# 1. Keynes s s Conjectures

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1 CONSUMPTION Most prominent work on consumption: 1. John Maynard Keynes: consumption and current income 2. Irving Fisher and Intertemporal Choice 3. Franco Modigliani: the Life-Cycle Hypothesis 4. Milton Friedman: the Permanent Income Hypothesis 5. Robert Hall: the Random-Walk Hypothesis slide 0 1. Keynes s s Conjectures 1. 0 < MPC < 1 2. APC falls as Y rises APC = average propensity to consume 3. C = f ( Y ) only slide 1 The Keynesian Function C C C cy 1 c c = MPC C Y slide 2 1

2 Early Empirical Successes Households with higher incomes: consume more MPC > 0 save more MPC < 1 save a larger fraction of their income APC as Y S/Y=1-C/Y rises as Y rises Strong correlation between income and consumption slide 3 Later: The Puzzle C/Y is stable in long time series data. C Long-Run consumption function Short-run consumption function Y slide 4 2. Basic two-period model (Fisher) Consumer: max u(c 1,c 2 ) Subject to intetermporal budget constraint Period 1: the present Period 2: the future Notation Y 1 is income in period 1 Y 2 is income in period 2 is consumption in period 1 is consumption in period 2 S = Y 1 is saving in period 1 (S < 0 if the consumer borrows in period 1) slide 5 2

3 The intertemporal budget constraint Period 2 budget constraint: = ( Y 1 )(1+r) + Y 2 Rearrange: C2 Y2 C1 Y1 1 r 1 r slide 6 The intertemporal budget constraint (1 r) Y Y 1 2 What is the slope? Y 2 Y 1 Y 1 2 r) (1 slide 7 Consumer preferences What is the slope? I I slide 8 3

4 Optimization MRS = 1+r O slide 9 How C responds to changes iny If today s income rises, consumption will rise both today and tomorrow slide 10 How C responds to changes inr income effect If consumer is a saver, the rise in r makes him better off, which tends to increase consumption in both periods. substitution effect The rise in r increases the opportunity cost of current consumption, which tends to reduce and increase. Both effects. : ambiguous slide 11 4

5 Constraints on borrowing In Fisher s theory, timing of income is irrelevant Example: If consumer learns that her future income will increase, she can spread the extra consumption over both periods by borrowing in the current period. However, if there are borrowing constraints consumption may behave as in the Keynesian theory even though she is rational & forward-looking slide 12 Constraints on borrowing Borrowing constraint: Y 1 If Y 2 rises. may not be able to increase Y 2 Y 1 slide 13 Consumer optimization when the borrowing constraint is binding D : unconstrained choice E: constrained E D Y 1 slide 14 5

6 1 vs 2: Keynes vs. Fisher Keynes: C = f (Y) Fisher: C = f (Y 1, Y 2, r) slide Life-Cycle Hypothesis (Modigliani) Income varies systematically over the phases of the consumer s life cycle Saving allows the consumer to achieve smooth consumption. The basic model: W = initial wealth Y = annual income until retirement (assumed constant) R = number of years until retirement T = lifetime in years Assumptions: zero real interest rate (for simplicity) consumption-smoothing is optimal slide 16 Life-Cycle Hypothesis Lifetime resources = W + RY To achieve smooth consumption C = (W + RY )/T C = W + Y = (1/T ) = MPC out of wealth = (R/T ) = MPC out of income slide 17 6

7 The Life-Cycle Hypothesis \$ Wealth Income Saving Dissaving Retirement begins End of life slide 18 Implications of the LCH LCH and the consumption puzzle: APC C/Y = (W/Y ) + Rich households W/Y low Poor households W/Y high APC falling cross-sectionally Over time, aggregate wealth and income grow together APC stable. slide Permanent Income Hypothesis (Friedman 57) PIH : Y = Y P + Y T permanent income Y P (average income people expect to earn in their life) transitory income Y T Consumers save & borrow to smooth consumption in response to transitory shocks The PIH consumption function: C = Y P = fraction of permanent income that people consume per year. slide 20 7

8 PIH PIH APC = C/Y = Y P / (Y T + Y P ) Rich (poor) households Y T high (low) Then APC falling cross-sectionally Over time, Y T negligible, which implies a stable APC. Can solve consumption puzzle slide 21 3 vs 4 : PIH vs. LCH In both, people try to achieve smooth consumption in the face of changing current income. LCH : current income changes systematically throughout life cycle. PIH : current income is subject to random, transitory fluctuations. Both can explain the consumption puzzle. slide The Random-Walk (Hall, 1978) based on Fisher & PIH, in which forwardlooking consumers base consumption on expected future income Hall adds the assumption of rational expectations slide 23 8

9 The Random-Walk Hypothesis If PIH is correct and consumers have rational expectations, then consumption should follow a random walk Anticipated Y changes will not change C. Only unanticipated changes in Y or W that alter expected permanent income will change C IMPLICATION Only unexpected policies will have real effects slide 24 Chapter summary Keynes suggested that consumption depends primarily on current income. Recent work suggests instead that consumption depends on current income expected future income wealth interest rates Economists disagree over the relative importance of these factors and of borrowing constraints and psychological factors. slide 25 9

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