B3 - Consumption

Question 1

WHAT IS THE FUNCTION OF CONSUMPTIONS TO DISPOSABLE INCOME?

Answer 1

C=C(Y-T)

Question 2

What are the ideas of 5 prominent economists?

Answer 2

1. John Maynard Keynes
2. Franco Modigliani
3. Milton Friedman
4. Robert Hall
5. David Laibson

Question 3

WHAT IS JOHN MAYNARD KEYNES THREE CONJECTURES? (APPROACH 1)?

Answer 3

1. The MPC (dc/dy) is between 0 and 1
2. The average propensity to consume (C/Y) falls as income rises.
   -> For the rich, save proportionally more than the poor, saving is seen as luxuary.
3. Income is primary determinant of consumption and interest rates do not play an important role.

Question 4

WHAT IS THE KEYNESIAN CONSUMPTION FUNCTION?

Question 5

WHAT IS THE NOTATION OF THE KEYNESIAN CONSUMPTION FUNCTION?

Answer 5

• The constant (>0) can be interpreted as ‘autonomous consumption’
• The MPC is dc/dy = c, where 0<c<1

Question 6

CONSTRUCT THE KCF DIAGRAM, SHOWING ALL 3 CONJECTURES.

Question 7

WHAT ARE THE EMPIRICAL VALIDITY TO SUPPORT FOR 1 AND 2 CONJECTURES?

Question 8

WHAT IS THE FIRST EMPIRICAL CHALLENGES?

Answer 8

‘Secular Stagnation’ predicted during WWII:

• The KCF implied that the APC would declince as income grew after the war.
• This would have resulted in persistent weakness in the demand for goods and services

Question 9

WHAT WAS THE PREDICTION OF EMPIRICAL CHALLENGES 1?

Answer 9

PREDICTION: perennial weakness in AD as the government retreated from its heavy war-time spending

-> Therefore, this prediction was inaccurate; the APC was more stable than the KCF predicted

Question 10

WHAT WAS THE KEY FINDING IN THE SECOND EMPIRICAL CHALLENGES?

Answer 10

Key Finding: the ratio of consumption to income was stable from decade-to-decade, despite large increases in income over the period of study.

Question 11

WHAT IS THE CONSUMPTION PUZZLE IN THE EMPIRICAL CHALLENGES II?

Answer 11

Keynes’ conjectures seemed to hold in the cross-section and over short time period. However, over longer period C/Y varied very little.

Question 12

CONSTRUCT THE TWO CONSUMPTION FUNCTIONS

Question 13

EXPLAIN HOW THESE TWO FUNCTIONS CAN COEXIST?

Question 14

WHAT IS THE FRANCO MODIGLIANI APPORACH (APPROACH 2)?

Answer 14

Approach: Consumption should depend on lifetime income, but income typically varies systematically over a person’s lifetime.

Answer 15

Saving allows income to be transferred from those
periods in which it is high to those periods in which it is
low.
This observation leads to the life-cycle hypothesis.

Question 16

WHAT WAS THE OBVIOUS EXAMPLE?

Answer 16

Work vs Retirement

• Fairly predictable income pattern
• Labour market income falls to zero when you retire
• try to maintain a reasonable standard of living
• Save during working years in order to support so consumption during retirement.

Question 17

WHAT IS THE LIFE-CYCLE HYPOTHESIS?

Answer 17

The assumption is consumer wants to achieve the smoothest path of consumption over her lifetime.

Another assumption is that interest rate of zero

Question 18

HOW DO WRITE THE FUNCTION OF WHEN INTEREST RATE IS ZERO?

Answer 18

𝐶 = (𝑊 + 𝑅𝑌 )/𝑇

AND IT CAN BE WRITTEN AS:

𝐶 = (1/𝑇 )𝑊 + (𝑅/𝑇 )𝑌

Answer 19

𝐶 = 𝛼𝑊 + 𝛽𝑌

Question 20

WHAT IS THE NOTATION FOR THE EQUATION ‘𝐶 = 𝛼𝑊 + 𝛽𝑌’ ?

Answer 20

• 𝛼 is the marginal propensity to consume out of ‘wealth’
  (∂C/∂W).
• 𝛽 is the marginal propensity to consume out of ‘income’
  (∂C/∂Y).

Question 22

FROM THE EQUATION WHAT DO WE LEARN ABOUT THE SHORT AND LONG -RUN?

