16

CHAPTER

Consumption

MACROECONOMICS SIXTH EDITION

N. GREGORY MANKIW
PowerPoint® Slides by Ron Cronovich
© 2008 Worth Publishers, all rights reserved
 In this chapter, you will learn…

an introduction to the most prominent work on

consumption, including:
▪ John Maynard Keynes: consumption and current
income
▪ Irving Fisher: intertemporal choice
▪ Franco Modigliani: the life-cycle hypothesis
▪ Milton Friedman: the permanent income hypothesis
▪ Robert Hall: the random-walk hypothesis
▪ David Laibson: the pull of instant gratification

CHAPTER 16 Consumption slide 1

 Keynes’s conjectures

1. 0 < MPC < 1

2. Average propensity to consume (APC )

falls as income rises.
(APC = C/Y )
3. Income is the main determinant of
consumption.

CHAPTER 16 Consumption slide 2

 The Keynesian consumption
function

C = C + cY

c c = MPC
= slope of the
1
consumption
C function

Y
CHAPTER 16 Consumption slide 3
 The Keynesian consumption
function
As income rises, consumers save a bigger
C fraction of their income, so APC falls.

C = C + cY

C C
APC = = + c
Y Y
slope = APC
Y
CHAPTER 16 Consumption slide 4
 Early empirical successes:
Results from early studies
▪ Households with higher incomes:
▪ consume more,  MPC > 0
▪ save more,  MPC < 1
▪ save a larger fraction of their income,
 APC  as Y 
▪ Very strong correlation between income and
consumption:
 income seemed to be the main
determinant of consumption
CHAPTER 16 Consumption slide 5
 Problems for the
Keynesian consumption function
▪ Based on the Keynesian consumption function,
economists predicted that C would grow more
slowly than Y over time.
▪ This prediction did not come true:
▪ As incomes grew, APC did not fall,
and C grew at the same rate as income.
▪ Simon Kuznets showed that C/Y was
very stable in long time series data.

CHAPTER 16 Consumption slide 6

 The Consumption Puzzle

Consumption function
C from long time series
data (constant APC )

Consumption function
from cross-sectional
household data
(falling APC )

Y
CHAPTER 16 Consumption slide 7
 Irving Fisher and Intertemporal
Choice
▪ The basis for much subsequent work on
consumption.
▪ Assumes consumer is forward-looking and
chooses consumption for the present and future
to maximize lifetime satisfaction.
▪ Consumer’s choices are subject to an
intertemporal budget constraint,
a measure of the total resources available for
present and future consumption.
CHAPTER 16 Consumption slide 8
 The basic two-period model
▪ Period 1: the present
▪ Period 2: the future
▪ Notation
Y1, Y2 = income in period 1, 2
C1, C2 = consumption in period 1, 2
S = Y1 - C1 = saving in period 1
(S < 0 if the consumer borrows in period 1)

CHAPTER 16 Consumption slide 9

 Deriving the intertemporal
budget constraint

▪ Period 2 budget constraint:

C 2 = Y 2 + (1 + r ) S
= Y 2 + (1 + r ) (Y1 - C 1 )

▪ Rearrange terms:
(1 + r )C 1 + C 2 = Y 2 + (1 + r )Y1

▪ Divide through by (1+r ) to get…

CHAPTER 16 Consumption slide 10

 The intertemporal budget
constraint

C2 Y2
C1 + = Y1 +
1+r 1+r

present value of present value of

lifetime consumption lifetime income

CHAPTER 16 Consumption slide 11

 The intertemporal budget
constraint
C2 C2 Y2
C1 + = Y1 +
1+r 1+r

(1 + r )Y1 +Y 2
Consump =
Saving income in
The budget both periods
constraint shows
all combinations Y2
of C1 and C2 that Borrowing
just exhaust the
consumer’s C1
Y1
resources.
Y1 +Y 2 (1 + r )
CHAPTER 16 Consumption slide 12
 The intertemporal budget
constraint
C2 C2 Y2
C1 + = Y1 +
1+r 1+r
The slope of
the budget
line equals 1
-(1+r ) (1+r )

Y2

C1
Y1

CHAPTER 16 Consumption slide 13

 Consumer preferences
Higher
C2
An indifference indifference
curve shows curves
all combinations represent
of C1 and C2 higher levels
that make the of happiness.
consumer
equally happy. IC2

IC1
C1

CHAPTER 16 Consumption slide 14

 Consumer preferences

C2 The slope of
Marginal rate of an indifference
substitution (MRS ): curve at any
the amount of C2 point equals
the consumer the MRS
would be willing to 1 at that point.
substitute for MRS
one unit of C1.

