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 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. 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.

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

19 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.

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

21 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