EC210 Macro Flashcards
Keynesian Consumption Function
• The Keynesian consumption function states that consumption depends on current income: C = a + bY, where a>0 and 0<b>0, when Y increase, APC falls
• The average propensity to save: APS = 1-APC
• So, falling APC implies rising APS
• Keynes: “it is also obvious that a higher level of absolute level of income… will lead, as a rule, to a greater proportion of income being saved”
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Consumption puzzle
- What is the empirical relationship between consumption and current income?
- Studies did not find a consistent and stable relationship
- Across households at a point in time, they found that APC was falling
- But within a country over time, APC was constant
- This is Kuznets consumption puzzle
Dynamic consumption theories
- Milton Friedman: Permanent income theory of consumption
- Franco Modigliani: Life-cycle theory of consumption
- Both theories highlight the role of permanent or life-time income in determining consumption
A two-period model of consumption
- A two-period model provides a simple way to illustrate the key features of dynamic theories of consumption. It captures:
- The idea of “dynamic optimisation”
- The difference between “permanent/lifetime” income and “current” income
- Period 1 = 1 present
- Period 2 = 2 future
Increase in current vs. future income
- Both have positive income effects: current and future consumption increase
- The consumer acts to smooth consumption over time
- When current income increases, saving increases
- When future income increases, saving decreases
Temporary vs. permanent increase in income
- As a permanent increase in income will have a larger effect on lifetime wealth than a temporary increase, there will be a larger effect on current consumption
- A consumer will tend to save most of a purely temporary income increase
Solving the consumption puzzle
- Falling APC across households and constant APC over time
- Across households, much of the variation in income reflects factors such as unemployment and the fact that households are at different points in their life cycles
- Over time for the aggregate economy, almost all variation in aggregate income reflects long run growth, i.e. permanent increases in the economy’s resources, because transitory components across households cancel out
Life-cycle theory of consumption
- Income varies systematically over the phases of the consumer’s “life cycle”, so consumers plan over their entire lifetime to achieve smooth consumption
- Hence consumption depends on life-time income and saving is used to achieve smooth consumption
- If changes in current income have a very small impact on life-time income, they have very little impact on consumption
- Life-cycle pattern: borrow when young (income is low), save during middle age (income is high), and dis-save during old age (retirement)
Permanent income theory of consumption
Current income is the sum of:
• Permanent income: average income, which people expect to persist into the future
• Transitory income: temporary deviations from average income
• Permanent income is the level of consumption that can be sustained, and this is what would be chosen by individuals who would like to smooth consumption
• If changes in current income are mainly transitory they have very little impact on consumption
• A positive transitory shock goes into saving while a negative transitory shock implies dis-saving or borrowing
Aggregate consumption smoothing?
- If there are transitory changes in aggregate income (e.g. business cycles) then the theories also predicts smoothing of aggregate consumption
- Empirically, aggregate consumption of non-durables and services is smooth relative to aggregate income, but the consumption of durables is more volatile than income
- But durables consumption is economically more like investment than consumption
- But aggregate consumption is not much smoother than income, even for short-live business cycle episodes (interest rate changes? Credit-market imperfections?)
An increase in the real interest rate
- A higher real interest rate increases the relative price of current consumption
- This leads to both income and substitution effects
Solving the two-period model
- The optimal choice of consumption today equates the marginal cost with the marginal benefit
- The optimal consumption level of any two goods must equate their marginal rate of substitution to their relative price, i.e. the indifferences curve is tangent to the budget line
- To solve for c and c’ explicitly, we need to know the utility function u(c.)
- The key parameter in the utility function is the inter-temporal elasticity of substitution, which determines how “smooth” the optimal consumption pattern is
- Consider the case that inter-temporary elasticity of substitution is equal to one (logarithmic utility): u(c.) = ln(c.)
- The solution implies that current consumption depends on lifetime wealth
- The effect of changes in current income (y) on current consumption depends on how y affects wealth
- This result can be easily extended to a model with T periods. The larger is T, the smaller is the effect of current income y on wealth, so the smaller is the effect of y on c
Ricardian Equivalence
- The Ricardian Equivalence proposition states that a change in timing of taxes by the government has no effect on consumption
- A key message is that a tax cut is not a free lunch
- Trying to stimulate the economy through debt financed spending does not change demand
The government present-value budget constraint
- Add government to the two-period model
- The government’s current-period budget constraint is: G = T(tax) + B(borrowing)
- The government’s future-period budget constraint is: G’ + (1+r)B = T’
- So the government’s present-value budget constraint is: G + G’/1+r = T + T’/1+r
Competitive Equilibrium
- Total private saving is equal to the quantity of government bonds issued in the current period: Sp = B
- Credit market equilibrium implies that the income-expenditure identity holds: Y = C + G
