A Shocking Rise in White Death Rates in Midlife—and What It Says about American Society by Anne Case and Angus Deaton This paper documents a marked increase in the all-cause mortality of middle-aged white non-Hispanic men and women in the United States between 1999 and 2013. This change reversed decades of progress in mortality and was unique to the United States; no other rich country saw a similar turnaround. The midlife mortality reversal was confined to white non-Hispanics; black non-Hispanics and Hispanics at midlife, and those aged 65 and above in every racial and ethnic group, continued to see mortality rates fall. This increase for whites was largely accounted for by increasing death rates from drug and alcohol poisonings, suicide, and chronic liver diseases and cirrhosis. Although all education groups saw increases in mortality from suicide and poisonings, and an overall increase in external cause mortality, those with less education saw the most marked increases. Rising midlife mortality rates of white non-Hispanics were paralleled by increases in midlife morbidity. Self-reported declines in health, mental health, and ability to conduct activities of daily living, and increases in chronic pain and inability to work, as well as clinically measured deteriorations in liver function, all point to growing distress in this population. We comment on potential economic causes and consequences of this deterioration.

The Structure of the Model I—The Spending Sector * Consumption, Investment, Government and Net exports II—The Monetary Sector * Money demand and Money Supply * Financial sector III—The Production Sector *Capital, Labor….. IV—The Labor Market Sector *Labor Demand and Supply

Consumption Function A good illustration of the interplay of theory and data. The consumption/saving decision is the key behavioral element of the Solow growth model. Also underlies the multiplier effects in the short run model. Consumption is also the biggest component of AD. We cannot have a good understanding of the economy unless we have a good theory of consumption The primary motivation of the chapter is the puzzle of the difference between the short-run (cross-section) and long-run (time-series) consumption function.

U.S. consumption, 2014:2 (RGDP=$15,994.3 chained 2009) Services Nondurables Durables Consumption % of GDP Chained $ billions $10,910.4 68.23% 7180.4 2,352.9 1,401.0 44.9 14.71 8.8 source: Bureau of Economic Analysis, U.S. Department of Commerce http://www.bea.gov 4

U.S. Investment, 2014:2 Inventory Residential Business fixed % of GDP Chained $ billions $2,694.7 16.9% 83.9 493.8 2,093.3 0.5 3.1 13.1 source: Bureau of Economic Analysis, U.S. Department of Commerce http://www.bea.gov 5

Share of consumers spending

The U.S. Consumption Function The line CF0 is an estimate of the U.S. consumption function during the 1960s. Each blue dot represents consumption expenditure and disposable income in the United States for a year between 1960 and 2007. The line CF1 is an estimate of the U.S. consumption function during the 2000s.

The U.S. Consumption Function The slope of the consumption function—the marginal propensity to consume—is 0.87. The consumption function shifted upward as influences on consumption expenditure other than disposable income changed.

Figure 9.2 (a) Growth in Consumption and Investment Mankiw: Macroeconomics, Seventh Edition Copyright © 2010 by Worth Publishers 9

U.S. Personal Saving

Theories of Consumption Four approaches to the Consumption Function (1) Absolute Income Hypotheses (Keynes?) (2) Relative Income Hypothesis (James Duesenberry 1949 ~ From Thorstein Veblen) (3) Life Cycle Hypothesis (Ando & Modigliani) (4) Permanent Income Hypothesis (Friedman) Theories 3 and 4 are most compatible with Neo-classical economics.

Theories of Consumption Keynesian Consumption Function * The starting point for Keynes’s theory of consumer behavior is the following concept: “The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge of human nature and from the detailed facts of experience, is that men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income.” John M. Keynes, The General Theory of Employment, Interest and Money (1936)

(1) Keynesian Consumption Function This psychological law translates into the Keynesian consumption function: C = a + b*Yd Where a > 0, 0 < b < 1 b = Marginal Propensity to consume (MPC) =ΔC/ΔYd APC = Average Propensity to consume = C/Yd APC = a/Yd + b This implies APC is greater than MPC and follows that the APC declines as the level of income increases. This version of the consumption function (specifically when a =0, C = b*Yd ) has been called the Absolute Income Hypothesis; consumption is assumed to react rather mechanically to actual current levels of income.

Keynes’s simple consumption function can be summarized: Keynes’s Conjectures Keynes’s simple consumption function can be summarized: (a) Current consumption depends on current income. (b)The MPC is between zero and one. (c) The APC is a decreasing function of income.

The Keynesian Consumption Function As income rises, the APC falls (consumers save a bigger fraction of their income). C Y d C = a + b*Yd Pick a point on the consumption function; that point represents a particular combination of consumption and income. Now draw a ray from the origin to that point. The slope of that ray equals the average propensity to consume at that point. (Why? The slope equals the rise over the run. The rise from zero to that point equals the value of C at that point. The run from zero to that point equals the value of Y at that point. Hence, the rise over the run equals C/Y, or the APC.) At higher values of Y, the APC (or the slope of the ray from the origin) is smaller. This is what Keynes conjectured: at higher values of income, people spend a smaller fraction of their income. slope = APC

Implications: The fact that the proportion of income saved apparently increased as income rose led some early Keynesians to be concerned about secular stagnation in the economy. The Stagnation thesis (Alvin Hansen, 1939) * Due to lack of effective demand. (unless balanced by the growth of the other components aggregate demand: government spending & Investment.

