consumption theory

Question 1

aggregate demand

Answer 1

Y= C+I+G+NX

Question 2

consumption

Answer 2

what do do with income and a decision not to save

largest component of GDP- two-thirds in developed economies

less volatile than output and investment- consumption smoothing

Question 3

keynesian consumption function and consumption puzzle

Answer 3

C= C (bar) +cY

Consumption = autonomous consumption plus the marginal propensity to consume times income

Keynes theory has consumption function as a key part of business cycles

key points from this…

Marginal propensity (MPC) to consume is between 0 and 1

MPC- If one extra pound is earned how much will the household choose to consume. Some will be spent or saved

In Keynes work- a large fiscal policy multipliers comes from the assumption of high MPC (choose to consume a lot)

Average propensity to consume (APC) falls as income rises, rich people save a higher proportion of money than poor people.

No interest rate in Keynes function, doesn’t determine consumption

Question 4

keynes theory success

Answer 4

housholds survey data showed higher income, consume more, saved more and saved a larger fraction of income

time series (short) consumption saving low when income low

data also suggested income as a primary determinant of consumption

Question 5

Keynes problem (Consumption puzzle)

Answer 5

with keynes consumption- possible depression after ww2, income grow and consumption would fall as economy became richer nowhere fro excessive saving as wartime demand diminished

keynes suggested fiscal stimulus would be necessary to expand AD

but high incomes did not lead to higher saving rate, APC didn’t fall.

Question 6

First observation of Puzzle

Answer 6

Kuznets constructed new data on Y and C finding large increases in income over studied period and APC remained remarkably stable from decade to decade

keynes worked for household and short data but problems arose with longer data

Question 7

indifference curves

Answer 7

combinations of period one and period two consumption that make the household equally happy

Question 8

absolute slope of indifference curve

Answer 8

marginal rate of intertemporal substitution (MRIS)

MRIS is how much future consumption the household is willing to give up to increase present consumption by 1 unit

Question 9

indifference curve MRIS

Answer 9

When consumption tomorrow is higher the MRIS is high- the household is willing to give up more of tomorrow’s consumption in exchange for 1 extra unit of consumption today

Question 10

opportunity cost of increasing consumption today by 1 unit

Answer 10

1+r (consumption that is foregone tmrw)

Question 11

optimal consumption

Answer 11

MRIS+(1+r)

individual discount rate = market discount rate

how much C2 the consumer is willing to trade for 1 unit of C1 = how much C2 the market is willing to trade for 1 unit of C1

MRIS > 1+r worth giving up C2 and vice versa

the tangency point between an indifference curve and the IBC (that achieves the highest indifference curve and determines if a household is a net lender or borrower)

Question 12

optimal consumption algebraically

Answer 12

U’(C1)/U’(C2) = (1+r)

Question 13

what happens if income changes

Answer 13

temporary- changes in either presen or future income, work bonus

permanent changes- promotion

both cases shift the IBCto the right but temporary changes lead to smaller shifts

if Y1 increases butt Y2 remains unchanged consumption will increase in both periods

as

households prefer stable consumption pattern and will save part of the current increase in income (consumption smoothing)

Y2 increases then current consumption increases as well as consumption depends on lifetime wealth

this contrasts keynes who said that current consumption depends on current income

Question 14

policy insights related to temp increase in income

Answer 14

may not be effective in stimulating due to increase being smoothed across a life time

impact of tax cut might be lower than a model with a keynesian consumption function

Question 15

change in real interest rate

Answer 15

increase in r

increases slope of the IBC, rotating clockwise around the endowment point

increases the cost of borrowing

having an substitution effect, reduces current consumption and increases future consumption- relatively more to consume today

Income effect- borrower- increases interest payments on your current borrowing reducing disposable income and consumption

saver- disposable income increases and increased consumption

Question 16

what does model suggest about changing interest rates

Answer 16

model suggests changing ir can affect consumption decision by changing consumption (via changing borrowing and saving)

central banks cutting interest rates during a recession to stimulate the economy, but interest rate changes can lead to consumption decision across many periods which dampen its short run effectiveness

Question 17

borrowing constraints

Answer 17

if there are agents can’t borrow as much as they like/need

due to incomplete markets, asymmetric information and uncertainty

model smooths consumption perfectly- model generates too much smoothness as consumption depends strongly on disposable income.

(credit constrained)

Question 18

what if households cant borrow

Answer 18

cant reach highest indifference curve

consumes all period one income today

IBC is kinked, optimal consumption is C1=Y1

changes in current income changes consumption

explains C is more volatile than predicted by models

credit rationing sub optimal consumption and higher volatility

Question 19

theories that reconcile the consumption puzzle

Answer 19

France Modigliani’s Life Cycle hypothesis (LCH)

Milton Friedman’s Permanent-Income Hypothesis
(PIH)

Question 20

Life Cycle Hypotheisis (LCH)

Answer 20

income varies systematically over peoples lives

saving allows movement of income from high income periods to low income periods

C=aW+Beta(Y)

a- MPC out of Wealth (W)

Beta- MPC out of current income(Y)

over time as W rises the consumption function shifts up

LCH- APC is C/Y = a(W/Y) + Beta

(Short time series) as W does not vary proportionatlry with income from person to person, year to year high Y results in low APC

long time series, W and Y do vary proportionally, consumption function shifts up over time as W rises leaving APC more stable over time

Question 21

Permanent-Income Hypothesis (PIH)

Answer 21

PIH, people experience random and transitory changes in their income over time

PIH, divides income into permanent and Transitory Income

Y=Yp+Yt

permanent- part of income that people to expect to persist into the future

transitory- part of income that people do not expect to persist
(random deviation from average income, win in gamble)

theory believes permanent income is main source of consumption

saving and borrowing used to smooth over fluctuations in transitory income

Question 22

PIH consumption function

Answer 22

C= aY^p

Question 23

PIH APC

Answer 23

C/Y = a(Y^p)/Y

Question 24

PIH short term series data

Answer 24

increase in Y comes from changes in Y^T and are not spent

when Y rises because of Y^T the APC temporarily falls- higher Y results in low APC

Question 25

PIH Long time series

Answer 25

Changes in Y are dominated by changes in Y^P so APC remains constant decade to decade

Question 26

consumption smoothing

Answer 26

optimal choice by households to smooth out impact of temporary disturbances to income on consumption plans by borrowing (negative shock) or saving (positive shock)

Question 27

main consumption function

Answer 27

C= C(Y,W) consumption is increasing in both income and wealth