consumption function can be written as
1 R C W Y T T
Macroeconomics II Lecture Notes Prepared 19 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • Thus with our example, R = 45 and T = 60.
• The consumption function can be written as
C 0.017W 0.75Y
• The equation above shows that consumption depends on both wealth and income.
Macroeconomics II Lecture Notes Prepared 20 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • For the whole economy, the aggregate consumption function can be expressed as:
C W Y
• Where is the MPC out of wealth and is the MPC out of income.
Macroeconomics II Lecture Notes Prepared 21 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • Implications: • For any given wealth, W, the LCH yields a conventional consumption function (we already know). • However, the intercept of the consumption function is not fixed, but depends on the level of wealth. • See figure on next slide!
Macroeconomics II Lecture Notes Prepared 22 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE
Macroeconomics II Lecture Notes Prepared 23 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • Implications: • The LCH can also solve the puzzle. Given the consumption function, the APC is below:
C W Y Y
Macroeconomics II Lecture Notes Prepared 24 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • Implications: Here is the explanation in respect of the puzzle:
Because wealth does not vary proportionately with income from person to person or from year to year, we should expect to find that high income corresponds to low APC when looking at data across individuals or over short periods of time. Macroeconomics II Lecture Notes Prepared 25 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE • Implications: • Nevertheless, over long periods of time, wealth and income grow together resulting in a constant W/Y ratio, and thus a constant APC.
• Put differently, as wealth increases the consumption function shifts upward. This upward shift prevents the APC from falling as income rises.
Macroeconomics II Lecture Notes Prepared 26 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE • Implications: • Once we have a theory of consumption we also have a theory of saving.
• The LCH also predicts that saving varies over an individual’s lifetime.
Macroeconomics II Lecture Notes Prepared 27 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE • Implications: • If an individual begins working life, s/he will accumulate wealth during the working years, and then run down their wealth during retirement years.
• Thus, the young who are working save, whilst the old who are retired dissave.
Macroeconomics II Lecture Notes Prepared 28 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • The Permanent-Income Hypothesis (PIC) is based on a book written in 1957.
• The Permanent-Income theory of consumption argues that consumption is related not to current income but to a longer- term estimate of income: what Friedman termed permanent-income. Macroeconomics II Lecture Notes Prepared 29 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • The P-I theory complements Modigliani’s LCH. But unlike the LCH which argues that income follows a regular pattern over an individual’s lifetime, the P-IH emphasises that individuals experience random and temporary changes in their incomes from year to year. Macroeconomics II Lecture Notes Prepared 30 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • Permanent income is the steady rate of consumption an individual could maintain for the rest of his/her life, given the present level of wealth and income earned now and in the future.
Macroeconomics II Lecture Notes Prepared 31 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • Friedman’s model of consumption begins with the assumption of individual consumer utility maximisation.
• This gives us the consumption function between an individual’s consumption and present value. Macroeconomics II Lecture Notes Prepared 32 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis
i i i i c f (PV ); f 0
• This is the consumption function for a representative individual, ‘i’, over time.
• Only note that Friedman’s treatment of PV is different from Ando-Modigliani’s.
Macroeconomics II Lecture Notes Prepared 33 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • The present value of the total income stream is the current asset value of the income stream. Multiplying this asset value by the rate of return, r, yields Friedman’s permanent income from that asset value: i i yP r.PV
Macroeconomics II Lecture Notes Prepared 34 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • But as with Ando-Modigliani, Friedman assumes that the consumer wants to smooth his/her actual income stream into a more or less flat consumption pattern.
i • This gives a level of permanent consumption, i cP that is proportional to y P .
Macroeconomics II Lecture Notes Prepared 35 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • This may be stated as follows: i i i cP k yP • k i is the ratio of permanent consumption to permanent income, this depends on the interest rate, individual tastes, and the variability of expected income.
Macroeconomics II Lecture Notes Prepared 36 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • Aggregating over the entire population and generalising, we have a simple form of the equation: C cYP
• Where YP is permanent (disposable) income.
