Topic 13:

macro Consumption
(chapter 16) (revised 11/19/03)

macroeconomics
fifth edition

N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich

© 2002 Worth Publishers, all rights reserved

 Chapter overview
This chapter surveys the most prominent work
on consumption:
 John Maynard Keynes: consumption and
current income
 Irving Fisher and Intertemporal Choice
 Franco Modigliani: the Life-Cycle Hypothesis
 Milton Friedman: the Permanent Income
Hypothesis
 Robert Hall: the Random-Walk Hypothesis
 David Laibson: the pull of instant gratification

CHAPTER 16 Consumption slide 1

 Keynes’s Conjectures
1.

2.
where APC
= average propensity to consume
= C/Y
3.

CHAPTER 16 Consumption slide 2

The Keynesian Consumption Function
A consumption function with the
C properties Keynes conjectured:

C  C  cY

c c = MPC
= slope of the
1
consumption
C function

CHAPTER 16 Consumption slide 3

The Keynesian Consumption Function
As income rises, the APC falls (consumers
C save a bigger fraction of their income).

C  C  cY

APC  _____________

slope = APC
Y

CHAPTER 16 Consumption slide 4

Early Empirical Successes:
Results from Early Studies
 Households with higher incomes:

 MPC > 0

 MPC < 1

 APC  as Y 
 Very strong correlation between income and
consumption
 income seemed to be the main
determinant of consumption
CHAPTER 16 Consumption slide 5
Problems for the
Keynesian Consumption Function
Based on the Keynesian consumption function,
economists predicted that __________
_________________________________.
This prediction did not come true:
 As incomes grew, the APC did not fall,
and C grew just as fast.
 Simon Kuznets showed that C/Y was
very stable in long time series data.

CHAPTER 16 Consumption slide 6

 The Consumption Puzzle

Consumption function
C from long time series
data (constant APC )

Consumption function
from cross-sectional
household data
(falling APC )

CHAPTER 16 Consumption slide 7

Irving Fisher and Intertemporal Choice
 The basis for much subsequent work on
consumption.
 Assumes consumer is forward-looking and
chooses consumption for the present and
future to maximize lifetime satisfaction.
 Consumer’s choices are subject to an
___________________________,
a measure of the total resources available
for present and future consumption

CHAPTER 16 Consumption slide 8

 The basic two-period model
 Period 1: the present
 Period 2: the future
 Notation
Y1 is income in period 1
Y2 is income in period 2
C1 is consumption in period 1
C2 is consumption in period 2
S = Y1 - C1 is ______________
(S < 0 if the consumer borrows in period 1)

CHAPTER 16 Consumption slide 9

Deriving the
intertemporal budget constraint
 Period 2 budget constraint:
C 2  Y 2  (1  r ) S
 _______________

 Rearrange to put C terms on one side

and Y terms on the other:
(1  r ) C 1  C 2  Y 2  (1  r )Y1

 Finally, divide through by (1+r ):

CHAPTER 16 Consumption slide 10

The intertemporal budget constraint

C2 Y2
C1   Y1 
1r 1r

present value of present value of

______________ _____________

CHAPTER 16 Consumption slide 11

 The intertemporal budget constraint

C2 C2 Y2
C1   Y1 
1r 1r
The budget
constraint
shows all __________ Consump =
combinations _____ income in
of C1 and C2 both periods
that just
exhaust the Y2
consumer’s _______
resources.
C1
Y1
_____________

CHAPTER 16 Consumption slide 12

The intertemporal budget constraint

C2 C2 Y2
C1   Y1 
The slope of 1r 1r
the budget
line equals
_________ ) 1
(1+r )

Y2

C1
Y1

CHAPTER 16 Consumption slide 13

 Consumer preferences

An ________ C2 Higher
______shows indifference
all combinations curves
of C1 and C2 that represent
make the higher levels
consumer of happiness.
_____________ Y
_____________.
X
Z IC2

W IC1
C1

CHAPTER 16 Consumption slide 14

 Consumer preferences

C2 The slope of
an indifference
Marginal rate of curve at any
substitution (MRS ): point equals
the amount of C2 the MRS
1 at that point.
consumer would be
MRS
________________
_________________.
IC1
C1
So the MRS is the (negative) of the
___________________________.
CHAPTER 16 Consumption slide 15
 Optimization

C2
The optimal (C1,C2) At the
is where the budget optimal point,
line just touches the __________
highest indifference
curve.
O

