Macro Economics two chapter two for lectures1 22.pdf

Economics macro

1. Arba Minch University
College of Business and Economics
Department of Economics
by
Zigale Y.(M.Sc.)
Macroeconomics Economics
11/26/2021 1

2. CHAPTER ONE
Theories Of Consumption
➢Introduction
➢Chapter Outline:
•The concept of consumption
•Keynes and the consumption function
•Fisher and intertemporal choice
•Modigliani and the life-cycle hypothesis
•Friedman and the permanent income hypothesis
•Robert Hall and the random walk hypothesis
➢summery

3. 1.2. The Concept of Consumption
Whatisconsumption?
Consumption,ineconomicstheuseofgoodsandservices
byhouseholds.
definedasspendingforacquisitionofutility
Theideaofconsumptionismicroormacroidea?
Howdohouseholdsdecidehowmuchoftheirincometo
consumetodayandhowmuchtosaveforthefuture?
3

4. Cont’d …
Thisisamicroeconomicquestionbecauseitaddressesthe
behaviorofindividualdecisionmakers.
However,itsanswerhasmacroeconomicconsequences.
Households’consumptiondecisionsaffecttheeconomyas
awholebehavesbothinthelongrunandintheshortrun.
Theconsumptiondecisioniscrucialforlong-runanalysis
becauseofitsroleineconomicgrowth.
Theconsumptiondecisioniscrucialforshort-runanalysis
becauseofitsroleindeterminingaggregatedemand.
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5. Cont’d …
Consumptionistwo-thirdsof??????�??????,sofluctuationsin
consumptionareakeyelementofboomsandrecessions.
Consumptionwithafunctionthatrelatesconsumptionto
disposableincome:�=�(??????−??????).
1.3.KeynesandtheConsumptionFunction
Keynesmadetheconsumptionfunctioncentraltohis
theoryofeconomicfluctuations,
andithasplayedakeyroleinmacroeconomicanalysis
eversince.
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6. Keynes’s Conjectures
1).0<MPC<1,whatisMPC?
Theamountconsumedoutofanadditionalmoneyof
incomeiscalledMPC.
2).Averagepropensitytoconsume(APC)fallsasincome
rises.(APC=C/Y)
3).Incomeisthemaindeterminantofconsumption.
Theinterestratedoesnothaveanimportantrole.
Onthebasisofthesethreeconjectures,theKeynesian
consumptionfunctionisoftenwrittenas
??????=ഥ??????+????????????,ഥ??????>&#3627409358;,&#3627409358;<??????<&#3627409359;
whereCisconsumption,Yisdisposableincome,ҧ&#3627408438;is
constant,??????marginalpropensitytoconsume. 6

7. Cont’d …
7

8. The Early Empirical Successes
SoonafterKeynesproposedtheconsumptionfunction,
economistsbegancollectingandexaminingdatatotesthis
conjectures.
TheearlieststudiesindicatedthattheKeynesian
consumptionfunctionisagoodapproximationofhow
consumersbehave.
Insomeofthesestudies,researcherssurveyedhouseholds
andcollecteddataonconsumptionandincome.
Theyfoundthathouseholdswithhigherincomeconsumed
more,whichconfirmsthatthemarginalpropensityto
consumeisgreaterthanzero.
11/26/2021 8

9. Cont’d …
Theyalsofoundthathouseholdswithhigher
incomesavedmore,whichconfirmsthatthe
marginalpropensitytoconsumeislessthanone.
Inaddition,theseresearchersfoundthathigher-
incomehouseholdssavedalargerfractionoftheir
income,whichconfirmsthatAPCfallsasincome
rises.
Thus,thesedataverifiedKeynes’sconjecturesaboutthe
marginalandaveragepropensitiestoconsume.
Inotherstudies,researchersexaminedaggregatedataon
consumptionandincomefortheperiodbetweenthe
twoworldwars(i.e.,short-timeseriesdata).
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10. Cont’d …
ThesedataalsosupportedtheKeynesianconsumption
function.
Inyearswhenincomewasunusuallylow,suchasduringthe
depthsoftheGreatDepression,bothconsumptionandsaving
werelow,indicatingthattheMPCisbetweenzeroandone.
Inaddition,,duringthoseyearsoflowincome,theratioof
consumptiontoincomewashigh,confirmingKeynes’ssecond
conjecturethatisAPCfail.
Thus,thedataalsoconfirmedKeynes’sthirdconjecturethat
incomeistheprimarydeterminantofhowmuchpeoplechoose
toconsume. 10

