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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. 2 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. 9 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 10 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. z0 Budget constraint: D D -z (1 r ) C (1 r ) Yz z -z z0 z0 Discount rate on utility (δ) = real interest rate (r) = 0 11 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. 12 Initial Solution C, Y, S Diagram of Life Cycle Model Showing Consumption Smoothing Income, Y Consumption, C Saving, S | 0 R age | D 13 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 14 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 15 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 17 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 19 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. 20 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 21 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. 22 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 23 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) 24 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? 25