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Consumption: MACROECONOMICS, 7th. Edition N. Gregory Mankiw Mannig J. Simidian
Consumption: MACROECONOMICS, 7th. Edition N. Gregory Mankiw Mannig J. Simidian
CHAPTER 17
Consumption
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Chapter Seventeen 5
During World War II, on the basis of Keynes’s consumption function,
economists predicted that the economy would experience what they
called secular stagnation—a long depression of infinite duration—
unless the government used fiscal policy to stimulate aggregate demand.
It turned out that the end of the war did not throw the United States into an
depression, but it did suggest that Keynes’s conjecture that the average
propensity to consume would fall as income rose appeared not to hold.
Chapter Seventeen 11
Y Z
X IC2
W IC1
First-period consumption
Indifference curves represent the consumer’s preferences over first-
period and second-period consumption. An indifference curve gives the
combinations of consumption in the two periods that make the consumer
equally happy. Higher indifferences curves such as IC2 are preferred to
lower ones such as IC1. The consumer is equally happy at points W, X,
and Y, but prefers point Z to all the others. Point Z is on a higher
Chapter Seventeen 12
indifference curve and is therefore not equally preferred to W, X, and Y.
O
IC3
IC2
IC1
First-period consumption
The consumer achieves his highest (or optimal) level of satisfaction
by choosing the point on the budget constraint that is on the highest
indifference curve. Here the slope of the indifference curve
equals the slope of the budget line. At the optimum, the indifference
curve is tangent to the budget constraint. The slope of the indifference
curve is the marginal rate of substitution MRS, and the slope of the
budget line is 1 + the real interest rate. At point O, MRS = 1 + r.
Chapter Seventeen 13
O
IC2
IC1
First-period consumption
An increase in either first-period income or second-period income
shifts the budget constraint outward. If consumption in period one and
consumption in period two are both normal goods—those that are
demanded more as income rises, this increase in income raises
consumption in both periods.
Chapter Seventeen 14
Economists decompose the impact of an increase in the real interest
rate on consumption into two effects: an income effect and a
substitution effect. The income effect is the change in consumption
that results from the movement to a higher indifference curve. The
substitution effect is the change in consumption that results from the
change in the relative price of consumption in the two periods.
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.
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In 1957, Milton Friedman proposed the permanent-income hypothesis
to explain consumer behavior. Its essence is that current consumption is
proportional to permanent income. Friedman’s permanent-income
hypothesis complements Modigliani’s life-cycle hypothesis: both use
Fisher’s theory of the consumer to argue that consumption should not
depend on current income alone. But unlike the life-cycle hypothesis,
which emphasizes that income follows a regular pattern over a person’s
lifetime, the permanent-income hypothesis emphasizes that people
experience random and temporary changes in their incomes from year
to year.
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Recently, economists have turned to psychology for further explanations
of consumer behavior. They have suggested that consumption decisions
are not made completely rationally. This new subfield infusing
psychology into economics is called behavior economics. Harvard’s
David Laibson notes that many consumers judge themselves to be
Imperfect decisionmakers. Consumers’ preferences may be time-
inconsistent: they may alter their decisions simply because time passes.
Pull of Instant
Gratification
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Marginal propensity to consume Substitution effect
Average propensity to consume Borrowing constraint
Intertemporal budget constraint Life-cycle hypothesis
Discounting Precautionary saving
Indifference curves Permanent-income hypothesis
Marginal rate of substitution Permanent income
Normal good Transitory income
Income effect Random walk
Chapter Seventeen 21