11. Cont’d …
SecularStagnation,SimonKuznets,andthe
ConsumptionPuzzle.
AlthoughtheKeynesianconsumptionfunctionmetwithearly
successes,twoanomaliessoonarose.
Thefirstanomalybecameapparentaftersomeeconomists
madeadire-and,itturnedout,erroneous-predictionduring
WorldWarII.
Theyfearedthattheremightnotbeenoughprofitable
investmentprojectstoabsorballthissaving.
Ifso,thelowconsumptionwouldleadtoaninadequate
demandforgoodsandservices,resultinginadepressiononce
thewartimedemandfromthegovernmentceased. 11

12. Cont’d …
Inotherwords,onthebasisoftheKeynesianconsumptionfunction,
theseeconomistspredictedthattheeconomywouldexperiencewhat
theycalledsecularstagnation-alongdepressionofindefinite
duration-unlessfiscalpolicywasusedtoexpandaggregatedemand.
Fortunatelyfortheeconomy,butunfortunatelyfortheKeynesian
consumptionfunction,theendofWorldWarIIdidnotthrowthe
countryintoanotherdepression.
Althoughincomesweremuchhigherafterthewarthanbefore,these
higherincomesdidnotleadtolargeincreasesintherateofsaving.
Keynes’sconjecturethattheaveragepropensitytoconsumewould
fallasincomeroseappearednottohold.
12

13. Cont’d …
TheSecondanomalyarosewheneconomistSimonKuznets
constructednewaggregatedataonconsumptionandincome
datingbackto1869.
Kuznetsassembledthesedatainthe1940s.andwouldlater
receivetheNobelPrizeforthiswork.
Hediscoveredthattheratioofconsumptiontoincomewas
remarkablystablefromdecadetodecade,despitelarge
increasesinincomeovertheperiodhestudied.
Again,Keynes’sconjecturethattheaveragepropensityto
consumewouldfallasincomeroseappearednottohold.
13

14. Cont’d …
Thefailureofthesecular-stagnationhypothesisandthe
findingsofKuznetsbothindicatedthattheaveragepropensity
toconsumeisfairlyconstantoverlongperiodsoftime.
Thisfactpresentedapuzzlethatmotivatedmuchofthe
subsequentworkonconsumption.
Economistswantedtoknowwhysomestudiesconfirmed
Keynes’sconjecturesandothersrefutedthem.
Thatis,whydidKeynes’sconjecturesholdupwellinthe
studiesofhouseholddataandinthestudiesofshorttime-
series,butfailwhenlongtime-serieswereexamined?
14

15. Cont’d …
Figure1-2illustratesthepuzzle.Theevidencesuggestedthat
thereweretwoconsumptionfunctions.Forthehouseholddata
orfortheshorttime-series,theKeynesianconsumption
functionappearedtoworkwell.
Yetforthelongtime-series,theconsumptionfunction
appearedtohaveaconstantaveragepropensitytoconsume.
11/26/2021 15

16. Cont’d …
11/26/2021 16

17. 1.4 Fisher and Intertemporal Choice
TheconsumptionfunctionintroducedbyKeynesrelates
currentconsumptiontocurrentincome.
Thisrelationship,however,isincompleteatbest.
Whenpeopledecidehowmuchtoconsumeandhow
muchtosave,theyconsiderboththepresentandthe
future.
Themoreconsumptiontheyenjoytoday,thelesstheywill
beabletoenjoytomorrow.
17

