CHAOTER ONE

1.1 Consumption Spending and the Consumption Function

Consumer expenditure constitutes more than half a percentage of GNP in most
economies; so any analysis of the factors determining the level of GNP must be
considered with consumer expenditure at some point. Analytically, in 1936 Keynes
made the consumption function the basic element in the income - expenditure approach
to the determination of national income.
In the multiplier analysis of macroeconomics I, we know that the consumption function
is the principal building block. In this analysis, consumption function is one of the
determinants of fiscal and monetary policy. The consumption - expenditure of a
household depends on the disposable income (in come left after tax). That means C = C
(Yd). Where C = Consumption function and Yd = Disposable income.
However, this specification does not say anything more. How do households allocate
their income between consumption and saving? How do households decide how much
to consume today and how much to save for the future?
Thus, these are left unanswered in the Keynesian short - run consumption function.
These are micro economic issues as they address the behavior of individual economic
agents i.e., household. Yet its answers have a macroeconomic consequence. This is
because households' consumption decisions affect the economy as a whole behaves
both in the long- run and in the -short - run.
This effect can be seen in two ways:
i. Consumption decision is crucial for long - run analysis because of its effect in
economic growth. The Solow model, one of the growth models, states that
saving rate is a key determinant of the steady - state capital stock and thus of
economic growth. Saving measures how much of its income the present
generation is putting aside of its future and for future generations. In other
words, the decision to save is affected by the decision to consume and in
return affects the accumulation of capital stock and the economic growth.
 ii. The consumption decision is crucial for short - run analysis because of its role
in the determination of aggregate demand. In most cases it is assumed that
consumption is 2/3 of GDP. Thus, fluctuations in consumption are key
elements of economic booms and recessions that occur in the business cycle.

1.2 Theories of Consumer Behavior a Consumption Function.

For the question what determines the aggregate consumption function, there was a hot
debate among intellectuals for years. Yet no consensus is reached on the exact
determinant of consumption. Some economists believed that it is the current income of
households, which is the key factor that affects the current consumption while for other
economists it is not the current income but the future income of households that affects
their present consumption. Still other groups of economists tried to approach the issue
by dividing income of households as permanent and transitory and argued that the
former is the key factor which affects current consumption of households.
Therefore, our analysis of consumer behavior and the consumption function has these
ideas or debates as core points, which will be briefly reviewed using the following
theories developed different economists:

1.2.1- Keynesian theory of consumption.

Keynes wrote his book in 1930s. "The General Theory of Employment, Money and
Interest" At that time there was no national income accounting statistics that show the
overall effect of consumption on the economy, no household budget survey i.e.
households' income, consumption and expenditure surveys.
Thus, instead of relying on statistical analysis Keynes made his study based on cross-
section that means based on introspection and causal observations. But today,
economists who study the behavior of households and the consumption function rely
on sophisticated techniques of data analysis, with the help of computers, they analysis
aggregate data on the behavior of the overall economy from the national income
accounting statistics and detailed data on the behavior of individual households from
household surveys.
The short - run consumption function that Keynes introduced is shown in figure 1.1,
which plots real consumer expenditure C against real income Y. This function reflects
the observations that as income increases people tend to spend a decreasing percentage
of income, or conversely tend to save an increasing percentage of income.

C(Y)

Fig 1.1. Keynes' consumption function.

Y
Thus, lacking the above sources of information regarding consumption, Keynes made
the following conjectures:
1. The slope of the consumption function called the marginal propensity to consume
lies between zero and unity, i.e., o < MPC < 1 implying that as income increases
consumption will increase, but by less than the increase in income. Keynes wrote
that" the fundamental psychological law, up on which we are entitled to depend
with greater confidence,.......... is that men are disposed as a rule and on the average,
to increase their consumption as their income increases, but not by as much as the
increase in their income” That is, when a person earns an extra Birr, he/she typically
spends some of it and saves a fraction of it.
2. Keynes posited that the slope of a line from the origin to a point on the consumption
function called Average prosperity to consume (APC) or the ratio of consumption to
income, falls as income rises.
C
¿
APC Y
Keynes saw this as the behavior of households' consumption expenditure in the short -
run over the duration of a business cycle. He reasoned that as income falls relative to
recent levels, people will protect consumption standards by not cutting consumption
proportionally to the drop in income, and conversely as income rises, consumption will
not rise proportionally. He believed that saving was a luxury, so that the rich save a
higher proportion of their income than the poor.
3. Keynes believed (thought) that income is the primary determinant of consumption
and the rate of interest does not have an important role.
However; this third proposition contradicts the belief of Classical economists who
preceded him.
According to Classical economists a high interest rate encourage saving and
discourages current consumption.
Keynes admitted that the interest rate could influence consumption as a matter of
theory. Yet he wrote that “the main conclusion suggested by experience, I think, is that
the short - period influence of interest rate on individual spending out of a given
income is secondary and relatively unimportant."
On the basis of the above three conjectures, the Keynesian consumption function is
often written as:

C= C + C ' Y , Where C ≡ amount of consumption

C ≡ Autonomous consumption (i.e., amount consumed at
zero level of income.
C' =The marginal propensity out of income (MPC)
Y ¿ amount of income
C C + C'Y C 1
¿ ≡ = + C ' ⇒ APC α
1) APC Y Y Y Y
dC (C + C ' Y )
= d = C '< 1
2) MPC = dY dY
d ( APC ) d (C + C ' ) −C
≡ = 2 <0
3) dY dY Y
Empirical Evidences
After Keynes has formulated the above consumption function and the conjectures
discussed, economists began collecting data on consumption to test and evaluate the
validity of the Keynesian consumption function.
The studies were:
 Cross – sectional, i.e. consumption across units
 Time series -, i.e. consumption data a cross time.
On the basis of these earliest studies indicated that the Keynesian consumption to be a
good approximation of how consumers behave. Thus some of the findings were the
following:

