Copyright 2005 © McGraw-Hill Ryerson Ltd.

Consumption and Saving 14 Consumption and Saving Learning objectives Understand that consumption is a large but relatively stable fraction of GDP. Understand the relationship between changes in the real interest rate and changes in consumption and savings. Understand the modern theories of consumption behaviour link lifetime consumption to lifetime income. Understand that empirical evidence suggests that both modern theories and simple “psychological rule-of-thumb” models contribute to explaining consumption. PowerPoint® slides prepared by Marc Prud’Homme, University of Ottawa Copyright 2005 © McGraw-Hill Ryerson Ltd.

The Keynesian Consumption Function Chapter 14: Consumption and Saving The Consumption Function: (1) See Figure 14.1 As income increases this will increase consumption. Only for short-run analysis (Large MPC) No interest rate Depends only on current consumption Copyright 2005 © McGraw-Hill Ryerson Ltd.

The Keynesian Consumption Function Figure 14-1: An Estimated Early Consumption Function, 1961-2002 Chapter 14: Consumption and Saving Copyright 2005 © McGraw-Hill Ryerson Ltd.

Intertemporal Choice Maximizing Utility: Indifference Curves Chapter 14: Consumption and Saving Indifference Curve: A graphical representation of consumer preferences, showing combinations of current and future consumption for which total utility is constant. Marginal rate of Substitution: The rate at which a consumer is willing to give up an amount of consumption today in order to receive increased consumption in the next period, holding total utility constant. Budget Constraint: Is the line that shows the combinations of consumption today and consumption next period that the consumer can choose, given real income and the real interest rate. Copyright 2005 © McGraw-Hill Ryerson Ltd.

Intertemporal Choice Ct + 1 IC2 Figure 14-2: Indifference Curves Chapter 14: Consumption and Saving Ct + 1 IC2 The consumer is indifferent between bundles A and bundle B. IC1 Total utility is higher on IC2 compared to IC1. B CBt CBt+1 Future Consumption A CAt Cat+1 Ct Current Consumption Copyright 2005 © McGraw-Hill Ryerson Ltd.

Intertemporal Choice Yt + 1 + (1 + r)Yt Yt + 1 Yt + Yt / (1 + r) Yt Figure 14-3: The Budget Constraint Chapter 14: Consumption and Saving Ct + 1 The budget constraint is the line that shows the combinations of consumption today and consumption next period that the consumer can choose, given real income and real interest rate. Yt + 1 + (1 + r)Yt Future Consumption Yt + 1 Yt Yt + Yt / (1 + r) Ct Current Consumption Copyright 2005 © McGraw-Hill Ryerson Ltd.

Intertemporal Choice Figure 14-4 (a): Changes in the Budget Constraint Chapter 14: Consumption and Saving Y’t + Y’t + 1 / (1 + r) Y’t + 1 + (1 + r)Y’t An increase in income in either period will shift out the budget constraint, increasing the consumption possibilities in both periods. Yt + 1 + (1 + r)Yt Yt + Yt + 1 / (1 + r) Future Consumption Current Consumption Copyright 2005 © McGraw-Hill Ryerson Ltd.

Intertemporal Choice Yt + 1 Yt Figure 14-4 (b): Changes in the Budget Constraint Chapter 14: Consumption and Saving Yt + Yt + 1 / (1 + r’) Yt + 1 + (1 + r’)Yt An increase in the real rate of interest will rotate the budget constraint, making the slope steeper. Yt + 1 + (1 + r)Yt Yt + Yt + 1 / (1 + r) Future Consumption Yt + 1 Yt Current Consumption Copyright 2005 © McGraw-Hill Ryerson Ltd.

Intertemporal Choice C*t + 1 C*t Ct + 1 E IC3 IC2 IC1 Ct Figure 14-5: Choosing Optimum Consumption and Savings Chapter 14: Consumption and Saving Ct + 1 Optimum consumption in each period is given by point E. At point E, the slope of the budget constraint equals the slope of the indifference curve. At the marginal rate of substitution equals the real rate of interest. IC3 IC2 IC1 Future Consumption C*t + 1 C*t E Ct Current Consumption Copyright 2005 © McGraw-Hill Ryerson Ltd.

Intertemporal Choice Chapter 14: Consumption and Saving Normal Good: A good for which an increase in income causes the demand for the good to increase. Substitution Effect: All else being equal, an increase in the real rate of interest will cause current consumption to go down and current savings to go up. Income Effect: The change in consumption due to the fact that the consumer can now reach a higher indifference curve. Copyright 2005 © McGraw-Hill Ryerson Ltd.