18. Cont’d …
TheeconomistIrvingFisherdevelopedthemodelwith
whicheconomistsanalyzehowrational,forward-looking
consumersmakeintertemporalchoices-
thatis,choicesinvolvingdifferentperiodsoftime.
Fisher’smodelilluminatestheconstraintsconsumersface,
thepreferencestheyhave,andhowtheseconstraintsand
preferencestogetherdeterminetheirchoicesabout
consumptionandsaving.
18

19. 1.3.1.The Intertemporal Budget Constraint
Peopleconsumelessthantheydesireisthattheirconsumption
isconstrainedbytheirincome.
Inotherwords,consumersfacealimitonhowmuchtheycan
spend,calledabudgetconstraint.
Whentheyaredecidinghowmuchtoconsumetodayversus
howmuchtosaveforthefuture,theyfaceanintertemporal
budgetconstraint,
Whichmeasuresthetotalresourcesavailableforconsumption
todayandinthefuture.
Fisher’smodelistoexaminethisconstraint.
19

20. Cont’d …
Toanalysisthisweexaminethedecisionfacingaconsumer
wholivesfortwoperiods.
Periodonerepresentstheconsumer’syouthORatpresentand
periodtworepresentstheconsumer’soldorfutureage.
TheconsumerearnsincomeY
1andconsumesC
1inperiod
one,andearnsincomeY
2andconsumesC
2inperiodtwo.
(Allvariablesarereal-thatis,adjustedforinflation.)Because
theconsumerhastheopportunitytoborrowandsave,
Consumptioninanysingleperiodcanbeeithergreaterorless
thanincomeinthatperiod.
11/26/2021 20

21. Cont’d …
Considerhowtheconsumer’sincomeinthetwoperiods
constrainsconsumptioninthetwoperiods.
Inthefirstperiod,savingequalsincomeminusconsumption.
Thatis:
Inthesecondperiod,consumptionequalstheaccumulated
saving,includingtheinterestearnedonthatsaving,plus
second-periodincome.
Thatis,
11/26/2021 21

22. Cont’d …
•Period 1: the present
•Period 2: the future
•Notation
Y
1, Y
2= income in period 1, 2
C
1, C
2= consumption in period 1, 2
S= Y
1-C
1= saving in period 1
(S< 0 if the consumer borrows in period 1)
which is negative saving ( dissaving)
11/26/2021 22

23. intertemporal budget constraint
•Period 2 budget constraint:22
(1 )C Y r S= + + 2 1 1
(1 )( )Y r Y C= + + −
▪Rearrange terms:1 2 2 1
(1 ) (1 )r C C Y r Y+ + = + +
▪Divide through by (1+r) to get…

24. The intertemporal budget constraint22
11
11
CY
CY
rr
+ = +
++
present value of
lifetime consumption
present value of
lifetime income

25. Cont’d …
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26. The intertemporal budget constraint
The budget
constraint shows all
combinations
of C
1and C
2that
just exhaust the
consumer’s
resources.
C
1
C
212
(1 )Y Y r++ 12
(1 )r Y Y++
Y
1
Y
2
Borrowing
Saving
Consump =
income in
both periods22
11
11
CY
CY
rr
+ = +
++

27. The intertemporal budget constraint
The slope of
the budget
line equals
−(1+r )
C
1
C
2
Y
1
Y
2
1
(1+r)22
11
11
CY
CY
rr
+ = +
++

28. Cont’d …
AtpointA,theconsumerconsumesexactlyhisincomeineach
period(C
1=Y
1andC
2=Y
2),sothereisneithersavingnor
borrowingbetweenthetwoperiods.
AtpointB,theconsumerconsumesnothinginthefirstperiod
(C
1=0)andsavesallincome,sosecond-periodconsumptionC
2
is(1+r)Y
1+Y
2.
AtpointC,theconsumerplanstoconsumenothinginthe
secondperiod(C
2=0)andborrowsasmuchaspossibleagainst
second-periodincome,sofirst-periodconsumptionC
1isY
1+
Y
2/(1+r).