Cross - sectional findings

 Higher income households consume more i.e., MPC> 0
 Households with higher income save more i.e. MPC< 1.
 Higher income households save a higher fraction of their income, i.e., APC falls
as income rises.
Time series data analysis
Researchers examined aggregate data on consumption and income for the period
between the two world wars. These data also support Keynesian consumption function
with the following out comes.
 In years when income is unusually low, such as during the depth of the great
depression, both consumption and saving were low, i.e., 0< MPC< 1.
 In addition, during these low income periods, the ration of consumption to
income (APC) was high, confirming that Keynes' second conjecture works.
 Because the correlation between consumption & income was so strong, no other
variable appear to be important for explaining consumption. Thus, the data also
confirmed Keynes' 3rd assumption (conjecture) that in come is the primary
determinant of how much people choose to consume. Although the Keynesian
consumption function did well in the early empirical work using both cross-
sectional and time series data, two counter arguments emerged soon after.
1.2.2. Secular stagnation: Simon Kuznets and the
Consumption Puzzle.
Two anomalies of Keynesian consumption function.
i.. It turned out erroneous - during WWII on the basis of the Keynesian consumption
function, economists reasoned that as income in the economy grew over time,
households would consume smaller and smaller fraction of their incomes. They
feared that there might not be enough profitable investment projects to absorb all
these savings. If so, the lower consumption would lead to an inadequate demand for
goods and services, resulting in a depression once the war time demand from the
government ceased. In other words, on the basis of the Keynesian consumption
function, these economists predicted that the economy would experience what they
called secular stagnation unless fiscal policy is used to expand aggregate demand.

ii. Simon Kuznets discovered that the ratio of consumption to income was remarkably
stable from decade to decade, despite large increase in income over time the period
he studied again as in the previous case. Thus, Keynes' conjecture that the APC falls
as income rises appeared not to hold.
Kuznets' data pointed out two important things about consumption behavior.
 First, it appeared that on average over the long- run the ratio of consumer
expenditure to income, C/Y or APC, showed no downward trend, so the MPC =
APC as income grew along the trend. That means that along the trend the C = c
(y) function was a straight line passing through the origin, as shown in figure 1.2.

C
Long – run function: MPC = APC

Short run Function: MPC< APC

Y
Fig 1.2 Long - run and Short- run consumption functions.
 Second, Kuznets' study suggested that years when the C/Y ratio was below the
long - run APC occurred during booms periods, and years with C/Y above the
average occurred during periods of economic slump.

That means that the C/Y ratio varied inversely with income during cyclical
fluctuations, so that for the short period corresponding to a business cycle empirical
studies would show consumption as a function of income to have a slope like that of a
short - run functions of figure 1-2 rather than the long - run functions.
The failure the secular - stagnation hypothesis and the findings of Kuznets both
indicated that the APC is fairly constant over along period of time.
Studies of household data and short - time series found that a relationship similar to the
one Keynes conjectured. In figure 1- 2 this relationship is called the short - run
consumption function with falling APC as income rises. But studies of long time series
data found that the APC did not vary systematically with income. This relationship is
called long -run consumption function.
Note that the short- run consumption function has falling APC while the long - run
consumption function has constant APC.
Empirical studies were suggesting that there were two consumption functions. The
Keynesian consumption function filled to take into account these consumption
functions.
Short - run consumption function
- Studies of household data and relatively short time seriesed found that APC falls as
income rises. The short run consumption function can be specified as:

C= C + C ' Y ,Where C > 0, 0< C ' <1.

C C + C'Y C
= = + C'
APC = Y Y Y
Thus APC falls as Y rises.

2. Long - run consumption function.

- Studies of long - term data found that APC did not vary systematically with income.
This is called the Long run consumption function given by:

C ¿ kY , k >0
C kY
= ≡ k
APC = Y Y
Thus APC is constant as income changes.

Fig 1.3. C C = kY

C=

1.2.3. Irving Fisher

Y and the Inter-
temporal Choice
The consumption function introduced by Keynes relates current consumption to current
income. This relationship, however, is incomplete at best. When people decide how
much to consume and how much to save, they consider both the present and the future.
The more consumption they enjoy today, the less they will be able to enjoy tomorrow.
In making this trade off, households must look ahead to the income they expect to
receive in the future and to the consumption of goods and services they hope to be able
to afford.
In this regard, Irving Fisher developed the model with which economists analyze how
rational, forward - looking consumers make inter-temporal choices - that is, choices
involving different periods of time. This model illuminates the constraints consumers
face, the preferences they have, and how these constraints and preferences together
determine their choices about consumption and saving.

i. The Inter-temporal Budget Constraint.

The reason why people consume less than they desire is that their consumption is
constrained by their income. In other words, consumers face a limit on how much
they can spend called budget constraint. When they are deciding how much to
consume today versus how much to save for the future, they face an inter - temporal
budget constraint which measures the total resources available for consumption
today and in the future.

Optimizing consumption: a two - period Example

Following the original work of Irving Fisher, we can begin with a single consumer with
a utility function U = (Co... Ct ..........CT)
Where, lifetime utility is a function of his real consumption C in all time period up to T,
the instant before he dies. The consumer will try to maximize his utility, that is obtain
the highest level of utility, subject to the constraint that the present value of his total
consumption in life can not exceed the present value of his total income in life; that is,
T T
Ct YT
∑ = ∑ ,
0 ( 1 + r )t 0 ( 1 + r )t
Where, T is the individual's expected lifetime.
The constraint says that the consumer can allocate his income stream to a consumption
stream by borrowing and lending, but the present value of consumption is limited by
the present value of income. For this restriction to hold as a strict equality, we assume
that if the person receives an inheritance, he passes on a bequest of an equal amount.
We thus have an individual with an expected stream of lifetime income who will want
to spread that income over a consumption pattern in an optimum way. We might
imagine that his expected income stream begins and ends low, with a rise in midlife,
and he wants to smooth out into a more even consumption stream.
To capture the essence of this problem let us consider as an example of a two period
case in which the individual is living for two periods:
  Period one the consumer's youth age
 Period two the consumer's old age.
 Income in period one to be represented by Y1
 Income in period two designated by Y2
 Consumption in period one represented by C1
 Consumption in period two represented by C2

Note that all variables are assumed to be real, i.e., are adjusted for inflation. This is
because the consumer has the opportunity to borrow and save; consumption in any
single period can be either greater or less than income in that period.
Thus, (1) S = Y1 - C1 ...................... in period one.
In the second period, consumption equals the accumulated saving, including the
interest earned on that saving plus second period income.

