Lecture 3. Consumption

MACROECONOMICS FOR POLICY
EPM 5122
CONSUMPTION AND SAVING
Dr. Dale Mudenda @2020

Introduction
 Recall: GNP is made of many components ands can be

viewed as either a flow of product of income: so that:
 C+I+G+(X-M)= C+S+T+ Rf
 Rf --Is total private transfer to foreigners
 In case of a closed economy, it means the output will be:
 C+I+G =Y= C+S+T
 National income Y is measured in current prices often

referred to as nominal or money GNP:
 values output using current prices
 not corrected for inflation
Macroeconomics for Policy D Mudenda

EXAMPLE:
apples oranges
year P Q P Q
2011 K10 400 K2.00 1000
2012 K11 500 K2.50 1100
2013 K12 600 K3.00 1200
Compute nominal GDP in each year:

Increase:
2011: K10 x 400 + K2 x 1000 = K6,000
37.5%
2012: K11 x 500 + K2.50 x 1100 = K8,250
30.9%
2013: K12 x 600 + K3 x 1200 = K10,800
Real GDP values output using the prices of a base year as corrected
for inflation
apples Oranges
year P Q P Q
2011 K10 400 K2.00 1000
2012 K11 500 K2.50 1100
2013 K12 600 K3.00 1200
Compute real GDP in each year,

using 2011 as the base year:
Increase:
2011: K10 x 400 + K2 x 1000 = K6,000
20.0%
2012: K10 x 500 + K2 x 1100 = K7,200
16.7%
2013: K10 x 600 + K2 x 1200 = K8,400
EXAMPLE:
Nominal Real
year GDP GDP
2011 K6000 K6000
2012 K8250 K7200
2013 K10,800 K8400
In each year,
 nominal GDP is measured using the (then)
current prices.
 real GDP is measured using constant prices from
the base year (2011 in this example).

EXAMPLE:
Nominal Real
year GDP GDP
2011 K6000 K6000
37.5% 20.0%
2012 K8250 K7200
30.9% 16.7%
2013 K10,800 K8400
 The change in nominal GDP reflects both prices and
quantities.
▪ The change in real GDP is the amount that
GDP would change if prices were constant
(i.e., if zero inflation).
Hence, real GDP is corrected for inflation.
Example
 The nominal income Y can be broken down into price and

real output Y =Py
 Out put y can be disaggregated as:
• c+i+g =y= c+s+t
 Subtracting real consumption gives us the investment savings
balance: i+g =s+t

Consumption
 Outline
 Consumption Function
 Simple Keynesian Consumption function
 Consumer preferences
 Inter-temporal choice
 Properties of Consumption function
 Consumption and income
 Consumption and wealth
 Consumption taxation and Public Debt
 Ricardian Equivalence

Consumption Function
 Introduction
 Recall: Y = C+I+G
 Consumption is one of largest component of aggregate
demand or GDP
 Understanding consumption will helps us
 build short run business cycle model
 Understand how business cycles and other macroeconomic
policies affect welfare

The Keynesian Consumption Function
 Function
 C = C(Yd) where c is the marginal propensity to consume
 0 < MPC < 1
 Average propensity to consume (APC ) falls as income rises.
(APC = C/Yd )
 That is, the rich are assumed to have higher average saving
rate than the poor
 Income is the main determinant of consumption
C = a + cYd a  0 and 0  c  1

C = a + cYd a  0 and 0  c  1
Consumption
c c = MPC
= slope of the
1 consumption
function
Yd

 Two problems with the Keynesian consumption function:
C = a + cYd a  0 and 0  c  1
1. Theoretical – while consumption is related to income, it is
not clear why current consumption of an optimizing agent
should depend only on income and not also interest rate and
expected future income
2. Although data shows that the rich save more than the poor,
empirical evidence suggest that the ratio of aggregate
consumption to aggregate income is constant over the long
term
There is need for a theory of consumption that explains the
observed r/ship between consumption and income. We develop
this in next section

Consumer preferences
 We use the micro-foundation theory of consumption –with

specified consumer preferences
 Assumes consumer is forward-looking and chooses
consumption for the present and future to maximize
lifetime satisfaction
 For simplicity divide time into two for now
 Current period is 1
 Future period is 2
 In each period (t=1,2) the consumer derives utility U(Ct )
from consumption.
 Because consumers are impatient, they prefer a unit of
utility today to a unit of utility tomorrow:
Consumer preferences
 From period 1, the consumer’s life utility is given by

