MACROEC

ONOMICS
II
Chapter Seventeen
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 CHAPTER
ONE

THEORIES OF CONSUMPTION
AND
CONSUMPTION EXPENDITURE
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Consumption Function
The consumption decision is crucial for short-run analysis because of
its role in determining aggregate demand. Consumption is 2/3 of GDP,
so fluctuations in consumption are a key element of booms and
recessions.
Consumption Theories: 1) Keynesian Consumption Function
The consumption function was central to Keynes’ theory of economic
fluctuations presented in The General Theory in 1936.
1. Keynes conjectured that the marginal propensity to consume— the
amount consumed out of an additional dollar of income is between
zero and one. He claimed that the fundamental law is that out of
every dollar of earned income, people will consume part of it and
save the rest.
2. Keynes also proposed the average propensity to consume, the ratio
of consumption to income falls as income rises.
3. Keynes also held that income is the primary determinant of
consumption and that the interest rate does not have a key role.
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 C = C + c Y, C > 0, 0 < c <1
C
Consumption
spending by disposable
households marginal income
propensity to
consume (MPC)
C
Y

C determines the intercept on the

vertical axis. The slope of the
Chapter Seventeen consumption function is lower case c,
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the MPC.
 This consumption function
APC = C/Y = C/Y + c exhibits three properties that
Keynes conjectured. First,
C the marginal propensity to
consume c is between zero
and one. Second, the average
APC1 propensity to consume falls
C APC2 as income rises. Third,
11 consumption is determined by
current income Y.
Y
As Y rises, C/Y falls, and so the average propensity to consume C/Y
falls. Notice that the interest rate is not included in this equation as a
determinant of consumption.
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 To understand the marginal propensity to consume (MPC),
consider a shopping scenario. A person who loves to shop
probably has a large MPC, let’s say (.99). This means that for
every extra dollar he or she earns after tax deductions, he or
she spends $.99 of it.

The MPC measures the sensitivity of the change in one

variable, consumption, with respect to a change in the other
variable, income.

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During World War II, on the basis of Keynes’s consumption function,
economists predicted that the economy would experience what they
called secular stagnation—a long depression of infinite duration—
unless the government used fiscal policy to stimulate aggregate
demand.
It turned out that the end of the war did not throw the US into another
depression, but it did suggest that Keynes’s conjecture that the average
propensity to consume would fall as income rose appeared not to hold.

Simon Kuznets constructed new aggregate data on consumption and

investment dating back to 1869. His work would later earn him a
Nobel Prize. Kuznets discovered that the ratio of consumption to
income was stable over time, despite large increases in income; again,
Keynes’s conjecture was called into question. This brings us to the
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puzzle…
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The failure of the secular-stagnation hypothesis and the findings of
Kuznets both indicated that the average propensity to consume is fairly
constant over time. This presented a puzzle: Why did Keynes’s
conjectures hold up well in the studies of household data and in the
studies of short time-series, but fail when long-time series were
examined?

Long-run Studies of household data and short

C consumption time-series found a relationship
function between consumption and income
(constant APC) similar to the one Keynes conjectured—
Short-run this is called the short-run consumption
consumption function. But, studies using long time-
function series found that the APC did not vary
(falling APC) systematically with income—this
Y relationship is called the long-run
Chapter Seventeen
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The economist Irving Fisher developed the model with which
economists analyze how rational, forward-looking consumers make
intertemporal choices—that is, choices involving different periods
of time. The model illuminates the constraints consumers face, the
preferences they have, and how these constraints and preferences
together determine their choices about consumption and saving.

When consumers are deciding how much to consume today versus

how much to consume in the future, they face an intertemporal
budget constraint, which measures the total resources available for
consumption today and in the future.

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Here is an interpretation of the consumer’s budget constraint:

The consumer’s budget constraint implies that if the interest rate is

zero, the budget constraint shows that total consumption in the two
periods equals total income in the two periods. In the usual case in
which the interest rate is greater than zero, future consumption and
future income are discounted by a factor of 1 + r. This discounting
arises from the interest earned on savings. Because the consumer earns
interest on current income that is saved, future income is worth less
than current income. Also, because future consumption is paid for out
of savings that have earned interest, future consumption costs less than
current consumption.
The factor 1/(1+r) is the price of second-period consumption measured
in terms of first-period consumption; it is the amount of first-period
consumption that the consumer must forgo to obtain 1 unit of second-
period consumption.
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Here are the combinations of first-period and second-period consumption
the consumer can choose. If he chooses a point between A and B, he
consumes less than his income in the first period and saves the rest for
the second period. If he chooses between A and C, he consumes more than
his income in the first period and borrows to make up the difference.

