The economics of consumption
1
Notes on the mid-term exam
The midterm examination is Wednesday October 21, 11:35 – 12:50.
All information posted on the course web site.
Coverage: It will cover all materials through the material on Consumption
(which will be covered through October 19).
Format (the following is indicative only):
There will be three parts.
First section will be “shorties”: definitions, true-false, compare, or the like.
The other sections will be problems and thought questions.
Sample midterm and solution will be posted
Review sessions:
A schedule will be posted online
Prof review session here on Friday.
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Logistics
Econ122a. Midterm logistics
Date
Time
Place
Name
review
review
review
review
16-Oct
19-Oct
19-Oct
19-Oct
11:35-12:50 pm
2:30 - 3:30 pm
5:30 - 6:30 pm
6:30 - 7:30 pm
DL220
BCT CO31
BCT CO31
WLH 117
Nordhaus
Federico
Chris
Melanie
review
20-Oct
5 - 9:00pm
WLH208
All
exam
exam
21-Oct
21-Oct
11:35-12:50 pm
11:35-12:50 pm
LC102
DL220
A-L
M-Z
3
Importance of consumption in macro
1. Consumption is two-thirds of GDP –
understanding its determinants is major part
of the ball game.
2. Consumption is the entire point of the
economy:
3. Consumption plays two roles in
microeconomics:
a. It is a major part of AD in the short run:
recall IS curve in which
Y = C(Yd) + I + G + NX
b. What is not consumed is saved and
influences national investment and economic
growth
4
Growth in C and GDP
Rate of growth per year
.08
.06
.04
.02
.00
Consumption
GDP
-.02
-.04
1970
1975
1980
1985
1990
1995
2000
2005
2010
5
The importance of fiscal policy today
When the economy is in a liquidity trap and recession, major available
policy tool is fiscal policy (remember IS-LM and Summers quote)
But, fiscal policy has multiple problems:
Purchases:
- Controversial because increase size of government
- Long lags (recognition, decision, implementation)
- Infrastructure and other programs have long gestation periods.
Tax Cuts:
- One view: people will smooth consumption, and even anticipate a
future tax increase, and there will be little or no response.
- Other view: people are short-sighted and/or liquidity constrained,
and they will spend a substantial fraction of increased incomes
Here is where we need to study carefully the economics of
consumption.
6
Alternative Theories of Consumption
The basic Keynesian insight is that consumption depends
fundamentally on personal income (“consumption function”)
This enters into the Keynesian models as C = α + βYd
On a closer look, a major puzzle: the short-run and cross-sectional
consumption functions looked very different from the long-term
consumption function.
7
Short-run v. Long-run Consumption Function
Mankiw, p. 499.
8
Alternative Theories of Consumption
The basic Keynesian insight is that consumption depends
fundamentally on personal income (“consumption function”)
This enters into the Keynesian models as C = α + βYd
On a closer look, a major puzzle: the short-run and cross-sectional
consumption functions looked very different from the long-term
consumption function.
There are four major approaches in macroeconomics:
*1. Fisher's approach: sometimes called the neoclassical model
2. Keynes original approach of the consumption function
*3. Life-cycle or permanent income approaches (Modigliani,
Friedman)
4.Rational expectations (Euler equation) approaches (Hall, Barro,...)
*We will sketch the life cycle model in class; Fisher in Mankiw and
section.
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Consumption and Disposable Income
Real personal consumption expenditures
10,000
8,000
6,000
4,000
2,000
0
0
2,000
4,000
6,000
8,000
10,000
Real personal disposable income
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Basic Assumptions of Life Cycle Model
Basic idea:
People have expectations of lifetime income; they determine their
consumption stream optimally; this leads consumers to “smooth”
consumption over their lifetime.
Assumptions:
“Life cycle” for planning from age 0 to D.
Earn Y per year for ages 0 to R.
Retire from R to D.
Maximize utility function:
D
max V(C1 , C 2 , ..., C D )   ( 1   ) z U( C z ), for ages z  0 to D.
z0
Budget constraint:
D
D
-z
(1

r
)
C

(1

r
)
Yz


z
-z
z0
z0
Discount rate on utility (δ) = real interest rate (r) = 0
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Techniques for Finding Solution
1. Two periods:
max U(C1 )  U(C2 )  U(C1 )  U(Y1  Y2 - C1 )
{Cz }
Maximizing this leads to U’(C1)=U’(C2). This implies that C1 = C2 ,
which is consumption smoothing. The Cs are independent of
the Ys.
2. Lagrangean maximization (advanced math econ):
D
 D
-z
max L C1 ,...,CD  =  (1+ δ) U(C z ) + λ   (1+ r ) C z -  (1+ r )-z Yz

