Chapter 2 - Cengage Learning

Macroeconomics

Chamberlin and Yueh

Chapter 2

Lecture slides

Use with Macroeconomics by Graeme Chamberlin and Linda Yueh ISBN 1-84480-042-1

© 2006 Cengage Learning

Consumption

• Theories of Consumption Behaviour

• Keynesian Consumption Function

• Permanent Income Hypothesis and the Life

Cycle Hypothesis

• Explaining Consumption Patterns



Learning Objectives

• Defining consumption, consumer expenditure and saving

• Understanding the link between consumption and income described by the Keynesian consumption function

• Using the optimal consumption model to describe how consumption decisions are related to rational utility maximising behaviour

• Show how the Permanent Income Hypothesis and Life

Cycle Hypothesis base consumption decisions on future as well as current income

• Explain how changes in expectations, interest rates, wealth, credit constraints and uncertainty can account for recent changes in consumption and saving



Aggregate Demand

• Consumer expenditure by households on goods and services represents the largest part of aggregate demand .

• Since 1980, this has on average accounted for 63% of total aggregate demand in the UK, and similar figures would be expected for other developed countries.

• The size of total consumer expenditure is the result of choices made by private households. The counterpart to the consumption decision is saving, which is typically any income a household decides chooses not to spend. Savings, though, can of course be used to fund future consumption.



Consumption and Consumer

Expenditure

• Distinction between consumption and consumer expenditure.

• Consumer expenditure is the act of purchasing a good or service.

• Consumption, on the other hand, is the act of deriving a flow of benefits from the usage of those goods or services.

• Used interchangeably because durable goods represent a relatively small proportion of total household expenditure, so the vast majority of consumer expenditure can also be thought of as consumption. Secondly, consumer expenditure, and not consumption, plays the central role in the circular flow of income.



Categories of Consumer Expenditure

• Consumer expenditure can be further broken down into spending on services, and on durable and nondurable goods:

• A durable good is one that can be used many times, such as a washing machine, a television, an automobile, and so on.

• A non-durable good is one that is used up in its consumption, for example, food, energy and public transport.

• Services obviously share the same characteristics as non-durable goods



Consumer Expenditure, UK



Theories of Consumption Behaviour

• Keynesian consumption function: households base consumption decisions solely on current income.

• The Permanent Income/Life Cycle Hypothesis argues that households take a much longer term view of income.

Consumption choices will therefore be forward-looking, depending not just on current income, but also on expectations about future income.



The Keynesian Consumption

Function

• Also known as the absolute income hypothesis (AIP).

• Consumption is a function of income:

C

 a

 cY

• a = autonomous consumption

• c = marginal propensity to consume

•

Y = aggregate income.



Keynesian Consumption Function



Autonomous Consumption

• Autonomous consumption, a , is consumption which is undertaken independently of income.

• Also, consuming out of wealth would count as autonomous consumption. If a household owned a stock of financial assets, these could be used to support consumption regardless of the amount of current income. (i.e., autonomous consumption is equal to a proportion of wealth).

• The level of autonomous consumption determines where the consumption function intersects the vertical axis.

Anything that leads to a change in this would lead to a shift in the consumption function.



Marginal Propensity to Consume

• The marginal propensity to consume , mpc , gives the relationship between changes in consumption and changes in income.

• It is the change in consumption that would result from a £1 change in income.

• Thus, it determines the slope of the consumption function.




• If the mpc were to rise, then the entire consumption function would pivot upwards, reflecting the change in the slope: c





C



Y




• Therefore, the change in consumption following a change in income is simply:



C

 c



Y

• Conventionally, the mpc lies between 0 and 1 (although not necessarily), meaning that consumption moves less than one-to-one with changes in income. This is because saving acts as a counterpart to consumption.



Marginal Propensity to Save

• The marginal propensity to save, mps . This simply tells us how much saving will change when income varies by £1, or



S

 s



Y

• Therefore the marginal propensity to save is defined as: s





S



Y



Change in Income

• Given that all income is either consumed or saved, it must be the case that any change in income is equal to the sum of the changes in consumption and saving:



Y

 

C

 

S



Change in Income

• Dividing both sides by the change of income results in a very simple rule:



Y



Y





C



Y





S



Y

• So, we can conclude that:

1

 c

 s



MPC+MPS=1

• The marginal propensity to consume and the marginal propensity to save should add up to 1.

• This does not preclude the marginal propensity to consume from exceeding 1, but in this case it would imply that the marginal propensity to save is negative.

• This is possible if there is borrowing or dis-saving, as this could fund extra consumption in excess of the change in income.



Global Application 2.1

• The Marginal

Propensity to Consume and Aggregate

Consumption

• Linear consumption function



GA 2.1

• Non-linear consumption function

• What are the implications for government policy?



