L1 - consumption (Keynes and Fisher)

Loughborough University - Intermediate Macroeconomics (ECB001)

Lecture 1: Consumption

  • Lecturer: Dawid Trzeciakiewicz

  • Institution: Loughborough Business School

GDP Composition (2018 USA)

  • Gross domestic product: 20580 billion USD (100.0%) - Personal Consumption Expenditures: 13999 billion USD (68.0%)

    • Durable Goods: 1475.6 billion USD (7.2%)

    • Nondurable Goods: 2889.2 billion USD (14.0%)

    • Services: 9633.9 billion USD (46.8%)

    • Gross Private Domestic Investment: 3628.3 billion USD (17.6%)

    • Nonresidential Investment: 2786.9 billion USD (13.5%)

    • Residential Investment: 786.7 billion USD (3.8%)

    • Change in Private Inventories: 54.7 billion USD (0.3%)

    • Government Consumption and Investment: 3591.5 billion USD (17.5%)

    • Net Exports of Goods and Services: -638.2 billion USD (-3.1%)

    • Exports: 2510.3 billion USD (12.2%)

    • Imports: 3148.5 billion USD (15.3%)

  • Source: BEA https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=2#reqid=19&step=2&isuri=1&1921=survey

Overview of Key Consumption Theories

  • Lecture Topics: - John Maynard Keynes: Consumption and Current Income

    • Irving Fisher: Intertemporal Choice

    • Franco Modigliani: The Life-Cycle Hypothesis

    • Milton Friedman: The Permanent Income Hypothesis

    • Robert Hall: Random-Walk Hypothesis

    • Borrowing Constraints

    • Precautionary Savings

References

  • Textbook Sources: - Mankiw, N. G. (2022), Macroeconomics, Worth Publishers, International edition, Chapter 20

    • Mankiw, N. G. (2019), Macroeconomics, Macmillan International, 10th ed. Chapter 19

    • Mankiw, N. G., Taylor, M. P. (2014), Macroeconomics European Edition, Worth Publishers, 2nd ed. Chapter 18

    • Williamson, S.D. (2018), Macroeconomics, Pearson Education Limited, 6th ed. Chapter 9

    • Chamberlin, G., Yueh, L. Y. (2006), Macroeconomics, Thomson Learning.

Keynesian Consumption Function

Key Postulates:

  1. Determinants of Consumption:

    • Disposable income is the main determinant of consumption. This means that how much people spend (consume) is primarily driven by the money they have leftover after taxes and transfers, which they are free to spend or save. If disposable income goes up, people tend to consume more; if it goes down, they consume less.

  2. Marginal Propensity to Consume (MPC):

    • Defined as the change in consumption divided by the change in disposable income:

      MPC = \frac{\partial C}{\partial Y} \approx \frac{\Delta C}{\Delta Y}

    • Explanation: The MPC tells us how much of an extra pound (or dollar) of disposable income a person will spend rather than save. For example, if your MPC is 0.8, it means that for every additional pound you receive, you will spend 80 pence and save 20 pence.

    • MPC is expected to fall between 0 and 1: This means that people typically spend some of their extra income, but not all of it (MPC < 1), and they also don't spend more than the extra income they received (MPC > 0).

  3. Average Propensity to Consume (APC):

    • The ratio of consumption to income that decreases as income increases:

      APC = \frac{C}{Y}

    • Explanation: The APC tells us, on average, what proportion of total income is spent on consumption. For example, if your income is £1000 and you spend £900, your APC is 0.9. Keynes argued that as a person's income goes up, they might save a larger proportion of their income, causing the APC to fall. They still spend more in total, but the fraction of their income they spend decreases.

Interaction with Technology for Questions

  • Access interactive questions at vevox.app with session ID: 196-337-378

Keynesian Consumption Function Output

  • The Keynesian consumption function derived from Keynes’s hypotheses:

    C = \bar{C} + MPC \times Y

    • Explanation of Symbols and their Roles:

      • C = Consumption (Endogenous Variable): This is the total amount of spending by households on goods and services. It's an endogenous variable because its value is determined within this model.

