1 The economics of consumption

2 From: President Ella Eli To: Yale Students Re: Generous Gift My dear students, I am delighted to report that a generous alumna has made a gift of $1000 per Yale student, available immediately. You can come by the office and pick up your check any time. Professor Nordhaus has requested that you detail how you would spend the funds. Would you please write this down in your notebooks in class today. You will find it instructive as you discuss Consumption in class this week. With best wishes, President Ella Eli P.S. Professor Nordhaus has told me about “elevator quizzes,” which are a great idea. This is not an elevator quiz, but you should hold on to your answers for later reference. EE

Importance of consumption in macro 1. Consumption is two-thirds of GDP – understanding its determinants is major part of the ball game. 2. Consumption is the entire point of the economy: 3. Consumption plays two roles in microeconomics: a. AD: It is a major part of AD in the short run: recall IS curve in which Y = C(Y d ) + I + G + NX b. AS: What is not consumed is saved and influences national investment and economic growth 3

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Growth in C and GDP (quarterly) 6 Chicken or egg: -ΔC causes recession? -Recession causes ΔC?

7 Alternative Theories of Consumption The basic Keynesian insight is that consumption depends fundamentally on personal income (“consumption function”) This enters into the Keynesian models as C = α + βY d On a closer look, a major puzzle: the short-run and cross-sectional consumption functions looked very different from the long-term consumption function.

Consumption and Disposable Income 8

Short-run v. Long-run Consumption Function 9

10 Alternative Theories of Consumption There are four major approaches in macroeconomics: *1. Fisher's approach: sometimes called the neoclassical model 2. Keynes original approach of the consumption function *3. Life-cycle or permanent income approaches (Modigliani, Friedman) 4.Rational expectations (Euler equation) approaches (in Jones) *We will do in class, but more Fisher in section.

11 Intertemporal Consumption Choice: Fisher’s model Basic idea: People have expectations of lifetime income; they determine their consumption stream optimally; this leads consumers to “smooth” consumption over their lifetime. Assumptions of two period model: Periods 1 and 2 Income Y 1 and Y 2 Maximize utility: Budget constraint: We will do graphical case now and calculus later.

C1C1 C2C2 Budget constraint: C 1 +C 2 /(1+r)=Y 1 [no income in retirement] Y1Y1 Indifference curve between current and future consumption E* S1*S1*

C1C1 C2C2 Key result: consumption independent of timing of income!!! Called “consumption smoothing” Y1Y1 E* S1*S1*

Summary to here Income over life cycle is the major determinant of consumption and saving. In idealized case, have consumption smoothing over lifetime. Now move from two-period (Fisher model) to multi-period (life cycle model). 14

15 Basic Assumptions of Life Cycle Model Basic idea: People have expectations of lifetime income; they determine their consumption stream optimally; this leads consumers to “smooth” consumption over their lifetime. Assumptions: “Life cycle” for planning from age 1 to D. Earn Y per year for ages 1 to R. Retire from R to D. Maximize utility function: Budget constraint: Discount rate on utility (δ) = real interest rate (r) = 0 (for simplicity)

16 Techniques for Finding Solution 1. Two periods: Maximizing this leads to U’(C 1 )=U’(C 2 ). This implies that C 1 = C 2, which is consumption smoothing. The Cs are independent of the Ys. 2. Lagrangean maximization (advanced math econ): Maximizing implies that U ’(C 1 )=U’(C 2 )=-λ. T his implies that which again is consumption smoothing independent of Y.

C1C1 U Since U ’(C 1 )=U’(C 2 )=… = -λ, C is constant over time. Note: this assumes diminishing marginal utility or U”(C)<0. Make sure you know what this means.

18 Review of last time Life-cycle model: People plan their consumption over the future Assumptions: “Life cycle” for planning from age 1 to D. Earn constant Y per year for ages 1 to R. Retire from R to D. Maximize discounted utility: For simplicity, assume r = δ = 0.

19 age C, Y, S Income, Y RD || Consumption, C 0 Saving, S Diagram of Life Cycle Model Showing Consumption Smoothing Initial Solution

20 age C, Y, S Income, Y RD || Consumption, C’=C 0 Saving, S’ Anticipated change in timing of income Income “splash” (Y’) with no W increase Anticipated income change of ΔY. Because it is anticipated, no change in lifetime income, so no change in (smoothed) consumption. MPC = 0; MPS = 1.

21 age C, Y, S Income, Y RD || No C change! 0 Saving, S’ What about anticipated taxes? Income “splash” from tax cut

22 age C, Y, S Y RD || C 0 Unanticipated change in permanent income Y’ =unanticipated increase; W increases. C’ Unanticipated windfall of ΔY in period z. Leads to smoothing the windfall over remaining lifetime. (a)one time splash: MPC = ΔY/(D-z). For life expectancy of 40 years, would be MPC =.025. (b)Permanent income increase: MPC = ΔY(R-z)/(D-z) =.6 to.8

23 Example of the Life Cycle Model at Work : How would the consumption and saving of people with volatile or stable income streams look? See figure for Internet Entrepreneur and Yale Professor.