Income and disposable income

• For consumption decisions, though, households would be more concerned not so much about income, but disposable income .

• Disposable income is the income that a household can actually use to either save or spend.



Rewriting the Keynesian

Consumption Function

• Incorporating disposable income,

C

 a

 cY d

Y



Link between actual and disposable income

• Disposable Income = Actual Income – Taxes +

Transfer Payments.

• As the government is taking with one hand

(taxation) and giving with the other (transfer payments), their flows to and from the household sector can just be netted out: Net Taxes = Taxes –

Transfer Payments.

• Leaving us with Disposable Income = Actual

Income – Net Taxes .



Disposable Income less than Actual

Income

• Net taxes are usually positive meaning that taxation exceeds transfer payments. As a result, household disposable income should be lower than actual income.

• Figure 2.3 plots the history of GDP per head and household disposable income per head for the UK.

Over the past two decades, disposable income typically represents between 60-70% of total income.



UK GDP per head and HH disposable income



Lump sum taxes

• A simple way of representing the difference between actual and disposable income is through the use of lump sum taxes (T) .

• Disposable income can now be simply written in terms of actual income as:

Y d 

Y



T



Rewriting the Keynesian Consumption

Function with Lump Sum Taxes

• Using this definition of disposable income, the consumption function can be rewritten in the following way:

C

 a

 c



Y



T



• Changes in taxes will lead to changes in consumption through their effects on disposable income. Higher taxes will lead to a downward shift in the consumption function, meaning that at every level of actual income the level of consumption will be correspondingly lower.



Keynesian Consumption Function



UK household consumption and disposable income per person



Objections to Keynesian

Consumption Function

• The positive correlation predicted by the Keynesian consumption function seems to hold true. This offers some evidence that over time changes in consumption are driven by changes in disposable income.

• However, despite its basic logic and apparent ability to fit the data, objections were levied. These pointed to the

Keynesian model being an incomplete theory of consumer behaviour. This is because firstly it is not clear that consumer behaviour is consistent with rational behaviour, and secondly there is a need for models which allow a much richer set of factors to be determinants other than current disposable income.



The Permanent Income and Life

Cycle Hypotheses

• Both these theories share similar foundations, arguing that consumption decisions will be based on a longer term view of income.

• This result is just the outcome of households trying to maximise their lifetime utility (welfare).

• Therefore, to gain an understanding of the consumption smoothing nature of the LCH and the PIH, it is first necessary to outline the optimal consumption model .



Optimal Consumption Model

• The optimal consumption model describes how consumers should choose the path of consumption over time subject to the resource constraints they face in order to maximise their lifetime utility.

• Elements of the model: Optimal

Consumption, Intertemporal Budget

Constraint, and Optimal Choice.



Optimal Consumption

• Applying utility maximising behaviour to consumption choices over time can be demonstrated in a simple two period model.

These two periods represent the total lifetime of a household, where period 1 can be thought of as the current period, and period 2 as the future. The objective of the household is to choose a consumption plan for each period that maximises their total lifetime utility.



Intertemporal Budget Constraint

• The three characteristics of the intertemporal budget constraint are:

• Income in each period is given by

Y

1 respectively.

and by Y

2

,

• The household can transfer income across periods by borrowing and lending freely at an interest rate of r .

• Finally, the household must reach the end of period 2 without leaving debts, otherwise households would consume an infinite amount.



Two period budget constraint

• In period 1, the household receives income of , if it chooses to consume a level of C

1

; the difference is savings, S , so

S



Y

1



C

1

• The maximum second period consumption must not exceed the total amount of second period resources: C

2





1

 r



S



Y

2



Two period budget constraint

• Substituting in for saving, we can write the period

2 constraint as:

C

2





1

 r



Y

1



C

1





Y

2

• This highlights the trade-off that households face.

Given their income stream, the household can increase current consumption if they are prepared to consume less in the future. Likewise, accepting lower current consumption enables more to be consumed in the future.



Rewriting the I.B.C.

• Finally, an interesting way of writing the intertemporal budget constraint can be found by rearranging (2.5) one final time by dividing both sides by and collecting the consumption and income terms together on different sides of the equation:

C

1





1

C



2 r





Y

1



Y

2



1

 r






• The present discounted value of consumption cannot exceed the present discounted value of income.

• Future values are divided by the interest rate.

This is because the same unit of income is worth different amounts in different time periods as income cannot be transferred costlessly over time.







• The area defined by the budget constraint is known as the budget set , and represents all the possible points at which the household can consume over the two periods.

• The slope of the budget line is given by –(1+r). The interest rate reflects the cost of transferring consumption over time, whether it is the rate of return on savings or the cost of borrowing. When the household is free to borrow and save there is no reason for consumption to be tied to current income.