C2= S+ S .r +Y2
[2] C2 = S (1+r) + Y2
Where r = real interest rate.
Note that the variable S can represent either saving or borrowing and that these
equations hold in both cases.

From these two equations we can infer the following:

 If first period consumption (C 1) is less than first period income (Y1), then the
consumer is saving and saving (S) is greater than zero.
 If first period consumption (C1) is greater than first period income, then the
consumer is borrowing and saving (S) is less than zero. For simplicity, the
interest rate for borrowing is the same as the interest rate for saving. Thus, from
(1) and (2) above, we can derive the budget constraint as follows: substituting S =
Y1 - C1 and C2 = (1+r)S + Y2 then C2 = ( 1+r) ( Y1- C1) + Y2 as S = Y1 - C1

Rearranging, we have
 C2 Y2
= Y1 +
(3) C1 + 1+r 1+r

Equation (3) relates consumption in to the two periods to income in the two periods. It
is the standard way of expressing the consumer's inter - temporal budget constraint and
the budget constraint can be easily interpreted as follows:
 If the interest rate is equal to zero, then total consumption in the two periods
equals total incomes in the two periods.
 However, in the usual case interest rate is greater than zero, thus future
consumption and future income are discounted by a factor (1+r). This
discounting arises from the interest earned on savings. In essence, because the
consumer earns interest on current income that is saved, future income is worth
less than current income. Similarly, because future consumption is paid for out of
savings that have earned interest, future consumption costs less than current

1
consumption. The factor
( )
1+ r is the price of second - period consumption
that the consumer must forgo to obtain a unit of second - period consumption.

C2
Fig 1.4 Two - period
A Consumption
(1+r) Y1 + Y2 case.

B
C2 = Y 2

C C1
In figure 1.4, between point A and point B,
C1 = Y 1 Y1 +
the individual consumes less than his / her income and saves
Y 2 some. Whereas between
( 1+r ) and borrows against
point B and point C he/ she consumes more than his/ her income
his/ her future consumption. Three points are marked on this figure:
i - At point B, the consumer consumes exactly his income in each period ( C 1 = Y1 and
C2 = Y2) in this case, no saving and no borrowing between the two periods.
ii - At point A, the consumer consumes nothing in period - one (C 1 = 0) and saves all
income, so second - period consumption is C2 = ( 1+r) Y1 + Y2
iii - At Point C, the consumer plans to consume nothing in the second - period ( C 2 = 0)
and borrows as much as possible against second period income, thus first - period
consumption

Y2
C1 = Y 1 + ( 1+r )
Of course, these are only three of the many combinations that the consumer can
afford; all the points on the line from point A to point C are available for the consumer.
- All the points on and below the inter -temporal budget constraint are attainable
(feasible) consumption possibilities given income in the two periods. Another way to
develop the inter - temporal budget constraint is relaxing the assumption that the
individual lives for two - periods. Thus, if the individual lives for many, periods, the
inter - temporal budget constraint can be extended to:
C1 C2 Ct Y1 Y2 Yt
1
+ 2
+ . .+ t−1
= Y0 + 1
+ 2
+ t−1
(4) Co+ ( 1+r ) ( 1+r ) (1+ r ) ( 1+r ) ( 1+r ) ...+ ( 1+r )
Assume that the household starts life with some bequest from relatives, then the ITB
will become.

C2 Y2
= Y 1+ + ( 1+r ) B
(5) C1 + 1+r ( 1+r )

Where B ¿ amount of bequest .

On the other hand, if the household wants to leave some bequests or assets for
the future generation, the ITB constraint looks like:

C2 Y2 Qt
= Y1 + −
C1 + ( 1+r ) (1+r ) (1+ r )t−1
Where, Qt is the amount of assets at the end of period t.
 Household Decisions/ Consumer Preferences.
Households' preferences regarding consumption in two periods can be represented by
indifferent curves. Before we define what an indifferent curve is let us make the
following assumptions:
 Economic agents (or households) derive utility from consumption in each period.
 The level of utility achieved by some combination of consumption of
consumption in period - one and consumption in period - two is characterized by
a utility function given by U = U ( C1 + C2).

In the first - period the household chooses a combination of C 1 and C2 that yields the
highest level of Utility so long as C 1 and C2 lie on the budget line. All points that lie on
the budget line represent optimum level of utility. Thus, utility function is an increasing
function of
αU αU
> 0 , and >0
C1 and C2 i. e, αC 1 1 αC 2 2

In this case households prefer more of C 1 and C2 (the more is better) than less of both.
This type of preference can be represented in terms of an indifferent curve.
An indifference curve shows the combinations of first - period consumptions that make
the consumer equally happy Indifference curves are convex to the origin and down
ward slopping curves as the consumer consume more of C1, and then C2 will be less).