U = u (C1 ) + u1(+C2 ) , u '  0; u ' '  0,   0
 The consumer’s impatience is captured by  which is called
the rate of time preference
 It is positive because consumption today is valued more than
a similar amount of consumption tomorrow.
 As long as  is not infinitely high, the consumer has to decide
how he optimizes today’s consumption to tomorrow’s
 The assumption u’ >0 and u”<0 signify that the marginal
utility of consumption in any period is positive but
declining
 Increasing consumption in any period reduces the MU gain from
further consumption increase in that period.
Intertemporal budget constraint
 Consumer’s choices are subject to an intertemporal

budget constraint
 a measure of the total resources available for present and
future consumption
a. assume a budget constraint for two periods:
b. We have perfect capital markets –i.e., consumer can freely
lend and borrow as much as s/he needs at the market rate of
interest –This may not hold in reality
 In period 1, a consumer is endowed with a stock of real
financial wealth V1 and earns real labour income Y, pays
real amount of taxes T1 and spends the real amount C1 on
consumption
 Assume that all payments are made in period 1 so that the
consumer has the income as Y +V and nets off T and C.
 The remaining income for investment in interest-bearing
assets is:
V1 + Y1L − T1 − C1
 Assuming the saving earn interest r, the realt stock of
financial assets in period 2 is:
 V2 = (1 + r )(V1 + Y1L − T1 − C1 ) equation 3
 If a consumer is a net borrower, then V2 can be negative
 The consumer does not plan to consume beyond period 2.
so his budget constraint in period 2 is:
 C2 = V2 + Y2L − T2 equation 4
 Equation 4: says that the consumer spends all his wealth plus
after tax labour income on consumption in period 2
 Consolidating equations 3 and 4 into a single constraint
(insert 3 into 4) gives:
C2 = (1 + r )(V1 + Y1L − T1 − C1 ) + Y2L − T2
 Re-arranging gives
 5
 C2 Y2L − T2 5
C1 + = V1 + Y1 − T1 +
L
1+ r 1+ r
Equation (5) is the consumer’s inter-temporal budget
constraint. It says the present value of the
present value of
consumer’s lifetime consumption must equal the
lifetime consumption
present value of the consumer’s after-tax-labour
income plus the initial wealth
 This means that current consumption does not have to
equal current income but over a life cycle, the consumer
cant spend any more than his or her life total resources
that comprise
 labour income
 Initial financial wealth
Y2L − T2
 To rewrite the above eq. we define : H1 = Y − T1 +
L
eq6
1+ r
1
 H1 is the present value of the consumer’s disposable lifetime

labour income. It is referred to as human wealth or human
capital because it measures his or her capitalized earnings
potential in the labour market

 Sub 6 to 5 to obtain:
 C eq 7
C1 + 2 = V1 + H1
1+ r
 Please observe that H1 carries the time subscript 1 because

it caries income from period 1 onwards.
 Equation 7 says that the present value of real life consumption
is constrained by total real initial wealth consisting of the sum
of financial wealth and human wealth
 BUT how does a consumer allocate consumption over time?

Allocation of consumption over time
 The consumer will always choose his path of consumption

so as to maximize the life time utility function
U = u (C1 ) + u1(+C2 ) , u '  0; u ' '  0,   0

 eq 2
 This will be constrained or subject to intertemporal budget
set in equation 7, which can be expressed in terms of C2
C2
C1 + = V1 + H1
1+ r
C2 = (1 + r )(V1 + H1 − C1 )
 We assume a consumer’s wage rate is given and
 the working hours are determined by the institutional set-up
 In this case the labour income Y1 and Y2 and therefore H1 are
exogenously given to the consumer
 Sub C2 into the utility function (eq 2) to obtain:
 equation 8
U = u (C1 ) + u ((1+ r )(V1+1 + H1 −C1 ))
 The consumer in this case has to choose the C1 that

maximizes equation 8. The first order conditions are:
U 1+ r
= u ' (C1 ) − u(1 + r )(V1 + H1 − C1 ) = 0
C1 1+ 
 Which was written as:

1+ r
 u ' (C1 ) = u (C2 ) equ 9
1+ 
u ' (C1 )
= MRS (C2 , C1 ) = 1 + r
 Or as u (C2 ) /(1 +  ) equ 10

