Chapter 15

Introducing
Advanced
Macroeconomics:
Growth and business
cycles CONSUMPTION,
INCOME AND
WEALTH

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 THEMES

 Taxation, public debt and private consumption

 Why study consumption?
 The consumer’s intertemporal budget constraint
 Optimal allocation of consumption over time
 The simple Keynesian consumption function
 The relationship between consumption,
income, interest and wealth

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 THREE GOOD REASONS FOR STUDYING PRIVATE
CONSUMPTION

 Private consumption is by far the largest

component of aggregate demand.

 Economic welfare depends in large part on

consumption.

 The counterpart to consumption is saving, which

is a precondition for capital formation and long-
run growth.

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 FOCUS OF THE CHAPTER

 Focus on total consumption

 Focus on the allocation of consumption over time

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THE SIMPLE KEYNESIAN CONSUMPTION FUNCTION

Ct  a  b  Yt d , a  0, 0  b 1 (1)

b = dC/dYd = marginal propensity to consume

C/Yd = b+a/Yd = average propensity to consume

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 PROPERTIES OF THE KEYNESIAN CONSUMPTION
FUNCTION:

1) Current consumption depends only on

current income.

2) The marginal propensity to consume is positive,

but less than 1.

3) The average propensity to consume falls as

income goes up.

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 PROBLEMS WITH THE
KEYNESIAN CONSUMPTION FUNCTION

Theoretical problem:
Why should consumption depend only on current
income?
Empirical problem:
Microeconomic cross section data suggest that the average
propensity to consume falls as income goes up.

but

Macroeconomic time series data show that the average

propensity to consume does not systematically fall with
rising income, but that it is roughly constant.

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STYLIZED FACTS ABOUT THE RELATIONSHIP
BETWEEN CONSUMPTION AND INCOME:
MICROECONOMIC CROSS SECTION DATA
Consumption

Consumption

o
o Disposable
45
income

Stylized relationship between income and

consumption in microeconomic cross-section data
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STYLIZED FACTS ABOUT THE RELATIONSHIP
BETWEEN CONSUMPTION AND INCOME:
MACROECONOMIC TIME SERIES DATA
Consumption
Consumption

Consumption

o
45
Disposable
Disposable
income
income

Stylized relationship between income and

consumption in macroeconomic time series data
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 THE EVOLUTION OF THE AVERAGE PROPENSITY
TO CONSUME IN THE UNITED STATES AND DENMARK

The average propensity to consume in USA and

Denmark
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 CRITERIA FOR A SATISFACTORY
THEORY OF CONSUMPTION

 The theory must be consistent with optimizing behaviour at

the micro level.

 The theory must be consistent with the microeconomic

cross section data as well as with the macroeconomic time
series data.

In the following we will try to develop such a theory of

consumption.

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 CONSUMER PREFERENCES

The representative consumer’s planning horizon is divided

into two periods:

‘the present’ (period 1) and ‘the future’ (period 2)

Lifetime utility:
u (C2 )
U  u (C1 )  , u '  0, u ''  0,   0 (2)
1 

Properties of the utility function:

 The marginal utility of consumption in each period is positive, but

diminishing (provides an incentive for consumption smoothing).

 The consumer is impatient: the rate of time preference  is positive.

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 THE CONSUMER’S BUDGET CONSTRAINT

Notation

V = real financial wealth

r = real rate of interest

YL = real labour income

T = real net tax payment (taxes minus transfers)

C = real consumption

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 THE CONSUMER’S BUDGET CONSTRAINT

Assumptions

● All payments take place at the start of each period (unimportant

assumption).
● The capital market is perfect (no borrowing constraints).

The budget constraint for period 1

V2  1  r  V1  Y  T1  C1 
1
L
(3)

The budget constraint for period 2

C2  V2  Y  T2 2
L (4)

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 THE CONSUMER’S BUDGET CONSTRAINT

Insert (3) into (4) to get

The consumer’s intertemporal budget constraint

2  T2
L
C2 Y
C1   V1  Y1  T1 
L
(5)
1 r 1 r

Implication: the present value of total consumption over the

life cycle cannot exceed the present value of disposable
lifetime income plus the initial stock of wealth.

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 THE CONSUMER’S BUDGET CONSTRAINT
We can simplify the budget constraint by introducing the
concept of
Human wealth (human capital)
Y2L  T2 (6)
H1  Y  T1 
L

1 r
1

Human wealth is given by the present value of disposable

labour income over the remaining part of the life cycle.

