Macroeconomic Theory
Consumption
Attendance
Agenda
1
Consumption data
2
The Keynesian Consumption Function
3
Goods Market Equilibrium
4
Review and to Do
Attendance
Review
Consumption Data
- PCE
- durable goods
- non-durable goods
- services
- CE
- household interview data
- does not impute or use NPISHs
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(YD)
Often specified as:
C=c0+c1YD where:
c1 is the average propensity to consume out of current income
c0 is the portion of consumption NOT attributable to current income
Total Demand
Total demand in the economy is:
Z=C+ˉI+ˉG+¯NX
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 decrease production next period
If inventories are drawn down because Y<Z, we can assume producers will increase production next period
If inventories are at target because Y=Z producers will not change production (equilibrium)
Deriving Equilibrium
Y=Z
Y=cc+c1(Y−T)+ˉI+ˉG+¯NX
Y−c1Y=c0−c1T+ˉI+¯NX
Y=11−c1(c0−c1T+ˉI+ˉG+¯NX)
The Mulitplier and Autonomous Spending
Y=11−c1(c0−c1T+ˉI+ˉG+¯NX)
We call (c0−c1T+ˉI+ˉG+¯NX) autonomous spending
We call 11−c1 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 principle 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
Consumption Practice
Suppose the consumption equation is represented by the following: C=250+.8YD Assume that investment, govenment spending, and net exports can be described as: I=100
G=50
T=100
NX=0
- What are the values of c0 and c1?
- Solve for equilibrium GDP
- Plot equilibrium
- What is the multiplier in this economy?
- What is private savings (YD−C) in equilibrium?
- Assume that consumers try to increase savings by reducing autonomous consumption by 50. What is the effect on private savings?
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
ΔC→ΔY
- Period 2
c1(ΔY)
- Period 3
c1(c1ΔY)
- Period 4
c1(c1(c1(ΔY)))
Summing the series
ΔY+c1(ΔY)+c21(ΔY)+c31(ΔY)+…+cn1(ΔY) Extracting Y ΔY(1+c1+c21+…+cn1)
As the series approaches its limit:
ΔY(11−c1)
Forward Looking Consumption
Some problems with the simple Keynesian consumption function
- The Keynesian consumption function implies that the average propensity to consume:
CYd=c0+c1YdYd
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 W and lifetime earnings R×Y
C=W+RYT
C=(1/T)W+(R/T)Y
If all consumers do this, aggregate income looks like:
C=αW+βY in other words, wealth is now our C0
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
Y=YP+YT
Where YP is permanent income, and YT 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 realted 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
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.