      • \bar{C} = Autonomous Consumption (Intercept): This is the amount of consumption that would occur even if disposable income (Y) were zero. It represents basic necessities or consumption financed by borrowing or dissaving. It's a fixed amount, acting as the starting point of consumption.

      • MPC = Marginal Propensity to Consume (Slope): As explained earlier, this is the fraction of an additional unit of income that is consumed. In the equation, it's the slope of the consumption function, showing how much consumption changes for each unit change in income.

      • Y = Disposable Income (Exogenous Variable): This is the income available to households after taxes and transfers. It's an exogenous variable here, meaning its value is determined outside of this specific consumption model (e.g., by government policy or overall economic activity).

  • The importance of the 'MPC' remains between 0 < MPC < 1: This condition is crucial. If MPC were 0, people would save all extra income, and if it were 1, they would spend all extra income. If MPC were greater than 1, they would spend more than the extra income, which isn't sustainable. This range ensures that an increase in income leads to both increased consumption and increased saving.

Graphical Representation of APC

  • Graph describes the relationship between Average Propensity to Consume (APC) and income:

    • An increase in income results in a drop in APC. This happens because as people get wealthier, their basic needs are already met, so they tend to save a larger proportion of any additional income. While total consumption goes up, the percentage of their total income that is consumed tends to fall.

    • The slope of the line from the origin to a point on the consumption function illustrates the APC. Visually, a steeper line from the origin to a point on the consumption function indicates a higher APC. As income rises (moving right along the x-axis), if the consumption function is flatter than a line of proportional consumption (a 45-degree line), the line from the origin to the consumption curve will become less steep, indicating a lower APC.

  • As income increases, the APC typically decreases, indicating diminished consumption per unit of income gained. This reiterates the idea that wealthier individuals tend to save a larger fraction of their income, even though their absolute consumption levels are higher.

Empirical Findings on Key Consumption Theories

  • Early research aligned with the Keynesian model but encountered issues over long time series data:

    • Discrepancy where consumption (C) did not grow more slowly than income (Y). Keynes's theory suggested that as income grew over time, people would save a larger proportion, meaning consumption would grow at a slower rate than income (i.e., APC would fall). However, long-term data didn't consistently show this trend.

    • Simon Kuznets discovered stability in long-term APC data:

      • Long-run: APC remains constant. Kuznets' finding contradicted the idea of a continually falling APC. Over decades, the ratio of total consumption to total income in the economy seemed to remain relatively stable. This suggested that while individuals might save more as their income rises, overall societal consumption grows proportionally with overall income in the long run.

      • Short-run: APC decreases. This aligned with Keynes's hypothesis for shorter periods, where temporary increases in income might lead to a smaller proportion of that income being spent relative to past income levels.

Future Implications and Applications

  • A case study about a hypothetical tax cut:

    • Examine how a reduction in income tax from 20% to 19% would affect consumer spending over time, according to the Keynesian model. According to the Keynesian model, a tax cut increases disposable income (Y). With an MPC between 0 and 1, a portion of this increased disposable income will be spent (MPC \times \Delta Y), leading to an increase in consumer spending. This initial increase in spending can then lead to further increases in economic activity through the multiplier effect.

  • The nuance of measuring MPC in microeconomic literature as stated by Caroll et al. (2017) presents challenges to defining a universal MPC. This means that trying to find a single, fixed MPC value that applies to everyone, or even to the same person over all situations, is difficult. Factors like individual circumstances, wealth, expectations, and temporary vs. permanent income changes can all influence how much of an extra dollar someone spends.

Fisher’s Intertemporal Choice Theory

  • Outline of the Theory:

    • Consumers are seen as forward-looking, maximizing lifetime satisfaction via consumption choices. Unlike Keynes who focused on current income, Fisher's theory suggests that people don't just think about what they earn today. They plan their spending and saving across their entire lifetime, considering all their expected future income and wealth. Their goal is to maximize their overall happiness or