 Equations 9 and 10 are similar are alternative ways of

expression the consumer’s optimum conditions. The
equation 9: u ' (C1 ) = 1 + r u(C2 )
1+ 
 Says that if the consumer increased consumption by bone unit

in period 1, his lifetime utility will increase by u’(C1)
 If he choose to invest the funds in the capital market to earn real
interest rate r, the consumer will be able to increase
consumption in period 2 by the units 1+r
 This will generate an increase in life time utility equal to 1 + r u(C2 )
1+ 
 In optimum the consumer will be indifferent between
consuming an extra unit today and saving an extra unit today

u ' (C1 )
 Equation 10 = MRS (C2 , C1 ) = 1 + r is the usual
u (C2 ) /(1 +  )

optimum condition that the marginal rate of substitution (MRS)
between any tow goods must equal to the price ratio between the
two goods.
 In this case, the two goods are “present consumption, C1 and “Future
consumption C2)
 This can be expressed in diagram as follows

The intertemporal budget constraint
The budget C2 C1 +
C2
=
(V1 + H 1 )
constraint shows 1+ r 1+ r
all combinations
of C1 and C2 that
(1+r)(V1+H1) Consump =
just exhaust the
Saving income in both
consumer’s periods
resources.
|slope|=(1+r )
Borrowing
C1
(V1+Y1-T1) (V1+H1)
slide 24
 We incorporate the consumer’s indifference curve. Along it,
lifetime utility is constant. This, from the utility function, a
constant utility level implies:
dU = u ' (C1 )dC1 + u '( C2 )

1+ dC2
dC2 u ' (C1 )
or : - =
dC1 u ' (C2 ) /(1 +  )
 This equation shows that the slope of the indifference curve is
equal to the MRS between present and future consumption
MRS (C2:C1) – ratio of present to marginal lifetime utility of
future consumption
 The slope of the consumer’s lifetime budget equal 1+r

 If the consumer saves 1 unit of present consumption, 1+r
additional unit of future consumption will result because the
savings earn the real interest rate.
 1+r is the relative price of present consumption –since it
measures the amount future consumption by one unit

C2 Optimal intertemporal allocation of consumption

MRS = 1+r
(1+r)(V1+H1)
|slope| =MRS (C2:C1)
As equation 10 indicates, the slope of

the indifference curve equal the slope
of the budget constraint
IC This optimum consumption rule –is
called the Keynes-Ramsey Rule
• It suggests that consumers typically
use the capital markets to smooth
their consumption over time
0 V1+H1 C1
The optimal (C1,C2) is where the budget line just touches the highest
indifference curve.
 In a benchmark case, real interest equal to the rate of time

preference (r =)
 In this case the consumer’s impatience  is exactly offset by the
capital market reward r for postponing consumption
 In the case r = condition 10 can only be met if C1 = C2, i.e., if
consumption is constant over the consumer’s life cycle.
 If in period 1, the consumer starts with zero financial wealth
(V1 =0).
 If the labour income is not the same in both periods, he will
have to engage in financial saving in one period and financial
dissaving in the other period to keep consumption constant
over time.

With low labour income in period 1 than period 2

Ct, Y2 The consumer borrows in period 1 to smooth consumption
over lifecycle
The consumer reserves part of
Y2-T2
the high future labour income for
Saving in payment of interest
Period 2
C1-C2
Borrow in period 1
Y1-T1
0 1 2
t

With highlabour income in period 1 than period 2

Ct, Y2 The consumer saves in period 1 to smooth consumption
over lifecycle
The consumer reserves part of
Y1-T1
the high current labour income for
Saving in
financing period 2 consumption
Period 1
from current savings
C2-C2
Dissaving in
period 2
Y2-T2
0 1 2
t

Determinants of Current Consumption
 The Keyne-Ramsey rule in equation 10 only provides an

implicitly solution to the problem . To show the explicit
solution to consumption C1, we specify the consumer’s
utility function in form of a constant relative risk aversion
such as:

u (Ct ) = Ct( −1) /  for   0,  1 12
 −1
u(Ct ) = ln Ct for  = 1 13
 To interpret 12, we introduce the intertemporal elasticity of

substitution (IES) in consumption
 IES defined as the percentage change in the ratio of future to
present consunmption (C2/C1) implied by a percentage
change in the consumer’s MRS (C1:C2)
Determinants of Current Consumption
 The IES is defined as:

d (c) /(c2 / C1 d ln(c2 : c1 )
IES =• = equation 14
d ( MRS (c2 : c1 ) / MRS (c2 : c1 ) d ln MRS ((c2 : c1 )

 The IES measures the degree to which the consumer is
willing to substitute future for current consumption
 This can be illustrated as follows:

R/ship between consumption ratio and MRS
As we move from Eo to E1, the
slope = c12 / c11 Consumer becomes less willing
to trade present consumption for
Future consumption
This is reflected in the steeper
c12 E1 Slope of the indif. curve at E1 than
slope = MRS(c2 : c1 ) Eo
1 1
slope = c 02 / c10
Eo
0
c 2 slope = MRS(c02 : c10 )
It is easer for a consumer to
substitute future for present
consumption the flatter the ind
curve
c11 c10
The more the consumer if willing to engage in intertemporal substitution in consu.

