ECON 314 - Lecture 1 Pt. 2 - Consumption and Consumer Expendutre

ECON 314:
Macroeconomics II
ECON 314: Macroeconomics 2 Lecture Material

by Dr. Emmanuel A. Codjoe
Consumption
Resolving the Consumption Puzzle
• Milton Friedman’s permanent income
theory/hypothesis
• Franco Modigliani’s life-cycle theory/hypothesis
• These theories emphasise the role of permanent or
lifetime income in determining consumption
Consumption
• The Basic Foundation
• Both are underpinned by microeconomic theory.
• And also rely on the concepts of present value and
future value.
• That is, a Cedi tomorrow is worth less than a Cedi
today.
Consumption
Why is a Cedi today worth more than one
tomorrow?
• Individuals prefer present consumption to future
consumption.
• Inflation
• Uncertainty over future cash flows
Consumption
The Concept of Discounting
• We illustrate the concept of the present value (PV),

with a simple cash flow (Ci) over a period of time, n.
𝐶1 𝐶2 𝐶𝑛
𝑃𝑉 = 𝐶0 + + + . . . +
1 + 𝑟 (1 + 𝑟)2 (1 + 𝑟)𝑛
Consumption
• Suppose the cash flow (Ci) is the same in each

period, then we have the simple expression:
𝐶
𝑃𝑉 = 𝑛
(1 + 𝑟)
Consumption
• By similar reasoning, the future value (FV) of a cash
flow can be stated as:
𝑛
𝐹𝑉 = 𝐶(1 + 𝑟)

Consumption
• Irving Fisher and Intertemporal Choice
• This became the basis for much of the subsequent
work on the theories of consumption.
• Rational, forward-looking consumers; choose

consumption for the present and future to maximize
lifetime satisfaction.
Consumption
• The choices involved means a trade-off between
current consumption and future consumption.
• In do so, households consider expected future

income as well as the consumption of goods and
services they are likely to be able to afford.
Consumption
• Fisher’s model highlights three things:

1. Constraints faced by consumers
2. The preferences between the present and the future, and
3. How these constraints and preferences together
determine their choices about consumption and saving

Consumption
• The consumer’s choices are therefore subject to an
intertemporal budget constraint.
• Reflecting a consumer’s decision on how much to

consume today and how much to save for the
future.
Consumption
• We assume that our representative consumer lives for
two periods: period 1 (youth/today/present), and
period 2 (old age/future).
• Income and consumption in the two periods are

Ytoday, and Ctoday and Yfuture and Cfuture, respectively.
Consumption
• Consumption in any period need not necessarily be
equal to his current income=> Ytoday, ≠ Ctoday, and
Yfuture ≠ Cfuture.
• Nevertheless, consumption in the two periods is

constrained by income in the two periods.
Consumption
• Utility: utility is maximized based on consumption
today and in the future.
• Consumer receives u(c) units of utility from

consuming some amount c in any period. =>>
′ ′′
𝑢 (𝑐) > 0; 𝑢 (𝑐) <0
Consumption
• Utility is assumed to have cardinal properties, hence
we can sum the utilities over the two periods, today
and future.
• Total utility is thus given by:

𝑼 = 𝒖(𝒄𝒕𝒐𝒅𝒂𝒚 ) + 𝜷𝒖(𝒄𝒇𝒖𝒕𝒖𝒓𝒆 )
Consumption
• Intertemporal Budget Constraint: consumer is
faced with two budget constraints:
𝑐𝑡𝑜𝑑𝑎𝑦 = 𝑦𝑡𝑜𝑑𝑎𝑦 − 𝑠𝑡𝑜𝑑𝑎𝑦
𝑐𝑓𝑢𝑡𝑢𝑟𝑒 = 𝑦𝑓𝑢𝑡𝑢𝑟𝑒 + (1 + 𝑟)𝑠𝑡𝑜𝑑𝑎𝑦
Consumption
• Intertemporal Budget Constraint: by substituting 0
for today and 1 for future, and combining the two
constraints, we have:
𝑐1 = 𝑦1 + (1 + 𝑟)(𝑦0 − 𝑐0 )
Consumption
• Intertemporal Budget Constraint: re-writing in the
present value yields:
𝑐1 𝑦1
𝑐0 + = 𝑦0 +
(1 + 𝑟) (1 + 𝑟)
Consumption
• Intertemporal Budget Constraint: this shows
consumer can borrow or save in each period at the
prevailing interest rate.
• Another key aspect of this, is that the consumer’s
present discounted value of lifetime consumption
must equal its present discounted value of lifetime
income.
Consumption
• Intertemporal Budget Constraint: Over the
lifetime, the objective of the consumer is to maximise
utility to the point T, which is the instant before
death.
• How then does the consumer achieve maximum
utility?
Consumption
• Maximum utility: the present value of the
individual’s total consumption in life cannot exceed
the present value of the individual’s income in life.
𝑇 𝑇
𝑦𝑡 𝑐𝑡
෍ 𝑡
= ෍
(1 + 𝑟) (1 + 𝑟)𝑡
0 0
Consumption
• What are the Implications from this outcome?
• Consumer can allocate his/her income stream over
their lifetime by borrowing and lending.
• However, this condition must hold: the present value
of consumption is constrained by the present
value of income.
Consumption
• Back to the simple case of the two-period.
𝑐1 𝑦1
𝑐0 + = 𝑦0 +
(1+𝑟) (1+𝑟)
Present value of Present value of

