Consumption

Question 1

What was last term’s consumption function?

Answer 1

C=c(y-t)

Question 2

What is the KCF?

Answer 2

C= ̅C+cY
where ̅C is a constant and Y intercept
c is the marginal propensity to consume which is the percentage of disposable income that is consumed
Y is the disposable income

Question 3

What is the typical value of MPC in KCF and what does this mean?

Answer 3

MPC=c

which is between 0 and 1 which represents the fact that not all income is consumed some is saved.

Question 4

Define APC. What is the APC for KCF? What does this mean?

Answer 4

1. Consumption/income
2. C/Y= ̅C/Y+c
3. As income rises, consumption falls because the rich save more than the poor

Question 5

What evidence supported the KCF at the time of its conception?

Answer 5

1. Contextually, there was a deep recession which consumption to be strongly dependent on income which justifies the omission of interest rates.
2. During the time, consumption were exceptionally low as expected because income was low.
3. At the time income seemed to be the main driver of income which is why it is acceptable that the function is independent of interest rates.

Question 6

What was the greatest fear with the KCF?

Answer 6

• As income continues to grow, consumption falls according to Keynes.
• This would mean a persistent weakness in demand for goods and services.
• During WW1 there was a fear that demand and therefore consumption would continue to fall when the government scaled back their war spending
• This would lead to secular stagnation
• Thankfully this did not happen

Question 7

What was the evidence of Simon Kuznets questioned the validity of the KCF?

Answer 7

The collection of consumption of households over a long period of time:

• Keynes’ theory held up in the short run, APC decreased.
• However in the long run APC tends to be quite stable, even with large increases of income.

Question 8

According to the Irving fisher model what is the main flaw of the KCF model?

Answer 8

• current consumption depends on current income in the KCF
• Its more realistic that current consumption is dependent upon expected income as well.
• Fisher’s model deals with forward looking consumers who make intertemporal consumption choices

Question 9

What is the intertemporal budget constraint?

Answer 9

• Incorporates more than one time period and income can be transferred across time.
• For instance imagine someone with a two period life (working and then retirement)
• In the first period the consumer earns y1 and spends c1 and in the second period earns y2 and consumes c2.
• However the consumer can save or borrow which means their consumption is not limited to what they earn in each period.

Question 10

According to fisher’s model, what is the equation for saving in period one?
How do we know if the consumer is borrowing?

Answer 10

S=y1-c1

if the consumer is a saver S>0, if the consumer is a borrower S

Question 11

According to Fisher’s model what is the consumption restraint for a consumer in period 2?

Answer 11

c2=(1+r)S+y2

where r is the interest rate for both saving and borrowing

Question 12

Substitute for S, then rearrange the c2 budget constraint to get like terms on the same side.
What does this mean?

Answer 12

c2=(1+r)S+y2
c2=(1+r)(y1-c1)+y2
c2-[(1+r)(y1-c1)]=y2
c2/(1+r)-(y1-c1)=y2/(1+r)
c2/(1+r)+c1-y1=y2/(1+r)
c1+c2/(1+r)=y1+y2/(1+r)

This means future consumption is cheaper than current consumption as savings from period one gain interest.

Question 13

Graphically, what is the equation for the intertemporal budget constraint and how can you tell if the consumer is a borrower or saver?

Answer 13

c2= (1+r)c1+[(1+r)y1+y2]

Any point on the graph that is larger than y1 means the consumer is a borrower and any point on the graph that is smaller than y1 means the consumer is a saver.

Question 14

How are preferences represented with Irving Fisher’s model?

Answer 14

• Consumer preference curves
• The slope of the indifference curve is the marginal rate of substitution.
• This can be defined as how much of one good a consumer is willing to sacrifice for an additional unit of another good.
• If a consumer is willing to give up a large amount of good A for one additional unit of good B then B is more valuable.

Question 15

Explain the IBC

Answer 15

• Intertemporal budget consumption curve.
• It represents budget for consumer across two periods.
• Point of endowment is where Y1=Y2 where a consumer is neither a borrower or slave.
• If consumption point of c1 is before the endowment point it means the consumer is a a saver.
• If consumption point is above the point of endowment then the consumer is a borrower.

Question 16

What is consumption smoothing?

Answer 16

The evening out of income across time periods rather than the consumer experiencing a feast and then a famine across time periods.