29. 1.3.2.Consumer Preferences
Theconsumer’spreferencesregardingconsumptioninthe
twoperiodscanberepresentedbyindifferencecurves.
Anindifferencecurveshowsthecombinationsoffirst-
periodandsecond-periodconsumptionthatmakethe
consumerequallyhappy.
Theslopeisthemarginalrateofsubstitutionbetween
first-periodconsumptionandsecond-periodconsumption.
Ittellsustherateatwhichtheconsumeriswillingto
substitutesecond-periodconsumptionforfirst-period
consumption.
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30. Consumer preferences
An indifference
curveshows
all combinations of
C
1and C
2
that make the
consumer
equally happy.
C
1
C
2
IC
1
IC
2
Higher
indifference
curves
represent
higher levels
of happiness.

31. Consumer preferences
Marginal rate of
substitution(MRS):
the amount of C
2
the consumer
would be willing to
substitute for
one unit of C
1.
C
1
C
2
IC
1
The slope of
an indifference
curve at any
point equals
the MRS
at that point.
1
MRS

32. 1.3.4.Optimization
Havingdiscussedtheconsumer’sbudgetconstraintand
preferences,wecanconsiderthedecisionabouthowmuchto
consume.
Theconsumerwouldliketoendupwiththebestpossible
combinationofconsumptioninthetwoperiods-thatis,onthe
highestpossibleindifferencecurve.
Butthebudgetconstraintrequiresthattheconsumeralsoend
uponorbelowthebudgetline,becausethebudgetline
measuresthetotalresourcesavailabletohim.
11/26/2021 32

33. Inter Temporal Choice (Irving Fisher)
The consumer has to choose C1and C2so as to
✓The optimal solution is at a point where the slope of the
budget line, (1+r) equals the slope of an IC, MRS.
MRS = (1+r)
–The slope of the budget line means to increase C1 by one
unit, the consumer must sacrifice (1+r) units of C2.
–The slope of an indifference curve (MRS)measures the
amount of C
2the consumer would be willing to
substitute for one unit of C
1.22
11
11
CY
CY
rr
+ = +
++
33

34. Cont’d …
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35. Cont’d …
Thepointatwhichthecurveandlinetouch-pointOfor“optimum”-
isthebestcombinationofconsumptioninthetwoperiodsthatthe
consumercanafford.
attheoptimum,theslopeoftheindifferencecurveequalstheslope
ofthebudgetline.Theindifferencecurveistangenttothebudget
line.
Theconsumerchoosesconsumptioninthetwoperiodssothat
themarginalrateofsubstitutionequalsoneplusthereal
interestrate.
35

36. Cont’d …
11/26/2021 36
❖QUESTIONS
❖Abebe obeys the two-period Fisher’s model consumption.
He earns nothing in the first period, and earns 11,000 birr in
the second period. He can borrow or save money at the
interest rate??????. We observe that Abebe consuming 5000 birr
in the first period and 5000 in the second period. What is
the interest rate ???????

37. Keynes vs. Fisher
•Keynes:
Current consumption depends onlyon
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.

38. How Changes in Income Affect Consumption
AnincreaseineitherY
1orY
2shiftsthebudgetconstraint
outward.
Thehigherbudgetconstraintallowstheconsumerto
chooseabettercombinationoffirst-andsecond-period
consumption-thatis,theconsumercannowreacha
higherindifferencecurve.
Iftheyarebothnormalgoods,C
1andC
2,bothincrease,
regardlessofwhethertheincreaseinincomeoccursin
period1orperiod2.
11/26/2021 38

39. •How Consumptionresponds to changes in Y?
C
1
C
22. If they are both normal
goods, C
1and C
2,both
increase, regardless of
whether the increase in
income occurs in period
1 or period 2.
Note: A consumer may be a net saver or a net borrower. An
increase in current income due to borrowing or future
income due to saving will increase current and future
consumption (consumption smoothing motives).
39
Cont’d …