C1

CHAPTER 16 Consumption slide 16

 How C responds to changes in Y

C2 An increase in Y1 or Y2
Results: shifts the budget line
Provided they are outward.
both normal goods,
C1 and C2 both
increase,
…_____________
______________
______________
______________.
C1

CHAPTER 16 Consumption slide 17

 Temporary v. permanent
Temporary rise in Permanent rise in income:
income: Y1 alone Y1 and Y2 equally

C’ 2 C’2=Y’2
C2 = Y 2 C2= Y2

C’1 Y’1

Y1 =C1
Y’1 =‘C1
Y1=C

S’
1

C1 ' C1 C1 ' C1
Save part of income:  C moves with Y: 
Y1 ' Y1 Y1 ' Y1
So ________________. So _________________.
CHAPTER 16 Consumption slide 18
 Keynes vs. Fisher
 Keynes:
current consumption depends only on
current income
 Fisher:
current consumption depends only on
________________________________;
the timing of income is irrelevant
because the consumer can borrow or lend
between periods.

CHAPTER 16 Consumption slide 19

 How C responds to changes in r
C2
An increase in r
pivots the budget
line around the
point (Y1,Y2 ).
B

As depicted here, A
______________.
Y2
However, it could
turn out differently… C1
Y1

CHAPTER 16 Consumption slide 20

How C responds to changes in r
 ___________
If consumer is a saver, the rise in r makes him
better off, which tends to increase consumption
in both periods.
 ____________
The rise in r increases the opportunity cost of
current consumption, which tends to reduce C1
and increase C2.
 Both effects  C2.
Whether C1 rises or falls depends on the relative
size of the income & substitution effects.

CHAPTER 16 Consumption slide 21

 Constraints on borrowing
 In Fisher’s theory, the timing of income is irrelevant
because the consumer can borrow and lend across
periods.
 Example: If consumer learns that her future income
will increase, she can spread the extra consumption
over both periods by borrowing in the current period.
 However, if consumer faces _______________
(aka “liquidity constraints”), then she may not be able
to increase current consumption
and her consumption may behave as in the Keynesian
theory even though she is rational & forward-looking

CHAPTER 16 Consumption slide 22

 Constraints on borrowing

The borrowing C2
constraint takes
the form:
The budget
______ line with a
borrowing
constraint
Y2

Y1 C1

CHAPTER 16 Consumption slide 23

 Consumer optimization when the
borrowing constraint is not binding
C2

The borrowing
constraint is not
binding if the
consumer’s
optimal C1
___________.

Y1 C1

CHAPTER 16 Consumption slide 24

 Consumer optimization when the
borrowing constraint is binding

The optimal C2
choice is at
point D.
But since the
consumer
cannot borrow,
the best he can E
do is point E. D

Y1 C1

CHAPTER 16 Consumption slide 25

Suppose increase in income in period 1

So under C2 The rise in

borrowing income to Y’1
constraints, shifts the budget
current constraint right.
consumption C’1 rises with Y’1.
__________
E
__________
__________.
C1

CHAPTER 16 Consumption slide 26

 The Life-Cycle Hypothesis
 due to Franco Modigliani (1950s)
 Fisher’s model says that consumption
depends on lifetime income, and people try
to achieve smooth consumption.
 The LCH says that _________
__________ over the phases of the
consumer’s “life cycle,”
and saving allows the consumer to achieve
smooth consumption.

CHAPTER 16 Consumption slide 27

 The Life-Cycle Hypothesis
 The basic model:
W=
Y=
(assumed constant)
R = number of years until retirement
T = lifetime in years
 Assumptions:
– zero real interest rate (for simplicity)
– consumption-smoothing is optimal

CHAPTER 16 Consumption slide 28

 The Life-Cycle Hypothesis
 Lifetime resources =
 To achieve smooth consumption, consumer
divides her resources equally over time:
C = _____________ , or
C = aW + bY
where
a = (1/T ) is the marginal propensity to
consume out of wealth
b = (R/T ) is the marginal propensity to
consume out of income

CHAPTER 16 Consumption slide 29

Implications of the Life-Cycle Hypothesis
The Life-Cycle Hypothesis can solve the
consumption puzzle:
 The APC implied by the life-cycle
consumption function is
C/Y = _____________
 Across households, wealth does not vary as
much as income, so high income households
_______________________ than low income
households.
 Over time, aggregate wealth and income
grow together, causing APC __________.
CHAPTER 16 Consumption slide 30
 Implications of the Life-Cycle Hypothesis
$
The LCH
implies that
saving varies Wealth
systematically
over a
person’s Income
lifetime. Saving

Consumption Dissaving

Retirement End
begins of life
CHAPTER 16 Consumption slide 31
 Numerical Example
 Suppose you start working at age 20, work
until age 65, and expert to earn $50,000
each year, and you expect to live to 80.
 Lifetime income =
 Spread over 60 years, so
C=
So need to save $12,500 per year.