the greater will the value of IES defined in equation 14 will be
R/ship between consumption ratio and MRS
 From equation 12, we know that: u ' (ct ) = Ct−1/ 
 Since the MRS(C1 : C2 ) = u' (C1 ) /(u' (C2 ) /(1 +  ))

 it follows that: 1/ 
 C2 
MRS (C2 : C1 ) = (1 +  ) 
 C1 
1 C 
hence : MRS (C2 : C1 ) = ln(1 +  ) + ln  2 
  C1 
 From which we obtain the IES as:
d ln(C2 / C1 )
IES = =
d ln MRS (C2 : C1 )
 From equation 12, the intertemporal elasticity of substitution

is constant and equal to 
Cont
 Varying  affects the

variations in consumer Indifference curves
willingness to sub
consumption over time
 If  tend to zero, the =0
consumer becomes
unwilling to trade present
for future consumption
=
 As  tend to infinite, sub
possibilities becomes infinite
– straight ind curve

continued
1/ 
C 
 From above equation MRS (C2 : C1 ) = (1 +  ) 2 
 C1 
 And we know that in equilibrium: MRS = 1+r, equate the

two and make C2 subject of the formula to obtain:

 1+ r 
C2 =   C1
 1 +  

 From the lifetime budget constraint we have :
 C1+c2/(1+r) = V1 +H1. This using CRRA, gives
 C1 +(1+r)-1 (1+)-1 c1 =V1+H1
 Express this in terms of C1
 C1 =  (V1 + H1 ), 0  =
1
 −1 −
1 eq **
1 + (1 + r ) (1 +  )
continued
 Equation ** suggests that current consumption is

proportional to current wealth
 The propensity consume out of current wealth (theta) is
positive and less than 1 and its magnitude depends on real
interest rates

Properties of Consumptions Function
1. Consumption and Income

 The properties are implied in the equation:
1
C1 =• (V1 + H1 ), 0  =  −1 −
1 ***
1 + (1 + r ) (1 +  )
 There is a r/ship between consumption C1 and current

disposable labour income
Recall: Yd = Y –T and Y −T L
 H = Y −T + L 2 2
1+ r
1 1 1
 Insert H in ** we obtain:
Y2d
C1 =  (V1 + Y + d
),
1+ r
1
C1 = ˆY1d ***
 which we can write as: 

ˆ =  1 +
R 
+ v1 ;
Y2d
R= d ; v1 =
V1
****
 1+ r  Y1 Y1d

Properties: Consumption and Income
 Where ˆ measures propensity to consume out of current

income; R is the ratio of future income to current income
and v1 is the current wealth-income ratio:
 We use equations *** and **** to explain the empirical puzzle
that the average propensity to come current income seem to
decline with income based on microeconomic foundations and
it is constant in macroeconomic time series data
 Why declining tendency in Micro data sets
 First, at times individuals who record a high current income
may not expect to earn a similar high income in future:
 There is retirement and labour income may cease
 Businesses may boom and burst

 If a high current income is expected to be temporal the

ratio of to current income R will be relatively low –
implying a low APC current income
 Similarly, some consumers with low current income may
have good reason to expect that they will earn more in
future
 Budding business, students etc
 For such individuals, the R will be high and hence the APC out
of current income will be high
 Why APC seeming constant in time series or over
longer periods?

 In equation **** redefine the growth rate of real income

by g so that income in period 2 is Y2d = (1 + g )Y1d
 Then we get theta hat as:
ˆ 1+ g
 = 1+ + v1
1+ r
 While growth fluctuates in the short-run, it is fairly
constant over a long time. Hence the puzzle:
 In short: a temporally increase in income for an individual
consumer will reduce the expected values of the parameter
R and g and possibly the SR wealth income ratio v. Hence
the tendency for APC to fall with rising income in cross-
section of consumers. But LR, growth is constant
Consumption and Income
 The above observations are well postulated by:

i. Life cycle theory of consumption – Modigliani & Brumberg
ii. Permanent income hypothesis - Milton Friedman

life cycle hypothesis (LCH)
 In the 1950s Franco Modigliani developed with co-authors

the life cycle hypothesis (LCH) to describe consumption
and savings behaviour over individuals’ lifetime.
 This theory postulates that income varies systematically
over the phases of the consumer’s life cycle
 Demographics –such as age important in explaining savings
and Consumption
 saving allows the consumer to achieve smooth consumption
The Life-Cycle Hypothesis (1950s)
 The basic model:
V = initial wealth
Y = annual income until retirement (assumed constant)
R = number of years until retirement
T = lifetime in years
 Assumptions:
 zero real interest rate (for simplicity)
 consumption-smoothing is optimal
Franco Modigliani Nobel laureate

