T2 Topic 3: Consumption

Question 1

OECD average consumption % of GDP?

Answer 1

61% (lower in China 39%)

Question 2

Is consumption stable?

Answer 2

Yes, very, see page 3

Question 3

3 features of Keynes’ General Theory of consumption?

Answer 3

• 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)

Question 4

What is C(hat), Y and c?

Answer 4

Autonomous consumption (amount you’d consume if income, eg. using savings)
Disposable income
MPC

Question 5

Show, using a diagram, that rich people consume less as a fraction of their income?

Answer 5

See notes

Question 6

How did keynes view saving?

Answer 6

As a luxury good

Question 7

Empirical validity for KCF? (2)

Answer 7

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

Question 8

2 empirical challenges of KCF?

Answer 8

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

Question 9

What was Irving Fisher’s change to the KCF?

Answer 9

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)

Question 10

See

Answer 10

irving fisher model derivation etc

Question 11

What does 1/(1+r) measure in IF model, and what does this imply?

Answer 11

Measures price of C2 ITO C1, tf for r>0, consumption is ‘cheaper’ in period 2 but you have to wait for it

Question 12

Draw diagram for IF model 2nd period C vs 1st period C

Answer 12

now, see notes, and learn diagram with IC between consumption in diff periods

Question 13

If Y1 or Y2 increases in the IF model, what happens? What does this mean current consumption depends on?

Answer 13

Consumption will increase in both periods due to consumption smoothing, means it depends on the present value of income

Question 14

Analyse, using a diagram, the effect of an increase in the real interest rate, starting at point A where you are a saver?

Answer 14

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!)

Question 15

For a saver, on which good C1 or C2 will a definite effect happen if interest rates change? (IF model)

Answer 15

C2 (+ association) (assuming both normal goods)

Question 16

For a borrower, on which good C1 or C2 will a definite effect happen if interest rates change? (IF model)

Answer 16

C1 (-ve association) (assuming both normal goods)

Question 17

What is the assumption made in IF analysis regarding borrowing, and explain the realistic situation?

Answer 17

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

Question 18

In IF model, what does the diagram look like if the consumer can’t borrow in period 1?

Answer 18

Kinked budget constraint (draw diagram) (see where to go to if borrowing constraint binds!)

Question 19

Explain the main concept behind the Franco Modigliani approach?

Answer 19

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)

Question 20

For the FM model, in the equation 𝐶 = 𝛼𝑊 + 𝛽𝑌 what are alpha and beta?

Answer 20

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)

Question 21

Draw diagram for 𝐶 = 𝛼𝑊 + 𝛽𝑌 model? What happens if wealth changes?

Answer 21

Shift in curve since it is drawn for a given level of wealth! (see notes for diagram)

Question 22

Explain the SR and LR implications of FM model?

Answer 22

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.

Question 23

Note:

Answer 23

FM: SRCF holds W constant, LRCF allows it to vary

Question 24

Draw FM consumption diagram

Answer 24

Now, see notes (both diagrams)

Question 25

Explain Milton Friedman approach?

Answer 25

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

Question 26

Two Components of Current Income in PIH?

Answer 26

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.

Question 27

See ‘If’ bit on notes

Answer 27

now

Question 28

What does APC depend positively on?

Answer 28

The ratio of permanent to current income

Question 29

What was Friedman’s insight?

Answer 29

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

Question 30

See

Answer 30

cross section bit page 2 sid 2

Question 31

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)

Answer 31

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))

Question 32

What was Robert Hall’s approach to consumption?

Answer 32

Combining the PIH hypothesis with the idea of rational expectations

Question 33

Define rational expectations?

Answer 33

People use all information available to them to make ‘optimal forecasts’ about the future

Question 34

Why did robert hall think consumption follows a random walk?

Answer 34

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

Question 35

What is the implication of consumption following a random walk?

Answer 35

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

Question 36

See

Answer 36

application to US fiscal policy v important can explain pages 24-26

Question 37

What was David Laibson’s approach to consumption?

Answer 37

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

Question 38

Read

Answer 38

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.