IC1
C1

CHAPTER 16 Consumption slide 15

 Optimization

C2
The optimal (C1,C2)
At the optimal point,
is where the
MRS = 1+r
budget line
just touches
the highest
indifference curve. O

C1

CHAPTER 16 Consumption slide 16

 How C responds to changes in Y

C2 An increase
Results:
in Y1 or Y2
Provided they are
shifts the
both normal goods,
budget line
C1 and C2 both
outward.
increase,
…regardless of
whether the
income increase
occurs in period 1
or period 2. C1

CHAPTER 16 Consumption slide 17

 Keynes vs. Fisher

▪ Keynes:
Current consumption depends only on
current income.
▪ Fisher:
Current consumption depends only on
the present value of lifetime income.
The timing of income is irrelevant
because the consumer can borrow or lend
between periods.

CHAPTER 16 Consumption slide 18

 How C responds to changes in r
C2
As depicted here, An increase in r
pivots the budget
C1 falls and C2 rises.
line around the
However, it could point (Y1,Y2 ).
turn out differently… B

A
Y2

Y1 C1

CHAPTER 16 Consumption slide 19

 How C responds to changes in r

▪ income effect: If consumer is a saver,

the rise in r makes him better off, which tends to
increase consumption in both periods.
▪ substitution effect: The rise in r increases
the opportunity cost of current consumption,
which tends to reduce C1 and increase C2.
▪ Both effects  C2.
Whether C1 rises or falls depends on the relative
size of the income & substitution effects.

CHAPTER 16 Consumption slide 20

 Constraints on borrowing
▪ In Fisher’s theory, the timing of income is irrelevant:
Consumer can borrow and lend across periods.
▪ Example: If consumer learns that her future income
will increase, she can spread the extra consumption
over both periods by borrowing in the current period.
▪ However, if consumer faces borrowing constraints
(aka “liquidity constraints”), then she may not be
able to increase current consumption
…and her consumption may behave as in the
Keynesian theory even though she is rational &
forward-looking.
CHAPTER 16 Consumption slide 21
 Constraints on borrowing

C2
The budget
line with no
borrowing
constraints

Y2

Y1 C1

CHAPTER 16 Consumption slide 22

 Constraints on borrowing

C2
The borrowing
constraint takes
the form: The budget
line with a
C1  Y1
borrowing
Y2 constraint

Y1 C1

CHAPTER 16 Consumption slide 23

 Consumer optimization when the
borrowing constraint is not binding
C2
The borrowing
constraint is not
binding if the
consumer’s
optimal C1
is less than Y1.

Y1 C1

CHAPTER 16 Consumption slide 24

 Consumer optimization when the
borrowing constraint is binding
C2
The optimal
choice is at
point D.
But since the
consumer
cannot borrow, E
the best he can D
do is point E.

Y1 C1

CHAPTER 16 Consumption slide 25

 The Life-Cycle Hypothesis

▪ due to Franco Modigliani (1950s)

▪ Fisher’s model says that consumption depends
on lifetime income, and people try to achieve
smooth consumption.
▪ The LCH says that income varies systematically
over the phases of the consumer’s “life cycle,”
and saving allows the consumer to achieve
smooth consumption.

CHAPTER 16 Consumption slide 26

 The Life-Cycle Hypothesis

▪ The basic model:

W = initial wealth
Y = annual income until retirement
(assumed constant)
R = number of years until retirement
T = lifetime in years
▪ Assumptions:
▪ zero real interest rate (for simplicity)
▪ consumption-smoothing is optimal
CHAPTER 16 Consumption slide 27
 The Life-Cycle Hypothesis

▪ Lifetime resources = W + RY
▪ To achieve smooth consumption,
consumer divides her resources equally over time:
C = (W + RY )/T , or
C = aW + b Y
where
a = (1/T ) is the marginal propensity to
consume out of wealth
b = (R/T ) is the marginal propensity to consume
out of income
CHAPTER 16 Consumption slide 28
 Implications of the Life-Cycle
Hypothesis
The LCH can solve the consumption puzzle:
▪ The life-cycle consumption function implies
APC = C/Y = a(W/Y ) + b
▪ Across households, income varies more than
wealth, so high-income households should have
a lower APC than low-income households.
▪ Over time, aggregate wealth and income grow
together, causing APC to remain stable.

CHAPTER 16 Consumption slide 29

 Implications of the Life-Cycle
Hypothesis
$

The LCH
Wealth
implies that
saving varies
systematically Income
over a
person’s Saving
lifetime.
Consumption Dissaving

Retirement End
begins of life
CHAPTER 16 Consumption slide 30
 The Permanent Income Hypothesis

▪ due to Milton Friedman (1957)

▪ Y = YP + YT
where
Y = current income
Y P = permanent income
average income, which people expect to
persist into the future
Y T = transitory income
temporary deviations from average income

CHAPTER 16 Consumption slide 31

 The Permanent Income Hypothesis

▪ Consumers use saving & borrowing to smooth

consumption in response to transitory changes
in income.
▪ The PIH consumption function:
C = a YP
where a is the fraction of permanent income
that people consume per year.

