Consumption Lecture Notes

Consumption

Introduction

Adam Smith stated, "Consumption is the sole purpose of all production." This lecture addresses the following questions:

• How do households decide how much to consume today versus how much to save for the future?

• It discusses different theories of consumption and how well these theories explain observed data.

Keynesian Consumption Function

In the Keynesian cross model, private consumption is a component of expenditure.

• Assumption: Consumption consists of a fixed (necessity) part and a variable part proportional to output (income).

• Key Measures:

  • Average Propensity to Consume (APC): The share of total income that individuals consume.

  • Marginal Propensity to Consume (MPC): The share of additional (marginal) income that individuals consume.

Evaluating the Keynesian Consumption Function

Strengths:

• Consistent with cross-sectional data:

  • Consumption of the rich is higher than that of the poor (MPC > 0).

  • Savings of the rich are higher than those of the poor (MPC < 1).

  • The savings-to-income ratio is higher for the rich than for the poor (APC is decreasing in income).

Weaknesses:

• Inconsistent with time-series data:

  • The consumption-to-income ratio $(\frac{C}{Y})$ is stable even though income $Y$ increased over time.

  • This implies a constant APC, which contradicts Keynes' model.

  • This discrepancy is known as the consumption puzzle.

Fisher’s Two-Period Model of Consumption

• The Keynesian consumption function lacks microfoundations.

• Irving Fisher developed a microfounded model similar to the Ricardian equivalence model.

• In this model, the timing of income is irrelevant because consumers only care about the total present value of their income.

• This is similar to the timing of taxes in the Ricardian equivalence model.

• Future income is a determinant of current consumption, which is inconsistent with the Keynesian consumption function.

• Borrowing Constraints: The timing-irrelevance only holds when individuals are able to borrow (or borrowing constraints are not binding).

Explaining the Consumption Puzzle

• The Keynesian consumption function can explain aggregate consumption at one point in time but fails over extended periods (the consumption puzzle).

• Two theories explain why APC remains constant over time:

  • Life Cycle Hypothesis (LCH) (Franco Modigliani)

  • Permanent Income Hypothesis (PIH) (Milton Friedman)

Life Cycle Hypothesis (LCH) of Consumption

• LCH posits that consumption is affected not only by current income but also by expected future income.

• If income varies systematically over people’s lives, they use savings to transfer income from high-income periods to low-income periods, thereby smoothing consumption over their lifetime.

• Assumptions:

  • Perfect knowledge of lifetime: Individuals know when they will die.

  • Uniform consumption: Individuals prefer a constant stream of consumption over their lifetime.

  • Zero bequests: Individuals do not die with positive wealth but rather consume all their accumulated savings.

  • Zero real interest rate: (Simplifying assumption that can be generalized).

  • Ability to forecast future income: Individuals can correctly guess their future earnings.

Permanent Income Hypothesis (PIH) of Consumption

• The basic idea is that people's income contains both a random and a deterministic element, and people try to smooth away the random part.

• As with the LCH, current consumption should depend on more than just current income because people want to avoid fluctuations in their consumption over their lifetime.

The main topics of this lecture on consumption include:

1. Introduction

   • The significance of consumption in production and consumer decision-making.

2. Keynesian Consumption Function

   • The role of private consumption in expenditure, assumptions, and key measures (APC and MPC).

3. Evaluating the Keynesian Consumption Function

   • Strengths of the model regarding cross-sectional data and behavior of rich versus poor consumers.

   • Weaknesses due to inconsistencies with time-series data leading to the consumption puzzle.

4. Fisher’s Two-Period Model of Consumption

   • Development of a microfounded model by Irving Fisher, emphasizing timing of income and consumption.

5. Explaining the Consumption Puzzle

   • Examination of aggregate consumption over time and theories (LCH and PIH) that explain constant APC.

6. Life Cycle Hypothesis (LCH) of Consumption

   • LCH's perspective on how individuals manage consumption over their lifetime based on current and expected future income.

7. Permanent Income Hypothesis (PIH) of Consumption

   • Proposal that consumption behavior is influenced by fluctuations in income due to random and deterministic components.