C2

Fig 1.5 Two - period D

B
consumption case: utility
maximization added.
A

Suppose the household C was

initially at point A with IC
C11*and C2*
.Now let us see what will ICohappen when
0 C1
some C1* is taken away from the C*1 while enough
C*2household 1C2 C 2* is given so that the
household remain on the same indifferent curve. The result is a movement to point B
with less C1 and more C2 than before (as in point A).
The slope of the budget line is negative and the slope of the indifferent curve measures
that C2 must be increased in order for the household to be compensated for a small
reduction in C1 and vice versa, i.e. how much second - period consumption the
consumer requires in order to become compensated for a 1 unit reduction in first -
period consumption.
ΔC 2
Slope of the indifference curve = ΔC 1 and this is the
Marginal rate of substitution
− ΔC 2
MRS C1, C2 = ΔC 1

The marginal rate of substitution shows that the consumer is willing to substitute
second period consumption for first - period consumption.
Not that the indifference curves are not straight lines and as a result, the marginal rate
of substitution depends on the level of consumption in the two periods. When first -
period consumption is high and second - period consumption is low, as at point C, the
marginal rate of substitution is low. In this case, the consumer requires only a little extra
second - period consumption to give up one unit of first - period consumption.
Conversely, when first –period consumption is low, and second t - period consumption
is high, as at B, the marginal rate of substitution is high, i.e. the consumer requires much
additional second - period consumption to give up one unit of first - period
consumption.
However, the consumer is equally happy at all points on a given indifference curve, but
he/ she prefers some indifference curves to others. Because he or she prefers more
consumption to low, he or she prefers higher indifference curves to lower indifference
curves. In figure 1.5, he or she prefers IC1, to ICo and IC2 to IC1. The set of indifference
curves gives a complete ranking of the consumer's preferences. He or she prefers D to A
because D has more consumption in both periods. Yet compare D and B; D has more
consumption in period one and less in period two which is preferred D or B?
Obviously, because D is at a higher indifference curve than B, the consumer prefers D to
B.
Hence, we can use the set of indifference curves to rank any combinations of first period
and second - period consumption.

Optimization
[

The consumer would like to end up with the best possible combination of consumption
in the two periods; i.e. on the highest in difference curve. But the budget constraint
requires that the consumer also ends up on or below the budget line, since the budget
line measures the total resources available to him.
Many indifference curves cross the budget line. The highest indifference curve that the
consumer can obtain without violating the budget constraint is the indifference curve
that just barely touches the budget line, which is IC 2 in figure 1.5 The point at which the
curve and the budget line touch i.e. point A for " optimum" is the best combination of
consumption in the two periods that the consumer can afford.
Thus, utility is to be maximized when the indifference curve is tangent to the budget
constraint. At the point of tangency slope of the indifference curve equals to slope of the
budget constraint. Slope of the indifference curve is the MRS and the slope of the
budget constraint is one plus real interest rate.
Fisher's Inter-temporal Consumption Decision Model
Let us begin with a consumer with a utility function given above:
(1) U = ( Ct0......... Ct1.........CT)
Assumptions
First, to make the problem analytical, let us assume that the underlying utility
function is logarithmic that is,
−1
2
(1) U (C) = lnC. and, Thus u' (C) = 1/c and u" (C) = C
Second, we will assume that the utility function is additively separable over time. That
means that each period's marginal utility is independent of the consumption in all
other periods. In other words, current utility is independent of future utility.
Third, we assume that future utilities are discounted at the subjective rate of interest.
For the moment we will ignore uncertainty to avoid the complications of
expectations notation. Thus, these three assumptions give us the particular
specification of utility function of equation (1).

ln C1 ln Ct ln CT
+ . . .. .. . .. .+ + . . .. .. .+
(3) U = lnCo + 1+δ ( 1+δ )t ( 1+δ )T
T
ln C t
∑
= o ( 1+ δ )t

The constraint on the consumer's choices in this many - period case comes from total
resources available: Current plus future income. With no bequests, the inter - temporal
budget constraint over the remaining T years of life is

C1 CT Y1 YT
=Y o + + .. .. . .. .+
Co + 1+r +............+ ( 1+r )
T 1+r ( 1+r ) T '

Or in more compact notation

T T
∑ ( 1+Ctr ) t = ∑ Yt
(4) o o ( 1+r )t

This is the inter - temporal budget constraint interpreted at an arbitrary initial starting
point O. We want our theory to be able to explain consumer behavior beginning with
any given initial conditions or at any given point in time. In (4), r is the interest rate
available to the consumer for saving or borrowing.
The consumer faces the problem of maximizing the utility function given by (3),
Subject to the constraint given by (4).

T
ln ct
Max
∑
Thus, o ( 1+r )t
Ct
Subject to the constraint that

T T
Ct Yt
∑ = ∑
o ( 1+ r )t o ( 1+r )t
To solve this problem and obtain the maximizing stream of consumption C o........, CT, we
will use the method of Lagrange multiplier. We incorporate the constraint and the
objective together in to one express ion.
T T T
ln ct Yt Ct
Max L =
Ct, λ
∑
o ( 1+ δ )t
+ λ
[ ∑
o ( 1+ r )t
− ∑
o (1+r )t ]
The Lagrange multiplier λ is a positive constant that will turn out to measure the
marginal utility of an additional unit of wealth.
Having followed the Lagrange in reformulating the maximization problem, we can

move toward the solution by partially differentiating L With respect to all C's and λ ,
and setting these differentials equal to zero. This gives us the first - order conditions.
∂L 1
= − λ= o
(5a) ∂C o C o

∂L 1 1 λ
= ⋅ − = 0
(5b)
∂Ct ( 1+δ ) C t
t
( 1+ r )t
∂L 1 1 λ
= Tt
⋅ T − =0
(5c)
∂CT ( 1+δ ) C ( 1+r )T
T T
∂L Yt Ct
= ∑ t
− ∑ =0
(5d) ∂λ 0 ( 1+r ) 0 ( 1+r )t

There will be T marginal conditions like (5a) - (5c), one for each C in (
.(Co,...., Ct, ......... CT).
Equation (5d) gives us back the budget constraint
1 1 1 λ
= λ and (5 b ) ⋅ =
From (5a)
Co C t ( 1+δ )t
( 1+ r )t
Rearranging, we have

(1+ r )t 1
λ = t
, ,
( 1+ δ ) Ct

1 ( 1+r )t 1 C 1+r t

Thus,
Co
=
( 1+δ ) t
.
Ct
⇒ t =
Co 1+δ ( )
 t
ct 1+r
(6) Co =
( )
1+δ
For any adjacent periods
Ct 1+r 1+r
C t−1
=
1+δ
or C t =
1+δ ( ) C t−1

(7) Ct = Ct -1
( 1+r
1+ δ )

Where r ¿ return from saving

δ≡ return from consumption.

