ECON 314:
MACROECONOMICS II
CONSUMPTION AND
CONSUMER EXPENDITURE
1 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• Explaining the observed patterns in data
on consumption and income: short-run
and cross-sectional data show that MPC <
APC, whilst long-run data show MPC =
APC.
• Several explanations put forward to solve
the consumption puzzle.
2 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Franco Modigliani and the Life Cycle
Hypothesis (LCH)
• Key names: Franco Modigliani, Albert Ando
and Richard Brumberg
• The LCH was put forward in a series of
papers written in the 1950s
3 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• Modigliani emphasised that income varies systematically over individuals’ (people’s) life time.
• According to the LCH, the typical individual has an income stream which is relatively low at the beginning and end of his/her life (retirement), when his/her productivity is low, and high during the middle of his/her life.
4 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• The LCH therefore views individuals as
planning their consumption and savings
behaviour over long periods with the intention
of allocating their consumption in the best
possible way over their entire lifetimes.
• Individuals are assumed to maintain a more or
less constant, if slightly rising level of
consumption throughout their lifetime. 5
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• The constraint to this consumption stream is
that the present value of this total consumption
does not exceed the present value of total
income.
• This implies that in the early years of a person’s
life, s/he is a net borrower. In the middle years,
s/he saves and repays debt and provides for
retirement. In the retirement years, s/he
dissaves. 6
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• This pattern of consumption and saving can be
illustrated below:
T t
Income
c
Y
Net Borrower/Dissaving
7 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• This pattern of consumption and saving can be
illustrated below:
8 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• Thus, instead of relying on a single value
(based on a psychological rule of thumb)
for the MPC, the LCH (based on
optimizing behaviour) implies different
MPCs out of permanent income,
transitory income and wealth.
9 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• The key assumption (as noted earlier but
stated in other words) is that individuals
choose stable lifestyles, not saving
furiously in one period for a huge
spending spree in the next.
10 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• Remember that if the assumptions made,
both about individuals and the
population, are stable then we can add up
all the individual consumption functions to
obtain a stable aggregate function in which
the population consumes k percent of the
present value of its income stream in each
period:
11 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• The aggregate consumption function can be
expressed as follows:
• Where the variables are as previously
defined
)( 00 PVkc
12 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• The next crucial step is to operationalize the
PV0 term.
• Ando and Modigliani provided an excellent
answer. They noted that income can be
divided into income from labour (work)
and income from assets and property
(wealth)
Ly
Py13
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• Thus, the PV0 term can be expressed as:
• Where 0 is the current period, and t ranges
from 0 to the remaining years of life, T.
T T
t
P
t
t
L
t
r
y
r
yPV
0 0
0)1()1(
14 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• Let us now attempt a simplification of this
decision-making over a life time.
• Let us suppose the individual starts life at
the age of 20, and plans to work until 65,
and will die at 80.
15 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• Again we can suppose that is now
initial wealth (W), and is now Y, which
is income from earnings.
• If the number of years an individual
expects to work before retirement, can be
defined as R.
Py
16 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
Ly
CONSUMPTION AND CONSUMER
EXPENDITURE
• Then the individual’s lifetime resources is
made up of initial wealth, W, and lifetime
earnings (R x Y).
• For simplicity we assume that interest rate
is zero, although if this were positive then
interest on savings will be included.
17 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• The individual’s decision now involves
ensuring a smooth consumption path over
the remaining life, T.
• The individual is expected to divide his/her
lifetime resources (W + RY) equally over the
remaining number of years, T.
18
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• The consumption function can be written as
TRYWC /)(
YT
RW
TC
1
19 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• Thus with our example, R = 45 and T = 60.
• The consumption function can be written as
• The equation above shows that consumption
depends on both wealth and income.
YWC 75.0017.0
20 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• For the whole economy, the aggregate
consumption function can be expressed as:
• Where is the MPC out of wealth and is
the MPC out of income.
YWC
21 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• Implications:
• For any given wealth, W, the LCH yields a
conventional consumption function (we
already know).
• However, the intercept of the consumption
function is not fixed, but depends on the level
of wealth.
• See figure on next slide!
22
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
23 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• Implications:
• The LCH can also solve the puzzle. Given the
consumption function, the APC is below:
Y
W
Y
C
24 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• Implications:
Here is the explanation in respect of the puzzle:
Because wealth does not vary proportionately
with income from person to person or from
year to year, we should expect to find that high
income corresponds to low APC when looking
at data across individuals or over short periods
of time. 25
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• Implications:
• Nevertheless, over long periods of time, wealth
and income grow together resulting in a
constant W/Y ratio, and thus a constant APC.
