Term 1 Lecture 5: Consumption Flashcards
What is the MPC and APC ()
-MPC = Marginal Propensity to Consume = proportion of an additional dollar on income spent on consumption
-APC = Average propensity to consume = consumption/income
-The MPC is the gradient of the Keynesian consumption function, the APC is the gradient of the line connecting the origin to any point on the consumption function
What is the consumption puzzle (2, 1)
-Households with higher income save a larger fraction of income, so APC falls as Y increases
-However, evidence shows that Y/C was stable in long time series data
-This is the consumption puzzle, why individual households consumption is falling over time, but economy wide consumption remains constant over time
What assumptions are needed for much work on consumption, based around the Fisher model (2)
The consumer is assumed to be:
-forward looking
-choosing consumption for the present and future to satisfy lifetime consumption
What is the intertemporal budget constraint (1,3,1)
-The intertemporal budget constraint is a measure of the total resources available for present and future consumption
-C2 = Y2 + (1+r)S
-(1+r)C1 + C2 = Y2+(1+r)Y1
-C1 + C2/(1+r) = Y1 + C2/(1+r)
-LHS = present value of lifetime consumption, RHS = present value of life time income
How to diagramatically show the intertemporal budget constaint (3)
-Plot c1 on the x axis, c2 on the y axis
-The x intercept is Y1 + Y2/(1+r) (consuming all in present), y intercept is (1+r)Y1 + Y2 (consuming all in the future)
-Label a point on the constraint, with the x value being Y1 and y value being Y2, anywhere below the point accounts for borrowing, anywhere above the point accounts for saving
-The slope of the budget line = -(1+r)
What is the difference between Keynes and Fisher with consumption (2)
-Keynes believed the current consumption depends only on current income, whereas Fisher believed current consumption depends only on present value of lifetime income
-In Fishers theory, timing of income is irrelevant, as consumers can borrow and lend across periods
What does an interest rate rise do for the income and substitution effect (2)
-Income effect: if the consumer is a saver, the rise in r makes them better off, leading to increased consumption in both periods
-Substitution effect: rise in r increases opp. cost of current consumption, and rises future consumption
What happens when there is a constraint on borrowing (2)
-After y1, the budget constraint falls vertically downwards, as the consumer can’t borrow
-This is binding if the consumers optimal c1 > y1
What is the life cycle hypothesis, and what assumptions are made for it (2)
-Modigliani’s Life cycle hypothesis says that income varies over the phases of the consumers life cycle, and saving allows the consumer to achieve smooth consumption
-We assume r = 0, and consumption-smoothing is optimal
What is the formula for the life cycle hypothesis ()
-Life time resources = W + RY (wealth + average income x number of years until retirement)
-C = (W + RY)/t or αW + βY (α = (1/T) is the marginal propensity to consume out of wealth, β = (R/T) is the marginal propensity to consume out of income)
-When plotting income and consumption, the slope of the graph is equal to β <1
Why can the LCH explain the consumption puzzle ()
-The LCH implies APC =α(W/Y) + β
-Across households, income varies more than wealth, so high-income HH should have a lower APC
-Over time series aggregate data, aggregate wealth and income grow together, causing APC to remain stable
What is the permanent income hypothesis (2,1)
-Y = Y^p + Y^T (Current income = permanent income + transitory income)
-People spread there transitory income over time, to smooth consumption, and they save/borrow, depending on their permanent income
-The PIH consumption function = aY^p, where a is the fraction of permanent income people consume per year, with both MPC and APC = a (no autonomous consumption)
How does the permanent income hypothesis attempt to solve the consumption puzzle (3)
-The PIH implies APC = ay^p/p = a(y^p/(y^p+y^t)
-If high income households typically have high positive transitory income, APC is lower
-Over the long run, income variation is mainly due to variation in permanent income, implying a stable APC
What are the similarities/differences between the LCH and the PIH (1,1)
-Both the PIH and LCH try to smooth consumption, and both can explain the consumption puzzle
-However, the LCH thinks current income changes systematically as people move through their life cycle, but the PIH thinks current income is subject to random, transitory fluctuations
