chap16 - consumption

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M M ACROECONOMICS ACROECONOMICS C H A P T E R © 2007 Worth Publishers, all rights reserved SIXTH EDITION SIXTH EDITION PowerPoint PowerPoint ® Slides by Ron Cronovich Slides by Ron Cronovich N N . . G G REGORY REGORY M M ANKIW ANKIW Consumption 16

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Mankiw 6e PowerPoints© 2007 Worth Publishers, all rights reserved
SIXTH EDITION
N. GREGORY MANKIW
Consumption
16
This long chapter is a survey of the most prominent work on consumption since Keynes. It is particularly useful to students who expect to continue with graduate studies in economics.
After reviewing the Keynesian consumption function and its implications, the chapter presents Irving Fisher’s theory of intertemporal choice, the basis for much subsequent work on consumption. This section of the chapter uses indifference curves and budget constraints. The chapter and this PowerPoint presentation do not require or assume that students know these tools. But if they have not, then this section of the chapter is the most difficult.
The chapter then presents the Life-Cycle and Permanent Income Hypotheses, and discusses Hall’s Random Walk Hypothesis.
Finally, there is a brief discussion of some very recent work by Laibson and others on psychology and economics, in particular how the pull of instant gratification can cause consumers to deviate from perfect rationality.
Note: if you are covering Chapter 15 on government debt, please note that you can better explain Ricardian Equivalence (a topic from Chapter 15) using the Fisher model presented in this chapter. Just show students that a debt-financed tax cut is a movement along the budget constraint, not an outward shift of the constraint, and it should be clear that the optimal bundle of current and future consumption is not affected.
slide *
an introduction to the most prominent work on consumption, including:
John Maynard Keynes: consumption and current income
Irving Fisher: intertemporal choice
Milton Friedman: the permanent income hypothesis
Robert Hall: the random-walk hypothesis
David Laibson: the pull of instant gratification
slide *
falls as income rises.
consumption.
The MPC was defined in chapter 3 and used in various chapters since.
slide *
Interpretations of C-bar:
autonomous consumption: the portion of consumption that does not depend on income
the value of consumption if income were zero.
a shift parameter
The Keynesian consumption function
As income rises, consumers save a bigger fraction of their income, so APC falls.
C
Y
slope = APC
Pick a point on the consumption function; that point represents a particular combination of consumption and income.
Now draw a ray from the origin to that point. The slope of that ray equals the average propensity to consume at that point.
(Why? The slope equals the rise over the run. The rise from zero to that point equals the value of C at that point. The run from zero to that point equals the value of Y at that point. Hence, the rise over the run equals C/Y, or the APC.)
At higher values of Y, the APC (or the slope of the ray from the origin) is smaller. This is what Keynes conjectured: at higher values of income, people spend a smaller fraction of their income.
slide *
APC as Y
income seemed to be the main
determinant of consumption
Problems for the
Keynesian consumption function
Based on the Keynesian consumption function, economists predicted that C would grow more slowly than Y over time.
This prediction did not come true:
As incomes grew, APC did not fall,
and C grew at the same rate as income.
Simon Kuznets showed that C/Y was
very stable in long time series data.
slide *
Consumption function from cross-sectional household data
(falling APC )
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 intertemporal budget constraint,
a measure of the total resources available for present and future consumption.
slide *
(S < 0 if the consumer borrows in period 1)
Note: there is no saving in period 2. Period 2 is the final period, and there are no bequests, so saving in period 2 would only reduce lifetime consumption and therefore lifetime utility/satisfaction.
slide *
Explain the intuition/interpretation of the period 2 budget constraint.
If students understand it, then everything else follows nicely.
slide *
present value of lifetime consumption
present value of lifetime income
If your students are not familiar with the present value concept, it is explained in a very nice FYI box on p.463.
slide *
The budget constraint shows all combinations
of C1 and C2 that just exhaust the consumer’s resources.
C1
C2
Y1
Y2
Borrowing
Saving
Consump = income in both periods
The point (Y1, Y2) is always on the budget line because C1=Y1, C2=Y2
is always possible, regardless of the real interest rate or the existence of borrowing constraints.
To obtain the expression for the horizontal intercept, set C2=0 in the equation for the intertemporal budget constraint and solve for C1. Similarly, the expression for the vertical intercept is the value of C2 when C1=0. There is intuition for these expressions. Take the vertical intercept, for example. If the consumer sets C1=0, then he will be saving all of his first-period income. In the second period, he gets to consume this saving plus interest earned, (1+r)Y1, as well as his second-period income.