Empirical Evidences Using statistical techniques and annual data for a short period, 1929-1941, Keynesian economists obtained the following type of estimate for the consumption function: C = 26.5 + 0.75 Yd a = $26.5 billion, This confirms the Keynesian view that the APC exceeded the MPC and APC declines as income rises. Example: at Yd =$150 billion, APC = 0.927 Yd = $200 billion, APC = 0.883 The above equation seemed to predict levels of consumer expenditure during that period reasonably well.

Empirical Evidences… Further support for the Keynesian form of the consumption function came from comparative studies of families budgets. *Looking at budgets for families at progressively higher income levels, the absolute amount of consumption increased (MPC > 0), But by less than the increase in income ( 0 < MPC < 1) * Families at a higher income levels consumed a smaller proportion of income.  APC declined as income rose.

Simon Kuznets’ Consumption Data Kuznets, Simon. Uses of National Income in Peace and War, Occasional Paper 6. NY: NBER, 1942. Time series estimates of consumption and national income Overlapping decades 1879-1938, 5 year steps Each estimate is a decade average Kuznets, Simon. National Product Since 1869. NY: NBER, 1946. Extended data backward to 1869.

Kuznets’ Study of 1946 (National income (Y) and Consumption in billions of dollars) Years Y C C/Y 1869-78 9.3 8.1 0.87 1874-83 13.6 11.6 0.85 1879-88 17.9 15.3 1884-93 21.0 17.7 0.84 1889-98 24.2 20.2 0.83 1894-1903 29.8 25.4 1899-1908 37.3 32.3 1904-13 45.0 39.1 1909-18 50.6 44.0 1914-23 57.3 50.7 0.88 1919-28 69.0 62.0 0.90 1924-33 73.3 68.9 0.94 1929-38 72.0 71.0 0.99

Results: Kuznets’ Study (1946 study) Between 1869-1938, real income expanded to seven (7) times its 1869 level ($9.3 billion to $69 billion) But the average propensity to consume ranged between 0.838 and 0.898. That is, APC did not vary significantly in the face of vastly expanding income. Problem!

* There was no downward trend in the ratio real Empirical Evidences… Consumption and National Income (1869-1938) by Simon Kuznets * There was no downward trend in the ratio real consumption to real national income. * Nor is there evidence for a downward trend in APC in more recent years. Example: 1950 APC=0.93 1970 APC=0.89 1990 APC=0.93

Resolving the Empirical Puzzles Evidences from short-run annual time series data (1929-41) and family budget studies seemed to support the Keynesian view Times series data for a longer time period (1969-1938) suggest that the consumption-income relationship is proportional rather than the non-proportional relationship given by absolute income hypothesis. Resolving these puzzles has been the task of the modern theory of the consumption function.

The Consumption Puzzle Consumption function from long time series data (constant APC ) C Y Consumption function from cross-sectional household data (falling APC )

Reconciliation with Keynes’ Theory? Arthur Smithies, Econometrica, 1954. Uses per capita Yd and C, and a time trend. Argues that the Cons. Function is really Keynesian, but just looks Kuznets’ because of the shifts in the function. Says the data points just “happen” to line up to fit Kuznets’ consumption function. Ct* Kuznets t = 1925 t = 1924 t = 1923 Yt*

Second Failure of Keynesian Consumption Function Predictions of post-WWII period are grossly wrong Keynesian Theory argues that the average propensity to save (APS) rises with income (S = S0 + sY). Higher post-war incomes should imply excess saving. Will we go straight back to the Depression? Comparison of the forecasts with the actual results suggest that: consumption was “under”-predicted saving was “over”-predicted IMPLICATION: major determinants in the behavioral equations must be missing!

(2) The Relative Income Hypothesis James Duesenberry’s approach says that people are not just concerned about absolute levels of possession. They are in fact concerned about their possessions relative to others, “Keeping up with the Jones.” People are not necessarily happier if they have more money. They do however report higher happiness if they have more relative to others. Current economists still support this idea. Ex: Robert Frank Duesenberry argues that we have a greater tendency to resist spending decreases relative to falls in income than we do to increase expenditure relative to increases of income. The reason is that we don’t want to alter our standard of living downward. Duesenberry’s Habit Persistence Theory

Irving Fisher and Intertemporal Choice (1930) The consumption function by Keynes does not consider how people make decisions over time. In other words, when people decide how much to consume and how much to save, they take into account both the present and the future. People face a tradeoff Fisher developed an intertemporal model that shows how households make decisions about how much to consume and how much to save.