Hence, if Ct > Ct -1, then r > δ , that means future consumption is greater in value
than present consumption.
Before we discuss the implications of the inter -temporal consumption relations
in (6) and (7) let’s interpret them in terms of marginal utility relationships.
1
Rember that u(c) = lnC, so that u'(c) = C . This means that in general the
expression in equation (7) could be written as
U ' (C t ) 1+δ
=
(7a) U ' (Ct−1 1+r

1
In our particular example, because U'(C) = C this ratio in equation (7) is the inverse

Ct
Ct
of −1 in (7). Thus, the first - order conditions give the result that the ratio of
marginal utilities of consumption in each two adjacent periods over time is equal to the
ratio of the market interest rate to the consumer discount rate.

ii. Implication of the Inter-temporal Budget Constraint.

1. From (6) or (7) we see that whether consumption rises or falls over time depends
on whether the market rate of return is larger or smaller than the individual's

discount rate, that is whether r ¿ δ .

 2. From the technical solutions we see that if r > δ the consumption path would
be rising over time. Thus, it pays save to consume later. In other words, People
value future consumption more than current consumption. This is because r-

measures the return in additional saving whereas δ - measures the individual's

loss from waiting to consume to consume in the future.

Changes in Income and Interest Rate.

i. Changes in Income
Increase in either Y1 or Y2 shifts the budget constraint outward. Higher budget
constraint allows the consumer to choose a better combination of first - period and
second - period consumption i.e. the consumer can now reach a higher indifference
curve.

C2

E2
C

C2* E1
IC2

IC1
C1
*
C1 C1 **
Figure1.6 Two - period consumption case.
The consumer responds to the shift in his budget constraint by choosing more
consumption in both periods. Although not implied by the logic of the model alone, this
situation is the most usual. If a consumer wants more of a product when his or her
income rises, economists call it a normal good.
The key conclusion from the above figure is that regardless of whether the increase in
income occurs in the first - period or the second period, the consumer spreads it over
consumption in both periods. This behavior is sometimes called consumption
smoothing.
Such a situation occurs because the consumer can borrow and lend between periods,
the timing of income is irrelevant to how much is consumed today ( except, of course,
that future - income is discounted by the interest rate) The lesson of this analysis is that
consumption depends on the present value of current and future income.
Note that this conclusion is quite different from that reached by Keynes. Keynes posited
that a person's current consumption depends largely on his current income. Fisher's
model says, instead, that consumption is based on the resources the consumer expects
over his or her life time.

Consumption and the Present Value of Future Income

The explicit relation between present value and consumption can be obtained from the
constraint of the maximization problem, which is reproduced by the Lagrange
technique as equation (5d) and equation (6), which we can rewrite as:
Ct Co
t
=
(6a) ( 1+r ) ( 1+δ )t
Notice that from the first - order conditions of equation (5), this relationship holds for
all Ct periods.
- Let us now rewrite the constraint from (5a) using the definition of present value:
T T
Ct Yt
∑ = ∑ = PV o
o ( 1+r )t o ( 1+r )
t

We can pull Co of the left - hand side, noting (1+r)o = 1, to rewrite this as
T
Ct
∑ t
= PV o
Co + o ( 1+ r )
Now from equation (6a), which followed from the first order conditions, we can

Ct
substitute for each ( 1+r )t under the summation
Co
,
( 1+ δ )t to get
 T
Co
∑ t
= PV o
Co o ( 1+δ )
Factoring out Co, We obtain the final result,
T
1 1
( 1+ ∑
)
( 1+δ )t
= PV o or C o =
( 1
) PV 0 .

Co
o
1+ ∑
( )
( 1+δ )t
(8)
Equations (8), says that for a given discount rate δ , consumption is proportional to
the present value of future income, with the coefficient given in brackets in the
equation. In other words, consumption at any time t is proportional to the present value
of future income PVo at that period.

How changes in Real Interest Rate affect Consumption

Fisher's model considers two cases for this to answer:
 The case the consumer is initially saving.
 The case the consumer is initially borrowing
Figure1.7 Shows that an increase in real interest rate rotates the consumer's budget line
around the point ( Y1, Y2) and thereby alters the amount of consumption he or she
chooses in both periods. Here, the consumer moves from point A to point B. For the
indifference curves drawn in this figure, first- period consumption falls while second -
period consumption rises.
C2

IC2

C2 A

IC1
Y2
C

C1
Y1
C1
Figure1.7 The effects of change in interest rate on consumption.
Economists decompose the impact of an increase in the real interest rate on
consumption into two effects as income and substitution effects.
1. Income effect: - is the change in consumption that resulted from the movement to a
higher indifference curve. Because the consumer is now a saver rather than a
borrower ( as indicated by the fact that first - period consumption is less than first -
period income), the increase in interest rate makes the individual better off ( as
reflected by the movement to a higher indifference curve). If C 1 and C2 are both normal
goods, the consumer will want to spread this improvement in his welfare over both periods.
This income effect tends to make the consumer want more consumption in both periods.
2. Substitution effect: - is the change in consumption that resulted from the change in the
relative price of consumption in the two periods. In particular, consumption in period two
becomes less expensive relative to consumption in period one when interest rate rises. That
is, because the real interest rate earned on saving is higher, the consumer must now give up
less first - period consumption to obtain an extra unit of second period consumption.
This substitution effect tends to make the consumer choose more consumption in
period two and less in period one.
In general, the consumers choose depends up on both income effect ( IE) and
substitution effect (SE). Both effects act to increase the amount of second - period
consumption. Hence, we can conclude that an increase in the real interest rate raises
second - period consumption. But the two effects have opposite impacts on first - period
consumption. Hence, the increase in the real interest rate could either lower or raise
first - period consumption.

