Lecture 1

The Consumption Function

Recommended Texts
1. Branson, W.M. Macroeconomic Theory and Policy Third Edition, Chapter 12.
2. Dornbusch, R., S. Fischer and R. Startz Macroeconomics Ninth Edition Chapter 13.
3. Mankiw, D. Macroeconomics Chapter 15
4. Williamson, S.D. Macroeconomics, Second Edition Chapter 8.
The Keynesian Consumption
Keynes hypothesised that real consumption in the current period is a positive function
of real disposable income in the current period.

Ct = a + bYdt [1]
Where:
C is real consumption
a is autonomous consumption
b is the marginal propensity to consume 0<b<1
Yd is real disposable income
t is time

A number of observations can be made about the Keynesian consumption function.

· The marginal propensity to consume (MPC) is greater than zero and less than one.
If current disposable income should increase by one unit, consumption will increase
but not by as much as the increase in income.

From the Keynesian consumption function in equation 1 the average propensity to

consume (APC) is:

APC = Ct/Ydt = a/Ydt + b [2]

There are two things to note about the APC:

· It is greater in value than the MPC

· It declines as real disposable income rises

Empirical work on the consumption function was conducted using three types of data
sets.
1. Cross-sectional studies. Data was collected from households at a point in time. It
was found that the APC of low income households was greater than the APC of high
income households. This relationship confirmed the conclusions of the Keynesian
theory of consumption.
2. Short run time series data. This found that the marginal propensity to consume was
positive and less than one. The average propensity to consume was smaller than
average when income was above the long run trend and higher than average when
income was below the long-run trend. In the short run the APC > MPC.
3. Long-run time series data. The evidence found that the APC was constant and did
not decline as income increased in the long run. The value of the marginal propensity
to consume was equal to that of the average propensity to consume.

Thus the cross-sectional and short-run time series data confirmed the Keynesian
relationship between consumption and real disposable income. The long-run time
series data confirmed the positive relationship between consumption and income but
did not support the conclusion of the Keynesian consumption function that the APC
declines as income increases.

An analytical framework had to be developed to explain the existence of the cross-

sectional and short-run consumption functions on the one hand and the long-run
consumption function on the other.

The Inter-temporal Model of Consumption Choice

Let us assume that:
· A consumer lives for two periods, i.e. period 1 and period 2.
· The consumer earns income in period 1 and in period 2.
· Consumption in period 1 and consumption in period 2 are normal goods.
· There is a perfect credit market that allows the consumer to borrow or lend in
period 1 at real interest rate r.
· At the end of the consumer’s life there is no debt nor does the consumer leave any
bequests.
· The consumer wishes to maximise utility
U = U(c1, c2)
Let us assume that in period 1 consumption (C1) is less than income earned (Y1). The
excess of income over consumption is saved (S). Therefore:

C1 – Y 1 = S [3]

In the second period the consumer will consume his or her income and the savings and
interest earned from period 1:

C2 = Y2 + (1 + r) S [4]

Substituting for S from equation 3 into equation 4 yields

C2 = Y2 + (1 + r)( C1 – Y1) [5]

When we collect all the consumption variables to the left hand-side of the equation we
obtain:

C1 (1 + r) + C2 = Y1(1 + r) + Y2 [6]

Dividing equation 6 through by (1 + r) we obtain:

 C1 + C2/(1 + r) = Y1 + Y2/(1 + r) [7]

This is the consumer’s lifetime budget constraint. It states that the present value of
lifetime consumption should be equal to the present value of lifetime income. The
consumer will therefore maximise utility subject to the lifetime budget constraint.

Let us assume that the consumer consumes the entire lifetime income in period 1.
Then consumption in period will be given by Y1 + Y2/(1 + r). The consumer is able to
do this because in period 1 s/he can borrow against income that will be earned in
period 2. This gives us a point on the horizontal axis that measures cedis in period 1.

Y1(1 + r) + Y2 measures a point on the vertical axis that measures cedis in period 2. If
we make the heroic assumption that the consumer saves the entire income in period 1
and consumes it in period 2 then the individual can consume
Y1(1 + r) + Y2 in period 2.

The line joining the two points on the vertical and horizontal axis defines the budget
constraint facing the consumer. It defines the consumer’s consumption possibilities.
Between these two extremes the individual can consume different combinations of C1
and C2 whilst satisfying the lifetime budget constraint. The slope of the budget
constraint is determined by the real interest rate, r. The position of the budget
constraint is determined by the real exchange rate and the income earned in period 1
and income earned in period 2. The position of the budget constraint will change if
there is a change in income in period 1, if there is a change in income in period 2 or if
there is a change in income in both periods.