Answer 22

Short-run: Wealth (stock) is less variable than income (flow), income (Y) should correspond to a low APC

Long-run: Wealth and income vary in proportion (higher correlation), resulting in a stable W/Y and thus a constant APC.

Question 23

CONSTRUCT THE LIFE-CYCLE CONSUMPTION FUNCTION GRAPH

Question 24

CONSTRUCT THE GRAPH OF AN INCREASE IN WEALTH

Question 25

C,Y,W OVER THE LIFE CYCLE

Question 26

WHAT WAS FRIEDMAN’S APPROACH (APPROACH 3)?

Answer 26

• His Permanent Income Hypothesis complements Modigliani’s approach
• Both argue that current consumption does not depend upon current income alone - KCF suggested
• PIH allows for non-regular income patterns over the course of a person’s life
• People can expereince random and temporary changes in their income from year-to-year in this model.

Question 27

WHAT ARE THE TWO COMPONENTS OF CURRENT INCOME?

Answer 27

Y^P (permanent income): This component of income is where people expect to persist into the future and can be seen as average income.

-> For example, it can increase with the years of schooling (human capital)

Y^T (transitory income): This is the component of income where people do not expect to persist (fluctuations around the average).

-> For example, a farmer who enjoys a good harvest due to unusually favourable weather.

Question 28

WHAT IS THE EQUATION OF THE TWO COMPONENTS OF CURRENT INCOME?

Question 29

WHAT WAS FRIEDMAN’S INSIGHT?

Answer 29

Consumption is dependent upon permanent income because savings r borrowing can be used to smooth out transitory increases or decreases in income.

Question 30

WHAT IS ANOTHER RESOLUTION TO THE CONSUMPTION PUZZLE?

Answer 30

PIH suggest that the KCF uses the wrong variable.

Under PIH, the average propensity to consume is:

Question 31

WHAT DOES APC DEPENDS POSITIVELY UPON THE RATIO OF PERMANENT TO CURRENT INCOME?

Answer 31

If Y=Y^p: current income equals its long-run(average) value and APC = a

Question 32

WHAT THE APC TO CONSUME UNDER PIH EQUATION?

Question 33

EXPLAIN CROSS-SECTIONAL STUDIES

Question 34

EXPLAIN TIME SERIES STUDIES

Question 35

WHAT WAS ROBERT HALL APPROACH ( AAPROACH 4)?

Answer 35

• PIH incorporated the idea that consumption depends upon expectations
• Consumers base consumption decisions on their current and expected future income.
• The combination of the PIH perspective with the notion of ‘rational expectations’ ( where people use all available information to make ‘optimal forecasts’ about the future.)

Question 36

WHAT IS THE RANDOM EALK HYPOTHESIS?

Question 37

WHAT ARE THE IMPLICATIONS FOR POLICYMAKERS?

Answer 37

Only ‘unexpected’ policy changes influence current consumption if consumers obey the PIH and have rational expectations; all expected events are already taken into account.

Question 38

WHY IS RATIONAL EXPECTATION IMPORTANT FOR UNEXPECTED POLICY? PROVIDE AN EXAMPLE

Answer 38

It is important because all available information is used efficiently. Other information is ‘news’ and arrives at random.

E.g consumers may not react at all to a change in a tax rate if they anticipate the policy change in advance.

->Therefore, policymakers influence behaviour in part through their influence over consumer’s expectations.

Question 39

WHAT IS THE ECONOMIC STIMULUS ACT (2008)?

Answer 39

In response to the financial crisis and recession, the US Congress passed the Economics Stimulus Act of 2008.

This provided a $115bn one-off tax rebate to individuals.

Question 40

WHERE DID THE MONEY GO?

Answer 40

Many households chose to use their rebate to pay off existing debt rather than increase consumption spending.

Question 41

CONTESTED INTERPRETATION

Question 43

WHAT WAS DAVID LAIBSON’S APPROACH ( APPROACH 5)?

Answer 43

Incorporate principles of psychology into their economic models. This is because consumers doubt their decision-making capabilities. This is known as behavioral economics.

Question 44

THE PULL OF INSTANT GRATIFICATION?

Answer 44

Inconsistent preferences: Consumers may alter their choices as time passes.

Instead of modeling rational consumers, incorporate behavioral rules into the models.
-> Unclear whether this approach is useful for understanding consumer behavior.