Macroeconomics II Lecture Notes Prepared 37 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • Friedman also suggested we view current income as the sum of two components: permanent income and transitory income.
P T Y Y Y
Macroeconomics II Lecture Notes Prepared 38 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • How can we think about the measurement of permanent income?
• We know that an individual has a current level of income, and forms some idea of the level of consumption s/he can maintain for the rest of his/her life.
Macroeconomics II Lecture Notes Prepared 39 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • But suppose income goes up! Then the individual has to decide whether the increase is permanent or merely transitory/temporary!
• Permanent income is that part of income that individuals expect to persist into the future. Transitory income is that which individuals do not expect to persist.
Macroeconomics II Lecture Notes Prepared 40 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • Nevertheless, in any particular case, an individual may know whether an increase is permanent or transitory.
• But in general an individual is not likely to be so sure whether a change is permanent or transitory. Macroeconomics II Lecture Notes Prepared 41 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • Implications: • Regarding the consumption puzzle, the P-IH argues that the Keynesian consumption function uses the wrong variable; that is, current income instead of permanent income. • Relating current income to consumption results in what Friedman termed errors in variables problem. Macroeconomics II Lecture Notes Prepared 42 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • Implications: • According to the P-IH, the APC depends on the ratio of permanent income to current income.
C cYP Y P APC Y Y Y Macroeconomics II Lecture Notes Prepared 43 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • Implications: • When current income temporarily rises above permanent income, the APC temporarily falls.
• When current income temporarily falls below permanent income, the APC temporarily rises.
Macroeconomics II Lecture Notes Prepared 44 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • Implications: • Regarding studies using household data, Friedman reasoned that these data reflect a combination of permanent and transitory income.
• Households with high permanent income, have proportionately high consumption. And if all variations in income came from permanent income, then the APC will be the same for all households. Macroeconomics II Lecture Notes Prepared 45 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • Implications: • However, some of the variations are the results of transitory income, and households with high transitory income do not have higher consumption.
• Therefore, the evidence from the data tend to show that households with high-income, have on average lower APC. Macroeconomics II Lecture Notes Prepared 46 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • Implications: • Regarding time series data, Friedman argued that year-to-year fluctuations in income are dominated by transitory income.
• Therefore, years of high income should be years of low APC.
Macroeconomics II Lecture Notes Prepared 47 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Milton Friedman’s Permanent-Income Hypothesis • Implications: • But over long periods of time, say from decade to decade, variations in income are the result of permanent income.
• Therefore, in long time series one should observe a constant APC.
Macroeconomics II Lecture Notes Prepared 48 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Consumption Under Uncertainty: Robert Hall’s Random-Walk Hypothesis • The Random-Walk Hypothesis combines Irvin Fisher’s assumptions on forward-looking consumers with rational expectations.
• Rational expectations assumes that individuals use all available information to make optimal forecasts about the future.
Macroeconomics II Lecture Notes Prepared 49 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Consumption Under Uncertainty: Robert Hall’s Random-Walk Hypothesis • From our knowledge of the P-IH, we know that if permanent income were known exactly, then consumption will never change.
Macroeconomics II Lecture Notes Prepared 50 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Consumption Under Uncertainty: Robert Hall’s Random-Walk Hypothesis
• However with the RWH, there is a link between income uncertainty and changes in consumption.
• Changes in consumption therefore arise from surprise changes in income.
Macroeconomics II Lecture Notes Prepared 51 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Consumption Under Uncertainty: Robert Hall’s Random-Walk Hypothesis • According to the rational expectations theory, the surprise must be truly random and unpredictable.
• Thus the combination of permanent-income hypothesis and rational expectations implies that consumption follows a random walk.
• Robert Hall’s famous random walk model is specified as:
Macroeconomics II Lecture Notes Prepared 52 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Consumption Under Uncertainty: Robert Hall’s Random-Walk Hypothesis
Ct1 Ct
• This states that consumption tomorrow should equal consumption today plus a truly random error, Ct1 Ct Macroeconomics II Lecture Notes Prepared 53 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE Consumption Under Uncertainty: Robert Hall’s Random-Walk Hypothesis • Implications: • This approach to consumption has implications for the analysis of economic policies.