40. Cont’d …
11/26/2021 40

41. Changes in the Real Interest Rate Affect Consumption
Therearetwocasestoconsider:
Case1:theconsumerisinitiallysavingand
Case2:theconsumerisinitiallyborrowing.
Herewediscussthesavingcase;
anincreaseintherealinterestraterotatestheconsumer’s
budgetlinearoundthepoint(Y
1,Y
2).
Economistsdecomposetheimpactofanincreaseinthereal
interestrateonconsumptionintotwoeffects:anincome
effectandasubstitutioneffect.
41

42. Cont’d …
Theincomeeffect:Ifconsumerisasaver,theriseinrmakeshim
betteroff,whichtendstoincreaseconsumptioninbothperiods.
How?thechangeinconsumptionthatresultsfromthe
movementtoahigherindifferencecurve.
Becausetheconsumerisasaverratherthanaborrower(as
indicatedbythefactthatfirst-periodconsumptionislessthan
first-periodincome).
theincreaseintheinterestratemakeshimbetteroff(as
reflectedbythemovementtoahigherindifferencecurve).
11/26/2021 42

43. Cont’d …
Ifconsumptioninperiodoneandconsumptioninperiodtwo
arebothnormalgoods,theconsumerwillwanttospreadthis
improvementinhiswelfareoverbothperiods.
Thisincomeeffecttendstomaketheconsumerwantmore
consumptioninbothperiods.
Thesubstitutioneffect:Theriseinrincreasesopportunity
costofcurrentconsumption,whichtendstoreduceC
1and
increaseC
2.
thechangeinconsumptionthatresultsfromthechangeinthe
relativepriceofconsumptioninthetwoperiods. 43

44. Cont’d …
Inparticular,C2becomeslessexpensiverelativetoCin
periodonewhentheinterestraterises.
Thatis,becausetherealinterestrateearnedonsavingis
higher,theconsumermustnowgiveuplessfirst-periodC
toobtainanextraunitofsecond-periodC.
Thissubstitutioneffecttendstomaketheconsumer
choosemoreconsumptioninperiodtwoandless
consumptioninperiodone.
11/26/2021 44

45. Cont’d …
Theconsumer’schoicedependsonboththeincomeeffectandthe
substitutioneffect.
Botheffectsacttoincreasetheamountofsecond-period
consumption.
hence,wecanconcludethatanincreaseintherealinterestrate
raisessecond-periodconsumption.
Butthetwoeffectshaveoppositeimpactsonfirst-period
consumption,sotheincreaseintheinterestratecouldeitherraise
orlowerit.
Hence,dependingontherelativesizeoftheincomeand
substitutioneffects.
45

46. Cont’d …
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47. Cont’d …
Iftheconsumerisanetborrower,Theabilityto
borrowallowscurrentconsumptiontoexceedcurrentincome.
Inessence,whentheconsumerborrows,heconsumessomeof
hisfutureincometoday.
Constraints on Borrowing
However,formanypeopleborrowingisimpossible.
Forexample,astudentwishingtoenjoysummerbreakin
inLanganowouldprobablybeunabletofinancethis
vacationwithabankloan.
11/26/2021 47

48. Cont’d …
Theinabilitytoborrowpreventscurrentconsumptionfrom
exceedingcurrentincome.
Aconstraintonborrowingcanthereforebeexpressedas
&#3627408386;&#3627409359;≤??????&#3627409359;.
Thisinequalitystatesthatconsumptioninperiodonemustbe
lessthanorequaltoincomeinperiodone.
Thisadditionalconstraintontheconsumeriscalleda
borrowingconstraintor,sometimes,aliquidityconstraint.
Theconsumer’schoicemustsatisfyboththeintertemporal
budgetconstraintandtheborrowingconstraint.
48