Substitution of (6) into (5) yields a simplified expression for

The intertemporal budget constraint

C2
C1   V1  H1 (7)
1 r
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OPTIMAL ALLOCATION OF CONSUMPTION OVER TIME

Substitution of the budget constraint (7) into the utility

function (2) yields
u  (1  r )(V1  H1  C1 )  (8)
U  u (C1 ) 
1 
Maximization of (8) with respect to C1 yields the first-order
condition
dU  1 r    C2

 0  u '(C1 )    u '  (1  r )(V1  H1  C1 ) 
dC1  1    

 1 r  (9)
u '(C1 )    u '(C2 )
 1  
Interpretation: In the optimum the consumer is indifferent between
consuming an extra unit today and saving an extra unit today.
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 OPTIMAL ALLOCATION OF CONSUMPTION OVER
TIME

By rearranging (9) we get

The Keynes-Ramsey rule

u '(C1 )
 1 r (10)
u '(C2 ) / (1   )
Interpretation: the marginal rate of substitution between present
and future consumption (the left-hand side) must equal the
relative price of present consumption (the right-hand side), as
shown on the next slide.

Note: For r=  it follows from (9) and (10) that the consumer
wishes to smooth consumption completely, that is C1 = C2 . Slide
20-21 illustrates consumption smoothing in the case where V1 =
0.
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OPTIMAL ALLOCATION OF CONSUMPTION OVER
TIME
C2

optimal intertemporal allocation

of consumption

|slope| = MRS (C2 : C1 )

|slope| = 1 + r

saving

C1
V1+YL1-T1 H1+V1

The consumer’s optimal intertemporal

allocation of consumption ©The McGraw-Hill Companies, 2010
 OPTIMAL ALLOCATION OF CONSUMPTION OVER
TIME
Consumption
and income

YL2-T 2

Saving in period
2

C1=C2
Borrowing in period 1
YL1-T1

Time
0 1 2

Consumption smoothing for a consumer with relatively

low income during period 1 (V1=0)
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OPTIMAL ALLOCATION OF CONSUMPTION OVER
TIME
Consumption
and income

YL1-T1

Saving in period
1
C1=C2

Dissaving in
period 2

YL2-T2

Time
0 1 2

Consumption smoothing for a consumer with

relatively high income during period 1 (V1=0)
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DO CONSUMERS ACTUALLY SMOOTH CONSUMPTION?
income consumption
adjusted consumption

-1.6

-1.8

-2

-2.2
30 40 50 60
age
consumption and income profiles for couples in UK (born 1935-1939)

Consumption and income profiles for households in

the United Kingdom (born 1935-1939)
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 DERIVING THE CONSUMPTION FUNCTION

Suppose now that the consumer’s utility function takes the form
 Ct 1 /  1
u (Ct )  for   0,   1 (12)
 1

u (Ct )  ln Ct for  =1 (13)

To analyse the properties of this utility function, we introduce the

intertemporal elasticity of substitution in consumption (IES),
defined as
d (C2 / C1 ) /(C2 / C1 ) d ln(C2 / C1 )
IES   (14)
dMRS (C2 : C1 ) / MRS (C2 : C1 ) d ln MRS (C2 : C1 )

IES measures the degree to which the consumer is willing to substitute

between current and future consumption, as illustrated on the next slide.
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 C 22

slope=C12/C11

C1 E1
|slope|=MRS(C12:C11)
2
slope=C02/C01

E0
indifference curve
C0

|slope|=MRS(C02:C01)

C11
C11 C01

The relation between the consumption ratio (C2/C1) and

the marginal rate of substitution
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 DERIVING THE INTERTEMPORAL ELASTICITY OF
SUBSTITUTION

Since it follows from (12) that: u(Ct )  Ct 1/

we may now write MRS in the following way:

1/
 C2 
MRS  C2 : C1   1     
 C1 
and hence:
1 C 
ln MRS  C2 : C1   ln 1     ln  2 
  C1 
from which:
d ln  C2 C1 
IES   (15)
d ln MRS  C2 : C1 

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 THE UTILITY FUNCTION WITH A CONSTANT IES