• Put differently, as wealth increases the
consumption function shifts upward. This
upward shift prevents the APC from falling as
income rises.
26
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• Implications:
• Once we have a theory of consumption we
also have a theory of saving.
• The LCH also predicts that saving varies
over an individual’s lifetime.
27 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• Implications:
• If an individual begins working life, s/he will
accumulate wealth during the working years,
and then run down their wealth during
retirement years.
• Thus, the young who are working save,
whilst the old who are retired dissave.
28
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• The Permanent-Income Hypothesis (PIC) is based on a book written in 1957.
• The Permanent-Income theory of consumption argues that consumption is related not to current income but to a longer-term estimate of income: what Friedman termed permanent-income.
29 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• The P-I theory complements Modigliani’s
LCH. But unlike the LCH which argues that
income follows a regular pattern over an
individual’s lifetime, the P-IH emphasises
that individuals experience random and
temporary changes in their incomes from year
to year.
30 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• Permanent income is the steady rate of
consumption an individual could maintain for
the rest of his/her life, given the present level
of wealth and income earned now and in the
future.
31 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• Friedman’s model of consumption begins
with the assumption of individual consumer
utility maximisation.
• This gives us the consumption function
between an individual’s consumption and
present value.
32
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• This is the consumption function for a
representative individual, ‘i’, over time.
• Only note that Friedman’s treatment of PV is
different from Ando-Modigliani’s.
0);( iiii fPVfc
33 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• The present value of the total income stream is
the current asset value of the income stream.
Multiplying this asset value by the rate of return,
r, yields Friedman’s permanent income from that
asset value:
ii
P PVry .
34 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• But as with Ando-Modigliani, Friedman assumes
that the consumer wants to smooth his/her actual
income stream into a more or less flat
consumption pattern.
• This gives a level of permanent consumption,
that is proportional to .
i
Pci
Py
35 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• This may be stated as follows:
• is the ratio of permanent consumption to permanent income, this depends on the interest rate, individual tastes, and the variability of expected income.
i
P
ii
P ykc ik
36 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• Aggregating over the entire population and
generalising, we have a simple form of the
equation:
• Where YP is permanent (disposable) income.
cYPC
37 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• Friedman also suggested we view current
income as the sum of two components:
permanent income and transitory income.
TP YYY 38
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• How can we think about the measurement of
permanent income?
• We know that an individual has a current
level of income, and forms some idea of the
level of consumption s/he can maintain for
the rest of his/her life.
39 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• But suppose income goes up! Then the individual has to decide whether the increase is permanent or merely transitory/temporary!
• Permanent income is that part of income that individuals expect to persist into the future. Transitory income is that which individuals do not expect to persist.
40
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• Nevertheless, in any particular case, an
individual may know whether an increase is
permanent or transitory.
• But in general an individual is not likely to be
so sure whether a change is permanent or
transitory.
41
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• Implications:
• Regarding the consumption puzzle, the P-IH argues that the Keynesian consumption function uses the wrong variable; that is, current income instead of permanent income.
• Relating current income to consumption results in what Friedman termed errors in variables problem.
42
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• Implications:
• According to the P-IH, the APC depends on the
ratio of permanent income to current income.
Y
Y
Y
cYP
Y
CAPC
P
43 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• Implications:
• When current income temporarily rises above
permanent income, the APC temporarily falls.
• When current income temporarily falls below
permanent income, the APC temporarily rises.
44
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• Implications:
• Regarding studies using household data, Friedman reasoned that these data reflect a combination of permanent and transitory income.
• Households with high permanent income, have proportionately high consumption. And if all variations in income came from permanent income, then the APC will be the same for all households.
45 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• Implications:
• However, some of the variations are the results of
transitory income, and households with high
transitory income do not have higher consumption.
• Therefore, the evidence from the data tend to
show that households with high-income, have on
average lower APC.
46 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• Implications:
• Regarding time series data, Friedman argued that
year-to-year fluctuations in income are
dominated by transitory income.
• Therefore, years of high income should be
years of low APC.
47 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Milton Friedman’s Permanent-Income
Hypothesis
• Implications:
• But over long periods of time, say from decade
to decade, variations in income are the result of
permanent income.
• Therefore, in long time series one should
observe a constant APC.
48 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Consumption Under Uncertainty: Robert Hall’s
Random-Walk Hypothesis
• The Random-Walk Hypothesis combines Irvin
Fisher’s assumptions on forward-looking
consumers with rational expectations.
• Rational expectations assumes that individuals
use all available information to make optimal
forecasts about the future.