49. Cont’d …
TheshadedareaintheFigurebelowrepresentsthe
combinationsofC1andC2thatsatisfybothconstraints.
11/26/2021 49

50. Cont’d …
✓The borrowing constraint affects the consumption decision
✓When the consumer faces a borrowing constraint, there are two
possible situations.
✓In panel (a), the consumer chooses first-period consumption to be
less than first-period income, so the borrowing constraint is not
necessary/binding and does not affect consumption in either period.
✓In panel (b), the borrowing constraint is binding. The consumer
would like to borrow and choose point&#3627408387;. But because borrowing is
not allowed, the best available choice is point&#3627408388;. When the
borrowing constraint is binding, first-period consumption equals
first-period income.
11/26/2021

51. Cont’d …
11/26/2021 51

52. Cont’d …
❖To sum up, the analysis of borrowing constraints leads us to
conclude that there are two consumption functions.
✓For some consumers, the borrowing constraint is not binding,
and consumption in both periods depends on the present value
of lifetime income, ??????
&#3627409359;+[??????
&#3627409360;/(&#3627409359;+??????)].
✓For other consumers, the borrowing constraint binds, and the
consumption function is
✓&#3627408386;
&#3627409359;=??????
&#3627409359;and&#3627408386;
&#3627409360;=??????
&#3627409360;. Hence, for those consumers who
would like to borrow but cannot, consumption depends only on
current income.
11/26/2021 52

53. Franco Modigliani and the Life-Cycle Hypothesis
Fisher’sintertemporalchoicemodelsaysthatconsumptiondepends
onlifetimeincome,andpeopletrytoachievesmoothconsumption
throughborrowing.
Modiglianiemphasizedthatincomevariessystematicallyover
people’slivesandthatsavingallowsconsumerstomove
incomefromthosetimesinlifewhenincomeishightothose
timeswhenitislow.
Thisinterpretationofconsumerbehaviorformedthebasisfor
hislife-cyclehypothesis.
11/26/2021 53

54. Cont’d …
Oneimportantreasonthatincomevariesoveraperson’slifeis
retirement.
Mostpeopleplantostopworkingataboutage65,andthey
expecttheirincomestofallwhentheyretire.
Yettheydonotwantalargedropintheirstandardofliving,as
measuredbytheirconsumption.
Tomaintainconsumptionafterretirement,peoplemustsave
duringtheirworkingyears.
11/26/2021 54

55. Cont’d …
•Assumptions LCH:
–consumer divides resources over lifetime (see next slide)
–zero real interest rate (for simplicity)
–consumption-smoothing is optimal
✓The consumer’s lifetime resources are composed of initial
wealth Wand
✓life-time earnings of ??????×??????.
✓The consumer can divide up her lifetime resources among
her Tremaining years of life.
11/26/2021 55

56. Cont’d …
•Lifetime resources = W+ RY
Where W= initial wealth,
Y= annual income until retirement (assumed constant)
R= number of years until retirement
Toachievesmoothconsumption,consumerdividesher
resourcesequallyoverlifetime:
11/26/2021 56

57. Cont’d …
➢Where :T= consumer’s lifetime in years
a= (1/T ) is the marginal propensity to consume out of wealth
b= (R/T ) is the marginal propensity to consume out of income
•For example, if the consumer expects to live for 50 more years and
work for 30 of them, then T=50and R=30, so her
consumption function is?
Assumethataconsumerhasalreadylived30yearsand
expectstoliveformore40yearsofwhichheintendstowork
20years.Accordingtothelife-cyclehypothesis,the
consumptionfunctionoftheconsumeris?
11/26/2021 57

58. Cont’d …
LCHresolvedtheconsumptionpuzzle
ModiglianiresolvedtheconsumptionpuzzleposedbySimon
Kuznets’sdatabysayingthat:
✓In the short run when wealth is constant, average propensity to
consume falls.
✓In the long run, as wealth increases with income, average
propensity to consume is constant.
11/26/2021 58