 Lifetime resources = V+ RY
 To achieve smooth consumption, assume a consumer
divides resources equally over time:
 C = (V + RY )/T , or
 C = aV + b Y
where
a = (1/T ) is the marginal propensity to consume out of wealth
b = (R/T ) is the marginal propensity to consume out of income
 The Life-Cycle Hypothesis can solve the consumption
puzzle as follows:
 The APC implied by the life-cycle consumption function is
 C/Y = a(V/Y ) + b
 Across households, wealth does not vary as much as

income, so high income households should have a lower
APC than low income households
 In the LR, aggregate wealth and income grow together,
causing APC to remain stable
 The income time path for workers is humped
 Income increases with experience
 Income falls with retirement
 Households try to smooth consumption over life time to
keep consumption constant
 They borrow when young (Consumption > income) and have
negative assets
 In phase 2: hh in middle ages starts to earn slightly more

money and begins to save -income exceed consumption
 Final phase – retirement age – households dissave and

reach zero at the end of life . They run down their wealth or
financial assets to finance consumption (evidence show
that they tend to bequeath )
 The life cycle model predicts the following path of
consumption and assets: before entry into the labour
market individuals should borrow, they should accumulate
savings while working and dissave after they retire.

Implications of the Life-Cycle Hypothesis
$
implies that
saving varies
systematically Wealth
over a person’s
lifetime.
Income
Saving
Consumption Dissaving
Retirement End
begins of life
Macroeconomics for Policy D Mudenda slide 48
 The life cycle hypothesis has other important implications.

 Consumption responds little to temporary changes in
income and proportionally to permanent changes; also the
marginal propensity to consume out of current income
depends on age
 Some empirical observations seem at odds with the simple
LCH model.
 First, young individuals consume too little compared to
expected life-time income.
 A high marginal propensity to consume could point to myopia
or liquidity constraints
 Second, consumption seems to first increase and later fall

in line with labour income which appears at odds with
consumption smoothing.
 Browning and Crossley (2001) argue that precautionary
savings (prudence) and demographic changes (children in
family) could explain these changes over the working life.
 Third, the elderly dissave too little after retirement and
consumption falls discretely at retirement.
 These observations might be explained by precautionary
savings motive or the importance of bequests.
Permanent Income Hypothesis –Friedman
 He distinguishes two types of consumer incomes that HH
receive that is:
 current income Y as the sum of two components:
 permanent income YP (average income, which people expect
to persist into the future)
 transitory income Y T (temporary deviations from average
income) (Y = Y T +YP)
 HH/consumers use saving & borrowing to smooth
consumption in response to transitory changes in income.
 His postulated consumption function:
 C = kY P
 where k is the MPC out of permanent income
Permanent Income Hypothesis
The hypothesis attempts to solve the consumption puzzle:

▪ The PIH implies
APC = C/Y = kY P/Y
▪ To the extent that high income households have higher
transitory income than low income households, the APC will be
lower in high income households.
▪ Over the long run, income variation is due mainly if not solely to
variation in permanent income, which implies a stable APC.

Consumption and Interest Rates
 Real rate of interest r also affect consumption. The

propensity increases with r if  < 1 and decreases if  > 1
1
=  −1 −
1
1 + (1 + r ) (1 +  )
 It is not clear a priori which direction is correct as  can be

either smaller or larger than 1. The indeterminacy in how r
affects the propensity to consume is due to offsetting
substitution and income effect.
 SOME REFLECTIONS:

 The income effect is the change in consumption that results
from the movement to a higher indifference curve. Because
the consumer is a saver rather than a borrower
 the increase in the interest rate makes him better off
 If consumption in period one and consumption in period
two 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
 An increase in r pivots the
budget line around the C2 Slope =1+r’
point H1, H2
 A rise in the interest rate to B
r’>r implies:
 an increase of the relative
A IC2
price of current (C1)
relative to future (C2) H2 IC1
goods Slope = 1+r
 which induces the O

C1 H1
C1
consumer to substitute
away from current
consumption towards
future consumption
Intertemporal substitution and income effects
 The intertemporal substitution

effect leads to a fall in current
cons and increase in future
consumption generated by the
increase interest rate
 the higher interest rate reduces
first-period cons from
second-period cons from c1 to c1
*
 The equilibrium resulting from

the SE–is shown by the move
from the initial point (c1*,c2*)
to the new optimum at (c1’,c2’)