CHAPTER 16 Consumption slide 32

 The Permanent Income Hypothesis
The PIH can solve the consumption puzzle:
▪ The PIH implies
APC = C/Y = a Y P/Y
▪ If high-income households have higher transitory
income than low-income households,
APC is lower in high-income households.
▪ Over the long run, income variation is due mainly
(if not solely) to variation in permanent income,
which implies a stable APC.

CHAPTER 16 Consumption slide 33

 PIH vs. LCH

▪ Both: people try to smooth their consumption

in the face of changing current income.
▪ LCH: current income changes systematically
as people move through their life cycle.
▪ PIH: current income is subject to random,
transitory fluctuations.
▪ Both can explain the consumption puzzle.

CHAPTER 16 Consumption slide 34

 The Random-Walk Hypothesis

▪ due to Robert Hall (1978)

▪ based on Fisher’s model & PIH,
in which forward-looking consumers base
consumption on expected future income
▪ Hall adds the assumption of
rational expectations,
that people use all available information
to forecast future variables like income.

CHAPTER 16 Consumption slide 35

 The Random-Walk Hypothesis
▪ If PIH is correct and consumers have rational
expectations, then consumption should follow a
random walk: changes in consumption should
be unpredictable.
▪ A change in income or wealth that was
anticipated has already been factored into
expected permanent income,
so it will not change consumption.
▪ Only unanticipated changes in income or wealth
that alter expected permanent income
will change consumption.
CHAPTER 16 Consumption slide 36
 Implication of the R-W Hypothesis

If consumers obey the PIH

and have rational expectations,
then policy changes
will affect consumption
only if they are unanticipated.

CHAPTER 16 Consumption slide 37

 The Psychology of Instant
Gratification
▪ Theories from Fisher to Hall assume that
consumers are rational and act to maximize
lifetime utility.
▪ Recent studies by David Laibson and others
consider the psychology of consumers.

CHAPTER 16 Consumption slide 38

 The Psychology of Instant
Gratification
▪ Consumers consider themselves to be imperfect
decision-makers.
▪ In one survey, 76% said they were not saving
enough for retirement.
▪ Laibson: The “pull of instant gratification”
explains why people don’t save as much as a
perfectly rational lifetime utility maximizer would
save.

CHAPTER 16 Consumption slide 39

 Two questions and time
inconsistency
1. Would you prefer (A) a candy today, or
(B) two candies tomorrow?
2. Would you prefer (A) a candy in 100 days, or
(B) two candies in 101 days?
In studies, most people answered (A) to 1 and (B) to 2.
A person confronted with question 2 may choose (B).
But in 100 days, when confronted with question 1,
the pull of instant gratification may induce her to
change her answer to (A).

CHAPTER 16 Consumption slide 40

 Summing up
▪ Keynes: consumption depends primarily on
current income.
▪ Recent work: consumption also depends on
▪ expected future income
▪ wealth
▪ interest rates
▪ Economists disagree over the relative importance
of these factors, borrowing constraints,
and psychological factors.

CHAPTER 16 Consumption slide 41

 Chapter Summary
1. Keynesian consumption theory
▪ Keynes’ conjectures
▪ MPC is between 0 and 1
▪ APC falls as income rises
▪ current income is the main determinant of
current consumption
▪ Empirical studies
▪ in household data & short time series:
confirmation of Keynes’ conjectures
▪ in long-time series data:
APC does not fall as income rises
CHAPTER 16 Consumption slide 42
 Chapter Summary
2. Fisher’s theory of intertemporal choice
▪ Consumer chooses current & future
consumption to maximize lifetime satisfaction of
subject to an intertemporal budget constraint.
▪ Current consumption depends on lifetime
income, not current income, provided consumer
can borrow & save.

CHAPTER 16 Consumption slide 43

 Chapter Summary
3. Modigliani’s life-cycle hypothesis
▪ Income varies systematically over a lifetime.
▪ Consumers use saving & borrowing to smooth
consumption.
▪ Consumption depends on income & wealth.

CHAPTER 16 Consumption slide 44

 Chapter Summary

4. Friedman’s permanent-income hypothesis

▪ Consumption depends mainly on permanent
income.
▪ Consumers use saving & borrowing to smooth
consumption in the face of transitory fluctuations
in income.

CHAPTER 16 Consumption slide 45

 Chapter Summary

5. Hall’s random-walk hypothesis

▪ Combines PIH with rational expectations.
▪ Main result: changes in consumption are
unpredictable, occur only in response to
unanticipated changes in expected permanent
income.

CHAPTER 16 Consumption slide 46

 Chapter Summary

6. Laibson and the pull of instant gratification

▪ Uses psychology to understand consumer
behavior.
▪ The desire for instant gratification causes
people to save less than they rationally know
they should.

CHAPTER 16 Consumption slide 47