1. Chapter 16: Consumption

2. John M. Keynes: Absolute Income Hypothesis
Consumption is a linear function of disposable personal income,
C = C + cY
C = consumption expenditure
Y = disposable income
C = autonomous consumption (intercept of the line)
c = marginal propensity to consume (slope of the line)

3. Properties of Consumption Function
Consumption is determined by current income
Marginal propensity to consume (MPC = ΔC/ΔY) is between zero and one (0<c<1)
Average propensity to consume (APC = C/Y) falls as income rises

4. Short-run Consumption Function
Consumption expenditure
C = C + cY
Constant APC c C
Disposable income

5. Empirical Evidence
High income families have a higher marginal propensity to save (MPS = 1 – MPC)
High income families have a higher average propensity to save (APS = 1 – APC); APC falls with the level of income
In the long-run, autonomous consumption falls to zero
(C = 0)

6. Long-run Consumption Function
Consumption expenditure
C = ćY
Variable APC;
Ĉ = 0 ć Ĉ
Disposable income

7. Irving Fisher: Intertemporal Choice
Consumption decisions are based on current and future income
Current period income = current income plus present value of future income: Y1 + Y2 / (1 + r), where r is a discount rate
Future period income = future income plus future value of current income: Y2 + (1 + r)Y1

8. The Intertemporal Budget Line
Future Period B C2 A Y2 C2 C C1 Y1 C1
Current Period

9. The Intertemporal Budget Line
Along BC, there is a trade-off between current and future consumption spending
Along AB, C1<Y1, but C2>Y2: consumers would save in current period to finance consumption in second period
Along AC, C1>Y1, but C2<Y2: consumers would borrow in current period and will pay off debt in future period

10. Consumer Preferences
Consumer preferences are shown by a family of indifference curves
Any combination of current and future consumption along an indifference curve provides the same level of satisfaction for the consumer
A higher indifference curve yields combinations with greater satisfaction

11. Consumer Preferences Future Period B A Current Period
Combination B is preferred to
combination A because it yields
more in both periods B A
Current Period

12. The Consumer’s Optimum
Consumer equilibrium is achieved at the tangency of the highest attainable indifference curve and the budget line
The tangency determines the optimum allocation of consumption spending in both periods; i.e. highest level of satisfaction within the budget

13. The Consumer’s Optimum
Future Period
Higher income shifts the budget
line up, positioning the consumer
on a higher indifference curve and
consumer’s optimum B
C2f A
C1f
C1c
C2c
Current Period

14. Franco Modigliani: Life Cycle Hypothesis
Consumption depends on income and wealth
C = Consumption expenditure
W = Consumer wealth
R = Length of productive life time
T = Years of life

15. C = (W + RY)/T = (1/T)W + (R/T)Y
Consumption Function
C = (W + RY)/T = (1/T)W + (R/T)Y
Define:
α = 1/T is the MPC out of wealth
β = R/T is the MPC out of income
C = αW + βY

16. Consumption Function C = αW + βY αW β 1 Consumption expenditure
Disposable income
For the United States, α = 0.02 and β = 0.60.

17. Consumption Function Consumption expenditure αW2 αW1 Disposable income
Increased wealth shifts the consumption function upward.

18. Consumer Behavior over Life Time
Consumption spending is a stable function of income
Consumers save their leftover income
Consumers accumulate wealth during the productive lifetime
Consumer finance retirement by dissaving and selling-off their assets

19. Consumer Behavior over Life Time$
Wealth
Income
Saving
Consumption
Dissaving R T
Years

20. Milton Friedman: Permanent Income Hypothesis
Measured income consists of permanent and transitory income; Y = YP + YT
Permanent income is the average income we make during years of productive life
Transitory income is the random variation from the average

21. Consumption Function Consumption is a function of permanent income
C = αYP
Consumers use saving and borrowing to smooth consumption in response to transitory changes in income

22. Determinants of Consumption
Combining all the theories, we can conclude that consumption depends on
Current income
Expected future income
Wealth
Interest rate