59. Cont’d …
Thelife-cyclemodelmakesmanyotherpredictionsaswell.
Mostimportant,itpredictsthatsavingvariesoveraperson’s
lifetime.
Aperson'sconsumptionexpenditureisrelativelyhigh
duringyoungadulthood,decreasesduringthemiddle-age
years,andincreaseswhenthepersonisnearorinretirement.
✓Duringyoungadulthoodconsumptionexceedsincomeasthe
individualmaybebuyinganewhome,startingafamily,and
beginningacareer-theindividualwillborrowfromthefuture
tosupporttheseexpenditureneeds.
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60. Cont’d …
Duringthemiddleages,consumptionexpenditurebeginsto
leveloff,astheindividualrepaysanypastborrowingsand
beginstosaveforherorhisretirement.
Nearoruponretirement,consumptionexpendituremaybegin
todeclineastheindividualdissavesorlivesoffpastsavings
untildeath.
11/26/2021 60

61. Cont’d …
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62. Milton Friedman and the Permanent-Income Hypothesis
Friedman’spermanent-incomehypothesiscomplements
Modigliani’slife-cyclehypothesis:
bothuseIrvingFisher’stheoryoftheconsumertoarguethat
consumptionshouldnotdependoncurrentincomealone.
Butunlikethelife-cyclehypothesis,whichemphasizesthat
incomefollowsaregularpatternoveraperson’slifetime.
thepermanent-incomehypothesisemphasizesthatpeople
experiencerandomandtemporarychangesintheirincomes
fromyeartoyear.
11/26/2021 62

63. Cont’d …
FriedmansuggestedthatweviewcurrentincomeYasthesumof
twocomponents,permanentincomeY
P
andtransitoryincomeY
T
.
Thatis,
Y= Y
P
+ Y
T
•Permanent incomeis the part of income that people expect to
persist into the future.
•Transitory incomeis the part of income that people do not expect to
persist.
•Friedman reasoned that consumption should depend primarily on
permanent income.
•Because consumers use saving and borrowing to smooth
consumption in response to transitory changes in income.
63

64. Cont’d …
Friedmanconcludedthatweshouldviewtheconsumption
functionasapproximately
C= a Y
P
where ais the fraction of permanent income that people
consume per year.
HowPIHresolvedtheconsumptionpuzzle?
The PIH can solve the consumption puzzle:
–The PIH implies
APC= C / Y= a Y
P
/ Y
AccordingtothePIH,theAPCdependsontheratioof
permanentincometocurrentincome.
11/26/2021 64

65. Cont’d …
✓Whencurrentincometemporarilyrisesabovepermanent
income,theAPCtemporarilyfalls;
✓whencurrentincometemporarilyfallsbelowpermanent
income,theAPCtemporarilyrises.
✓Nowconsiderthestudiesofhouseholddata.
❖Friedmanreasonedthatthesedatareflectacombinationof
permanentandtransitoryincome:
✓Householdswithhighpermanentincomehaveproportionately
higherconsumption.
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66. Cont’d …
✓If all variation in current income came from the permanent
component, the average propensity to consume would be the
same in all households.
✓But some of the variation in income comes from the transitory
component, and households with high transitory income do not
have higher consumption.
Therefore,researchersfindthathigh-incomehouseholdshave,
onaverage,loweraveragepropensitiestoconsume.
APCislowerinhigh-averageincomehouseholds.
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67. Cont’d …
✓Similarly,considerthestudiesoftime-seriesdata.
✓overlongperiodsoftime,thevariationinincomecomesfrom
thepermanentcomponent.
✓Hence,inlongtime-series,oneshouldobserveaconstant
averagepropensitytoconsume,asinfactKuznetsfound.
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68. 1.6).Robert Hall and the Random-Walk Hypothesis
❖Thepermanent-incomehypothesisisbasedonFisher’smodel
ofinter-temporalchoice.
❖Itbuildsontheideathatforward-lookingconsumersbasetheir
consumptiondecisionsnotonlyontheircurrentincomebut
alsoontheincometheyexpecttoreceiveinthefuture.
❖Thus,thepermanent-incomehypothesishighlightsthat
consumptiondependsonpeople’sexpectations.
❖Recentresearchonconsumptionhascombinedthisviewofthe
consumerwiththeassumptionofrationalexpectations.
68