Constraints on Borrowing
Fisher's model assumes that the consumer can borrow as well as save. The ability to
borrow allows current consumption to current income. In essence, if he borrows, he
consumes some of his future income in advance. Yet for many people borrowing is
impossible. For example: A student wishing to enjoy summer break in Mekelle would
probably be unable to finance this vacation with a bank loan.
Let us examine how fisher's model (analysis) changes if the consumer cannot borrow.
The inability to borrow prevents current consumption from exceeding current income;
i.e. C1 < Y1. This inequality states that consumption in period - one must be less than or
equal to income in period one. This additional constraint on the consumer is called a
borrowing constraint or sometimes a liquidity constraint. Figure 1.8 shows that this
borrowing constraint restricts the consumer's set of choices. The consumer's choice must
satisfy both the inter - temporal budget constraint and the borrowing constraint. The
shaded area represents the combinations of first - period and second period
consumption that satisfy both constraints.

C2

Budget constraint

Borrowing constraint

C1
Y1
Figure1.8 The effects of borrowing on consumption.
Borrowing constraint
The effect of the borrowing constraint can be explained by the fact that if the
consumer can not borrow, he or she faces the additional constraint that first - period
consumption cannot exceed first - period income. The following figure shows this
borrowing constraint and its effect on consumption decision.
C2
C

D
 E

C1 C1
Y1 Y1

b) Borrowing
a) The borrowing constraint constraint binding.
not binding

The consumer's optimum with

borrowing constraint.
Whet the consumer faces a borrowing constraint, there are two possible situations:
a) The consumer chooses first - period consumption to be less than first - period
income, so the budget constraint is not binding and doesn't affect consumption in
both periods.
b) The budget constraint is binding, the consumer would like to borrow and choose
point D. But borrowing is not allowed, the best available choice is point E. When
the borrowing constraint is binding, first - period consumption equals to first -
period income.
In pannel (a), he wishes to consume less in period one than he earns. But in pannel (b)
he wishes to consume more in period one than he earns. He consumes all his first -
period income, and borrowing prevents him from consuming more. The analysis of
borrowing constraint leads us to conclude that there are two consumption functions.
For some consumers, borrowing is not binding, and consumption in both periods

Y2
depend on the present value of life time income,
( Y1
)
( 1+r )
.
for others the borrowing
constraint binds, and consumption function is

C1 ¿ Y 1 and C 2 ≡ Y 2
Hence, for those consumers who would like to borrow but cannot, consumption
depends only on current income.

1.2.4 The Ando - Modigliani Approach: The life - cycle

Hypotheses
According to Fisher's model, consumption depends on a person's lifetime income. But
Modigliani emphasized that income varies systematically over people's lives and that
saving allows consumers to move income from those periods in life when income is
high to those times when it is low.
In the 1950S, Modigliani proposed a theory of spending in which people make
intelligent choices about their spending at each age limited by the resources available
over their lives. By using assets and debts, working people can provide for their
retirement and tailor their spending to their needs at each age independent of income at
each age. The theory predicts that national saving depends on the growth of national
income, not its level, and that aggregate wealth depends on the length of retirement.

The Hypothesis
Income varies over a person's life because of retirement. Most people plan to stop
working at about age 70 and they expect their income to fall when they retire. Yet they
do not want a large drop in their standard of living, as measured by their consumption.
To maintain consumption after retirement, they must save during their working years.
According to Modigliani, the consumption function looks like
W +RY
C= T
Where, T the consumer expects to live another T years.
W wealth (initial)
R Retires R years from now.
Assume interest rate to be zero on saving. For instance, if the consumer expects to live
for 50 more years and work for 30 of them. In this case

T = 50 and R = 30 Thus, C= O.02w + 0.6y.

This equation says that consumption depends on income and wealth. Hence, an extra of
$ 1 of income raises consumption by $ o.6 per year. Whereas, an extra of $1 of wealth
raises consumption by $o.02 per year.
Hence, the economy's consumption function is

C= αw+β Y , where α ≡ MPC out of wealth, and β ¿ the MPC out of

income.

Implications
Figure 1.9 graphs the relationship between consumption and income predicted by the
life cycle model. In this model, the intercept of the consumption function, which shows
what would happen to consumption if Y = 0, is not a fixed value as before, instead, it is
α w and depends on the level of wealth.

C 1 β
α

Y
Figure 1.9 The life cycle model and the effect of wealth on consumption
C w
= α + β.
According to the life - cycle model, APC is Y Y because wealth does not
vary proportionality with income from person to person or from year to year, we
should find that if income increases APC will fall when looking at data across
individuals or over short periods of time. To show how the consumption function changes
overtime. Figure 1.10 below shows, for any given level of wealth, the life- cycle model looks
like the one Keynes suggested. But this holds only in the short - run when w is constant. In
the long - run as w rises, the consumption function shifts upward. This up ward shift
prevents APC from falling as Y increases. In this way, Modigliani resolved the
consumption puzzle posed by Simon Kuznets’ data.
C

α
W2
 α
W1
Y
Figure 1.10
The life - cycle model makes many other predictions as well. Most important is that it
predicts that saving varies over a person's lifetime. If a person begins adulthood with
no wealth, he or she will accumulate wealth during his or her working years and then
run down his or her wealth during his or her retirement years.