Consumer’s budget constraint

B
Saving
Vertical intercept is
(1+r)Y1 + Y2
A Borrowing
Y2
Horizontal intercept is
C Y1 + Y2/(1+r)
Y1
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The consumer’s preferences regarding consumption in the two
periods can be represented by indifference curves.

An indifference curve shows the combination of first-period and

second-period consumption that makes the consumer equally
satisfied.
The slope at any point on the indifference curve shows how much
second-period consumption the consumer requires in order to be
compensated for a 1-unit reduction in first-period consumption.
This slope is the marginal rate of substitution between first-period
consumption and second-period consumption. It tells us the rate at
which the consumer is willing to substitute second-period
consumption for first-period consumption.
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 Y Z
X IC2
W IC1
First-period consumption
Indifference curves represent the consumer’s preferences over first-
period and second-period consumption. An indifference curve gives the
combinations of consumption in the two periods that make the consumer
equally happy. Higher indifferences curves such as IC2 are preferred to
lower ones such as IC1. The consumer is equally happy at points W, X,
and Y, but prefers point Z to all the others. Point Z is on a higher
Chapter Seventeen
indifference
2/28/2025 curve and is therefore not equally preferred to W, X, and13Y.
 O
IC3
IC2
IC1
First-period consumption
The consumer achieves his highest (or optimal) level of satisfaction
by choosing the point on the budget constraint that is on the highest
indifference curve. Here the slope of the indifference curve
equals the slope of the budget line. At the optimum, the indifference
curve is tangent to the budget constraint. The slope of the indifference
curve is the marginal rate of substitution MRS, and the slope of the
budget line is 1 + the real interest rate. At point O, MRS = 1 + r.
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 O
IC2
IC1

First-period consumption
An increase in either first-period income or second-period income
shifts the budget constraint outward. If consumption in period one and
consumption in period two are both normal goods—those that are
demanded more as income rises, this increase in income raises
consumption in both periods.
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Economists decompose the impact of an increase in the real interest
rate on consumption into two effects: an income effect and a
substitution effect. The income effect is the change in consumption
that results from the movement to a higher indifference curve. The
substitution effect is the change in consumption that results from the
change in the relative price of consumption in the two periods.

New budget An increase in the interest rate

constraint rotates the budget constraint
around the point C, where C is
B Old budget (Y1, Y2). The higher interest rate
constraint reduces first period consumption
A
Y2 C IC2 (move to point A) and raises
IC1 second-period consumption
Chapter Seventeen Y1 (move to point B).
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First-period consumption
The inability to borrow prevents current consumption from exceeding
current income. A constraint on borrowing can therefore be expressed
as C1 < Y1.

This inequality states that consumption in period one must be less than
or equal to income in period one. This additional constraint on the
consumer is called a borrowing constraint, or sometimes, a liquidity
constraint.

The analysis of borrowing leads us to conclude that there are two

consumption functions. For some consumers, the borrowing
constraint is not binding, and consumption in both periods depends
on the present value of lifetime income. For other consumers, the
borrowing constraint binds. Hence, for those consumers who would
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to borrow but cannot, consumption depends only on current income.
17
In the 1950s, Franco Modigliani, Albert Ando, and Richard
Brumberg used Fisher’s model of consumer behavior to study the
consumption function. One of their goals was to study the
consumption puzzle.

According to Fisher’s model, consumption depends on a person’s

lifetime income.

Modigliani emphasized that income varies systematically over

people’s lives and that saving allows consumers to move income
from those times in life when income is high to those times when
income is low. This interpretation of consumer behavior formed the
basis of his life-cycle hypothesis.
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 The Hypothesis
One important reason that income varies over a person’s life is
retirement. Most people plan to stop working at about age 65, and they
expect their incomes to fall when they retire. Yet they do not want a
large drop in their standard of living, as measured by their consumption.
To maintain their level of consumption after retirement, people must
save during their working years.
Consider a consumer who expects to live another T years, has wealth
of W, and expects to earn income Y until s/he retires R years from now.
The consumer’s lifetime resources are composed of initial wealth W
and lifetime earnings of R × Y.