49 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Consumption Under Uncertainty: Robert Hall’s
Random-Walk Hypothesis
• From our knowledge of the P-IH, we know
that if permanent income were known
exactly, then consumption will never
change.
50 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Consumption Under Uncertainty: Robert Hall’s
Random-Walk Hypothesis
• However with the RWH, there is a link
between income uncertainty and changes in
consumption.
• Changes in consumption therefore arise
from surprise changes in income.
51 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Consumption Under Uncertainty: Robert Hall’s Random-Walk Hypothesis
• According to the rational expectations theory, the surprise must be truly random and unpredictable.
• Thus the combination of permanent-income hypothesis and rational expectations implies that consumption follows a random walk.
• Robert Hall’s famous random walk model is specified as:
52 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Consumption Under Uncertainty: Robert Hall’s
Random-Walk Hypothesis
• This states that consumption tomorrow should
equal consumption today plus a truly random
error,
tt CC 1
tt CC 153
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Consumption Under Uncertainty: Robert Hall’s Random-Walk Hypothesis
• Implications:
• This approach to consumption has implications for the analysis of economic policies.
• If consumers are believed to follow this approach, then only unexpected policy changes influence consumption. These policy changes become effective when they change expectations.
54
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Consumption Under Uncertainty: Robert Hall’s Random-Walk Hypothesis
• Implications:
• Essentially, the effectiveness of a policy is dependent on how the policy announcement affects expectations. If expectations are unaffected, the policy is ineffective.
• Thus, policy makers influence the economy not only through their actions but also through the public’s expectation of their actions.
55 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Liquidity Constraints and Myopia
• It is worth noting that the LCH and P-IH do not explain all of consumption behaviour.
• Why might this be so? Two explanations are liquidity constraints and myopia.
• The first argues that when permanent income is higher than current income, consumers are unable to borrow to consume at the higher level predicted by the LCH and P-IH.
56 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Liquidity Constraints and Myopia
• The second suggests that consumers simply aren’t as forward-looking the theories argue.
• A liquidity constraint exists when a consumer cannot borrow to sustain current consumption in the expectation of higher future income.
• This condition is faced by most students, and those who are unable to borrow when their incomes drop temporarily.
57 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Liquidity Constraints and Myopia
• Fisher’s model suggests that individuals can
borrow and save. The ability to borrow allows
current consumption to exceed current income.
• But with a liquidity constraint, current
consumption cannot exceed current income. A
borrowing constraint exists when .
11 YC
58 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Liquidity Constraints and Myopia
• The figure below illustrates how the
borrowing constraint restricts the consumer’s
set of choices.
• In these circumstances, the consumer’s choice
must satisfy both the inter-temporal budget
constraint and borrowing constraint.
59
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
60 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Liquidity Constraints and Myopia
• The shaded area represents the combinations of
the first-period consumption and second-period
consumption that satisfy both constraints.
• In the next figure we show two possibilities. In (a)
the consumer wishes to consume less in period one
than s/he earns. Hence the liquidity constraint is not
binding.
61
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Liquidity Constraints and Myopia
• In (b) the consumer will like to consume at point D, where s/he will consume more in period one than s/he earns, but the liquidity constraint prevents this outcome.
• The best outcome is for the individual to consume all of his/her period one income.
• The foregoing analysis suggests that there are two consumption functions, one for those facing liquidity constraints and one for those who are unconstrained by borrowing.
62 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
• the shad
63 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Liquidity Constraints and Myopia
• For such students who face the liquidity constraint, when they complete their education and get jobs, their incomes will rise and their consumption too will rise.
• But according to the LCH (and PIH), consumption should not rise much when income rises, so long as the increase in income was expected.
64 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
Liquidity Constraints and Myopia
• Because liquidity constraint is relieved, consumption will rise a lot when income rises. This implies that consumption will be more closely related to current income than is implied by the LCH and PIH.
• The explanation for myopia is hard to distinguish in practice from the liquidity constraints hypothesis. That is any expectation of a rise in income does not change consumption until the actual increase takes place.
65 Macroeconomics II Lecture Notes Prepared
by Dr. Emmanuel Codjoe
CONSUMPTION AND CONSUMER
EXPENDITURE
David Laibson and the Pull of Instant
Gratification
• Laibson argues that consumers judge themselves
to be imperfect decision-makers.
• Consumption decisions are influenced by
psychological factors, in contrast to the rational
utility maximisation presumption.
• This raises the possibility that consumers’
preferences are time-inconsistent.
66
Macroeconomics II Lecture Notes Prepared by Dr. Emmanuel Codjoe