© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 13 Consumption and Saving Item Etc. McGraw-Hill/Irwin Macroeconomics, 10e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

Introduction Consumption accounts for about 70% of AD Fluctuations in C are proportionately smaller than the fluctuations in GDP Consumption is relatively stable In this chapter we seek to understand consumption and the link between consumption and income Consumption theory The debate over different consumption theories = debate over the size of the marginal propensity to consume (MPC) Keynesian model MPC is high, modern theories MPC is low

Introduction Figure 13-2 plots changes in per capita consumption and changes in per capita disposable income Consumption follows income swings that last 5-10 years Consumption does not respond to spikes in income [Insert Figure 13-1 here] Long term changes in income generate changes in consumption, but short term changes in income do not.

Introduction Figure 13-2 compares consumption this quarter to the previous quarter: Consumption is almost perfectly predicted by previous consumption This relationship is an outcome of the link between current consumption and expected future consumption Used in the modern theories of consumption [Insert Figure 13-2 here]

Introduction Early Keynesian theories explained consumption as a function of current disposable income (Figure 13-3) No separation for temporary and permanent income This consumption function is of the form: (1), where c is the MPC and is on the [0,1] range Modern consumption theories incorporate intertemporal dynamics [Insert Figure 13-3 here]

Life Cycle Theory The life cycle hypothesis views individuals as planning their consumption and savings behavior over long periods with the intention of allocating their consumption in the best possible way over their entire lifetimes Different MPC out of permanent income, transitory income, and wealth compared to the Keynesian theory with a single MPC Key assumption: most people choose stable lifestyles, or smooth out consumption over their lifetime Individuals do not like consumption to change dramatically from year to year The simplest form of this assumption is to consume the same amount in every year

Life Cycle Theory Suppose an individual: Starts life at age 20 Plans to work until age 65 Will die at age 80 Has annual labor income of YL = $30,000 Lifetime resources are $30,000 x 45 = $1,350,000 Spreading lifetime resources over the number of years of life (80-20 = 60) allows for C = $1,350,000/60 = $22,500 The general formula is The marginal propensity to consume is

Life Cycle Theory Once we have a theory of consumption, we have a theory of savings (savings is income less consumption) Figure 13-4 traces out the path of consumption and saving using the life cycle theory Wealth peaks at retirement Wealth is zero at death Accumulate savings in working years, but dissave through retirement Income is positive in working years, and zero in retirement [Insert Figure 13-4 here]

Life Cycle Theory Continuing with the example, can compute different marginal propensities to consume for various measures of income: permanent and transitory income Suppose income increases permanently by $3,000: The extra $3,000 for each 45 years spread out over 60 years of life increases consumption by The marginal propensity to consume out of permanent income is Suppose income increased by $3,000 for only one year: The extra $3,000 over 60 years would increase consumption by The MPC out of transitory income is

Life Cycle Theory The MPC out of permanent income is large The MPC out of transitory income is small and fairly close to zero The life-cycle theory implies that the MPC out of wealth should equal the MPC out of transitory income WHY? Spending out of wealth is spread out over remaining years of life The MPC out of wealth is used to link changes in the value of assets to current consumption

Permanent Income Theory Permanent income theory of consumption is like the life cycle hypothesis in that current consumption is not dependent upon current income, but on a longer-term estimate of income Milton Friedman called this permanent income Permanent income is the steady rate of expenditure a person could maintain for the rest of his/her life, given the present level of wealth and the income earned now and in the future The consumption function is then: (2), where YP is permanent disposable income Life cycle hypothesis and permanent income hypothesis are very similar, and are often combined as the PILCH.

Consumption Under Uncertainty If permanent income were known, according the PILCH, consumption would never change The modern version of PILCH emphasizes the link between income uncertainty and changes in consumption and takes a more formal approach to consumer maximization Under this newer version of consumption theory, changes in consumption arise from surprise changes in income Absent such surprises, consumption this period is the same as last period and is the same as next period Consumption can be modeled as: , where consumption tomorrow is equal to consumption today plus a truly random error (Robert Hall)

Liquidity Constraints and Myopia Why might the PILCH miss explaining close to half of consumption behavior? Two explanations include: Liquidity constraints: consumer unable to borrow to sustain current consumption in the expectation of higher future income When permanent income is higher than current income, consumers are unable to borrow to consume at the higher level predicted by PILCH Consumption more closely linked to current income Myopia: Consumers simply are not as forward looking as the PILCH suggests Difficult to differentiate between the two, but both imply current consumption dependent upon current disposable income, rather than future levels.

Uncertainty and Buffer Stock Saving Life cycle hypothesis is that people save to finance retirement Additional saving goals also matter, especially with the presence of uncertainty Research suggests that some save to leave bequests to children Different motives for bequests: altruistic motive and strategic motive Some saving is precautionary  undertaken to guard against unexpected events (ex. Health care costs) Saving is used as a buffer stock  added to when times are good in order to maintain consumption when times are bad One piece of evidence for these other motives is that older people rarely dissave, or draw down their wealth, but live off of income (Ex. Interest and dividends from wealth)