1. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Chapter 15 The Economics of Consumption Behavior

2. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-2 Theories of Consumer Behavior Recall: The Keynesian theory assumed that consumption depended on disposable income. Modern theories of consumption state that consumers have Forward-Looking Expectations, which are estimates of the future values of economic variables. – The Permanent Income Hypothesis (PIH) holds that consumption spending depends on the long-run average (or permanent) income that people expect to receive. – The Live-Cycle Hypothesis (LCH) implies that households base their current consumption on their expected total lifetime incomes and their wealth.

3. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-3 Figure 15-1 Real Consumer Expenditure and its Three Components, 1960–2007 Source: Bureau of Economic Analysis, NIPA Tables.

4. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-4 Composition of Consumption Spending The following table shows the percentage of consumption spending broken into 3 categories: Type of Consumption 1960:Q12007:Q3 Durable Goods5.914.9 Nondurable Goods41.228.7 Services52.956.4

5. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-5 Cross-Section vs. Time Series Evidence A Cross Section consists of data for numerous units (e.g. households, firms, cities or states) observed over a single period of time. A Time Series consists of data covering a span of time for one or more variables of interest. Cross section data supports Keynes’ view that higher disposable income leads to higher saving rates, but time series data shows that saving rates have not increased as the U.S. has become wealthier.

6. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-6 Figure 15-2 The Relation Between Disposable Income (Y D ), Consumption Spending (C), and the Ratio of Saving to Income (S/Y D ) (1 of 3)

7. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-7 Figure 15-2 The Relation Between Disposable Income (Y D ), Consumption Spending (C), and the Ratio of Saving to Income (S/Y D ) (2 of 3)

8. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-8 Figure 15-2 The Relation Between Disposable Income (Y D ), Consumption Spending (C), and the Ratio of Saving to Income (S/Y D ) (3 of 3)

9. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-9 Figure 15-2 The Relation Between Disposable Income (Y D ), Consumption Spending (C), and the Ratio of Saving to Income (S/Y D )

10. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-10 Figure 15-3 Ratio of Personal Saving to Disposable Personal Income (S/Y D ), Averages over Business Cycles, 1894–2007 Sources: For 1987–99: Paul David and John Scadding, “Private Savings: Ultrarationality, Aggregation, and ‘Denison’s Law,’ ” Journal of Political Economy (March/April 1974). For 1900–32: Historical Statistics of the United States Millennial Edition. 1933–2007: National Income and Product Accounts. Business cycle data from NBER Business Cycle Expansions and Contractions.

11. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-11 The Permanent Income Hypothesis Permanent Income (Y P ) is the annual average income that people expect to receive over a period of years in the future. – People are assumed to estimate Y P as follows: The PIH states that individuals consume a constant fraction (k) of their permanent income:  Furthermore, consumption can be shown to depend on both Transitory Income (Y t ) and Y P, but the marginal propensity to consume out of Y t is zero.

12. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-12 Implications of the PIH The motivation for the PIH was the conflict between cross-section data and time series data related to saving. The PIH contends that the high saving ratios of high-income people are due to their having atypically large, positive, Y t. – Similarly, low-income people dissave because they are more likely than the average person to have actual incomes that are temporarily below their Y P. The long-run near-constancy of the saving ratio is due to the stability of Y P.

13. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-13 Figure 15-4 The Permanent-Income Hypothesis of Consumption and Saving

14. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-14 The Life-Cycle Hypothesis Franco Modigliani of MIT suggested that people would try to stabilize their consumption over their entire lifetime. – C 0 L = Y 0 R or where C 0 = lifetime consumption per year L = lifespan (in years) Y 0 = income per year R = # of years of employment – With an endowment of assets equal to A 1, lifetime consumption becomes:

15. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-15 Implications of the LCH The life-cycle hypothesis can explain the positive association of saving and income, since the upward trend in per capita real GDP raises both the saving and income of those of working age relative to those who are retired. A temporary increase in income in boom years will be consumed over one’s entire life leading to higher saving in boom years.

16. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-16 Figure 15-5 The Behavior of Consumption, Saving, and Assets under the Life-Cycle Hypothesis

17. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-17 Figure 15-6 Consumption, Saving, and Assets under the Life-Cycle Hypothesis When There Is an Initial Stock of Assets

18. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-18 Rational Expectations and Consumption The Rational Expectations hypothesis suggests that people use forecasts of future economic magnitudes based on all information currently available about the structure and past performance of the economy and future government policies. – Since all past information is taken into account in forming expectations, only new information will change estimated permanent income  Consumption only changes if unanticipated events occur. – But empirically the behavior of consumption appears to be too volatile to be consistent with this theory.

19. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-19 International Perspective: Why Do Some Countries Save So Much?

20. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-20 Household Assets and the Collapse of S In the late 1990s, household saving as a percentage of disposable income was the lowest in the U.S. since the Great Depression. Why? The PIH would predict that higher incomes in the 1990s would have pushed up the saving rate. The LCH has consumption depending on lifetime income and on real assets. – The stock market boom in the late 1990s greatly increased people’s wealth  C  relative to income pushing down the saving rate. – Saving did not revive in the when the stock market subsequently declined. Why? Rising value of real estate Low interest rates

21. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-21 Figure 15-7 The Household Saving Rate and the Ratio of Household Net Worth to Personal Disposable Income, 1970–2007 Sources: Federal Reserve Board Flow of Funds Accounts and Bureau of Economic Analysis NIPA Tables. Details in Appendix C-4.

22. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-22 Figure 15-8 Components of Household Assets as a Ratio to Personal Disposable Income, 1970–2006, in Percent Sources: Federal Reserve Board Flow of Funds Accounts and Bureau of Economic Analysis NIPA Tables. Details in Appendix C-4.

23. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-23 Official Household Saving Data The National Income and Product Accounts (NIPA) measure saving as: S = Y D – C – interest payments Some flaws in the NIPA measure of S include: – NIPA does not include capital gains on stocks, bonds, houses, and other assets. – NIPA does not include purchases of consumer durable goods, which would provide a stream of benefits in the future. – Inflation raises the nominal interest paid leading to overestimates of S in periods of high inflation. The Flow of Funds (FFA) measure of S includes net investment in consumer durables.

24. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-24 Figure 15-9 Household Saving in the NIPA and Flow of Funds Accounts, 1960–2006 Sources: Federal Reserve Board Flow of Funds Accounts and Bureau of Economic Analysis NIPA Tables. Details in Appendix C-4.

25. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-25 Figure 15-10 Flow of Funds Accounts and Gains-Inclusive Saving Rates, 1976–2006 Sources: Federal Reserve Board Flow of Funds Accounts and Bureau of Economic Analysis NIPA Tables. Details in Appendix C-4.

26. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-26 Chapter Equations

27. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-27 Chapter Equations

28. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-28 Chapter Equations

29. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-29 Chapter Equations