Economic 157b

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The economics of consumption
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Notes on the mid-term exam The midterm
examination is Wednesday October 21, 1135
1250. All information posted on the course web
site. Coverage It will cover all materials
through the material on Consumption (which will
be covered through October 19). Format (the
following is indicative only) There will be
three parts. First section will be shorties
definitions, true-false, compare, or the
like. The other sections will be problems and
thought questions. Sample midterm and solution
will be postedReview sessions A schedule will
be posted online Prof review session here on
Friday.
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Logistics
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Importance of consumption in macro

• 1. Consumption is two-thirds of GDP
  understanding its determinants is major part of
  the ball game.
• 2. Consumption is the entire point of the
  economy
• 3. Consumption plays two roles in microeconomics
• a. It is a major part of AD in the short run
  recall IS curve in which
• Y C(Yd) I G NX
• b. What is not consumed is saved and influences
  national investment and economic growth

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Growth in C and GDP
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The importance of fiscal policy today

• When the economy is in a liquidity trap and
  recession, major available policy tool is fiscal
  policy (remember IS-LM and Summers quote)
• But, fiscal policy has multiple problems
• Purchases
• - Controversial because increase size of
  government
• - Long lags (recognition, decision,
  implementation)
• - Infrastructure and other programs have long
  gestation periods.
• Tax Cuts
• - One view people will smooth consumption, and
  even anticipate a future tax increase, and there
  will be little or no response.
• - Other view people are short-sighted and/or
  liquidity constrained, and they will spend a
  substantial fraction of increased incomes
• Here is where we need to study carefully the
  economics of consumption.

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Alternative Theories of Consumption

• The basic Keynesian insight is that consumption
  depends fundamentally on personal income
  (consumption function)
• This enters into the Keynesian models as C a
  ßYd
• On a closer look, a major puzzle the short-run
  and cross-sectional consumption functions looked
  very different from the long-term consumption
  function.

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Short-run v. Long-run Consumption Function
Mankiw, p. 499.
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Alternative Theories of Consumption

• The basic Keynesian insight is that consumption
  depends fundamentally on personal income
  (consumption function)
• This enters into the Keynesian models as C a
  ßYd
• On a closer look, a major puzzle the short-run
  and cross-sectional consumption functions looked
  very different from the long-term consumption
  function.
• There are four major approaches in
  macroeconomics
• 1. Fisher's approach sometimes called the
  neoclassical model
• 2. Keynes original approach of the consumption
  function
• 3. Life-cycle or permanent income approaches
  (Modigliani, Friedman)
• 4.Rational expectations (Euler equation)
  approaches (Hall, Barro,...)
• We will sketch the life cycle model in class
  Fisher in Mankiw and section.

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Consumption and Disposable Income
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Basic Assumptions of Life Cycle Model

• Basic idea
• People have expectations of lifetime income they
  determine their consumption stream optimally
  this leads consumers to smooth consumption over
  their lifetime.
• Assumptions
• Life cycle for planning from age 0 to D.
• Earn Y per year for ages 0 to R.
• Retire from R to D.
• Maximize utility function
• Budget constraint
• Discount rate on utility (d) real interest rate
  (r) 0

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Techniques for Finding Solution

• 1. Two periods
• Maximizing this leads to U(C1)U(C2). This
  implies that C1 C2 , which is consumption
  smoothing. The Cs are independent of the Ys.
• 2. Lagrangean maximization (advanced math econ)
• Maximizing implies that U(C1)U(C2)?. This
  implies that
• which again is consumption smoothing independent
  of Y.

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Initial Solution
C, Y, S
Diagram of Life Cycle Model Showing Consumption
Smoothing
Income, Y
Consumption, C
Saving, S
age


R
D
0
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Anticipated change in timing of income
C, Y, S
Income splash with no W increase (Y)
Income, Y
Anticipated income change of ?Y. Because it is
anticipated, no change in lifetime income, so no
change in (smoothed) consumption. MPC 0 MPS
1.
Consumption, CC
Saving, S
age


R
D
0
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Unanticipated change in permanent income
C, Y, S
Y unanticipated increase W increases.

• Unanticipated windfall of ?Y.
• Leads to smoothing the windfall over remaining
  lifetime.
• one time splash MPC ?Y/(D-z). For life
  expectancy of 40 years, would be MPC .025.
• Permanent income increase MPC ?Y(R-z)/(D-z)
  .6 to .8

Y
C
C
age


R
D
0
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Example of the Life Cycle Model at Work

• How would the consumption and saving of people
  with volatile or stable income streams look?
• See figure for Entrepreneur Ghates and Professor
  Nerd.

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Major result of LCM consumption smoothing
Y Entrepreneur
Y professor
C of both!
D
age
R
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Further Extensions

• 1. Liquidity constraints
• Case of Yale students where income growing
  rapidly
• Here consumption is limited by borrowing
  constraint
• 2. The impact of taxes
• What is the impact if taxes are anticipated and
  paid back during lifetime? No impact! MPC from
  taxes 0.
• see 2008 temporary tax cut
• Barro (Ricardian) model extends this to future
  generations.

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Example of consumption smoothing the 2008 tax
rebate
Estimated MPC 0.07 (0.04)
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Further Extensions

• 3.Wealth effects
• Examples How would you spend an unanticipated
  inheritance of 1m? What is MPC of trust-fund
  babies? What would be the effect of stock-market
  decline or housing bubble and burst?
• Life cycle model predicts that initial wealth (or
  surprise inheritances) would be spread over life
  cycle.
• Intuition an inheritance is just like an income
  splash.
• So the augmented life cycle model is
• Ct ß0 ß1 Ypt ß2 Wt
• where Ypt is permanent or expected labor income
  and Wt is wealth.

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What is the Effect of Stock Market Booms and
Busts on Consumption?
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The stock market, the housing market, and
consumption

• Economists think that the bursting of the stock
  market bubble in 2000 or the housing market today
  contributed to recessions.
• Reasons? Decline in consumption (today) and
  investment (later)
• Rationale the wealth effect on consumptoin
• Analysis in the life-cycle model
• In augmented life-cycle model Ct ß0 ß1 Ypt
  ß2 Wt standard estimates are that ß2 .03
  - .06 (example in a minute)
• Effect in the Roaring 90s and the housing crash
  today.

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Regression

• Dependent Variable Real consumption
  expenditures
• Method Least Squares
• Sample 1952.1 2009.2
• Variable Coefficient Std. Error P
• Real Disposable income 0.63 0.026 .0000
• Real wealth 0.024 0.0032 .0000
• R-squared 0.9983

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Wealth and Consumption through Two Bubbles
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Key ideas

1. Consumption derived from consumer maximization
2. Pure model leads to consumption smoothing
3. All kinds of fun predictions
4. But impediments to pure model
5. Remember the wealth effect
6. Big open issue how big is the short-run MPC?