CHAPTER 16 Consumption slide 32

 Example continued
 Suppose you win a lottery which gives you $1000
today.
 Will spread it out over all T years, so consumption
rises by only $1000/T = $16.70 this year.
 So temporary rise in income has a _____
____________.
 But if lottery gives you $1000 every year for the T
years, consumption rises by ________
_________ this year.

CHAPTER 16 Consumption slide 33

The Permanent Income Hypothesis
 due to Milton Friedman (1957)
 The PIH views current income Y as the sum
of two components:
_______________ Y P
(average income, which people expect to
persist into the future)
_______________ Y T
(temporary deviations from average
income)

CHAPTER 16 Consumption slide 34

The Permanent Income Hypothesis
 Consumers use saving & borrowing to
smooth consumption in response to
transitory changes in income.
 The PIH consumption function:
C =
where a is the fraction of permanent
income that people consume per year.

CHAPTER 16 Consumption slide 35

The Permanent Income Hypothesis
The PIH can solve the consumption puzzle:
 The PIH implies
APC = C/Y =
 To the extent that high income households
have higher transitory income than low
income households, the APC will be _____
_________________ income households.
 Over the long run, income variation is due
mainly if not solely to variation in permanent
income, which implies a __________.

CHAPTER 16 Consumption slide 36

 PIH vs. LCH
 In both, people try to achieve smooth
consumption in the face of changing current
income.
 In the LCH, current income changes
systematically as people move through their
life cycle.
 In the PIH, current income is subject to
random, transitory fluctuations.
 Both hypotheses can explain the consumption
puzzle.

CHAPTER 16 Consumption slide 37

 The Random-Walk Hypothesis
 due to Robert Hall (1978)
 based on Fisher’s model & PIH, in which
forward-looking consumers base consumption
on expected future income
 Hall adds the assumption of rational
expectations, that people use all available
information to forecast future variables like
income.

CHAPTER 16 Consumption slide 38

 The Random-Walk Hypothesis
 If PIH is correct and consumers have rational
expectations, then consumption should follow a
random walk: ________________________
_____________________.
• A change in income or wealth that was
anticipated has already been factored into
expected permanent income, so it will not
change consumption.
• Only unanticipated changes in income or wealth
that alter expected permanent income will
change consumption.

CHAPTER 16 Consumption slide 39

Implication of the R-W Hypothesis

If consumers obey the PIH

and have rational expectations,
then policy changes
will affect consumption
only if _________________.

CHAPTER 16 Consumption slide 40

The Psychology of Instant Gratification
 Theories from Fisher to Hall assumes that
consumers are rational and act to maximize
lifetime utility.
 recent studies by David Laibson and others
consider the psychology of consumers.

CHAPTER 16 Consumption slide 41

The Psychology of Instant Gratification
 Consumers consider themselves to be
imperfect decision-makers.
– E.g., in one survey, 76% said they were
not saving enough for retirement.
 Laibson: The “pull of instant gratification”
explains why people don’t save as much as a
perfectly rational lifetime utility maximizer
would save.

CHAPTER 16 Consumption slide 42

Two Questions and Time Inconsistency
1. Would you prefer
(A) a candy today, or
(B) two candies tomorrow?
2. Would you prefer
(A) a candy in 100 days, or
(B) two candies in 101 days?
In studies, most people answered A to question 1,
and B to question 2.
A person confronted with question 2 may choose B.
100 days later, when he is confronted with question
1, the pull of instant gratification may induce him to
change his mind.
CHAPTER 16 Consumption slide 43
 Summing up
 Recall simple Keynesian consumption function:
C  C  cY
where only current income (Y) mattered.

 Research shows other things should be included:

– expected future income (perm’t income model)
– wealth (life cycle model)
– interest rates (Fisher model)
– but current income should still be present (due
to borrowing constraints)

 Modern policy analysis models allow for all this.

CHAPTER 16 Consumption slide 44