Consumption

Hrushikesh Mallick
Keynes on Consumption
Output is always equal to income, which in turn equals to expenditure.
Y=C+I+G+X-M

Y
d
is the personal disposable income=
Private disposable income is the GDP plus net factor incomes from abroad
plus transfers from abroad as well as payments from the government less
direct taxes paid.

C=a+bY
d
Where 0<b<1

Where, b =MPC = C/Y
d
APC= C/Y
d
=a/Y + bY
d
/Y
d
Implication of Keynes theory : MPC < APC
Yd=C+S
S=Y
d
-C

=Yd-(a+cY
d
)
= - a+(1-c)Y
d
Savings rate = APS = s=S/Yd =-a/Yd d+(1-c)

Consumption Smoothing
In consumption smoothing approach, agents optimize
subject to constraints.
Theory of consumption is the consequence of rational
agents seeking to maximize their preference subject to the
opportunities that they face.
Agents are not just reactive and tied solely to present
when current consumption moves in step with current
income - but rather forward looking.
Successful portrayal of economic behaviour involves taking
into consideration at least two periods a present and a
future known as intertemporal analysis.
In such analysis, the fundamental consideration is that
alternatives chosen today affect the menu of alternatives
available in the future.
Intertemporal Constraints & Preferences
In deciding what to do with incomes, people may
consume them all now or save a part of it for future.
Question in intertemporal analysis: How do rational
consumers distribute their consumption over time?
Suppose there are two time periods current and
future.
Alternative facing the consumer is present
consumption (C
1
) vs. future consumption ( C
2
).
Intertemporal Budget Constraint (IBC)
To derive IBC, assume consumer has the choice of consuming their entire
income in each period.

With Y
1
and Y
2
denoting current and future income, the consumer sets
C
1
=Y
1
and C
2
=Y
2
.

Another option is to deposit all the entire income earned in period 1 in a
bank and with interest rate r per cent, they would be able to get (1+r)Y
1

as the principal plus interest payment in the future. Individual would not
consume any income at present (C
1
=0) and saving it all, derive an income
from their savings (1+r)Y
1
.

Since there are only two periods saving along with their second period
income Y
2
, so that C
2
= Y
2
+(1+r)Y
1
.

But it may not be a practical because if the consumer does not
consume today he may not be alive in future. This is only a theoretical
possibility.

Another extreme behavior is to forget altogether that there is a
future and consume all the future and present income today.
Consuming tomorrows income requires borrowing that
amount today and in present value terms Y
2
of future income is
equivalent to Y2/(1+r) in a bank today.
This follows if we were to deposit Y2/(1+r) in a bank today we
would get back [Y
2
/(1+r)](1+r) =Y
2
in the next period as
repayments on deposits.
So consuming both tomorrow's and todays income right away
today tends C
2
=0 and C
1
=Y
1
+[Y
2
/(1+r)].
It is not necessary to save or borrow the maximum amount
possible. If from current income Y
1
the individual consumes
only a part of it such that C
1
<Y
1
and saves (Y
1
- C
1
), then
earnings on that savings in the next period = (1+r) (Y
1
-C
1
),
which must be spent along with next periods income Y
2
on
next periods consumption C
2
.
Thus, (1+r)(Y
1
-C
1
) + Y
2
= C
2
Dividing (1+r) throughout:

r
C
r
Y
C Y
+
=
+
+
1 1
2 2
1 1
r
C
C
r
Y
Y
+
+ =
+
+
1 1
2
1
2
1
Rearranging this expression gives equation
for IBC

E
Y1
Y2
F
D
Slope= -
(1+r)
(1+r)Y
1
+Y
2
Y
1
+Y
2
/(1+r)
C
1
C
2
IBC: It depicts the current and future consumption possibilities from the stream of income
available across time.
Which point will the consumer select on the IBC?
This will be given by their preference function.
This is defined by a utility function:
U=U(C
1
,C
2
)
C
2
C
1
The slope of intertemporal IC measures the
MRS between future and current
consumption. It is the rate at which the
present consumption can be substituted for
the future consumption with no change in
utility.
C
2
C
1
B

A marginal change in consumption results in a change in utility expressed by the marginal
utility of consumption or MU
C
.

