T2 Topic 3: Consumption Flashcards
OECD average consumption % of GDP?
61% (lower in China 39%)
Is consumption stable?
Yes, very, see page 3
3 features of Keynes’ General Theory of consumption?
- MPC is between 0 and 1
- APC falls as income rises (rich spend lower fraction of income)
- Income primary determinant of consumption (interest rates irrelevant)
What is C(hat), Y and c?
Autonomous consumption (amount you’d consume if income, eg. using savings)
Disposable income
MPC
Show, using a diagram, that rich people consume less as a fraction of their income?
See notes
How did keynes view saving?
As a luxury good
Empirical validity for KCF? (2)
Since created during the great depression, this theory fit well:
1) C and S seemed low during GD, when GDP was also low
2) Income appeared to be the main driver of C tf omitting i seemed correct
2 empirical challenges of KCF?
1) Secular stagnation - as income grows over time, KCF implies that APC would decline -> no spending today and everyone saving for future -> weak demand
2) Kuznets - found the ratio of C to Y (APC) was stable between decades despite large increases in income
What was Irving Fisher’s change to the KCF?
He realised that C also depends on expected future income (intertemporal C choices). Intertemporal budget constraint incorporates more than 1 time period (Y can be transferred across time)
See
irving fisher model derivation etc
What does 1/(1+r) measure in IF model, and what does this imply?
Measures price of C2 ITO C1, tf for r>0, consumption is ‘cheaper’ in period 2 but you have to wait for it
Draw diagram for IF model 2nd period C vs 1st period C
now, see notes, and learn diagram with IC between consumption in diff periods
If Y1 or Y2 increases in the IF model, what happens? What does this mean current consumption depends on?
Consumption will increase in both periods due to consumption smoothing, means it depends on the present value of income
Analyse, using a diagram, the effect of an increase in the real interest rate, starting at point A where you are a saver?
Eq. to a decrease in price of good C2 (ie. saving is cheaper/better return) tf subs. and income effect, inc. in C2 and decrease in C! (see diagram) (do analysis for a borrower too!)
For a saver, on which good C1 or C2 will a definite effect happen if interest rates change? (IF model)
C2 (+ association) (assuming both normal goods)
For a borrower, on which good C1 or C2 will a definite effect happen if interest rates change? (IF model)
C1 (-ve association) (assuming both normal goods)
What is the assumption made in IF analysis regarding borrowing, and explain the realistic situation?
Assumption: Consumers always have access to borrowing tf C1>Y1
Reality, may struggle to access finance (eg. if unemployed) tf borrowing/liquidity constraint:
C1<=Y1
In IF model, what does the diagram look like if the consumer can’t borrow in period 1?
Kinked budget constraint (draw diagram) (see where to go to if borrowing constraint binds!)
Explain the main concept behind the Franco Modigliani approach?
Life Cycle Hypothesis: Model allows income to vary systematically over a person’s lifetime; tf savings can be transferred from time when income is high to time when it is low (eg. Work vs. Retirement)
For the FM model, in the equation 𝐶 = 𝛼𝑊 + 𝛽𝑌 what are alpha and beta?
Alpha: MPC out of ‘Wealth’
Beta: MPC out of ‘Income’
Note: wealth is stock variable and income is flow variable (see notes for explanation of model)
Draw diagram for 𝐶 = 𝛼𝑊 + 𝛽𝑌 model? What happens if wealth changes?
Shift in curve since it is drawn for a given level of wealth! (see notes for diagram)
Explain the SR and LR implications of FM model?
Short-run: Wealth (stock) is less variable than income (flow), hence high income should correspond to a low APC.
Long-run: Wealth and income vary in proportion (i.e. higher correlation), resulting in stable (constant) W/Y and thus a constant APC.
Note:
FM: SRCF holds W constant, LRCF allows it to vary
Draw FM consumption diagram
Now, see notes (both diagrams)
Explain Milton Friedman approach?
Permanent Income Hypothesis: Similar to FM (both argue current consumption doesn’t depend on current income alone) BUT PIH allows allows for non-regular income patterns tf random and temporary changes in income year on year
Two Components of Current Income in PIH?
𝒀^𝑷 is ‘permanent income’: This is the component of income that people expect to persist into the future. (ie. avg. income)
𝒀^𝑻 is ‘transitory income’: This is the component of income that people do not expect to persist (i.e. fluctuations around the average). Imagine a farmer who enjoys a good harvest due to unusually favourable weather conditions.
See ‘If’ bit on notes
now
What does APC depend positively on?
The ratio of permanent to current income
What was Friedman’s insight?
Consumption should depend primarily upon permanent income because saving or borrowing can be used to smooth out transitory increases or decreases in income
See
cross section bit page 2 sid 2
Time series: by comparing year-on-year fluctuations (changes in Y(T)) with decade-on-decade (changes in Y(P)), what did Kuznets and Friedmann find? (one thing each)
Friedmann found that years of high income were also periods of low APC, and vice versa
Kuznets found over long periods, APC is close to constant (ie. over time SR fluctuations average out so Y=Y(P))
What was Robert Hall’s approach to consumption?
Combining the PIH hypothesis with the idea of rational expectations
Define rational expectations?
People use all information available to them to make ‘optimal forecasts’ about the future
Why did robert hall think consumption follows a random walk?
Consumers want to try to smooth consumption over their lifetimes tf choose consumption level in any period baed on expected lifetime income. Over time, ‘news’ they receive -> changes in expected lifetime income (ie. surprises) which are unexpected and unpredictable tf C is unpredictable too and follows a random walk
What is the implication of consumption following a random walk?
Only UNEXPECTED policy changes will influence consumption (PIH and RE) since expected changes will already have been taken into account!
tf policymakers influence behaviour partly through their influence over consumer’s expectations
See
application to US fiscal policy v important can explain pages 24-26
What was David Laibson’s approach to consumption?
Uses the idea that consumers don’t always act rationally; for example one study found that 76% of Americans didn’t believe they were saving enough for retirement
Read
Inconsistent preferences: Consumers may alter their choices as time passes.
e.g. a consumer who resolves to save more for retirement may allow herself “one last” spending splurge shortly after; you may promise to change diet/exercise regime as a New Year’s resolution – mañana, St. Augustine’s prayer.