If the consumer chooses C1<Y1, then the consumer will be saving, so his C2 will exceed his Y2.
Conversely, if consumer chooses C1>Y1, then consumer is borrowing, so his second-period consumption will fall short of his second-period income (he must use some of the second-period income to repay the loan).
slide *
-(1+r )
The slope of the budget line equals -(1+r):
To increase C1 by one unit, the consumer must sacrifice (1+r) units of C2.
slide *
that make the consumer
C1
C2
IC1
IC2
slide *
the consumer
one unit of C1.
The slope of an indifference curve at any point equals the MRS
at that point.
budget line
just touches
C1
C2
O
All points along the budget line are affordable, including the two points where the orange indifference curve intersects the budget line. However, the consumer prefers (and can afford) point O to these points, because O is on a higher indifference curve.
At the optimal point, the slope of the indifference curve (MRS) equals the slope of the budget line (1+r).
slide *
An increase
Results:
Provided they are both normal goods, C1 and C2 both increase,
…regardless of whether the income increase occurs in period 1 or period 2.
C1
C2
slide *
current income.
the present value of lifetime income.
The timing of income is irrelevant
because the consumer can borrow or lend between periods.
If you covered Ricardian Equivalence in Chapter 15, you might wish to revisit it briefly at or around this point in the presentation.
Draw the intertemporal budget constraint. Pick a point on it to represent
(Y1–T1, Y2–T2).
Now suppose the government gives each consumer a one-unit tax cut. Disposable income in period 1 rises by 1.
Assume the government is not changing G1 or G2, and, just to keep things simple, assume that the government’s budget was balanced prior to the tax cut.
Then, cutting taxes by one unit in period 1 requires that the government borrow one unit in period 1, which it must repay with interest in period 2. In order to retire this debt in period 2, the government must raise period-2 taxes by (1+r).
Thus, disposable income rises by 1 in period 1 and falls by (1+r) in period 2.
Notice that the present value of the fall in period-2 income is exactly equal to the rise in period 1 income. Thus, consumer is not any better off.
What’s happened here is that the government has altered the timing of taxes (shifting some of the burden from the present to the future), but has not altered the present value of lifetime taxes. Therefore, the budget constraint does not shift out. Rather, the income point simply moves along the line toward the southeast (one unit to the right, and 1+r units downward).
The combination (C1, C2) that was optimal before will still be feasible and optimal.
slide *
An increase in r pivots the budget line around the
point (Y1,Y2 ).
However, it could turn out differently…
A
C1
C2
Y1
Y2
A
B
slide *
How C responds to changes in r
income effect: If consumer is a saver,
the rise in r makes him better off, which tends to increase consumption in both periods.
substitution effect: 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.
Note: Keynes conjectured that the interest rate matters for consumption only in theory. In Fisher’s theory, the interest rate doesn’t affect current consumption if the income and substitution effects are of equal magnitude.
After you have shown and explained this slide, it would be useful to pause for a moment and ask your students (perhaps working in pairs) to do the analysis of an increase in the interest rate on the consumption choices of a borrower. In that case, the income effect tends to reduce both current and future consumption, because the interest rate hike makes the borrower worse off. The substitution effect still tends to increase future consumption while reducing current consumption. In the end, current consumption falls unambiguously; future consumption falls if the income effect dominates the substitution effect, and rises if the reverse occurs.
slide *
Constraints on borrowing
In Fisher’s theory, the timing of income is irrelevant: 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 borrowing constraints (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.
slide *
Y1
Y2
C1
C2
slide *
C1 Y1
slide *
The borrowing constraint is not binding if the consumer’s
optimal C1
(Figure 16-9, panel (a), on p.470)
In this case, the consumer optimally was not going to borrow, so his inability to borrow has no impact on his choices.
slide *
The optimal choice is at point D.
But since the consumer cannot borrow, the best he can do is point E.
Y1
D
E
C1
C2
(Figure 16-9, panel (b), on p.470)
In this case, the consumer would like to borrow to achieve his optimal consumption at point D. If he faces a borrowing constraint, though, then the best he can do is at point E.
If you have a few minutes of classtime available, have your students do the following experiment:
(This is especially useful if you have recently covered Chapter 15 on Government Debt)
Suppose Y1 is increased by $1000 while Y2 is reduced by $1000(1+r), so that the present value of lifetime income is unchanged. Determine the impact on C1
- when consumer does not face a binding borrowing constraint
- when consumer does face a binding borrowing constraint
Then relate the results to the discussion of Ricardian Equivalence from Chapter 15.