Question 17

According to substitution and income effects what happens is real interest rate goes up when the consumer is initially a saver? (IBC)

Answer 17

Substitution effect: Future consumption (c2) has gone down in price so c2 is cheaper than c1 so the consumer comes more of c2 and less of c1.
Income effect: An increase in interest rates increases the return on saving which increases income so consumption in c1 and c2 increases due to consumption smoothing.

Question 18

According to substitution and income effects what happens is real interest rate goes up when the consumer is initially a borrower? (IBC)

Answer 18

Substitution effect: current consumption (c1) has increased in price so future consumption is now cheaper. This causes c2 to increase and c1 to decrease.
Income effect: An increase in real interest rates increases the interest paid on a loan in c1 so the consumer feels poorer which causes a decrease in consumption in both c1 and c2.

Question 19

According to the IBC why might a consumer’s budget be constrained? and how is this represented?

Answer 19

In one period a consumer may be unable to borrow in period one e.g. if they are a student or unemployed in period one and therefore consumption is capped at y1. This is represented by a kinked IBD as C1 must be less or equal to Y1.

Question 20

What is the name of Franco Modigliani’s consumption function?

Answer 20

Life cycle hypothesis

Question 21

Briefly explain the life cycle hypothesis?

Answer 21

Income varies across a person’s life, savings allows income to be transferred across times of high income to low income.

Question 22

Using the work vs retirement example explain the life cycle model.

Answer 22

When r=the consumer retires income from the labour market is 0
Consumers want smooth consumption although it does not have to be perfect. The best way to achieve this is to save whilst working.

Question 23

What is the consumption function for the LCH?

Answer 23

C=W/T+RY/T
C=αW+βY
where α=1/T and β= R/T
W is wealth stock as well as the Y intercept
T is life expectancy
R is years until retirement
Y is income
α is the marginal propensity to consume out of wealth and β is the marginal propensity to consume out of income as well as the slope.

Question 24

What happens to wealth stocks in the short run and long run and how does this solve the problem of the KCF (LCH)?

Answer 24

In the short run wealth stocks are constant which is why APC and therefore consumption decreases with income. In the long run wealth stocks can increase which is represented by a shifting of the consumption function upwards. This explains why in the long run consumption:income ratio is constant because wealth varies in the long run.

Question 25

Describe the graph of saving and dissaving for the LCH.

Answer 25

The graph is triangle shaped with a rectangle at the bottom split vertically in half and the left half is split in half horizontally with the top box marked savings and the bottom is consumption. The left box is marked dissaving . The graph represents the accumulation then depletion of savings. Y axis is money and x axis is age.

Question 26

What is the name of Milton Friedman’s consumption theory?

Answer 26

Permanent income hypothesis

Question 27

Describe PIH.

Answer 27

Allows for irregular income unlike LCH. Income is made up of two components- Permanent income: Income you expect to persist into the future this can increase with education (Y^p). And transitory income (Y^t): Income that people do not expect to persist e.g. A farmer having a profitable harvest due to unusually good weather. The argument here is that consumption is dependent only on permanent income as consumers are unlikely to increase their consumption due to short lasting increases in income.

Question 28

According to PIH what is the consumption function?

Answer 28

C=αY^P

where α is the fraction of permanent income consumed.

Question 29

What does APC depend on in the PIH?

Answer 29

On the ratio between permanent income and current income:

• If Y=Y^p then α=APC
• If Y>Y^p then APC is smaller than α just as keynes predicted growth in income causes decline in APC
• If Y

Question 30

According to PIH what findings regarding income fluctuations did Friedman find?

Answer 30

Year on year fluctuations in income are caused by transitory income and decade on decade fluctuations of income are caused by permanent income.

Question 31

What is Robert Hall’s theory?

Answer 31

Random walk hypothesis

Question 32

Explain the random walk theory?

Answer 32

Theory that combines PIH with the notion of rational expectations instead of adaptive expectations (which simply extrapolates the present into the future.) Consumers choose their consumption based on expectations of future income. Consumption changes when consumers receive unexpected news as they have to revise their consumption. Theses changes are a result of surprises which are by definition, random just like a random walk.

Question 33

According to the RWT what does consumption depend on?

Answer 33

Solely on unexpected changes in policy, consumers may not even seem to respond to policy changes they were warned about in advance.