 The dashed budget constraint

with slope –(1+r’) passes
through the initial point
(c1*,c2*) which is still feasible.
 The SE causes the consumer to
increase consumption in
period 2
 In general , whether C1 rises or
falls depends on the relative size
of the income & substitution
effects

 Income Effect occurs if a
consumer is a saver,
 the rise in r makes him
better off because higher
interest rate raises lifetime
income
 As a result, the consumer
will tend to increase
consumption in both
periods.
 For a borrower the l income
effect of a rise in interest rates
is negative (due to higher debt
repayment) leading to less
consumption in both periods.
 The total effect is a combination of intertemporal

substitution and income effects
 In the equation:
1
=  −1
1
1 + (1 + r ) (1 +  ) −

  -measures the strength of the SE and the sign of  / r
depends on the magnitude 
 If the substitution elasticity equal 1, the income and SE
offset each other and the propensity to consume will be
unaffected
 In general, for savers, the SE and IE reinforce each other

and imply higher consumption in period 2,
 but since they have opposite signs their total effect on period 1
consumption is ambiguous .
 For savers, the new optimal point is (c1**,c2**)
 In case of borrowers – the rise in r reduces c1 since both
effects reinforce each other, but the overall change is
ambiguous for c2.
Note
 A higher interest rate will also affect the level of wealth

itself
 Often the financial wealth V1 comprises the value of stock
and of housing capital
 These assets tend to be influenced by the interest rates in a
negative way:
 In particular, higher interest rates means that expected future
dividends are discounted more heavily leading to a fall in share
prices
 Further, it tends to increase the user cost of owner-occupied
housing , which reduces housing demand and in turn drives
down the market value of the existing housing stock
 Thus a rise in r will reduce the wealth income ratio v1
Note
 In addition, the higher interest rate means that expected

future labour income is discounted heavily
Y2d
C1 =  (V1 + Y + d
),
1+ r
1
 Thus the value of human wealth goes down -high interest

rates make future labour income less valuable by making it
easier to attain a given level of future consumption through
saving out of current income
 The fall in the value of human wealth induced byb the rise
in r tends to reduce the propensity to consume current
income

Constraints on borrowing
 Market are not always  Constraint free market

perfect. Thus it may not
always be possible for a
consumer to borrow as
much as he wishes at the
going market interest C2 The budget
rates (e.g. students) line with no
borrowing
constraints
H2
H1 C1
Borrowing Constraints
Page 2
C2 The borrowing constraint is not C2 Page 1
binding if the consumer’s optimal

The budget
C1 is less than H1.
line with a
borrowing
constraint
H2
H1 C1
H1 C1 The borrowing constraint takes the
form: C1  H1
Consumer optimization when the borrowing
constraint is binding
The optimal C2
choice is at
point D.
But since the
consumer
cannot borrow,
the best he can E
do is point E. D
Y1 C1
slide 65
Consumption and Taxation
 The question here is, what is the effect of government tax

and debt policies on private consumption demand?
 In general the effect depends on how consumers form their
expectations about the future
 We distinguish between temporal and permanent tax cuts.

 Recall our consumption function
Y2L − T2
C1 =  (Y − T1 +
L
+ V1 )
1+ r
1
 If government wants to stimulate consumption demand, it can

cut taxes T1 ( possibly economy is in recession)

 Assume the consumers consider the tax cut as temporal

(possibly because gov’t indicates that it revert to earlier
taxes once the recession is over)
 Consumers will expect T2 to be unchanged and the
immediate impact of the tax cut will be:
C1
= −
T1
 Implying that temporal tax cuts by govt by one unit will
result in an increase in consumption by  units
 Hence a temporal cut in taxes will stimulate the current
consumption. Since  < 1, part of the increase in disposable
income will be saved , as w way of smoothing consumption
 Permanent Tax cuts:
 If consumers expect the tax cut to be permanent, then they will
expect T2 to go down by the same amount as T1
 Given the equation:
Y2L − T2
C1 =  (Y − T1 +
L
+ V1 )
1+ r
1
 The effect of the tax will be

C1 C1 1
+ = − (1 + )
T1 T2 1+ r
 This show that permanent tax cut will have a stronger

impact on current consumption than temporal tax
cuts.
 In a benchmark model where the interest rate r equal the

time preference parameter  (i.e., consumer wants to
consume equal amounts in both periods)
 In this case, the optimal condition will be
C1 C1
+ = −1 if r = 
T1 T2
 This says that if the consumer wants to smooth

consumption perfectly overtime, s/he will consume all of
the period’s tax cut during that period
 This is because the expected future disposable income has
gone up by the same amount as the current income.

