Mankiw 5_e Chapter 16_ Consumption

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Mankiw 5_e Chapter 16_ Consumption Powered By Docstoc
					                 Chapter 10




CHAPTER 10   Consumption demand   slide 0
              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 10   Consumption demand                      slide 1
      1. Fluctuations in GDP




CHAPTER 10   Consumption demand   slide 2
      1. Fluctuations in GDP




CHAPTER 10   Consumption demand   slide 3
            Fluctuations in GDP
Why consumption fluctuates less than GDP?
-    Consumption depends on disposable income, if
     disposable income fluctuates less, consumption
     fluctuates less.
Note: GDP is 40% greater than personal disp. Income
  (includes depreciation, taxes, transfers, etc). Taxes
  fall during recessions and transfers increase,
  therefore disposable income does not fall as much
  as GDP.




    CHAPTER 10   Consumption demand                       slide 4
        Fluctuations in GDP




CHAPTER 10   Consumption demand   slide 5
        Fluctuations in GDP




CHAPTER 10   Consumption demand   slide 6
Simple Keynesian consumption function

                    C = 0.94 Yd


  MPC = 0.94: US public spends 0.94 from
    disposable income and saves 0.6.
  - Sometimes less, sometimes greater:

                 Error = C – 0.94 Yd




  CHAPTER 10   Consumption demand          slide 7
      Are these errors large?




CHAPTER 10   Consumption demand   slide 8
    Short Run – Long Run MPC
Long Run MPC- how much consumption increases over the long
   haul when personal disposable income rises – LRMPC = 0.94
Short Run MPC – how much consumption rises over short run
   (during one year or one business cycle)




 CHAPTER 10    Consumption demand                              slide 9
CHAPTER 10   Consumption demand   slide 10
    The forward looking theory of
            consumption
Theories that explain the puzzle:
Milton Friedman (1950) – permanent income theory
Franco Modigliani(1950) – life cycle theory
Both: FORWARD LOOKING THEORY OF
   CONSUMPTION – individual consumers are
   forward looking decision makers
- families expect that income is long lasting, and base
    their consumption on their today’s disposable
    income, but also future income from working,
    accumulating wealth and future taxes.

 CHAPTER 10   Consumption demand                      slide 11
Intertemporal Budget Constraint
§ 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


 CHAPTER 10   Consumption demand               slide 12
Intertemporal budget constraint




CHAPTER 10   Consumption demand   slide 13
Intertemporal budget constraint
         At+1 = At + Rat + Et –Tt – Ct
At - assets in the beginning of year
R – interest rate on assets
Et- income from working during year t
Tt- taxes during year t
Ct – consumption during year t



 CHAPTER 10   Consumption demand         slide 14
Preferences: steady consumption
Forward looking theory of consumption:
Most people prefer to keep their consumption fairly
   steady from year to year.




 CHAPTER 10    Consumption demand                     slide 15
Preferences: how large an inheritance for
          the next generation?




   CHAPTER 10   Consumption demand     slide 16
MPC – Temporary versus permanent
           changes
There is a relationship between family’s current assets +
   expectations about future earnings and its consumption
   decision.
How much C changes when Yd changes?
For forward looking consumers – depends on how long the
    income change will last – temporary or permanent
§    Income increases permanently (permanent cut in taxes) –
     consumption rises by the full amount of increases in income.
§    Income increases temporary (temporary cut in taxes) –
     consumption rises by the interest earned by the increment +
     a bit more if it does not want to pass the full amount on to
     the next generation.


    CHAPTER 10   Consumption demand                             slide 17
Anticipated versus unanticipated changes
                in income
  Current consumption responds not only to
    changes in current income but also to
    changes in expected future income.




   CHAPTER 10   Consumption demand           slide 18
    How well does the forward looking
                theory?
Key point: MPC depends on whether the new funds are a one
   time increment or they will occur in the future: low when
   temporary changes (average = interest rate) + and high
   (close to 1) if permanent changes.
What have we seen:
§    If consumers expect short run fluctuations – in recession –
     they no drop their consumption as if it was permanent –
     consumers view recessions and booms as temporary
§    Exception that proves the rule: in the recession 1973:
     increase in oil price – permanent – forward looking theory
     predicts that consumers would have to cut their expenditures
     more than in a typical recession, this is what happened.