The consumer can divide up his/her lifetime resources among his/er T

remaining years of life. We assume that s/he wishes to achieve the
smoothest possible path of consumption over his/her lifetime.
Therefore, s/he divides this total of W + RY equally among the T years
and each year consumes C = (W + RY)/T. We can write this person’s
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consumption
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For example, if the consumer expects to live for 50 more years and
work for 30 of them, then T = 50 and R = 30, so her consumption
function is
C = 0.02W + 0.6Y.
This equation says that consumption depends on both income and
wealth. An extra $1 of income per year raises consumption by $0.60
per year, and an extra $1 of wealth raises consumption by $0.02 per
year.

If every individual in the economy plans consumption like this, then

the aggregate consumption function is much the same as the
individual one.
In particular, aggregate consumption depends on both wealth and
income. i.e, the economy’s consumption function is C = aW + bY,
where the parameter a is the marginal propensity to consume out of
wealth, and the parameter b is the marginal propensity to consume
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of income 20
This life-cycle model of consumer behavior can solve the
consumption puzzle.
According to the life-cycle consumption function, the average
propensity to consume is C/Y = a(W/Y) + b. Because wealth does
not vary proportionately with income from person to person or from
year to year, we should find that high income corresponds to a low
average propensity to consume when looking at data across
individuals or over short periods of time.

But over long periods of time, wealth and income grow together,
resulting in a constant ratio W/Y and thus a constant average
propensity to consume.

The life-cycle model makes many other predictions as well. Most

important, it predicts that saving varies over a person’s lifetime. If a
person begins adulthood with no wealth, s/he will accumulate wealth
during his/er working years and then run down her wealth during
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his/er retirement years.
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The first explanation is that the elderly are concerned about
unpredictable expenses. Additional saving that arises from
uncertainty is called precautionary saving. One reason for
precautionary saving by the elderly is the possibility of living longer
than expected and thus having to provide for a longer than average
span of retirement. Another reason is the possibility of illness and
large medical bills. The elderly may respond to this uncertainty by
saving more in order to be better prepared for these contingencies.
The precautionary-saving explanation is not completely persuasive,
because the elderly can largely insure against these risks. To protect
against uncertainty regarding life span, they can buy annuities from
insurance companies. For a fixed fee, annuities offer a stream of
income that lasts as long as the recipient lives. Uncertainty about
medical expenses should be largely eliminated by Medicare, the
government's health insurance plan for the elderly, and by private
insurance plans.
The second explanation for the failure of the elderly to dissave is
Chapter Seventeen
that they may want to leave bequests to their children.
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In 1957, Milton Friedman proposed the permanent-income hypothesis
to explain consumer behavior. Its essence is that current consumption is
proportional to permanent income. Friedman’s permanent-income
hypothesis complements Modigliani’s life-cycle hypothesis: both use
Fisher’s theory of the consumer to argue that consumption should not
depend on current income alone. But unlike the life-cycle hypothesis,
which emphasizes that income follows a regular pattern over a person’s
lifetime, the permanent-income hypothesis emphasizes that people
experience random and temporary changes in their incomes from year
to year.

Friedman suggested that we view current income Y as the sum of two

components, permanent income YP and transitory income YT.
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 The Hypothesis

Friedman suggested that we view current income Y as the sum of two

components, permanent income YP and transitory income YT. That is,
Y = YP + Y T.

Permanent income is the part of income that people expect to persist

into the future; whereas transitory income is the part of income that
people do not expect to persist. Put differently, permanent income is
average income, and transitory income is the random deviation from
that average.

Friedman reasoned that consumption should depend primarily on

permanent income, because consumers use saving and borrowing to
smooth consumption in response to transitory changes in income.
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Friedman concluded that we should view the consumption function
as approximately C = aYP, where a is a constant that measures the
fraction of permanent income consumed.

The permanent-income hypothesis, as expressed by this equation,

states that consumption is proportional to permanent income.

Friedman’s hypothesis implies for the average propensity to

consume. Divide both sides of his consumption function by Y to
obtain APC = C/Y = aYP /Y. According to the permanent-income
hypothesis, the average propensity to consume depends on the ratio
of permanent income to current income.

When current income temporarily rises above permanent income,

the average propensity to consume temporarily falls; when current
income temporarily falls below permanent income, the average
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Robert Hall was first to derive the implications of rational
expectations for consumption. He showed that if the permanent-
income hypothesis is correct, and if consumers have rational
expectations, then changes in consumption over time should be
unpredictable. When changes in a variable are unpredictable, the
variable is said to follow a random walk.