At Point B, if we reduce consumption of C
1
by an amount C
1
, then reduction in utility =
MUc
1
(C
1
)

To compensate the individual for the loss of utility from
decline in present consumption, it requires future
consumption to be augmented.
If future consumption is augmented by C
2
, the increase in
utility from increase in consumption will be MUc
2
(C
2
).
An individuals time preference for consumption is usually
such that the utility from consumption received in the future
is valued less than the utility from consumption today.
Assuming subjective discount rate at which individual values
the future consumption relative to current consumption be
given by >0.
Accordingly the value of the gain in utility from an increase
in future consumption is given by:




o +
A
1
) C (
MU
2
c
2
For individual to be on the same IC, the value of
the gain in the utility from the increased future
consumption must exactly offset the loss of
utility from a reduction in present consumption:
) C ( MU
1
) C (
MU
1 c
2
c
1 2
A =
+
A
o
) 1 (
MU
MU
C
C
2
1
c
c
1
2
o + =
A
A
Slope of intertemporal IC is called the marginal rate of time preference (MRTP), to
differentiate it from slope of atemporal IC which is MRS (MUc
1
/MUc
2
).
) 1 (
MU
MU
C
C
2
1
c
c
1
2
o + =
A
A
= MRTP
If C
2/
C
2
>1 at point B, the consumer exhibits
positive time preference at that point and requires
more than one unit of future consumption to
compensate them for the loss of a unit current
consumption.
If C
2/
C
2
=1, the consumer has neutral time
preferences with present and future consumption.
C
2/
C
2
<1, consumer exhibits negative time
preference and willing to forgo a unit of current
consumption in return for a less than a unit of
future consumption.
Equilibrium
C
2
C
1
IC
1
Equilibrium: Optimal consumption is
where an IC is tangential to the IBC. In this
case individual saves some of their
current income with a view to increase
consumption possibilities in future
is the subjective discount rate for valuing
future consumption. Higher is the value of
, the more impatient is the individual for
current consumption relative to future.
45
0
Slope of IC =

2
1
c
c
MU
MU
) 1 ( o +
Slope of IBC=(1+r)
A maximizing preference requires that:

) 1 (
C
C
) 1 (
MU
MU
) 1 (
C
C
1
2
c
c
1
2
2
1
r
d
d
+ = + = + = o o
) 1 (
) 1 (
C
C
1
2
o +
+
=
r
When =r, c
2
=c
1
, consumer equates
consumption in two periods which is referred
as consumption smoothing.

When >r, c
2
>c
1,
consumer is impatient and
tilts his consumption towards the present
referred as consumption tilting

Time Preference & the Individual
A patient individual has
a high preference for
consumption in future.
An impatient individual
prefers consumption
today at the expense of
consumption in the
future.
C
2
C
1
C
2
C
1
Patient consumer
Impatient consumer
Suppose individuals preference is such that
they smoothen the consumption C
2
=C
1
.
Substituting this allocation of lifetime
consumption into IBC and solving for current
consumption we will obtain:

W
r
Y
Y
r
C
C =
+
+ =
+
+
1 1
2
1
2
1
1
1
1
1
2
1
C
r
r
W
r
C
C
+
+
= =
+
+
)
1
(
2
1
2
1
2
1 1
r
Y
Y
r
r
W
r
r
C
+
+
+
+
=
+
+
=
Permanent Income (Milton Friedman)
Consumption smoothing is identical to the
individual consuming permanent income and
saving the difference between the actual and
permanent income.
An individual who smoothens consumption
across time periods has a saving given by the
difference between permanent income and
actual income.

Contd..
Y
p
is a kind of average of present and future
incomes.
It is a constant stream of income(Yp, Yp) in
periods 1 and 2 which gives same lifetime income
stream as does the fluctuating income stream
(Y
1
,Y
2
). In short, Y
p
, the annuity value of Y
1
and Y
2

is given by

r
Y
Y
r
Y
Y
p
p
+
+ =
+
+
1 1
2
1
r
Y
Y Y
r
r
p
+
+ =
+
+
=
1 1
2
2
1 )
1
(
1
2
2
1
r
Y
Y
r
r
Y
p
+
+
+
+
=
C
1
= C
2
= Y
p
When individual prefer maintaining a stable
consumption path, consuming the same every
period, we can say consumption is set equal to
permanent income.
Individual decides consumption on the basis
of his Yp and not current income as in Keynes.
Savings: S
1
=Y
1
-C
1
=Y
1
-Y
p
Consumption Under Certainty: PIH
Consider an individual who lives for T periods
whose lifetime utility:
( ) , 0 ) ( ' ' , 0 ) ( '
1
< - > - =

=
u u C u U
T
t
t
Where u(.) is the instantaneous utility function and Ct is consumption in
period t. The individual has initial wealth of A
0
and labour incomes of Y1, Y2,
.YT in the T periods of his or her life; the individual takes these as given. The
individual can save or borrow at an exogenous r, subject to the constraint that
any outstanding debt repaid at the end of his or her life. For simplicity, this r is
set to 0. Thus, the individuals budget constraint:


= =
+ s
T
t
t
T
t
t
Y A C
1
0
1
Behaviour
Since MU of consumption is always positive, individual satisfies
the budget constraint with equality. The Langrangian for his or
her maximization problem:
( ) ) (
1 1
0
1

= = =
+ + = I
T
t
t
T
t
t
T
t
t
C Y A C u
The first order condition for C
t


= ) ( '
t
C u
Since the above holds in every period, the MU of consumption is constant. Since
the level of consumption uniquely determines MU, this means that consumption
must be constant. Thus, C1=C2=..=CT. Substituting this fact into the budget
constraint yields:
t all for Y A
T
C
T
t
t t
) (
1
1
0
=
+ =
The term in parentheses is the individuals total lifetime resources. Thus, it states that the
individual divides his or her lifetime resources equally among each period of life.
Implications
Individuals consumption in a given period is determined not by income that period, but by
income over his or her entire lifetime. Right hand side in the last equation is permanent
income.