• If consumers are believed to follow this approach, then only unexpected policy changes influence consumption. These policy changes become effective when they change
expectations. Macroeconomics II Lecture Notes Prepared 54 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Consumption Under Uncertainty: Robert Hall’s Random-Walk Hypothesis • Implications: • Essentially, the effectiveness of a policy is dependent on how the policy announcement affects expectations. If expectations are unaffected, the policy is ineffective.
• Thus, policy makers influence the economy not only through their actions but also through the public’s expectation of their actions. Macroeconomics II Lecture Notes Prepared 55 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Liquidity Constraints and Myopia • It is worth noting that the LCH and P-IH do not explain all of consumption behaviour.
• Why might this be so? Two explanations are liquidity constraints and myopia.
• The first argues that when permanent income is higher than current income, consumers are unable to borrow to consume at the higher level predicted by the LCH and P-IH. Macroeconomics II Lecture Notes Prepared 56 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Liquidity Constraints and Myopia • The second suggests that consumers simply aren’t as forward-looking the theories argue.
• A liquidity constraint exists when a consumer cannot borrow to sustain current consumption in the expectation of higher future income.
• This condition is faced by most students, and those who are unable to borrow when their incomes drop temporarily. Macroeconomics II Lecture Notes Prepared 57 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Liquidity Constraints and Myopia • Fisher’s model suggests that individuals can borrow and save. The ability to borrow allows current consumption to exceed current income.
• But with a liquidity constraint, current consumption cannot exceed current income. A borrowing constraint exists when . C1 Y1
Macroeconomics II Lecture Notes Prepared 58 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Liquidity Constraints and Myopia
• The figure below illustrates how the borrowing constraint restricts the consumer’s set of choices.
• In these circumstances, the consumer’s choice must satisfy both the inter-temporal budget constraint and borrowing constraint. Macroeconomics II Lecture Notes Prepared 59 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE
Macroeconomics II Lecture Notes Prepared 60 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE Liquidity Constraints and Myopia
• The shaded area represents the combinations of the first-period consumption and second-period consumption that satisfy both constraints.
• In the next figure we show two possibilities. In (a) the consumer wishes to consume less in period one than s/he earns. Hence the liquidity constraint is not binding. Macroeconomics II Lecture Notes Prepared 61 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE Liquidity Constraints and Myopia • In (b) the consumer will like to consume at point D, where s/he will consume more in period one than s/he earns, but the liquidity constraint prevents this outcome.
• The best outcome is for the individual to consume all of his/her period one income.
• The foregoing analysis suggests that there are two consumption functions, one for those facing liquidity constraints and one for those who are unconstrained by borrowing. Macroeconomics II Lecture Notes Prepared 62 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE
• the shad
Macroeconomics II Lecture Notes Prepared 63 by Dr. Emmanuel Codjoe CONSUMPTION AND CONSUMER EXPENDITURE Liquidity Constraints and Myopia • For such students who face the liquidity constraint, when they complete their education and get jobs, their incomes will rise and their consumption too will rise.
• But according to the LCH (and PIH), consumption should not rise much when income rises, so long as the increase in income was expected. Macroeconomics II Lecture Notes Prepared 64 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE Liquidity Constraints and Myopia • Because liquidity constraint is relieved, consumption will rise a lot when income rises. This implies that consumption will be more closely related to current income than is implied by the LCH and PIH.
• The explanation for myopia is hard to distinguish in practice from the liquidity constraints hypothesis. That is any expectation of a rise in income does not change consumption until the actual increase takes place. Macroeconomics II Lecture Notes Prepared 65 by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER EXPENDITURE David Laibson and the Pull of Instant Gratification • Laibson argues that consumers judge themselves to be imperfect decision-makers. • Consumption decisions are influenced by psychological factors, in contrast to the rational utility maximisation presumption. • This raises the possibility that consumers’ preferences are time-inconsistent. Macroeconomics II Lecture Notes Prepared 66 by Dr. Emmanuel Codjoe