Macroeconomic Theory

Some problems with the simple Keynesian consumption function

The Keynesian consumption function implies that the average propensity to consume:

So that as income rises, consumption becomes a declining share of total income
But as you have seen in your homeworks, consumption is a roughly constant (and recently increasing!) share of total income

The role of interest rates?

As we saw earlier, the classical theorists thought that interest rates played a big role in decisions to save and therefore consume.
But the interest rate plays no role in the Keynesian story

Why do people save?

People save because they think they will need money in the future
Macroeconomists often think of the decision to save as a decision to consume later
though there are some issues with this
Some economists have thus argued that consumption should in general depend on a consumers vision of the future

Life Cycle Savings

In a series of papers in the 1950s Franco Modigliani argued for a life cycle style consumption function
Saving allows consumers to move income from those times in life when income is high to those times when it is low.
Most people plan to stop working at about age 65, and they expect their incomes to fall when they retire. To maintain consumption, people must save during their working years.

Stable consumption over a lifetime

Suppose a consumer expects to live another T years, has wealth of W, and expects to earn income Y per year until he retires R years from now.
lifetime resources are composed of initial wealth and lifetime earnings

If all consumers do this, aggregate income looks like:

in other words, wealth is now our

Resolving the puzzle

While income increases in the short run, sure higher income corresponds to a lower average propensity to consumer
Over the long run though, income grows wealth, which shifts the consumption function up

Permanent income hypothesis

In a book published in 1957, Milton Friedman proposed the permanent-income hypothesis

Where is permanent income, and are transitory fluctuations in income

Friedman argued that permanent income will have much larger influence than transitory

Implications

According to the permanent-income hypothesis, the average propensity to consume depends on the ratio of permanent income to current income.
When current income temporarily rises above permanent income, the average propensity to consume temporarily falls; when current income temporarily falls below permanent income, the average propensity to consume temporarily rises.

Implications for the multiplier

Future oriented theories of consumption imply that government stimulus may not be as effective as the Keynesians suggested
In particular, if a tax cut or increase in government spending is a short term even (like stimulus checks), it will be primarily saved because it does not increase lifetime income
But it does imply that financial markets could play a big role in consumption

The Data

In practice consumption seems to be more volatile and more closely related to short term changes in income than future oriented theories predict.

Why?

Durable Goods

Durable goods tend to be very very volatile and closely related to short term income.

Three kinds of considerations:

Real interest rate
Credit availability
Uncertainty about future income

Credit Rationing

But even non-durables are more sensitive than we would expect.
One reason is that households must have large prior wealth, or access to credit to smooth consumption
Many households do not have stocks of wealth, and even more importantly, credit is often rationed
In part this is because of imperfect information

Credit Rationing

Stiglitz and Weiss (1981)

Credit rationing occurs when people are unable to obtain funds at the relevant market rate of interest
Imperfect information may lead to demands for equity or collateral from borrowers
- Banks only lend to those who don’t need the money!
We will cover this in more detail later

Duesenberry

As you read, Duesnberry had an alternative explanation to Friedman and others
If the rich save at higher rates than poor, why doesn’t saving rise as everyone becomes richer?
Duesenberry’s explanation of the discrepancy is that poverty is relative. The poor save at lower rates, he argued, because the higher spending of others kindles aspirations they find difficult to meet.
Duesenberry argued that families look not only to the living standards of others, but also to their own past experience

In sum

We can say:

Consumers try to smooth consumption

Wealth matters
Access to credit matters
Consumption is still pretty closely related to current income.

Macroeconomic Theory

Attendance

Agenda

Attendance

Reminder: Exam on Thursday of Next Week

Quick Practice

Forward Looking Consumption

Some problems with the simple Keynesian consumption function

The role of interest rates?

Why do people save?

Life Cycle Savings

Stable consumption over a lifetime

Resolving the puzzle

Permanent income hypothesis

Implications

Implications for the multiplier

The Data

Durable Goods

Credit Rationing

Credit Rationing

Duesenberry

In sum

Investment

Investment in the National Accounts

Inventories

The Significance of Investment

What determines investment spending?

Expected income

The cost of investment

Sources of Funds

Present value

Present value calculations

The Interest Rate

How Sensitive is Investment to Interest Rates?

Why is investment not sensitive to interest rates?

Review and To Do

Review