Macroeconomics
Lecture 12
Micro-foundation and
the Behavior Analysis
on Consumption
I. Introduction
The Critique to Keynesian Economics
The lacking in micro-foundation;
Unable to explain growth;
Unable to explain and deal with stagflation.
I. Introduction
The objective of this lecture
is to dealing with the first critique—the lacking of
micro-foundation by introducing
• some models of behavior analysis on the consumption
derived from optimization.
• The bounded rationality, which may regarded to be a
model of output determination in New Keynesian
analysis.
II. Irving Fisher’s Inter-temporal
Choice of Consumption
The Inter-temporal Budget Constraint
Suppose a consumer’s life can be divided into 2
periods, and therefore we denote
Y
1
Y1: income in period 1;
Y2: income in period 2;
C1: consumption in period 1;
C2: consumption in period 2.
II. Irving Fisher’s Inter-temporal
Choice of Consumption
The Inter-temporal Budget Constraint
(continued)
Since the consumer should be died in period 2,
saving should come only from period 1:
S = Y1 - C1 (A)
II. Irving Fisher’s Inter-temporal
Choice of Consumption
The Inter-temporal Budget Constraint
(continued)
This indicates that
C2 = (1+r)S+Y2 (B)
where r is the interest rate.
Note that here S can also be regarded as
borrowing (dis-saving).
II. Irving Fisher’s Inter-temporal
Choice of Consumption
The Inter-temporal Budget Constraint
(continued)
Express S in (B) in terms of (A), we obtain
C2 = (1+r)(Y1 - C1) + Y2
or
C1+C2/(1+r) = Y1 + Y2/(1+r)
This budget constraint can be graphed
as in the figure of the next page.
II. Irving Fisher’s Inter-temporal
Choice of Consumption
The Inter-temporal Budget Constraint
(continued)
II. Irving Fisher’s Inter-temporal
Choice of Consumption
The Inter-temporal Budget Constraint
(continued)
Important remark: Here it is assumed that the
future income Y2 is known in advance when the
consumer make his consumption decision at, say,
the beginning of period 1.
II. Irving Fisher’s Inter-temporal
Choice of Consumption
Consumer Preference
The consumer’s preference can be represented by
a utility function
U = U(C1, C2)
The property of such utility function could be
represented by a map of indifference curves (see
the figure in the next page).
II. Irving Fisher’s Inter-temporal
Choice of Consumption
Consumer Preference (continued)
II. Irving Fisher’s Inter-temporal
Choice of Consumption
Decision Problem
Choose C1 and C2 such that
Max U(C1,C2)
subject to
C1+C2/(1+r) = Y1 + Y2/(1+r)
II. Irving Fisher’s Inter-temporal
Choice of Consumption
Solution to the Decision Problem
MRS between C1 and C2 is equal to 1/(1+r)
(see the figure in the next page)
II. Irving Fisher’s Inter-temporal
Choice of Consumption
Solution to the Decision Problem (continued)
C1
1
1+r
0 C2
(1+r)Y1+Y2
II. Irving Fisher’s Inter-temporal
Choice of Consumption
The Effect of Income Change
Increasing income Y1 and Y2 will increase both C1
and C2 (see the figure in the next page).
II. Irving Fisher’s Inter-temporal
Choice of Consumption
The Effect of Income Change (continued)
1
1+r
0 C2
(1+r)Y1+Y2
II. Irving Fisher’s Inter-temporal
Choice of Consumption
The Effects of Interest Rate Change
Increasing interest rate r will increase C2 while
reduce C1 yet whether the utility will increase or
decrease is not clear (see the figure in the next
page)
II. Irving Fisher’s Inter-temporal
Choice of Consumption
The Effects of Interest Rate Change
(continued)
II. Irving Fisher’s Inter-temporal
Choice of Consumption
The Implication
Consumption is not only related to the current
income, but also to the interest rate and to the
future income the consumer expects.
There is no sense of saving over the life of the
consumer.
III. Modigliani’s Life
Cycle Hypothesis
The Basic Hypothesis
Income is varied systematically over a consumer’s
life.
The consumer pursues a relatively smoothed
consumption over its life.
III. Modigliani’s Life
Cycle Hypothesis
The Model
Let
T: the years the consumer expect to live
R: the years from now to retire
Y: income expect earned from now to retire
W: the current wealth
III. Modigliani’s Life
Cycle Hypothesis
The Model (continued)
Thus, the life time income (when ignoring interest
rate) is equal to
W+RY.
III. Modigliani’s Life
Cycle Hypothesis
The Model (continued)
The Decision Property: Since consumer pursues a
smoothed consumption sequence over his life, the
consumption in each period could be written as
C = (1/T)W+(R/T)Y
or
C = aW + bY
III. Modigliani’s Life
Cycle Hypothesis
The Implication
Since b = R/T < 1, the model indicates that saving
allows the consumer to move income from the
periods when income is high to the periods when
income is low.
IV. Friedman’s Permanent
Income Hypothesis
The Basic Hypothesis
The total income of a consumer is composed of
two parts:
• the permanent income Yp and
• the transitory income Yt
The consumer also pursues a relatively smoothed
consumption over its life.
IV. Friedman’s Permanent
Income Hypothesis
The Decision Property
Since consumer pursues a smoothed consumption
sequence over his life, the consumption in each
period could be written as
C = aYp + bYt
where b is much smaller in comparing
with a. Why?
IV. Friedman’s Permanent
Income Hypothesis
Implication
Change in consumption should mainly depend on
change in permanent income.
IV. Friedman’s Permanent
Income Hypothesis
The Challenge to Keynesian Theory from the
Behavior Analysis of Consumption
The key issues:
• Is consumption related to the current realized income?
• Is the marginal propensity to consume is less than 1?
V. The bounded
Rationality
The model of output decision in Keynesian analysis
Given P, W and Yd
max PY WL
subject to
Y f ( L)
Y Yd
Remark: the firm is in the competitive market?
V. The bounded
Rationality
Solution without bound
MC(Y*) = P
Here Y* can be regarded as the neoclassical
output, or an output without the demand
bound Yd
V. The bounded
Rationality
The bounded rationality: the output bounded
by the demand
Y d Y d Y *
Y * d
Y Y Y*
See the followed figure in the next page
V. The bounded
Rationality
The bounded rationality
V. The bounded
Rationality
The assumption of over capacity
Is this model of output determination
together with sticky price model indicates
excess capacity as a general or usual
phenomenon?