lifetime consumption lifetime income
Irving Fisher and Intertemporal Choice: Illustration
C2 C2 Y2
C1 + = Y1 +
1+r 1+r
(1 + r )Y1 +Y 2
Consumption
Saving = income in
The budget
both periods
constraint shows all
combinations Y2
of C1 and C2 that Borrowing
just exhaust the
consumer’s C1
resources. Y1
Y1 +Y 2 (1 + r )
Irving Fisher and Intertemporal Choice: Illustration
C2
C2 Y2
C1 + = Y1 +
1+r 1+r
1
The slope of the
(1+r )
budget line equals
-(1+r )
Y2
C1
Y1
Irving Fisher and Intertemporal Choice – Consumer
Preferences
C2 Higher indifference
curves represent
An indifference higher levels of
curve shows happiness.
all combinations of
C1 and C2
IC2
that make the
consumer IC1
equally happy. C1
Irving Fisher and Intertemporal Choice -
Optimization
C2
At the optimal point, MRS
The optimal (C1,C2) = 1+r
is where the
budget line
O
just touches
the highest
indifference curve.
C1
Irving Fisher and Intertemporal Choice: How C
responds to changes in Y
C2
Results:
An increase
Provided they are both in Y1 or Y2
normal goods, C1 and shifts the
C2 both increase, budget line outward.
…regardless of whether
the income increase
occurs in period 1 or
period 2. C1
Irving Fisher and Intertemporal Choice: How C
responds to changes in r
C2
An increase in r pivots the
budget line around the
As depicted here, point (Y1,Y2 ).
C1 falls and C2 rises. B
However, it could
turn out A
differently… Y2
Y1 C1
Consumption
• How do we judge the effect of changes in r on C?
• Income effect: If consumer is a saver, a rise in r
makes him/her better off, tending to increase c in
both periods.
• Substitution effect: The rise in r increases
the opportunity cost of current consumption, which
tends to reduce c1 and increase c2.
Consumption
• How do we judge the effect of changes in r on C?
• Both effects result in the increase in c2.
• Whether c1 rises or falls depends on the relative size

of the income & substitution effects.
Consumption
• What are the Implications of the Fisher Model?
• Consumption in the current period will vary less than

does income.
• Therefore, an increase in present income would be
spread across an increase in both present and future
consumption.
Consumption
• Analysed over a longer period of time (25 years),

would mean a present consumption increase
that is very small relative to the increase in
present income.
Consumption
• We now have the first general formulation of

the consumption function:
′
𝒄𝟏 = 𝒇(𝑷𝑽) such that 𝒇 > 𝟎
Consumption
Comparing Keynes vs Fisher
• Keynes:Current consumption depends only on
current income.
𝒅
𝑪 = 𝒇(𝒀 )
Consumption
Comparing Keynes vs Fisher
• Fisher:Current consumption depends only on
the present value of lifetime income.
• Thetiming of income is irrelevant because the

consumer can borrow or lend between periods.

ECON 314 - Lecture 1 Pt. 2 - Consumption and Consumer Expendutre

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ECON 314 - Lecture 1 Pt. 2 - Consumption and Consumer Expendutre

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ECON 314:

ECON 314: Macroeconomics 2 Lecture Material

• We illustrate the concept of the present value (PV),

• Suppose the cash flow (Ci) is the same in each

ECON 314: Macroeconomics 2 Lecture Material

• Rational, forward-looking consumers; choose

• In do so, households consider expected future

• Fisher’s model highlights three things:

ECON 314: Macroeconomics 2 Lecture Material

• Reflecting a consumer’s decision on how much to

• Income and consumption in the two periods are

• Nevertheless, consumption in the two periods is

• Consumer receives u(c) units of utility from

• Total utility is thus given by:

Present value of Present value of

• Both effects result in the increase in c2.

• Whether c1 rises or falls depends on the relative size

• Consumption in the current period will vary less than

• Analysed over a longer period of time (25 years),

• We now have the first general formulation of

• Thetiming of income is irrelevant because the

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