Consumption

Question 1

We will look at 5 approaches of theories of consumption

Answer 1

Keynes
Modigliani - Life cycle hypothesis
Friedman - Permanent income hypothesis
Hall - random walk hypothesis
Laibson - inconsistent preferences

Question 2

Approach 1: Keynes: 3 main characteristics

Answer 2

MPC between 0-1

Average propensity to consume (C/Y) falls as income rises; rich save proportionately more than the poor, saving is a luxury.

Income is the main determinant of consumption, not interest rates.

Question 3

Keynesian consumption function

Answer 3

C = Cbar +cY

Or Cbar = autonomous consumption (when income=0)
c = MPC (used to be b)
Y = disposable income. (Used to be Y-T)

Question 4

Keynes consumption function (KCF) in diagram form - that conforms to all 3 characteristics

Question 5

Empirical validity of Keynes model - which event supports this

Answer 5

The Great Depression supports Keynes model, of income being the main determinant of consumption (Not interest rates)

Question 6

Empirical application evaluation (2)

What is the main conclusion from this, and what is this idea known as?

Answer 6

1. Secular stagnation during WW2.
   Recall KCF’s 2nd characteristic suggests rich save more than poor (APC falls) (saving a luxury).

However in reality APC was more stable than KCF predicted.

2. Kuznets found ratio of consumption to income was stable despite large increases in income (KCF says consumption should fall as income rises)

In real life, APC falls only in short run/cross section (explained by transitory incomes-Friedman). But in long term, ACF is stable. This is called the consumption puzzle.

Question 7

How to draw this consumption puzzle

Answer 7

Short run consumption function is flatter as we have falling APC - consumption increases less as income increase

Long run consumption constant APC

Question 8

Modigliani and Friedman’s main idea

Answer 8

People prefer smooth consumption, so don’t only account for current income, but expected future income.

Question 9

Approach 2: Modigliani

Answer 9

Consumption depends on lifetime income, which varies systematically. (Systematically is a criticism - too simplistic)

Saving allows income to be transferred from periods in which it is high (young-working) to periods when low (old) , leading to the life cycle hypothesis

Question 10

Life cycle hypothesis:

Consider a consumer who expects to live for another T years, has wealth of W (stock) and expects to earn income Y (flow) over the next R years until retirement…

Express this…

Answer 10

C = (W+RY)/T (Wealth x income x years worked) then divide by T to make smooth.

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

which we can aggregate up further…

Question 11

If we aggregate up, what is the equation and what do we get?

Answer 11

We get 2 MPCs

C= aW + βY

a is MPC out of wealth (stock)
b is MPC out of income (flow)

Question 12

Once we have the aggregate consumption formula,

What is the key finding we can now make?

Answer 12

We can find APC.
C=aW + βY
APC = C/Y
C/Y= a(W/Y) + β

SR = wealth (stock) is less variable than income (flow); so high income (Y) means low APC. (flows are easier more flexible)

LR = wealth and income vary by similar proportion (higher correlated), resulting in stable W/Y and a constant APC.

(As the consumption puzzle shows!)

Question 13

Life cycle consumption function graph

and how does it differ from Keynesian consumption function

Answer 13

In KCF, intercept was Cbar (autonomous consumption when Y=0)

Now, the intercept is drawn for a given with wealth, so intercept is aW.

Question 14

Increase in wealth diagram, and when can this happen?

Answer 14

An increase in wealth would shift upwards, since aW is the intercept.

This can happen from the short run to long run (since wealth is constant in SR, vs variable in long run)

Question 15

C,Y,W Life cycle diagram:

axis’, and what happens (explain 4 variables)

Answer 15

Y axis is £
X axis age

Consumption - constant, so vertical line as smooth.
Wealth - increases while working since saving, until retirement it falls. (Dis-saving)
Income - constant, so vertical line, until retirement when immediately drops to 0. (PIH later questions smooth income…)
Saving - represented by the box between income and consumption. (Since what is not spent is saved)

Question 16

Approach 3: Friedman - complements Modigliani (both argue consumption does not depend on current income alone, future expected income)

What was Friedmans main theory?

Answer 16

Permanent income hypothesis - consumption should depend on permanent income Yp

Question 17

How does Friedman’s Permeanent income hypothesis differ from Modigliani?

Answer 17

PIH allows for non-regular income patterns over a lifetime.
I.e people can experience random and temporary changes in income.

(Modigliani’s is oversimplified in assuming income is smooth, as we see in slide 11)

Question 18

Friedman looks at the 2 components of current income.
Current income formula

Answer 18

Y = Yp +Yt

Yp is permanent income.
Yt is transitory income

Question 19

Permanent income vs transitory income

Answer 19

Permanent income is income that people expect to persist into the future, so essentially the average income.