The budget constraint of the individual can also be presented as:

Y2 - C2 = - (1 + r) Y1 – C1 [8]

Where -(1 + r) is the slope of the budget constraint. (1 + r) measures the relative price
of consumption in the first period in terms of consumption in the second period. If the
real interest rate r is 15%, then if the individual consumes GH¢75 in the first period it
means that s/he has given up GH¢86.25 in the second period. As the rate of interest
increases the price of current consumption in terms of future consumption increases.

The relative price of consumption in the second period in terms of consumption in the
first period is given by 1/(1 + r). Let us assume that r is 15%. Thus if the consumer
wishes to consume GH¢75 in the second period then s/he must give up GH¢65.2 in
the first period. As the rate of interest rises the price of future consumption in terms of
current consumption declines.

Where along the budget line the consumer will choose, i.e. the combination of C1 and
C2 that the consumer chooses will depend on the consumer’s preferences. We shall
assume that the consumer’s preferences are defined as follows:
· An increase in consumption in period 1 or in period 2 will make the consumer
better off.
· The consumer preference is that consumption in period 1 and in period 2 is as equal
as possible.
· Consumption in period 1 and consumption in period 2 are normal goods.

The consumer’s preferences can be represented by a set of indifference curves. The

slope of the indifference curve measures the marginal rate of substitution of
consumption in the first period for consumption in the second period.

The consumer’s welfare is maximised at the point where the budget constraint is
tangent to an indifference curve. Welfare is maximised where:

MRSc1,c2 = (1 + r) [9]

This states that the marginal rate of substitution of first period consumption for second
period consumption is equal to the relative price of first period consumption in terms
of second period consumption. The rate at which the consumer is willing to trade off
first period consumption for second period consumption is equal to the rate at which
the consumer can trade first period consumption for second period consumption.

Thus the consumer can maximise welfare when consumption in period 1 is less than
income in period 1. The excess of income in period 1 is saved for consumption in
period 2. In period 2 the consumer is then able to consume over and above period 2’s
income.

Alternatively the consumer can maximise welfare when consumption in period 1 is

greater than income in period 1. The excess of consumption over income is made
possible by borrowing against period 2’s income. In period 2, consumption will be
less than income in period 1 because the consumer would have to repay the loan. The
maximum that the consumer can borrow in period 1 is Y2/(1+r), i.e. the present value
of period 2’s income.

Analysing the Effect of a Transitory Change in Income on Consumption

The consumer is maximising welfare. We shall assume that consumption in period 1 is
equal to income in period 1.

Let us assume that there is an increase in income in period 1 only. This means that the
increase in income does not extend to period 2. Thus the increase in income is
temporary or transitory. The increase in income in period 1 will cause a parallel
outward shift in the budget constraint. The shift in the budget constraint is determined
by the size of the change in period 1’s income. The slope of the budget constraint will
remain constant because the real interest rate has not changed. The effect of the
increase in income in period 1 is to cause lifetime income to increase.

Consumption in period 1 and consumption in period 2 are normal goods. The increase
in lifetime income will cause consumption in both periods to increase. Consumption
in period 1 will increase but not by as much as the increase in income in period 1. The
consumer will save some of the increase in income in period 1 for consumption in
period 2. Consumption in period 2 will increase and it will be greater than period 2’s
income. This is an example of consumption smoothing. Not all of the increase in
income was consumed in period 1. The consumer has spread the increase in income in
period 1 across the two periods and has increased consumption in both periods.

Analysing the effect of an increase in income in the second period

Let us assume that Ama has been promoted. Her income in the next period will
increase. We shall assume that her consumption in period 1 is equal to income in
period 1 and she is maximising welfare.

Since her income in period 2 will increase this means that her lifetime income
increases as well. There will be a parallel outward shift in the budget constraint
determined by the increase in income in period 2. The slope of the budget constraint
remains constant because the real interest rate does not change.

Consumption in period 1 and consumption in period 2 are normal goods.

Consumption in both periods will rise. Consumption in period 2 will rise by less than
the increase in income. Consumption in period 1 will rise and will be above income in
period 1. There will be a decrease in savings. Ama has smoothed consumption over
time.

In this analytical framework current period consumption, i.e. consumption in period 1

will increase by less than the increase in income. An increase in income in any period
will be spread across consumption in period 1 and in period 2.

In this model consumption in the current period is a function of the present value of
income.

Ct = f(PVt) [10]

An increase in the present value of income at time t will cause consumption in time t
to increase.