    CHAPTER 10   Consumption demand                                slide 19
         Consumer preferences

An indifference        C2            Higher
curve shows all                      indifference
combinations of                      curves
C1 and C2 that                       represent
make the                             higher levels
consumer                             of happiness.
equally happy.
                                      IC2

                                     IC1
                                               C1


   CHAPTER 10   Consumption demand              slide 20
              Keynes vs. Fisher
§ Keynes:
 current consumption depends only on
 current income
§ Fisher:
 current consumption depends only on
 the present value of lifetime income;
 the timing of income is irrelevant
 because the consumer can borrow or lend
 between periods.


 CHAPTER 10    Consumption demand          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 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

   CHAPTER 10   Consumption demand                         slide 22
So assets matter for consumption?
 § due to Franco Modigliani (1950s)
 § Fisher’s model says that consumption depends on
   lifetime income, and people try to achieve smooth
   consumption.
 § The Ando- Modigliani theory - a change in
   income , given the value of assets, is a indicative of
   a permanent change in income (the current level of
   income is representative for all future incomes). Or ,
   else, a change in the value of total assets, given the
   level of income, would be a temporary change (ex.
   One time increase in the value of corporate stock)




  CHAPTER 10   Consumption demand                      slide 23
     The Life-Cycle Hypothesis
§ The basic model:
  A = assets
  Yd = disposable income

                  C = b 1 Yd + b 2 A
§ Modification of the Keynesian cons. fc.: assets have
  been added to income.
§ Errors can be eliminated from Keynesian fc.
§ Ex. The decline in consumption can be explained
  (1973) by the drop in stock markets.


 CHAPTER 10   Consumption demand                     slide 24
The Permanent Income Hypothesis
§ due to Milton Friedman (1957)
§ The PIH defined permanent income as the constant
  level of annual income = family’s assets + expected
  future income. All other changes in income are
  transitory.
§ MPC from permanent income must be 1, and from
  transitory income must be close to 0.
§ permanent income Y P (average income, which
  people expect to persist into the future) and
  transitory income Y T (temporary deviations from
  average income)

 CHAPTER 10   Consumption demand                        slide 25
The Permanent Income Hypothesis
The PIH consumption function:
      C = b p Yp
Yp – permanent disposable income
bp- close to 1
Ass. that permanent income is an average of income
  over the several years: if current income suddenly
  increase there is only a small increase in permanent
  income.
Consumption should depend on past income as well
  as current income (helps people better forecast
  future income).


 CHAPTER 10   Consumption demand                     slide 26
 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 10   Consumption demand                  slide 27
  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.

 CHAPTER 10   Consumption demand                  slide 28
Implication of the R-W Hypothesis


        If consumers obey the PIH
      and have rational expectations,
            then policy changes
          will affect consumption
       only if they are unanticipated.



 CHAPTER 10   Consumption demand         slide 29
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 10   Consumption demand               slide 30
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 10   Consumption demand                 slide 31
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 10   Consumption demand                     slide 32
               Summing up
§ Keynes suggested that consumption depends
 primarily on current income.
§ Recent work suggests instead that consumption
 depends on
  – current income
  – expected future income
  – wealth
  – interest rates
§ Economists disagree over the relative
 importance of these factors and of borrowing
 constraints and psychological factors.

 CHAPTER 10   Consumption demand                slide 33
              Chapter summary
1. Keynesian consumption theory
   § Keynes’ conjectures
      § MPC is between 0 and 1
      § 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:
       MPC close to 1.


 CHAPTER 10   Consumption demand                    slide 34
              Chapter summary
2. Fisher’s theory of intertemporal choice
   § Consumer chooses current & future
     consumption to maximize lifetime satisfaction
     subject to an intertemporal budget constraint.
   § Current consumption depends on lifetime
     income, not current income, provided consumer
     can borrow & save.
3. Modigliani
   § Income varies systematically over a lifetime.
   § Consumers use saving & borrowing to smooth
     consumption.
   § Consumption depends on income & wealth.
 CHAPTER 10   Consumption demand                     slide 35
              Chapter summary
4. Friedman’s Permanent-Income Hypothesis
   § Consumption depends mainly on permanent
     income.
   § Consumers use saving & borrowing to smooth
     consumption in the face of transitory
     fluctuations in income.
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 10   Consumption demand                   slide 36
              Chapter summary
6. Laibson and the pull of instant gratification
   § Uses psychology to understand consumer
     behavior.
   § The desire for instant gratification causes people
     to save less than they rationally know they
     should.




 CHAPTER 10   Consumption demand                    slide 37

				
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