Y, C
Consumption

Income
Saving
Saving

t - years

T
Dissaving End of life
Figure 1.11 Saving and consumption over theDissaving
life of the consumer
Income and Consumption over the Life - Cycle.
If the consumer smoothes consumption over his Life cycle (as indicated above) he will
save and accumulate wealth during working years and disave and rundown his wealth
during retirement
-From figure 1.11, higher income groups correspond to middle age and these groups
save more as a result consumption is lower. Thus, APC will be lower.
Low income groups are those at the younger and older age. For old age as compared to
their income, their income is declining while their consumption increases. Hence,
higher APC.
According to the Life - cycle model, because people want to smooth consumption over
their lives, the young who are working save, While the old who are retired dissave.
Consumption and Saving of the Elderly.
The elderly do not disave as much as the model predicts. In other words, the elderly do
not run down their wealth as quickly as one would expect if they were trying to smooth
their consumption over their remaining years of life.

Two chief Explanations

1- The elderly are concerned about unpredictable expenses. Additional saving that
arises from uncertainty is called precautionary saving - one reason for
precautionary saving by the elderly is the possibility of living longer than
expected and thus having to provide for longer than the average span of
retirement. Or the possibility of illness and large medical bills. They may
respond to this uncertainly by saving more in order to be better prepared for
these contingencies. The precautionary saving is not persuasive because elderly
can largely insure against these risks. They can buy annuities from insurance
companies. For a fixed fee, annuities offer a stream of income that lasts as long
as the recipient lives.
2- The elderly may want to leave bequests to their children. In this case, they save
during working years than consume more.
In general, research on the elderly suggests that the simple life - cycle model
cannot fully explain consumer behavior. There is no doubt that providing for retirement
is an impotent motive for saving, but other motives such as precautionary saving and
bequests appear important as well.

The model of Ando - Modigliani Life - cycle Hypothesis

i
C t =k (PV
i
t
i ) i
, Where 0< k < 1
k = the fraction of consumer i’s PV of income that he wants to consume in period t.
It depends on the slope of his indifference curves, embodied in the utility
function and on the interest rate (r) and the consumer's personal discount rate (
α )
 The above equation states that if an increase in any income entry, present or
expected, raises the consumer's estimate of PV, he will consume the fraction k i
of the increase in the current period.

i
PV t = consumer i's present value of income at period t.

If the population distribution by age and income is relatively constant, and tastes
between present and future consumption (that is, the average slope of indifference
curves) are stable through time, we can aggregate the entire individual consumption
function to a stable aggregate function.

Ct = k ( PV t ) ... ..... ... ( 1 )

Here, our aim is to make the PV term measurable economic variables (observable). The
theory involves consumption as a function of expected income, which of course cannot
be measured. The problem is to link expected income back to measured variables by
making further assumption. Ando and Modigliani begin to make the PV term
operational by noting that income can be divided into income from labor Y L and income
from assets or property YP.
L

PV o =
T
∑
y t
+ ∑
T
YP
o ( 1+r )t 0 ( 1+r )t (2)
Where time to be the current period and t ranges from zero to the remaining years of
life, T.
Now if capital markets are reasonable efficient, we can assume that
the PV of the income from an asset is equal to the value of the asset itself, measured at
the beginning of the current period. That is,
p

∑
T
Y t
= α0
o ( 1+ r )t (3)
Where α is real household net worth at the beginning of the period.
Further more, we can separate out known current labor income from unknown, or
expected, future labor income. This gives us for PVo,
L

PV o y
L

o +
T
∑
y t
+ αo
o ( 1+r )t (4)
The next step is to determine how expected labor income
Yt L …………….. YTL might be related to current observable variables.
First let us assume that there is an average expected labor income in time t o,
L
e T
Y
Y
e

o , Such that
Y o
1
= T −1 ∑
1
t

( 1+r )t (5)
Where T- 1 is the average remaining life expectancy of the population and
1
the term ( T −1 ) averages the PV of future labor income over T-1 years.
Then the expected labor income term in the expression for present value
PVo can be written as
L

∑
T
Y t
= (T −1 ) Y
e

o
1 ( 1+ r )t (6)
This gives us an expression for the present value of the income stream,
L e
PV o = Y o + ( T −1 ) Y o +α 0 (7)
Equation (7) has only one remaining variable that is not yet measurable, i.e.,
average expected labor income Ye. Assume that average expected labor income is just a
multiple of present labor income.
e L
Y o = β Y o; β >0 (8).
This assumes that if current income rises, people adjust their expectation of future
L

incomes up so that Y rises by the fraction β of the increase in

e Y t . Note
that this assumption assists great importance to movements in current income
as a determinant of current consumption. If an increase in current income shifts
the entire expected income stream substantially it will have a much larger effect
 on current consumption than it would if the expected income stream did not
shift, leaving the increment to current income to be allocated to consumption
over the remaining years of life. Thus, substituting equation [8] in equation [7),
we have
L
PV o = [ 1+ β ( T −1 ) ] Y o + αo (9)
As an operational expression for PV, in that both Y L and α can be measured

statistically. Hence, substituting this equation into equation (1), for consumption yields.
L

Co = k [ 1+ β ( T −1 ) ] Y o + kα o (10)
Equation (x) is the statistically measurable form of the Ando- Modigliani consumption
function. The Ando - Modigliani consumption function of equation (10) is shown in
figure1.12 below, which graphs consumption against labor income. The intercept of the
graph is set by the level of assets α t. The slope of the function, MPC out of labor

income, is the coefficient of YL.In the short - run cyclical fluctuations with assets
remaining fairly constant, consumption and income will vary along a single
consumption function. In the long - run, as saving causes assets to rise, the consumption
function shifts up as α t increases.
C X

kat
o YL

Thus, over time we may observe a set of point such as those along the line OX in figure
1.12, which shows a constant C/Y ratio along trend as the economy grows.
If the C/Y ratio given the equation is constant as income growth along trend, then line
OX, which gives MPC C/Y, will go through the origin, The ratio C/Y will be constant if
YL/Y - the labor share in total income and α /Y - the ratio of assets, or capital, to out

put are roughly constant as the economy grows along the trend.

