Macroeconomic Theory

Consumption

Nathaniel Cline

Agenda

1

Consumption data

2

The Keynesian Consumption Function

3

Goods Market Equilibrium

4

Review and to Do

Consumption in the National Accounts

  • In the national accounts compiled by the BEA, consumption is called: Personal Consumption Expenditures (PCE)

  • This is misleading though, as “persons” can refer to nonprofit institutions serving households (NPISHs)

  • It also includes third party spending on behalf of households (employer health insurance, Medicaid, etc…)

  • PCE also includes “imputed” purchases like owner’s equivalent rent

PCE types

  • Services: commodities that cannot be stored or inventoried and that are usually consumed at the place and time of purchase.

  • Durable goods: Tangible products that last at least 3 years

  • expensive, easily postponed, often financed on credit

  • Nondurable goods: Tangible products that last less than 3 years

Consumption in the CE

The BEA conducts a consumer expenditure survey whose main differences include:

  • Not counting NPISHs

  • Survey of households, not collected from industry

  • Not imputing housing

And so on…

It also collects income and demographic information

Income

\[ Y_D = Y - T \]

Where:

\(Y\) is real income

\(T\) are taxes next of transfers

So:

\(Y_d\) is disposable income

Consumption

Keynes proposed that on average, consumption was closely related to current income, but would not move 1 for 1 will current income:

\[C=C(Y_D)\]

Often specified as:

\[ C = c_0 + c_1Y_D\] where:

\(c_1\) is the average propensity to consume out of current income

\(c_0\) is the portion of consumption NOT attributable to current income

Defining Total Demand

For a moment, assume all other expenditures in the economy are fixed:

\(I = \bar{I}\)

\(G = \bar{G}\)

\(NX = \bar{NX}\)

Total demand in the economy is:

\[Z= C + \bar{I} + \bar{G} + \bar{NX}\]

\[Z= c_0 + c_1Y_D + \bar{I}+ \bar{G} + \bar{NX}\]

\[Z= c_0 + c_1(Y-T) + \bar{G} + \bar{I} + \bar{NX}\]

A Note on Inventories

\[Z= c_0 + c_1(Y-T) + \bar{G} + \bar{NX}\]

For the moment, assume that Z, as written above, excludes changes in inventories (goods in process or ready for sale but not sold)

This means that when:

\[Y = Z\]

Inventory accumulation/decumulation is zero

Equilibrium and Inventories

We assume that producers make predictions about demand and have a target inventory

These two considerations help them determine the amount to produce

However, they could be wrong, in which case inventories will either be drawn down or pile up

Equilibrium and Inventories

If inventories pile up because \(Y>Z\), we can assume producers will increase production next period

If inventories are drawn down because \(Y<Z\), we can assume producers will decrease production next period

If inventories are at target because \(Y=Z\) producers will not change production (equilibrium)

Equilibrium Algebraically

Deriving Equilibrium

\[ Y = Z \]

\[Y = c_c + c_1(Y-T) + \bar{I} +\bar{G} + \bar{NX}\]

\[Y - c_1Y = c_0 -c_1T + \bar{I} + \bar{NX}\]

\[Y = \frac{1}{1-c_1}(c_0 - c_1T + \bar{I} + \bar{G} + \bar{NX})\]

The Mulitplier and Autonomous Spending

\[Y = \frac{1}{1-c_1}(c_0 - c_1T + \bar{I} + \bar{G} + \bar{NX})\]


We call \((c_0 - c_1T + \bar{I} + \bar{G} + \bar{NX})\) autonomous spending


We call \(\frac{1}{1-c_1}\) the multiplier

The Multiplier

  • The multiplier implies that a change in autonomous spending will cause an even larger change in equilibrium GDP

  • Spending creates income which then induces further spending

  • This priniciple is at the core of a lot of macroeconomic policy making

  • You can think of autonomous spending as a splash, and the multiplier as ripples

Equilibrium Graphically

Adjustment to Equilibrium

Adjustment

  • The adjustment of output over time is called the dynamics of adjustment.

  • How long the adjustment takes depends on how and when firms revise their production schedule.

  • In other words, the full multiplier effect won’t happen immediately.

Effects of a change in spending over time

  • Period 1

\[\Delta C \rightarrow \Delta Y\]

  • Period 2

\[c_1(\Delta Y)\]

  • Period 3

\[c_1(c_1 \Delta Y)\]

  • Period 4

\[c_1(c_1 (c_1 (\Delta Y)))\]

Summing the series

\[\Delta Y + c_1(\Delta Y) + c_1^2 (\Delta Y) + c_1^3 (\Delta Y) + \ldots + c_1^n(\Delta Y)\] Extracting Y \[\Delta Y (1 + c_1 + c_1^2 + \ldots + c_1^n)\]

As the series approaches its limit:

\[\Delta Y (\frac{1}{1-c_1})\]

Review

1

Consumption data

2

The Keynesian Consumption Function

3

Goods Market Equilibrium

To-Do

  • Read pp.250 - 259 in “Consumption and Investment”

  • Read “The Mysterious Disappearance of James Duesenberry”

  • We will do some practice consumption problems in-class next week with a homework due on Wednesday