Intertemporal Choice Ct + 1 Ct Figure 14-6: Effects of an increase in Income Chapter 14: Consumption and Saving Ct + 1 An increase in income in either period shifts the budget constraint outward. Future Consumption Ct Current Consumption Copyright 2005 © McGraw-Hill Ryerson Ltd.

Intertemporal Choice ∆Ct + 1 Yt + 1 Yt ∆Ct Figure 14-7: Effects of an Increase in the Real Interest Rate. Chapter 14: Consumption and Saving If the income effect is smaller than, or in the same direction as, the substitution effect, the net result is lower period t consumption and higher savings. An increase in the real rate of interest makes the budget line steeper. E’ ∆Ct + 1 Future Consumption E Yt + 1 Yt Ct ∆Ct Current Consumption Copyright 2005 © McGraw-Hill Ryerson Ltd.

Intertemporal Choice Figure 14-8: The Savings rate and the Real Interest Rate, 1961-2002. Chapter 14: Consumption and Saving Copyright 2005 © McGraw-Hill Ryerson Ltd.

Life-Cycle-Permanent-Income Theory of Consumption and saving Chapter 14: Consumption and Saving Life-cycle Hypothesis: Emphasises choices about how to maintain a stable standard of living in the face of changes in income over the course of a life. (2) Permanent-income Theory: Says that people form expectations of their future income and choose how much to consume based on those as well as their current income. (3) Copyright 2005 © McGraw-Hill Ryerson Ltd.

Life-Cycle-Permanent-Income Theory of Consumption and saving Figure 14-9: Lifetime Income, Consumption, Saving, and Wealth in the LC Model Chapter 14: Consumption and Saving Copyright 2005 © McGraw-Hill Ryerson Ltd.

Consumption Under Uncertainty Chapter 14: Consumption and Saving Lifetime Utility: The sum of period-by-period utilities. Lifetime budget constraint: The sum of period-by-period consumption. Lifetime utility = u(Ct) + u(Ct + 1) + … + u(CT - 1) + u(CT) Subject to Ct + Ct + 1 + … + CT - 1 + CT = Wealth + YLt + Ylt + 1 + … + YLT - 1 + YLT (4) Marginal lifetime utility of consumption: The increase in utility from a small increase in consumption. The optimal choice is the consumption path that equates the Marginal lifetime utility of consumption across periods. Copyright 2005 © McGraw-Hill Ryerson Ltd.

Consumption Under Uncertainty Chapter 14: Consumption and Saving Random-walk model of consumption: Consumption tomorrow should equal consumption today plus a truly random error. (5) Copyright 2005 © McGraw-Hill Ryerson Ltd.

Policy in Action Temporary Tax Cuts and the Consumer Copyright 2005 © McGraw-Hill Ryerson Ltd.

Consumption Under Uncertainty Chapter 14: Consumption and Saving The LC-PIH: The Traditional Model Strikes Back Excess sensitivity: Consumption reacts too strongly to predictable changes in income. Excess smoothness: Consumption responds too little to surprise changes in income. (6) Copyright 2005 © McGraw-Hill Ryerson Ltd.

Consumption Under Uncertainty Chapter 14: Consumption and Saving Liquidity Constraints and Myopia Liquidity constraints: When a consumer cannot borrow to sustain current consumption in the expectations of higher future consumption. Myopia: The idea that consumers are not as forward thinking as the LC-PIH suggests. Uncertainty and Buffer-stock Saving Buffer-stock: Excess consumer savings used to maintain consumption when income is lower than usual (saving for a rainy day). Copyright 2005 © McGraw-Hill Ryerson Ltd.

Chapter Summary Chapter 14: Consumption and Saving Theoretically, if the income effect is outweighed by the substitution effect, an increase in the real rate of interest leads to a decrease in current consumption and an increase in savings. The life-cycle-permanent-income hypothesis (LC-PIH) predicts that the marginal propensity to consume out of permanent income is large and that the marginal propensity out of transitory income is very small. Observed consumption is much smoother than the simple Keynesian consumption function predicts. Copyright 2005 © McGraw-Hill Ryerson Ltd.

Chapter Summary (cont’d) Chapter 14: Consumption and Saving The LC-PIH is a very attractive theory, but it does not give a complete explanation of consumption behaviour. The life-cycle hypothesis suggests that the propensities of an individual to consume out of disposable income and out of wealth depend on the person’s age. Copyright 2005 © McGraw-Hill Ryerson Ltd.

The End Chapter 14: Consumption and Saving Copyright 2005 © McGraw-Hill Ryerson Ltd.