69. 1.6).Robert Hall and the Random-Walk Hypothesis
❖TheeconomistRobertHallwasthefirsttoderivethe
implicationsofrationalexpectationsforconsumption.
❖ItisbasedonFisher’smodel&PIH,inwhichforward-looking
consumersbaseconsumptiononexpectedfutureincome.
❖Halladdstheassumptionofrationalexpectations,thatpeople
useallavailableinformationtoforecastfuturevariableslike
income.
❖Therational-expectationsassumptionstatesthatpeopleuseall
availableinformationtomakeoptimalforecastsaboutthe
future.
69

70. Cont’d …
Heshowedthatifthepermanent-incomehypothesisiscorrect
andifconsumershaverationalexpectations,thenchangesin
consumptionovertimeshouldbeunpredictable.
Whenchangesinavariableareunpredictable,thevariableis
saidtofollowarandomwalk.
AccordingtoHall,thecombinationofthepermanent-income
hypothesisandrationalexpectationsimpliesthatconsumption
followsarandomwalk.
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71. Cont’d …
AccordingtoHall,thecombinationofthePIHand
rationalexpectationsimpliesthatconsumptionfollowsa
randomwalk.
Hallreasonedasfollows:
Atanymoment,consumerschooseconsumptionbasedon
theircurrentexpectationsoftheirlifetimeincomes.
Overtime,theychangetheirconsumptionbecausethey
receivenewsthatcausesthemtorevisetheirexpectations.
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72. Cont’d …
Inotherwords,changesinconsumptionreflect
“surprises”aboutlifetimeincome.
Ifconsumersareoptimallyusingallavailableinformation,
thentheyshouldbesurprisedonlybyeventsthatwere
entirelyunpredictable.
Therefore,changesintheirconsumptionshouldbe
unpredictableaswell.
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73. Cont’d …
✓If RWH is correct and consumers have rational expectations,
then consumption should follow a random walk: changes in
consumption should be unpredictable.
–Achangeinincomeorwealththatwasanticipatedhas
alreadybeenfactoredintoexpectedpermanentincome,so
itwillnotchangeconsumption.
–Onlyunanticipatedchangesinincomeorwealththatalter
expectedpermanentincomewillchangeconsumption.
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74. Cont’d …
✓Therational-expectationsapproachtoconsumptionhas
implicationsnotonlyforforecastingbutalsofortheanalysis
ofeconomicpolicies.
✓Ifconsumersobeythepermanent-incomehypothesisand
haverationalexpectations,thenonlyunexpectedpolicy
changesinfluenceconsumption.
✓Thesepolicychangestakeeffectwhentheychange
expectations.
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75. Cont’d …
Forexample,supposethattodaythegovernmentpassesatax
increasetobeeffectivenextyear.
Inthiscase,consumersreceivethenewsabouttheirlifetime
incomeswhenthegovernmentpassesthelaw(orevenearlier
ifthelaw’spassagewaspredictable).
Thearrivalofthisnewscausesconsumerstorevisetheir
expectationsandreducetheirconsumption.
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76. 1.7.The Psychology of Instant Gratification
•TheoriesfromFishertoHallassumethat
consumersarerationalandacttomaximize
lifetimeutility.
•RecentstudiesbyDavidLaibsonandothers
considerthepsychologyofconsumers.
•Thedesireforinstantgratificationcausespeople
tosavelessthantheyrationallyknowtheyshould

77. The Psychology of Instant Gratification
•Consumers consider themselves to be
imperfect decision-makers.
–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.

78. 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 1 and (B) to 2.
A person confronted with question 2 may choose (B).
But in 100 days, when confronted with question 1,
the pull of instant gratification may induce her to change
her answer to (A).

79. Cont’d …
Reading assignment on
adaptive and naïve expectation on
consumption
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80. Cont’d …
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