Note that the intertemporal redistribution of income in this exercise could be achieved by a debt-financed tax cut in period 1, followed by a tax increase in period 2 that is just sufficient to retire the debt.
In the text, pages 470-71 contain a case study on the high Japanese saving rate that relates to the material on borrowing constraints just covered.
slide *
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 income varies systematically over the phases of the consumer’s “life cycle,”
and saving allows the consumer to achieve smooth consumption.
slide *
R = number of years until retirement
T = lifetime in years
consumption-smoothing is optimal
The initial wealth could be zero, or could be a gift from parents to help the consumer get started on her own.
slide *
C = (W + RY )/T , or
C = aW + bY
consume out of wealth
b = (R/T ) is the marginal propensity to consume out of income
slide *
The LCH can solve the consumption puzzle:
The life-cycle consumption function implies
APC = C/Y = a(W/Y ) + b
Across households, income varies more than wealth, so high-income households should have a lower APC than low-income households.
Over time, aggregate wealth and income grow together, causing APC to remain stable.
slide *
Implications of the Life-Cycle Hypothesis
The LCH implies that saving varies systematically over a person’s lifetime.
Saving
Dissaving
Retirement
begins
End
where
average income, which people expect to persist into the future
Y T = transitory income
temporary deviations from average income
The middle of page 476 gives two hypothetical examples that help students understand the concepts of permanent and transitory income.
slide *
The Permanent Income Hypothesis
Consumers use saving & borrowing to smooth consumption in response to transitory changes in income.
The PIH consumption function:
C = a Y P
where a is the fraction of permanent income that people consume per year.
slide *
The PIH implies
If high-income households have higher transitory income than low-income households,
APC is lower in high-income households.
Over the long run, income variation is due mainly (if not solely) to variation in permanent income, which implies a stable APC.
slide *
LCH: current income changes systematically
as people move through their life cycle.
PIH: current income is subject to random, transitory fluctuations.
Both can explain the consumption puzzle.
slide *
based on Fisher’s model & PIH,
in which forward-looking consumers base consumption on expected future income
Hall adds the assumption of
rational expectations,
slide *
The Random-Walk Hypothesis
If PIH is correct and consumers have rational expectations, then consumption should follow a random walk: changes in consumption should
be unpredictable.
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.
and have rational expectations, then policy changes
will affect consumption
only if they are unanticipated.
This result is important because many policies affect the economy by influencing consumption and saving. For example, a tax cut to stimulate aggregate demand only works if consumers respond to the tax cut by increasing spending. The R-W Hypothesis implies that consumption will respond only if consumers had not anticipated the tax cut.
This result also implies that consumption will respond immediately to news about future changes in income. Students connect with the following example: Suppose a student is job-hunting in her senior year for a job that will begin after graduation. If the student secures a job with a higher salary than she had expected, she is likely to start spending more now in anticipation of the higher-than-expected permanent income.
slide *
The Psychology of Instant Gratification
Theories from Fisher to Hall assume that consumers are rational and act to maximize lifetime utility.
Recent studies by David Laibson and others consider the psychology of consumers.
slide *
Consumers consider themselves to be imperfect decision-makers.
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.
slide *
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 1 and (B) to 2.
A person confronted with question 2 may choose (B).
But in 100 days, when confronted with question 1,
the pull of instant gratification may induce her to change her answer to (A).
The text discusses time inconsistency in this context. Time inconsistency was introduced and defined in chapter 14.
slide *
Recent work: consumption also depends on
expected future income
Economists disagree over the relative importance of these factors, borrowing constraints,
and psychological factors.
APC falls as income rises
current income is the main determinant of current consumption
Empirical studies
in household data & short time series: confirmation of Keynes’ conjectures
in long-time series data:
CHAPTER 16 Consumption
Consumer chooses current & future consumption to maximize lifetime satisfaction of subject to an intertemporal budget constraint.
Current consumption depends on lifetime income, not current income, provided consumer can borrow & save.
CHAPTER 16 Consumption
Income varies systematically over a lifetime.
Consumers use saving & borrowing to smooth consumption.
Consumption depends on income & wealth.
CHAPTER 16 Consumption
Consumption depends mainly on permanent income.
Consumers use saving & borrowing to smooth consumption in the face of transitory fluctuations in income.
CHAPTER 16 Consumption
5. Hall’s random-walk hypothesis
Combines PIH with rational expectations.
Main result: changes in consumption are unpredictable, occur only in response to unanticipated changes in expected permanent income.
CHAPTER 16 Consumption
Uses psychology to understand consumer behavior.
The desire for instant gratification causes people to save less than they rationally know they should.
CHAPTER 16 Consumption