The Ricardian Equivalence Theorem
 If current and future government spending are held
constant, then a change in current taxes with an equal and
opposite change in the present value of future taxes leaves
the equilibrium real interest rate r and the consumption of
individuals unchanged
 a change in the timing of taxes by the government is neutral
 The reasoning may be as follows; assume government
introduces a tax cut in period 1 dT1 <0 but does not plan to
reduce current or planned future spending, it follows that
future taxes will have to increase to finance the deficit dT2
>0 i.e., the principal debt and interest rate so that
dT2
dT1 + =0
1+ r

The Ricardian Equivalence Theorem
 If consumers have rational expectations, i.e., they look

forward and understand the implications of the
intertemporal govt budget constraint
 In this case consumers realise that a reduction in taxes now
without cutting future govt spending , the present vale of
taxes will have to increase by as much as the current tax
cut
dT2
dc = − (dT1 + )=0
1+ r
 -Saying a current tax cut which is not accompanied by a cut
in present of planned future govt spending will have no
effect on private consumption, national saving and the real
interest rate even in the short run
Logic in simple
 Consumers are forward-looking, and know that a debt-financed

tax cut today implies an increase in future taxes that is equal---in
present value---to the tax cut.
 Thus, the tax cut does not make consumers better off, so they do
not raise consumption.
 They save the full tax cut in order to repay the future tax liability.
 debt issued by the government in period 1 does not constitute net
wealth and leaves individual decision completely unaffected.
 Result: Private saving rises by the amount public saving falls,
leaving national saving unchanged.
 This strong neutrality result is called Ricardian equivalence (Barro
1974).

Limitations of Ricardian equivalence
 Borrowing constraints: Some consumers are not able to

borrow enough to achieve their optimal consumption, and
would therefore spend a tax cut.
 Future generations:
 If consumers expect that the burden of repaying a tax cut will
fall on future generations, then a tax cut now makes them feel
better off, so they increase spending

Departures from classical consumers
 This section looks at deviations from classical (LCH and PIH)

models of consumer behaviour and discusses empirical evidence.
 Keynes (1936) postulates a linear consumption function where
aggregate consumption demand depends linearly on current
aggregate income:
 𝐶1 = 𝑎 + 𝑐𝑌1 ………….
 where a is a constant and c is the marginal propensity to consume

which lies between zero and one.
 Keynes thought of this function as representing a “fundamental
psychological law”.
 Friedman (1957) strongly criticises Keynes and argues that
consumption demand depends on permanent income instead.
 However the classical theories (LCH and PIH) rely crucially on
individuals having access to credit markets and being able to
borrow and lend freely at interest rate r to smooth consumption
over time.
 What happens if some consumers are liquidity constraint?
 Suppose a fraction of consumers are liquidity constrained.
 They would like to borrow against future income, but cannot
use it as collateral.
 Such liquidity constrained (henceforth LC) consumers are
forced to consume at their current income level
 𝑐1𝐿𝐶 = 𝑦1 …………….
Figure 6-Intertemporal choice of LC Consumer
 Figure 6 shows that LC

consumers would achieve
higher utility by borrowing
against higher future
income and consume at
(c1*,c2*), but the binding
constraint makes this
optimum unfeasible.
Figure 6-Intertemporal choice of LC Consumer
 What happens to the

choice of LC consumers if
the interest rate increases
and the slope of the budget
constraint in Figure rises?
The answer is that changes
in interest rate r leave
constrained consumption
demand (𝑐1𝐿𝐶 ) unchanged.
Intertemporal choice of LC Consumer
 Consumption demand of
LC consumers depends
only on current income
and changes in the interest
rate or future income are
not relevant.
 Suppose next that a fraction λ of the population is liquidity

constrained and behaves and the remainder (1- λ) behaves
like classical consumers with consumption function
 𝑐1𝑑 (r, PV(y),..).
 Aggregate consumption is the weighted sum of the two
terms
 𝐶1𝑇𝑜𝑡𝑎𝑙 = 𝜆𝑐1𝐿𝐶 + 1 − 𝜆 𝑐1𝑑 = 𝜆𝑦1 + (1 − 𝜆)𝑐1𝑑 (𝑟, 𝑃𝑉 𝑦 )
 or written more compactly as Keynesian consumption

function
 𝐶1𝐾 ≅ 𝑎 + 𝑐𝑌1
 where a ≡ (1 − 𝜆)𝑐1𝑑 (𝑟, 𝑃𝑉 𝑦 )is not constant, but function
of the interest rate r and c measures the fraction of LC
consumers in the economy.
 Campbell and Mankiw (1989) test the validity