1.2.5. Milton Friedman and the Permanent Income

Hypothesis

The Life - cycle model assumes that income follows a regular pattern over a person's
Life. However, people experience random and temporary changes in their incomes
from year to year. In this regard, Friedman suggested that we view current income as
the sum of two components: permanent income (YP) and transitory income ( YT).

Thus, Y = YP+ YT (1)

Where, YP - the part of income that people expect to persist into the future - where as Y T-
the part of income that people do not expect to persist. That means Y T is a random
deviation from the average income of consumers.
For example, a man, who has a law degree, earned more this year than Aster,
who is a high school dropout. The man’s higher income resulted from higher
permanent income, because his education will continue to provide him higher salary.
Take another scenario now, that Hagos, a Welkayt orange grower, earned less
than usually this year because a freeze destroyed his crop. Gebre, a Mekelle orange
grower, earned more than usual because the freeze in welkayt drove up the price of
oranges. Gebre's higher income resulted from higher transitory income, because he is no
more likely than Hagos to have good weather next year.
In line with this, Friedman reasoned that consumption should depend primarily on Y P,
because consumers use saving and borrowing to smooth consumption in response to
transitory changes in income. That means consumers spend their permanent income,
but they save rather than spend most of their transitory income. For instance, a lottery
winner saves much of the transitory income received from the National Lottery of
Ethiopia.
The permanent - income hypothesis as expressed by the following equation states that
consumption is proportional to permanent income. That is.
 p

C= ∂ Y (2)

Where, YP is permanent income and ∂ measures the fraction of YP that is consumed.

Implications: - The permanent income hypothesis solves the consumption puzzle by
suggesting that the standard Keynesian consumption function uses the wrong variable.
According to this hypothesis, consumption depends on permanent income; yet others
try to relate consumption to current income(Y).
Friedman argued that this error- in - variables explains the seemingly contradictory
findings.

YP
α
Now, APC = C/Y = Y (3)
When current income (Y) temporarily rises above the permanent income, APC
temporarily falls. When the current income temporarily falls below the Y p, then APC
temporarily rises.

Friedman reasoned that studies of household data reflect a combination of Y p and YT.
Households with high Yp have proportionately higher consumption. If all variations in
current income came from Yp, then APC would be the same in all households. But some
of the variations came from the YT, and those with higher income (YT) do not have
higher consumption. Therefore, researchers find that higher - income households have
on average, lower APC.
Friedman reasoned that Year - to - Year fluctuations in income are dominated by Y T;
Years of high income should be years of low APC. But over the long - run, say from
decade to decade, the variation came from Yp. Hence, in long - time - series, there is a
constant APC as found by Kuznets.
The permanent income hypothesis helps us to predict how the economy responds to
changes in fiscal policies.
According to the IS - LM model of Macroeconomics I, tax cuts stimulate consumption
and raise aggregate demand. On the other hand, increases in tax depress the economy
and decrease aggregate demand.
Hence, the permanent income hypothesis confirms the idea that consumption only
responds to changes in Yp, transitory changes in taxes will have only a negligible effect
on consumption and aggregate demand. If a change in tax is to have a large effect on
consumption and aggregate demand, it must be permanent income.

1.2.6 The Relative Income Hypothesis

The relative income hypothesis argues that the fraction of a family’s income devoted to
consumption depends on the level of its income relative to the income of other families
with which it identifies rather than on the absolute level of its income. If a family’s
income rises but its relative position on the income scale remains unchanged because
the incomes of other family’s with whom it identifies have risen at same rate, its
division of income between consumption and saving will remain unchanged.
The family’s absolute income has risen, so its absolute consumption and saving will also
rise, but the fraction of income devoted to consumption will be the same as it was at the
lower level.
On the other hand, if a family’s income remains unchanged but the incomes of these
other families’ rise, its income position relative to that of the other families has then
changed.
According to the relative income hypothesis, the deterioration in the relative position of
this family would lead to a rise in the fraction of its income devoted to consumption,
despite the fact that there has been no change in its absolute income.

Summary
1- Keynes conjectured that MPC is between zero and one and as income increases, the
APC will fall, and that current income is the primary determinant of consumption.
Studies of household data and short time - series confirmed Keynes's conjectures.
Yet studies of long time - series found no tendency for the APC to fall as income
increases over time.
2- Recent work on consumptions builds on I. Fisher's model of the consumer In this
model the consumer faces an inter - temporal budget constraint and chooses
consumption for the present and future to achieve the highest level of life time
 satisfaction. As long as the consumer can save and borrow, consumption depends
on the consumer's life time resources.
3- Modigliani’s Life - cycle hypothesis emphasized that income varies over a person's
life time and consumers use saving and borrowing to smooth their consumption
over their life time. According to this model consumption depends on both income
and wealth.
4- Friedman’s permanent - income explains that individuals experience both permanent
and transitory fluctuations in their income because consumers can save and borrow,
and because they want to smooth their consumption, consumption does not respond
much to transitory income. Consumption depends primarily on permanent income

1.2.6. Discussion Questions

1. What do we mean by secular stagnation?
2. Briefly explain the three conjectures that Keynes identified.
3. Does the life- cycle hypothesis solve the consumption puzzle? Explain.
4. What are the implications of the inter-temporal budget constraint?
5. Briefly explain the following:
a. the life-cycle hypothesis
b. the permanent income hypothesis
c. the present value of future income.
6. Briefly explain consumption smoothing and why it happens.
7. Briefly explain ITBC
8. Why consumption is impossible for some people?
9. On what grounds does the Fisherian model differ from the Keynesian
consumption model?
10. Briefly explain liquidity constraint.