Thus our utility function (12) has the property that IES is
constant and equal to  . The magnitude of  depends on
the curvature of the indifference curves, as illustrated below
C2

indifference curves

 =0

0< <∞



C1

The relation between the shape of the indifference curve

and the intertemporal substitution elasticity
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 DERIVING THE CONSUMPTION FUNCTION

From the Keynes-Ramsey rule we know that

MRS ( C2 : C1 ) = 1+r

Given the utility function (12), this rule implies that

(1   )(C2 / C1 )1/  1  r 

 1  r  1/
C1/2     C1 
 1  


 1 r 
C2    C1 (16)
 1  
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 DERIVING THE CONSUMPTION FUNCTION

From the intertemporal budget constraint (7) we know that

C2
C1   V1  H1 (7)
1 r

Inserting (16) into (7), we get

C1  (1  r ) 1 (1   )  C1  V1  H1

C1    (V1  H1 ), (17)

1
0    1 
1
1  (1  r ) (1   )

Implication: Current consumption is proportional to total current wealth.

The propensity to consume wealth is positive, but less than one.
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 CONSUMPTION AND INCOME

Using the definition of human wealth given in (6), we find from

(17) that  d Y2d 
C1     Y1   V1  , Yt d  Yt L  Tt (18)
 1 r 
which may be rewritten as
C1 ˆ
d
 (19)
Y1

ˆ  R  Y2d V1
   1   v1  , R d , v1  d (20)
 1 r  Y1 Y1

If the expected rate of income growth is denoted by g, we may

write equation (20) in the following way:
1 g (21)
ˆ  1   v1
1 r
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 EXPLAINING THE RELATIONSHIP
BETWEEN CONSUMPTION AND INCOME

Cross section data: In a cross section of consumers in a given year

many persons with a low current income may expect to earn a higher
future income. Hence, they will have a high propensity to consume, since
R in (20) will be high. Other individuals with high current incomes will
expect a lower future income (a low value of R) and will therefore have a
low propensity to consume.
The difference between current and future income may be due to the
fact that income varies systematically over the life cycle (the life cycle
theory, Modigliani), or may be due to temporary random fluctuations in
income (the permanent income theory, Friedman).

Time series data: In the long run the variables g, r and v1 are
roughly constant. Hence, the average propensity to consume will also be
roughly constant, according to (21).

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 CONSUMPTION AND WEALTH

Equation (21) implies that the propensity to consume varies

positively with the wealth-income ratio v1. The figure below
supports this theory.

Private consumption and wealth in Denmark

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 CONSUMPTION AND INTEREST

From (17) we recall that

C1    (V1  H1 ),

1
0    1 
1
1  (1  r ) (1   )

From the definition of  we find

d (1   )(1  r ) 2 (1   ) 
 (24)
dr 1  (1  r ) 1 (1   )   2
 

The effect of a change in the rate of interest on the

propensity to consume is ambiguous because of
offsetting income and substitution effects.
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 CONSUMPTION AND INTEREST

However, a rise in the real rate of interest also has two negative
wealth effects on consumption:

The human wealth effect: A rise in the rate of interest

reduces the present value of lifetime labour income, since

2  T2
L
Y
H1  Y1  T1 
L
(6)
1 r

The financial wealth effect: A rise in the rate of interest

reduces the market value of financial wealth, since stock prices
and housing prices vary negatively with the real interest rate.

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 THE GENERALIZED CONSUMPTION FUNCTION

We may summarize our theory of private consumption in the

generalized consumption function:

 
C1  C  Y1d , g , r , V1  (32)
 (  ) (  ) (?) (  ) 

Expectations about the future affect consumption via g and via V1

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 IMPORTANT CONCEPTS AND POINTS IN CHAPTER 15
 The simple Keynesian consumption function

 The lifetime utility function, the rate of time preference and the
intertemporal elasticity of substitution

 The consumer’s intertemporal budget constraint

 Human capital

 The optimal allocation of consumption over time: the Keynes-Ramsey rule

and consumption smoothing

 Derivation of the consumption function

Explanation of the relationship between income and consumption in cross

section data and in time series data: the life cycle theory and the
permanent income theory
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 IMPORTANT CONCEPTS AND POINTS IN CHAPTER 15

 The relationship between wealth and consumption

 The relationship between the real interest rate and consumption

 The effects of temporary and permanent tax cuts

 The intertemporal government budget constraint

 The Ricardian Equivalence Theorem

 Reasons why Ricardian Equivalence is likely to fail

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