According to Hall, the combination of the permanent-income

hypothesis and rational expectations implies that consumption follows
a random walk. He reasoned as follows. According to the PIH,
consumers face fluctuating income and try their best to smooth their
consumption over time. At any moment, consumers choose
consumption based on their current expectations of their lifetime
incomes. Over time, they change their consumption because they
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Implications

 The rational-expectations approach to consumption has

implications not only for forecasting but also for the analysis of
economic policies.
 If consumers obey the PIH and have rational expectations, then
only unexpected policy changes influence consumption.
 These policy changes take effect when they change expectations.

 Hence, if consumers have rational expectations, policymakers

influence the economy not only through their actions but also
through the public’s expectation of their actions.

 Expectations, however, cannot be observed directly. Therefore, it is

often hard to know how and when changes in fiscal policy alter
aggregate demand.
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Recently, economists have turned to psychology for further
explanations of consumer behavior. They have suggested that
consumption decisions are not made completely rationally. This new
subfield infusing psychology into economics is called behavior
economics.

Harvard’s David Laibson notes that many consumers judge themselves

to be Imperfect decision makers. Consumers’ preferences may be time-
inconsistent: they may alter their decisions simply because time
passes.

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 EXPECTATIONS

How are expectations formed? People make expectations in

different ways. These are,
1. Static (Naïve) Expectation: What happened in the past or
yesterday will happen today and in future. For instance, if there
was inflation yesterday tomorrow will be the same as today
and yesterday.
2. Adaptive Expectation: This says what will happen
tomorrow is a function of what has happened yesterday or in the
past and some adjustments made from the errors of last period
today.
 Cont’d

3. Rational Expectation: Says rational agents will use all the

information available to them in making decisions about the
future. In short, agents will incorporate all “news” as it comes in.
News would come from personal experience in buying and
selling, from private contact or from newspapers and from one’s
own past prediction of errors. The last resource is especially
important for it brings the difference between the rational and
adaptive expectations. Thus, with rational expectation the
expected error is zero and the errors are not linked in any way by
a spiral correlation. This is an implication for the unbiasedness of
rational expectation.
 Answer the following questions accordingly!

1. Mr.A and Mr.B, both obey the two-period Fisher model of

consumption. Mr.A earns $100 in the first period and $100 in the
second period. Mr.B earns nothing in the first period and $210 in
the second period. Both of them can borrow or lend at the interest
rate r. Accordingly:
a) You observe both Mr.A and Mr.B consuming $100 in the first
period and $100 in the second period. Calculate the interest rate r?
b) Suppose the interest rate increases. What will happen to Mr.A’s
consumption in the first period? Is Mr.A better off or worse off
than before the interest rate rise?
(2marks)

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2. Demographers predict that the fraction of the population that is
elderly will increase over the next 20 years. What does the life-
cycle hypothesis predict for the influence of this demographic
change on the national saving rate? (1mark)

3. Life-cycle hypothesis does not explain role of current income in

explaining current consumption. (True/ False) (1mark)

4. Describe the evidence that was consistent with Keynes’s

conjectures and the evidence that was inconsistent with them.
(1mark)