Yt is transitory income, people do not expect to persist i.e fluctuations around the average, e.g an especially good harvest for a farmer so gains higher income.

Question 20

Friedman’s intuition

Answer 20

Consumption should depend primarily upon permanent income; saving or borrowing can be used to smooth out transitory increases or decreases in income to keep consumption smooth.

e.g you would respond differently to a permanent increase in income of £10,000 per year, compared to a transitory one-off increase of £10,000.

Question 21

So accordingly to this, what does the consumption function become

Answer 21

C= aYp

a is the fraction of permanent income consumed.
(I,e MPC for permanent income)

Question 22

PIH also rejects the KCF. Why?

Answer 22

PIH suggests KCF uses the wrong variable in APC.
KCF APC = C/Y = Cbar/Y + c
(Autonomous consumption/Y + MPC)

PIH APC
APC = C/Y = aYp/Y

Question 23

So under PIH conditions.
What happens to APC
if Y=Yp ,Y>Yp or Y<Yp

Answer 23

If Y=Yp, a=APC

if Y>Yp - current income>permanent income, and so APC falls below a temporarily (Y=Yp+Yt, and so income is temporarily higher as a result of Yt, reducing consumption, saving luxury!!!)

if Y<Yp - current income<permanent income, (so must’ve been a negative Yt, thus reducing current income (Y), so APC rises above a temporarily

Question 24

Explaining cross-sectional studies (Why APC varies across HHs)

Answer 24

If all variation in current income (Y) was purely due to changes in Yp permanent income, all would have the same APC (C/Y).

But it doesn’t. Current income includes Yt, and different HH will have different Yt, thus explaining why richer HH have a lower APC.

Question 25

Explaining time series studies (APC in short run vs long run)

Answer 25

In the short run we have fluctuations in income to reflect transitory changes (Yt) , so APC may be higher or lower depending on whether Y>Y or not. (Slide 13 e.g APC higher if Y>Yp) In long run, fluctuations in income are primarily due to permanent income. (constant APC)

Question 26

Approach 4: Robert Hall

Answer 26

Robert Hall uses this PIH (consumption based on current and expected future income [permanent income]) but adds rational expectations.

Question 27

What are rational expectations

Answer 27

People use ALL available info to make optimal forecasts about future. (Different from adaptive expectations eq 4 - which is naively applied, Etπt+₁=πt simplistic!!!)

Question 28

Hall’s Random walk hypothesis

Answer 28

Consumers face fluctuating income and seek to smooth consumption overtime, during this they receive news and surprises which makes them revise their expectations. These surprises are random, and so changes in consumption are unpredictble too, so consumption follows a random walk.

Question 29

What do consumers base their level of consumption depend on?

Answer 29

Expected lifetime income.

Question 30

How can their level of consumption change (2)

Answer 30

- News - Surprises Unpredictable thus we say consumption follows a random walk.

Question 31

Implications for policymakers for Hall’s approach.

Answer 31

ONLY UNEXPECTED policy changes influence consumption , since Hall’s approach uses PIH and rational expectations which accounts for EXPECTED events already. (So it is saying hexpected policy change should have no change on consumption)

Question 32

Example of policy being ineffective in influencing consumption since already accounted for in their PIH & rational expectations.

Answer 32

Economic stimulus act 2008. In response to the financial crisis, provided 115bn tax rebate (tax refund i.e cut) in attempt to boost consumption.

Question 33

What did consumers do instead?

Answer 33

HH chose to use money to pay off debt rather than consumption.

Question 34

What did Taylor suggest shouldve been done instead?

Answer 34

Extend the tax rebate (to increase permanent income)as opposed to a one-off payment (this is transitory income) in order to get the desired effect (increased consumption)

Question 35

Parker’s contested interpretation of the Economic Stimulus Act overall

Answer 35

Since the rebate was one-off and predictable, it should’ve made no difference at all to consumption. (Since accounted for in R.E…) However Parker found HH still spent 20/30% of the rebate on consumption, thus rejecting PIH & rational expectations.

Question 36

Approach 5: David Laibson (hint. Behavioural)

Answer 36

So far we assume consumers are rational. Here, consumers doubt their decision making capabilities, and have INCONSISTENT PREFERENCES.

Question 37

What is the idea of inconsistent preferences?

Answer 37

Consumers may alter their choices overtime. E.g consumer planning to save for retirement, but then allows herself one last spending splurge.

Question 38

Consider an increase in elderly population - What does the life cycle model predict will happen? 2. What further questions will be raised

Answer 38

Savings will fall, as more old people, so spending and running down their savings. 2. Who will buy their assets? Since more old now. May habve to accept a lower price, and thus compromise on their expected standard of living in retirement. This also arises the question to how the state should address this. E.g more generous pensions? Will youth have to pay higher tax to contribute to this?