 Using 1953-86 US data Campbell and Mankiw estimate the

share of rule-of-thumb consumers λ to be approximately
one half.
 Does this imply that 50% of the US population is liquidity
constrained? Not necessarily, since there are other reasons
that consumption could depend on current income: these
include life-cycle effects and precautionary motives
discussed earlier, deviations from “standard” optimization
or habit formation.
 The estimate of σ is not statistically different from zero

indicating little correlation between expected changes in
consumption and ex ante real interest rates. This finding is
consistent with Hall’s (1988).
 Flavin’s (1981) findings of excess sensitivity of consumption
to anticipated changes in current income are consistent
with the presence of liquidity constraints.
 Hall and Mishkin (1982) use panel data on food

expenditures and find that approximately 20% of US
households are liquidity constrained.
 Hayashi (1987) points out that even if consumers are
currently not constrained, the possibility of being
constrained in the future shortens their effective planning
horizon.
 Loewenstein and Thaler (1989) describe several anomalies

in intertemporal choice including time-inconsistent
preferences or nominal anchoring.
 Angeletos et al (2001) argue that the introduction of time-
inconsistent preferences through hyperbolic discounting
produces can help to explain the relatively low levels of
liquid assets (and large credit card debt) over the life cycle.
 Hyperbolic consumers are less able to smooth consumption
which is consistent with Flavin’s excess sensitivity result.

Lecture 3. Consumption

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MACROECONOMICS FOR POLICY

CONSUMPTION AND SAVING

Dr. Dale Mudenda @2020

 Recall: GNP is made of many components ands can be

 National income Y is measured in current prices often

Macroeconomics for Policy D Mudenda

Compute nominal GDP in each year:

Compute real GDP in each year,

Macroeconomics for Policy D Mudenda

 The nominal income Y can be broken down into price and

Macroeconomics for Policy D Mudenda

Macroeconomics for Policy D Mudenda

Macroeconomics for Policy D Mudenda

Macroeconomics for Policy D Mudenda

Macroeconomics for Policy D Mudenda

Macroeconomics for Policy D Mudenda

 We use the micro-foundation theory of consumption –with

 From period 1, the consumer’s life utility is given by

 Consumer’s choices are subject to an intertemporal

 H1 is the present value of the consumer’s disposable lifetime

Macroeconomics for Policy D Mudenda

 Please observe that H1 carries the time subscript 1 because

 BUT how does a consumer allocate consumption over time?

Macroeconomics for Policy D Mudenda

 The consumer will always choose his path of consumption

U = u (C1 ) + u1(+C2 ) , u '  0; u ' '  0,   0

 The consumer in this case has to choose the C1 that

 Which was written as:

Macroeconomics for Policy D Mudenda

 Equations 9 and 10 are similar are alternative ways of

 Says that if the consumer increased consumption by bone unit

Macroeconomics for Policy D Mudenda

Macroeconomics for Policy D Mudenda

dU = u ' (C1 )dC1 + u '( C2 )

 The slope of the consumer’s lifetime budget equal 1+r

Macroeconomics for Policy D Mudenda

C2 Optimal intertemporal allocation of consumption

As equation 10 indicates, the slope of

 In a benchmark case, real interest equal to the rate of time

Macroeconomics for Policy D Mudenda

With low labour income in period 1 than period 2

Macroeconomics for Policy D Mudenda

With highlabour income in period 1 than period 2

Macroeconomics for Policy D Mudenda

 The Keyne-Ramsey rule in equation 10 only provides an

 To interpret 12, we introduce the intertemporal elasticity of

 The IES is defined as:

 This can be illustrated as follows:

Macroeconomics for Policy D Mudenda

The more the consumer if willing to engage in intertemporal substitution in consu.

 From equation 12, we know that: u ' (ct ) = Ct−1/ 

 Since the MRS(C1 : C2 ) = u' (C1 ) /(u' (C2 ) /(1 +  ))

 From equation 12, the intertemporal elasticity of substitution

 Varying  affects the

Macroeconomics for Policy D Mudenda

 And we know that in equilibrium: MRS = 1+r, equate the

 Equation ** suggests that current consumption is

Macroeconomics for Policy D Mudenda

1. Consumption and Income

 There is a r/ship between consumption C1 and current

 which we can write as: 

Macroeconomics for Policy D Mudenda

 Where ˆ measures propensity to consume out of current