Intermediate macroeconomics chapt16

Chapter 16: Consumption


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)


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


Short-run Consumption Function
Consumption expenditure

C = C + cY
Constant APC

c
C
Disposable income

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)


Long-run Consumption Function
Consumption expenditure

C = ćY
Variable APC;
Ĉ=0

ć
Ĉ
Disposable income


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


The Intertemporal Budget Line
Future Period
B
C2
A

Y2
C2
C1

Y1

C1

C
Current Period


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 C2current period and will pay off debt in future period

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


Consumer Preferences
Future Period

Combination B is preferred to
combination A because it yields
more in both periods

B
A

Current Period


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

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
C2f
C1f

B
A

C1c

C2c

Current Period


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

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


Consumption Function
Consumption expenditure

1

C = αW + βY

β

αW
Disposable income
For the United States, α = 0.02 and β = 0.60.


Consumption Function
Consumption expenditure

αW2
αW1
Disposable income
Increased wealth shifts the consumption function upward.

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 sellingoff their assets


Consumer Behavior over Life Time
$
Wealth
Income
Saving
Consumption

Dissaving

R

T

Years


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


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


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