• The points where the budget constraint meets the axes represent the maximum possible consumption in each period.



Consumer Preferences

• A lifetime utility function tells us how much happiness or satisfaction a household will achieve from their lifetime pattern of consumption. This is given by:

U



U



C

1

, C

2





Lifetime utility function



Law of diminishing marginal utility of consumption

• The shape of the utility function is interesting; it can be described as a concave function. As consumption rises, total utility rises; but, it does so at a diminishing rate. This outcome is due to the law of diminishing marginal utility of consumption .

• Therefore, the marginal utility from an extra unit of consumption is much lower at high levels of consumption than at low levels.



Global Applications 2.3

• How’s Life? Is Consumption the Source of

Welfare?

•

Health Status, Employment Status, Family

Status, Education, Age, Religious Activity,

Voluntary Organisations, Trust, Governance

Measures, Individual and National Incomes



Marginal utility of consumption

• The marginal utility of consumption explains how total utility changes when consumption changes by one unit. It is therefore given by the ratio of the change in total utility and the change in consumption:

MU

C





U



C



Total Utility



Indifference Curves



Consumption Choices: Average preferred to Extremes



Household Maximisation



Consumption Smoothing

• What are the predictions of the utility maximising household model for aggregate consumption?

• First, the link between current income and consumption strongly advocated by the Keynesian consumption function is broken.

• Second, we expect to see evidence of consumption smoothing . This is a consequence of the law of diminishing marginal utility of consumption which pushes the household to prefer averages over extremes. The household would find it optimal to use borrowing and saving to achieve this end.



Net saver



Net borrower



The Life Cycle Hypothesis

• Franco Modigliani applies the consumption smoothing result to the pattern of lifetime consumption and income.

• In terms of income, a lifetime can be split into three distinct periods. The first corresponds to young age when little or no income is earned. Then, it is followed by a relatively long period of working life when income tends to rise with experience and seniority. Finally, before death there is a retirement period when income once again drops to nothing or near zero.



LCH



The Permanent Income Hypothesis

• Milton Friedman’s important contribution argues that measured income consists of two parts, permanent income and transitory income:

Y



Y

P 

Y

T



PIH

• The main predication of the PIH is that the household uses borrowing and saving in order to smooth out transitory income fluctuations, so consumption decisions will only be based on permanent income:

C

 c

P

Y

P



Predictions of the PIH

• The theory predicts that the marginal propensity to consume out of permanent income will be much higher than the marginal propensity to consume out of measured income, with empirical estimates c



1

• The short run consumption function (based on measured income) is much flatter than the long run consumption function (based on permanent income).



Short-run and Long-run

Consumption Functions



Explaining Consumption Patterns

• Changes in Current Income

• Other Factors Determining Consumption

• Changes in Future Income

•

Interest rates: Substitution and Income effects

•

Financial Market Constraints

• Financial Markets Deregulation

• Wealth

• Uncertainty and Precautionary Saving



Changes in Current Income



Other Factors Determining

Consumption

• An interesting, and often used, statistic for analysing consumer behaviour is the saving ratio . The saving ratio is simply the proportion of income that is saved, or . If it assumed that all income is either consumed or saved, then it must be true that:

C



S



Y



Saving ratio

• Thus, the saving ratio is:

S

Y



1



C

Y

• An analysis of the saving ratio enables us to observe changes in consumption other than those generated by changes in current income.



Saving ratio for the UK



Changes in Future Income

• Changes in future income will have exactly the same effects on the intertemporal budget constraint as changes in current income.

• A good indicator is the unemployment rate.



Saving ratio & Unemployment rate, UK



Consumer confidence & Consumer expenditure, UK



Interest rates

• The effect of interest rate changes are easily predicted using our two period consumption model. Interest rates represent the costs of borrowing and the returns to saving, and can be thought of as the price of moving income or resources over time.



Change in Interest rates



Impact on consumption

• Substitution effect: The interest rate represents the price of current consumption in terms of future consumption.

• Income effect: the direction depends on whether the consumer is initially a net borrower or a net saver.

• The overall effect of interest rates on consumption will therefore depend on whether the household is initially a net borrower or a net saver.



Net Saver



Net borrower



Saving ratio and Interest rate, UK



Empirical Evidence

• Empirical evidence tends to suggest that interest rate changes have small substitution effects on the timing of consumption, and therefore the income effect is usually dominant. Therefore, a rise in interest rates would increase the current consumption of net savers but reduce that of net borrowers.

• The evidence indicates that the saving ratio and the interest rate share a positive association. This would tend to indicate that most households are in fact net borrowers, so current consumption will respond inversely to interest rate changes.



Financial Market Constraints

• The presence of borrowing constraints has two interesting implications for the determination of consumption.