24 age Major result of LCM: consumption smoothing Professor C of both! R D eLove.com

25 Example of consumption smoothing: the 2008 tax rebate Estimated MPC= 0.25 (+0.04)

Vector auto-regressions (VAR) Nobel prize in Economics for 2011 won by Chris Sims (Princeton) in part for development of VAR technique. Vector autoregression (VAR) is a statistical model used to capture the linear interdependencies among multiple time series (vector Y t ): Y t = A 0 + A 1 Y t-1 + A 2 Y t-2 + A 2 Y t-2 + e t Sims emphasized it as “theory-free estimation.” Example of short run MPC using VAR: MPC = 0.16 ( ) Smaller than other estimates because of autoregressive properties. Summary: Econometric estimates of short-run MPC > life-cycle theory. 26

27 How about a nice car? What is your favorite car? What do you have? Why not smooth consumption to get your favorite car? Liquidity constraints Case of Yale students where income growing rapidly. Here consumption is limited by borrowing constraint. In class: A picture of the model with liquidity constraints. Is this reason for MPC higher than life cycle prediction? (Partially, but cannot explain response of non-constrained consumers)

Behavioral economics Basic idea: That people are not optimizers: - Draw upon behavioral psychology: anchoring, loss aversion, hyperbolic discounting, and similar phenomena Real-world examples for all of us: - Procrastination (as in procrastinate saving for the future). - Addictive substances (shop until you drop) Why is it “behavioral”? Because lead to inconsistent decisions that are regretted later - cheating, hangovers, unwanted pregnancies, jail Examples from macroeconomics: - MPC too high; low savings for retirement; subprime mortgages; sticky housing prices; too high discount rate in energy use 28

29 Press button for Econ 122

Elevator quiz 1.Look back to your answer from Monday on how you would allocate your $1000 unexpected generous gift. 2.Explain how this decision fits into the economics of consumption that we discussed in class and in the textbook. 3.We will discuss our answers when you are done. 4.Then hand it in at the end of class. 30

Taxes, interest rates, and saving “Raise the tax on the returns for saving, and people will save less. We can argue the magnitude, but to argue that saving does not respond at all is simply to argue that incentives and disincentives are irrelevant to behavior.” “Of Course Higher Taxes Slow Growth,” J.D. Foster and Curtis Dubay 31

Impact of higher interest rates on saving Important question for economics A common theme: - The country need to reduce taxes to increase savings - Examples: lower marginal tax rates, lower capital gains taxes, move to consumption taxes, - Mechanism: r a = r b (1-τ) What is the economic theory of this? What is econometric evidence on this? 32

C1C1 C2C2 Y1Y1 E* E** CASE I: Higher interest rate leads to lower saving because income effect outweighs substitution effect. [Pension example]

C1C1 C2C2 E* E** CASE II: Opposite case: higher r increases savings as substitution effect dominates

35 If we estimate the impact of changes in interest rates on consumption, we get paradoxical case (δs/δr < 0): The impact is essentially zero (and not robust to changes in specifications, samples, etc.)

Econometric savings schedule: S(r) 36

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38 What is the Effect of Stock Market Booms and Busts on Consumption?

And the housing price collapse… 39 Las Vegas, Miami Detroit Case-Shiller

Long-term housing trends 40 Source: Shiller

41 The Wealth Effect on Consumption Wealth effects: –Examples: Suppose the alumna gives you $1000. Or the housing market collapsed as after 2006? What would be the effect on C? Life cycle model predicts that initial wealth (or surprise inheritances) would be spread over life cycle. Intuition: an inheritance is just like an income splash. So the augmented life cycle model is C t = β 0 + β 1 Y p t + β 2 W t where Y p t is permanent or expected labor income and W t is wealth.

42 age C, Y, S Y R D || C 0 Initial wealth (from saving) Age = z Consider a person in the middle of the life cycle

43 age C, Y, S Y R D || C 0 Wealth shock (falling house prices) Age = z Now a wealth shock C’

44 The stock market, the housing market, and consumption Economists think that the bursting of housing bubble was a major source of current recession (US, Spain, ….) Reasons? Decline in consumption (today) and investment (later) Rationale: the “wealth effect” on consumption Analysis in the life-cycle model: –In augmented life-cycle model C t = β 0 + β 1 Y p t + β 2 W t standard estimates are that β 2 = (example in a minute) –Effect in the “Roaring 90s” and the housing crash today. This is often called “deleveraging” but a better description is a “wealth effect” (leverage is a balance sheet phenomenon).

45 Regression Dependent Variable: Real consumption expenditures Method: Least Squares with AR correction Sample: VariableCoefficientStd. ErrorP Real Disposable income Real wealth R-squared0.9997

46 Wealth and Consumption through Two Bubbles

47 Loss of wealth and savings rate increase

Key ideas on consumption and saving 1.Consumption derived from consumer maximization 2.Pure model leads to consumption smoothing 3.All kinds of important predictions 4.But pure model has “anomolies” and shows too large a short-run MPC relative to theory 5.Reasons are probably liquidity constraints and behavioral frictions. 6.Note the impact of interest rates and taxes on savings. 7.Remember the wealth effect 48