{C z }
z=0
z=0
 z=0
D
-z




Maximizing implies that U’(C1)=U’(C2)=λ. This implies that Ct  C
which again is consumption smoothing independent of Y.
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Initial Solution
C, Y, S
Diagram of Life
Cycle Model
Showing
Consumption
Smoothing
Income, Y
Consumption, C
Saving, S
|
0
R
age
|
D
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Anticipated change in timing of income
C, Y, S
Income “splash” with no W increase (Y’)
Income, Y
Anticipated income
change of ΔY.
Because it is
anticipated, no
change in lifetime
income, so no
change in
(smoothed)
consumption. MPC
= 0; MPS = 1.
Consumption, C’=C
Saving, S’
|
R
0
age
|
D
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Unanticipated change in permanent income
C, Y, S
Y’ =unanticipated increase; W increases.
Unanticipated windfall
of ΔY.
Leads to smoothing
the windfall over
remaining
lifetime.
(a) one time splash:
MPC = ΔY/(D-z).
For life
expectancy of 40
years, would be
MPC = .025.
(b) Permanent
income increase:
MPC = ΔY(Rz)/(D-z) = .6 to .8
Y
C’
C
|
R
0
age
|
D
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Example of the Life Cycle Model at Work:
• How would the consumption and saving of people with volatile or
stable income streams look?
• See figure for Entrepreneur Ghates and Professor Nerd.
16
Major result of LCM: consumption smoothing
Y: Entrepreneur
Y: professor
C of both!
age
R
D
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Further Extensions
1. Liquidity constraints
– Case of Yale students where income growing rapidly
– Here consumption is limited by borrowing constraint
2. The impact of taxes:
– What is the impact if taxes are anticipated and paid back during
lifetime? No impact! MPC from taxes = 0.
• see 2008 temporary tax cut
– Barro (Ricardian) model extends this to future generations.
18
Example of consumption smoothing: the 2008 tax rebate
Changes in C, DY, and S
800
600
C
DY
S
Estimated MPC= 0.07 (0.04)
400
200
0
-200
-400
06M01
06M07
07M01
07M07
08M01
08M07
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Further Extensions
3.Wealth effects:
Examples: How would you spend an unanticipated inheritance of
$1m? What is MPC of “trust-fund babies”? What would be the
effect of stock-market decline or housing bubble and burst?
- Life cycle model predicts that initial wealth (or surprise
inheritances) would be spread over life cycle.
• Intuition: an inheritance is just like an income splash.
- So the augmented life cycle model is
p
Ct = β0 + β1 Y t + β2 Wt
p
where Y t is permanent or expected labor income and Wt is
wealth.
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What is the Effect of Stock Market
Booms and Busts on Consumption?
Price-earnings ratios, US
40
Roaring 20s
50
30
10
Roading 90s
20
0
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
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The stock market, the housing market, and consumption
• Economists think that the bursting of the stock market bubble in
2000 or the housing market today contributed to recessions.
• Reasons? Decline in consumption (today) and investment (later)
• Rationale: the “wealth effect” on consumptoin
• Analysis in the life-cycle model:
p
– In augmented life-cycle model Ct = β0 + β1 Y t + β2 Wt
standard estimates are that β2 = .03 - .06 (example in a minute)
– Effect in the “Roaring 90s” and the housing crash today.
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Regression
Dependent Variable: Real consumption expenditures
Method: Least Squares
Sample: 1952.1 2009.2
Variable
Coefficient
Std. Error
P
Real Disposable income
0.63
0.026
.0000
Real wealth
0.024
0.0032
.0000
R-squared
0.9983
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Wealth and Consumption through Two Bubbles
Billions of 2005 $
12,000
500
Burst of housing
bubble; financial 400
crisis
8,000
4,000
300
0
200
-4,000
100
-8,000
-12,000
-16,000
0
Tech stock
bubble
98
99
00
01
02
-100
03
04
05
06
07
08
09
-200
Change in real HH wealth (left scale)
Change in consumption (right scale)
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Key ideas
1.
2.
3.
4.
5.
6.
Consumption derived from consumer maximization
Pure model leads to consumption smoothing
All kinds of fun predictions
But impediments to pure model
Remember the wealth effect
Big open issue: how big is the short-run MPC?
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