Intertemporal Budget Constraint Let us consider an individual who gets income today and tomorrow and who consumes today and tomorrow. What is her budget constraint? In the first period, she gets income Y1, which she consumes C1 or saves S: Y1 = C1 + S. In the second period, she earns interest on her savings. Her consumption in the 2nd period: C2 = Y2 + S (1 + r)

Intertemporal Budget Constraint…. From the first equation Y1 - C1 = S. Substituting into the second equation, we obtain: C1 (1+r) + C2 = Y1(1+r) + Y2 Or C1 + C2/(1+r)= Y1 + Y2 /(1+r) The present value of consumption must equal the present value of income. It is the consumer’s intertemporal budget constraint.

The Intertemporal Budget Constraint is the consumption bundle when period 1 saving is as large as possible. y2 is the consumption bundle when period 1 borrowing is as big as possible. y1 c1

Life Cycle Hypothesis (LCH) Franco Modigliani, Albert Ando, and Richard Bloomberg (1954) proposed an explanation based on the ideas in the Fisher model. They focused on the role of saving in smoothing individuals’ consumption over their lifetimes. “ The point of departure of the life cycle model is the hypothesis that consumption and saving decisions of households at each point of time reflect a more or less conscious attempt at achieving the preferred distribution of consumption over the life cycle, subject to the constraint imposed by the resources accruing to the household over its lifetime.” Franco Madigliani

Income and Consumption—LCH death Saving Consumption Income Dissaving T

Life Cycle…. A stylized fact of economic data is that consumption is much smoother than income. Let us consider the budget constraint of someone who expects to live for T more years, of which R will be spent working and T-R will spent in retirement with zero earnings. The consumer smoothes consumption expenditure over his/her life, spending 1/T of his/her life-time income each period.

Income and Consumption—LCH Assuming the initial wealth, W, and the real interest rate is zero, the constraint will be: C1 + C2 +…+ CT = W + Y1 + Y2 +…+ YR CT = W + RY C = (W + RY)/T Example: consumer expects to live for 60 years and working for 40 years. The function is C = 0.017 W + 0.67Y Therefore Consumption depends on both income and wealth.

Testing the LCH If the function form looks like this: Ando and Modigliani argue that expected future labor income is proportional to current income, so that the function can be reduced to: When they estimate this function, they get:

The ratio of labor income to disposable income is 0 The ratio of labor income to disposable income is 0.88 and the ratio of wealth to disposable income is 4.75. That means A=4.75Y this leads to

Policy Implications of LCH Changes in current income have a strong effect on current consumption ONLY if they affect expected lifetime income. In Q2 1975, a one-time tax rebate of $8 billion was paid out to taxpayers to stimulate AD. The rebate had little effect. The only way there can be a significant effect is if there is a strong liquidity constraint operating. This has implications for monetary policy.

Criticisms of LCH The households, at all times, have a definite, conscious vision of: The family’s future size and composition, including the life expectancy of each member, The entire lifetime profile of the labor income of each member—after the applicable taxes, The present and future extent and terms of any credit available, and The future emergencies, opportunities, and social pressures which might affect its consumption spending. It does not take into account liquidity constraints.

Permanent Income Hypothesis (PIH) Milton Friedman (A Theory of the Consumption Function. Princeton Univ. Press, 1957) Assumptions: Perfect certainty about: Future receipts Future interest rates Future prices, etc. People save to reduce fluctuations in expenditures People are immortal (or leave bequests) Individual’s utility function: u = u(c,c1) where c is current period consumption and c1 is next period consumption. People maximize utility based on their permanent (expected life-time) income Allocate their income inter-temporally

PIH Friedman postulates that consumption is proportional to permanent income: k = factor of proportionality (k>0) Friedman does not expect the above consumption function to predict consumption perfectly. Because measured income (Y) contains a random element called transitory income:

(4) The Permanent Income Hypothesis Suggested by Milton Friedman (1957) This hypothesis shares with the life cycle the assumption that long-term income is the primary determinant of consumption. Milton Friedman argues that it would be more sensible for people to use current income, but also at the same time to form expectations about future levels of income and the relative amounts of risk. Thus, they are forming an analysis of “permanent income.” Permanent Income = Past Income + Expected Future Income Transitory Income – Income that is earned in excess of, or perceived as an unexpected windfall. If you get income not equal to what you expected or to what you don’t expect to get again. So, he argues that we tend to spend more out of permanent income than out of transitory. In the Friedman analysis, he treats people as forming their level of expected future income based on their past incomes. This is known as adaptive expectations. Adaptive Expectations – looking forward in time using past expectations. In this case, we use a distributed lag of past income.

Reviews on the modern theory The lifecycle hypotheses pays more attention to the motives for saving,and provides convincing reasons to include wealth as well as income in the C function. The permanent income hypotheses pays more attention to the way in which individuals form expectations about their future income. Modern form of the consumption equation C = a Wealth + b YD + c YD-1

Current disposable income Household wealth Expected future income Consumption The following are the five most important variables that determine the level of consumption: Current disposable income Household wealth Expected future income The price level The interest rate 54