• The first is that even though households may be rational optimisers, the pattern of consumption will follow the predictions of the Keynesian model in being fairly tied to current income. Credit constrained households may wish to borrow against future income to increase current consumption but cannot. They will only be able to consume more when their current income increases.

• The second is that changes in the laws and regulations governing credit creation may lead to sudden large jumps in consumption.



Financial market deregulation in the

UK



Wealth

• If a household, in addition to their income, also has some initial wealth, this can be added to the intertemporal constraint:

C

1





1

C



2 r





W

1



Y

1



Y

2



1

 r





House Prices in the UK



Mortgage equity withdrawal, UK



UK stock market performance and pension funds



Market value of pension funds, UK



Global Applications 2.3

•

Consumption and Stock Markets in the

U.S.

• The dramatic movements in the stock market during the second half the 1990s and the beginning of the new millennium have ignited policymakers’ interest in the link between consumption and wealth, and particularly consumption and stock market prices, particularly the Dot Com bubble.



Wealth, Income, Consumer

Expenditure in the U.S.



Stock Markets and Wealth, U.S.



Composition of HH Wealth, U.S.



Uncertainty and Precautionary Saving

• One of the most powerful motivations for saving is in order to take precautions against uncertain future events. The saving for a rainy day argument is at the heart of the theory of precautionary saving .

• An increase in uncertainty about future income by reducing its certainty equivalence would have the same effect as a fall in its expected future value. Current consumption will fall and the saving ratio will rise, as households transfer resources to the future in order to cover the effects of uncertainty. Precautionary saving may provide an additional reason as to why the saving ratio may share a similar trend to the rate of unemployment.



Total Utility and Certainty

Equivalence



Global Application 2.6

•

The Econometrics of the Permanent Income

Hypothesis: Random Walk

• In a seminal paper by Robert Hall (1978), he argues that if the PIH is correct, then changes in consumption over time should be unpredictable.

This is because at any instance the future path of consumption already reflects the household’s complete information, so the only thing that will lead to a change in consumption is the arrival of new information that was previously unknown.

Therefore, consumption should follow a process known as a random walk .



Summary

• This chapter has outlined and applied the main theories accounting for consumer behaviour.

• The traditional model is the Keynesian consumption function which suggests that aggregate consumption is a linear function of the aggregate income. The empirical evidence tends to support a strong link between consumption and disposable income, especially over time.

• Shifts in the consumption function can result from any factor that changes autonomous consumption. These will predominately include wealth changes implying a higher level of consumption at every level of income.



Summary

• Objections to the Keynesian consumption function arose because it was at odds with the theory of rational choice.

This argues that consumption decisions should be consistent with households maximising lifetime utility and the main result is that households will base consumption decisions not just on current income but a longer term view of income. It also opens up an appealing role for expectations to play in determining consumption.

• Due to the law of diminishing marginal utility of consumption, the optimal consumption model suggests that households will save and borrow in order to smooth consumption over their lifetimes. This is the main prediction behind the Permanent Income Hypothesis and the Life Cycle Hypothesis.



Summary

• The optimal consumption model can also be applied to analyse a multitude of factors that might produce changes in consumption. These include changes in expected future income, changes in interest rates which produce income and substitution effects and have different consequences for savers and borrowers and changes in wealth which might arise from movement in house or financial assets prices.

• The impact of uncertainty on the precautionary saving motive was introduced, which showed that the effects of greater uncertainty over income can have similar effects as lower expectations.



Chapter 2 - Cengage Learning

Macroeconomics

Consumption

Learning Objectives

Aggregate Demand

Consumer Expenditure, UK

Autonomous Consumption

Marginal Propensity to Save

Change in Income

Change in Income

MPC+MPS=1

Global Application 2.1

GA 2.1

Income and disposable income

Lump sum taxes

Optimal Consumption Model

Optimal Consumption

Intertemporal Budget Constraint

Two period budget constraint

Two period budget constraint

Rewriting the I.B.C.

Intertemporal Budget Constraint

Intertemporal Budget Constraint

Intertemporal Budget Constraint

Consumer Preferences

Lifetime utility function

Global Applications 2.3

Marginal utility of consumption

Total Utility

Indifference Curves

Household Maximisation

Consumption Smoothing

Net saver

Net borrower

The Life Cycle Hypothesis

LCH

PIH

Predictions of the PIH

Changes in Current Income

Saving ratio

Saving ratio for the UK

Changes in Future Income

Interest rates

Change in Interest rates

Impact on consumption

Net Saver

Net borrower

Empirical Evidence

Financial Market Constraints

Wealth

House Prices in the UK

Mortgage equity withdrawal, UK

Global Applications 2.3

Stock Markets and Wealth, U.S.

Composition of HH Wealth, U.S.

Global Application 2.6

Summary

Summary

Summary

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