Macro - Week 4 Flashcards
Consumption, permanent income hypothesis, savings
1
Q
Households’ consumption / savings choice
A
- Important for growth: the division of society’s resources between consumption and various types of investment is central to standards of living in the long run.
- Important for business-cycles: to understand how shocks and policy affect output, we must understand how consumption and investment respond.
- Important for policy: how would the economy react to a change in taxes or in interest rates?
- Financial markets, for instance, affect the economy mainly through their impact on consumption and investment.
2
Q
permanent income hypothesis
A
- The permanent income hypothesis is a theory of consumer spending stating that people will spend money at a level consistent with their expected long-term average income. The level of expected long-term income then becomes thought of as the level of “permanent” income that can be safely spent. A worker will save only if his or her current income is higher than the anticipated level of permanent income, in order to guard against future declines in income.The hypothesis implies that changes in consumption behavior are not predictable because they are based on individual expectations. This has broad implications concerning economic policy.
- Under this theory, even if economic policies are successful in increasing income in the economy, the policies may not kick off a multiplier effect from increased consumer spending. Rather, the theory predicts there will not be an uptick in consumer spending until workers reform expectations about their future incomes.
- E.g. if a worker is aware that he or she is likely to receive an income bonus at the end of a particular pay period, it is plausible that said worker’s spending in advance of that bonus may change in anticipation of the additional earnings. However, it is also possible that workers may choose to not increase their spending based solely on a short-term windfall. They may instead make efforts to increase their savings, based on the expected boost in income.
- Similar for individuals who are informed that they are to receive an inheritance. Their personal expenditures could change to take advantage of the anticipated influx of funds, but per this theory they may maintain their current spending levels in order to save the supplemental assets. Or, they may seek to invest those supplemental funds in order to provide long-term growth of their money rather than spend it immediately on disposable products and services.
- Changes over time, however—through incremental salary raises or the assumption of new long-term jobs that bring higher, sustained pay—can lead to changes in permanent income. With their expectations elevated, employees may allow their expenditures to scale up in turn.
3
Q
permanent income hypothesis - individual problem
A
4
Q
permanent income hypothesis - savings
A
7
Q
Estimating consumption functions
A
8
Q
Friedman on relationship of income and consumption
A
9
Q
cross section model of consumption
A
10
Q
time series model of consumption
A
11
Q
random walk hypothesis of consumption
A
- Robert Hall was the first to derive the effects of rational expectations for consumption. His theory states that if Milton Friedman’s permanent income hypothesis is correct, which in short says current income should be viewed as the sum of permanent income and transitory income and that consumption depends primarily on permanent income, and if consumers have rational expectations, then any changes in consumption should be unpredictable, i.e. follow a random walk. Hall’s thoughts were: According to the permanent-income hypothesis, consumers deal with shifting income and try to smooth their consumption over time. At any given moment, a consumer selects their consumption based on their current expectations of their lifetime income. Throughout their life, consumers modify their consumption because they receive new information that makes them adjust their expectations. For example, a consumer receives an unexpected promotion at work and increases consumption. Whereas a consumer that is unexpectedly fired or demoted will decrease consumption. So changes in consumption reflect “surprises” about lifetime income. If consumers are optimally using all available information, then they should be surprised only by events that were completely unpredictable. Therefore, consumer’s changes in consumption should be unpredictable as well.
- Implications: “If consumers obey the permanent-income hypothesis and have rational expectations, then only unexpected policy changes influence consumption. These policy changes take effect when they change expectations.” Though the policy changes affect consumption only as much as they affect permanent income. Furthermore, only new information about policies can affect permanent income. This model implies that changes in consumption are unpredictable because consumers change their consumption only when they receive news about their lifetime resources.
12
Q
empirical test of random walk hypothesis
A
13
Q
interest rate and savings
A
- Consumption growth is determined by the real interest rate and the discount rate, not by the time pattern of income.
- Changes in the interest rate affect the growth rate of consumption, but how does it affect consumption itself (and savings)?
- The substitution effect is obvious: consumption in the future became relatively cheaper, so reduce consumption today to save for the future.
- A change of the interest rate also has an income effect, since total wealth is current assets plus the discounted value of future income.
- For net savers, the income and substitution effects work in opposing directions and total effect is ambiguous.
- This discussion appears to imply that unless the elasticity of substitution between consumption in different periods is large, increases in the interest rate are unlikely to bring about substantial increases in saving.
- There are two reasons, however, that the importance of this conclusion is limited:
- First, many of the changes we are interested in do not involve just changes in the interest rate. For tax policy, the relevant experiment is usually a change in composition between taxes on interest income and other taxes that leaves government revenue unchanged. Such a change has only a substitution effect, and thus necessarily shifts consumption toward the future.
- Second, if individuals have long horizons, small changes in saving can accumulate over time into large changes in wealth (Summers, 1981).
14
Q
consumption and risky assets
A
- Hedging:
- Employees should not save at invest in their own company (if the company goes bankrupt, they loose their job and their investment).
- Pension funds should not buy stocks of their own company.
- Asset holdings should be skewed against domestic companies.
15
Q
equity-premium puzzle
A
16
Q
permanent income hypothesis - implications
A
- Consumption and income life-cycle-patterns should be unrelated.
- Fraction of income saved is independent of how rich the individual is, it depends only on how far current income is from permanent income.
- Individuals with fast rising income profiles should borrow more early in life than individuals with flat income profiles.
- Temporary tax cuts may have little impact on consumption.
17
Q
Keynes on relationship of income and consumption
A
- “[T]he amount of aggregate consumption mainly depends on the amount of aggregate income,” and this relationship “is a fairly stable function.”
- Further, “it is also obvious that a higher absolute level of income […] will lead, as a rule, to a greater proportion of income being saved”.
- Studies that tested these predictions did not demonstrate a consistent, stable relationship.
- Across households at a point in time, the relationship is indeed of the type that Keynes postulated.
- But within a country over time, aggregate consumption is essentially proportional to aggregate income.