Chapter Seventeen Good Luck! 32

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 Answers
 1) We are given the two-period Fisher model of consumption,
where individuals can borrow or lend at an interest rate r.
 Step 1: Understanding the Consumption Choices Mr. A: Earns
$100 in both periods. Mr. B: Earns $0 in the first period and $210
in the second period. Both consume $100 in period 1 and $100 in
period 2.The interest rate 𝑟r is the same for both.
 Step 2: Setting Up Mr. B's Budget Constraint Since Mr. B has no
income in the first period but consumes $100, he must borrow in
the first period and repay it in the second period. If Mr. B borrows
$100 in period 1, he must repay 100(1+𝑟) in period 2.His total
second-period income is $210, so the budget constraint
is:210−100(1+𝑟)=100 210−100(1+r)=100, r = 0.1 (or 10%).Thus,
the interest rate is 10%.
 Cont’d
 Step 3: Effect of Interest Rate Increase on Mr. A’s Consumption
Mr. A is a lender because he has income in both periods and is
consuming exactly what he earns. When the interest rate rises,
saving becomes more attractive since future consumption grows at
a higher rate. This creates two effects : Substitution effect: Mr. A
will consume less today and save more because future consumption
is more rewarding. Income effect: Since Mr. A is a lender, higher
interest rates increase his future wealth, so he might want to
consume more in both periods. The overall effect depends on
which effect is stronger, but generally: If the substitution effect
dominates, Mr. A consumes less today. If the income effect
dominates, Mr. A may consume more today. Since Mr. A is a
lender, the substitution effect is likely stronger, meaning his first-
period consumption will decrease.
 Cont’d
 Step 4: Is Mr. A Better or Worse Off? Mr. A is better off because
he is a lender and higher interest rates increase his future income.
Even though his current consumption may decrease slightly, his
overall lifetime wealth is higher.
 Final Answers: Interest rate r=10% (or 0.1). Mr. A’s first-period
consumption will likely decrease. Mr. A is better off after the
interest rate rise.
 Question 2
 Effect of an Aging Population on the National Saving Rate
According to the Life-Cycle Hypothesis
 The Life-Cycle Hypothesis (LCH), developed by Franco
Modigliani, suggests that individuals plan their consumption and
savings over their lifetime to smooth consumption across different
stages of life. According to this theory:
 Young individuals borrow or save little since they are investing in
education and careers.
 Middle-aged individuals save more as they earn higher incomes
and prepare for retirement.
 Elderly individuals dissave (spend their accumulated savings) after
retirement.
 What Happens When the Fraction of Elderly People Increases?
 Cont’d
 Since elderly individuals tend to dissave, a larger proportion of
elderly people in the population means:
 National savings rate will decline because more people will be
withdrawing savings rather than accumulating them.
 Investment levels may fall, leading to lower capital accumulation
and possibly slower economic growth in the long run.
 Government programs like Social Security and pensions may face
more pressure due to increased payouts to retirees.
 Final Answer:
 The Life-Cycle Hypothesis predicts that the national saving rate
will decline as the fraction of the elderly population increases.
 Question 3
 True.
 The Life-Cycle Hypothesis (LCH), developed by Franco
Modigliani, suggests that individuals plan their consumption based
on their lifetime income, rather than just their current income. It
argues that people aim to smooth consumption over their entire life
by saving during high-earning years and dissaving during
retirement.
 Since LCH focuses on expected lifetime resources rather than
current income, it does not directly explain the role of current
income in determining current consumption. This contrasts with the
Keynesian consumption function, which assumes that current
income plays a primary role in determining consumption.
 Thus, the statement is True
 Question 4
 Evidence Consistent with Keynes’s Conjectures:
 Cross-Sectional Studies (Short-Run Evidence): Studies examining
household consumption patterns found that low-income households
had a higher APC than high-income households, supporting
Keynes’s second conjecture. The MPC was observed to be positive
and less than 1, consistent with Keynes’s first conjecture.
 Empirical Observations During the Great Depression: Keynes’s
model fit the data well during the Great Depression when
consumption appeared to depend heavily on current income, as
unemployment and declining incomes led to reduced spending.
 Short-Run Fluctuations in Consumption: During recessions, when
income falls, consumption also declines significantly, aligning with
Keynes’s view that current income drives consumption.
 Cont’d
 Evidence Inconsistent with Keynes’s Conjectures:
 Simon Kuznets’s Findings on Long-Run Consumption (APC
Stability): In the 1940s, Simon Kuznets analyzed long-term U.S.
data and found that APC remained stable over time, even as
income rose. This contradicted Keynes’s second conjecture, which
predicted that APC should decline as income increases.
 Permanent Income Hypothesis (Milton Friedman, 1957): Friedman
argued that consumption depends on permanent income (long-term
expected income), not just current income. Households smooth
consumption over time, borrowing in low-income periods and
saving in high-income periods. This refuted Keynes’s third
conjecture that current income alone determines consumption.
 Cont’d
 Life-Cycle Hypothesis (Franco Modigliani, 1950s): Modigliani’s
model suggested that consumption is planned over an individual's
lifetime, meaning savings and dissaving adjust based on expected
lifetime income rather than just current earnings. This also
weakened Keynes’s idea that consumption is driven mainly by
current income.
 Conclusion: While short-term empirical evidence supported
Keynes’s consumption function, long-term studies and alternative
theories (like the Permanent Income Hypothesis and Life-Cycle
Hypothesis) challenged the idea that consumption depends only on
current income. Modern economics integrates these findings into a
more comprehensive understanding of consumption behavior.
 THANK
U!
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