The difference between current and permanent income is transitory income. The above
equation implies that consumption depends on permanent income.
Individuals savings in period t is the difference between income and consumption.
Savings is high when income is high relative to its average i.e. when transitory income
is high. Similarly, when current income is less than permanent income, saving is negative.
This individual depends on savings and borrowing to smooth the path of consumption.
0
1
t t t
1
)
1
( C - Y = S A
T
Y
T
Y
T
t
t t
=

=
Stochastic Income Expectations (Hall)
Earlier we assumed future income is known
completely.
But future income is the association of different
probabilities with different income levels.
So an individual maximizes the expected utility and
not the total utility as presumed up to now.
Consumption smoothing requires an individual to
not just equate consumption across periods C
1
=C
2

but rather to set current consumption equal to
expectation of next periods consumption.
Contd
C
1
=E(C
2
) (1)
However, consumption in any time period can deviate from
its expected value by a random error factor.
C
2
=E(C
2
)+
2
(2)

2
is a surprise or innovation error which is non-
forecastable.
Expected value of next periods consumption:
E(C
2
)=C
2
-
2
Substituting this into (1) gives us for consumption
smoothing in a stochastic environment:
C
1
=C
2
-
2
C
2
=C
1
+
2
Generally, C
t
=C
t-1
+
t

Best forecast of next periods consumption is this periods
consumption.

Contd..
Halls result ran counter to existing views on
consumption.
Traditional view was: consumption over the
business cycle, when output and income declines,
consumption also declines but is expected t
recover due to predictable movements in
consumption.
Hallss result is that when output declines
unexpectedly, consumption declines only by the
amount of the fall in permanent income and so it
is not expected to recover.
Effect of Interest Rates
Consider an individual with income stream (Y1 , Y2) represented by
point E.
A rise in r will make the slope of the budget line (1+r) steeper IBC
rotates through point E.
It reduces present consumption and raised current savings.
An increase in r increases savings only if the individual is a net
borrower or if the substitution effect dominates the income effect.
A substitution effect indicates the change in consumption solely
due to change in r and measured along the initial IC.
Substitution effect of a rise in r causes current consumption to
decline and savings to rise.
An Income effect is the change in consumption due to change in
purchasing power or income implicit in the change in r.
Income effect is ambiguous. A net borrower increases savings but a
net lender reduces savings (increases current consumption).
A rise in r, makes the net lender to become rich.
Effect of rise in R
Individual was initially consuming at point P. The rise in r shifts
consumption to P. This reduces present consumption (increases current
savings) but increases future consumption.
Y
1
Y
2
Y
2
Y
1
C
1
C
2
C
1
C
1
C
2
C
1
C
2
C
2
P

P

P

E

E

P

Present Consump

Future Consump

Future Consump

Present Consump

Net Lender

Net Borrower

Increased savings

Decreased savings

Q

Q

Aggregate across Individuals (Franco
Modigliani)
We saw earlier decision to split the income between consumption
and savings from perspective of an individuals decision making.
In aggregate, individuals not only have different incomes but also
belong to different age group.
When young, they have low incomes and tend to dis-save (incur debt)
as they will be earning more later.
During working years, incomes rise to reach at its peak (just after
middle age) and repay the debt incurred earlier and save for the
retirement years.
When they reach retirement phases, their incomes due to them from
past work(pension) are much lower and they top this up with incomes
accrued from past savings to maintain stead level of consumption.
Two periods of dis-savings in Individuals life (early period prior to
work and retirement years). Savings is determined by ones stage in
life cycle.

Consumption, Savings and Income across a persons life
cycle: Life cycle income and Consumption
Savings<0
Savings>0
Consumption
Working years Retirement years Pre-working years
Income
Life cycle income & Savings
E: - Higher income during
working life relative to
retirement life.
Consumption smoothing
makes individuals transfer
incomes from working
years when incomes are
higher, to provide for
retirement when incomes
are lower.
U(C1,C2)
C2
Y2
Y1
C1
Savings<0
Savings>0
E
Retirement years
Working years
Borrowing Constraints & Consumption
Presence of borrowing constraints with r
on borrowing larger than the r on
lending rate results in budget
constraint XEZ. Individual who would
have preferred to consume at point B ,
where he would have borrowed against
his future income, is now forced to limit
his consumption by the amount of his
current income and consume at point E.
Y
2
Y
1
E

B

C
2
C
1
Z

(1+r
L
)Y
1
+Y
2
X

Y
1
+Y
2
/ (1+r
b
)