Microfoundations, part 1

Modern theories of consumption

Macroeconomics II
Joanna Siwińska-Gorzelak
WNE UW
 Lecture overview
This lecture focuses on the most prominent work
on consumption.
 John Maynard Keynes: consumption and current
income
 Irving Fisher: Intertemporal Choice
 Franco Modigliani: the Life-Cycle Hypothesis
 Milton Friedman: the Permanent Income
Hypothesis
 We will also take a glimpse at:
 Robert Hall: the Random-Walk Hypothesis
 David Laibson: the pull of instant gratification

slide 2
 Consumption
 The contemporary theory of consumption was developed
independently in the 1950s by Milton Friedman as the
permanent theory of consumption, and by Franco Modigliani
as the life cycle theory of consumption.
 Consumption for a foresighted consumer depends on:
– Financial wealth: The value of checking and saving accounts
– Housing wealth: The value of the house owned minus the mortgage
due
– Human wealth: After-tax labor income over working life
– Nonhuman wealth: The sum of financial wealth and housing wealth
 The Keynesian Consumption Function

Here’s a consumption function with the

C properties Keynes conjectured:

C  C  cY

c c = MPC
= slope of the
1
consumption
C function

slide 4
 Keynes’s Conjectures

1. 0 < MPC < 1

2. Average propensity to consume (APC )

falls as income rises.
(APC = C/Y )
3. Current disposable income is the main
determinant of consumption.

slide 5
 The Keynesian Consumption Function

As income rises, the APC falls (consumers

C save a bigger fraction of their income).

C  C  cY

C C
APC    c
Y Y

slope = APC
Y

slide 6
Early Empirical Successes: Results from Early
Studies
 Households with higher incomes:
 consume more
 MPC > 0
 save more
 MPC < 1
 save a larger fraction of their income
 APC  as Y 
 Very strong correlation between income and
consumption
 income seemed to be the main
determinant of consumption

slide 7
Problems for the Keynesian Consumption Function

Based on the Keynesian consumption function,

economists predicted that C would grow more
slowly than Y over time.
This prediction did not come true:
 As incomes grew, the APC did not fall,
and C grew just as fast.
 Simon Kuznets showed that C/Y was
very stable in long time series data.

slide 8
 The Consumption Puzzle

Consumption function from

C long time series data
(constant APC )

Consumption function from

cross-sectional household
data
(falling APC )

slide 9
 Irving Fisher and Intertemporal Choice

 The basis for much subsequent work on

consumption.
 Assumes consumer is forward-looking and
chooses consumption for the present and future
to maximize lifetime satisfaction (utility).
 Consumer’s choices are subject to an
intertemporal budget constraint,
a measure of the total resources available for
present and future consumption
slide 10
 The basic two-period model
 Period 1: the present
 Period 2: the future
 Notation
Y1 is income in period 1
Y2 is income in period 2
C1 is consumption in period 1
C2 is consumption in period 2
S = Y1 - C1 is saving in period 1
(S < 0 if the consumer borrows in period 1)

slide 11
Deriving the intertemporal budget constraint

 Period 2 budget constraint:

C 2  Y 2  (1  r ) S
 Y 2  (1  r ) (Y1 - C 1 )

 Rearrange to put C terms on one side

and Y terms on the other:
(1  r )C 1  C 2  Y 2  (1  r )Y1

 Finally, divide through by (1+r ):

slide 12
 The intertemporal budget constraint

C2 Y2
C1   Y1 
1r 1r

present value of present value of

lifetime consumption lifetime income

slide 13
 The intertemporal budget constraint

C2 C2 Y2
C1   Y1 
1r 1r
The budget
constraint
(1  r )Y1 Y 2
shows all Consump =
Saving income in both
combinations periods
of C1 and C2
that just
exhaust the Y2
Borrowing
consumer’s
resources.
C1
Y1
Y1 Y 2 (1  r )
slide 14
 The intertemporal budget constraint

C2 C2 Y2
C1   Y1 
The slope of 1r 1r
the budget
line equals
-(1+r ) 1
(1+r )

Y2

C1
Y1

slide 15
 Consumer preferences

An indifference C2 Higher
curve shows all indifference
combinations of curves
C1 and C2 that represent
make the higher levels
consumer equally of happiness.
happy.
IC2

IC1
C1

slide 16
 Consumer preferences

C2 The slope of
an indifference
Marginal rate of curve at any
substitution (MRS ): point equals
the amount of C2 the MRS
1 at that point.
consumer would be
MRS
willing to substitute for
one unit of C1.
IC1
C1

slide 17
 Optimization

C2
The optimal (C1,C2) is At the
where the budget line optimal point,
just touches the MRS = 1+r
highest indifference
curve.
O

C1

slide 18
Formal approach to optimization – the method
of Lagrange multipliers
Y2 C2
U  u (c1 , c 2 ) s.t. Y1   C1 
(1  r ) (1  r )
Y2 C2
L  u (c1 , c 2 )  1 [Y1  - C1 - ]
(1  r ) (1  r )

 The solution is that:

U U
 (1  r )
c1 c 2
 How C responds to changes in Y

C2 An increase in Y1 or Y2
Results: shifts the budget line
Provided they are outward.
both normal goods,
C1 and C2 both
increase,
…regardless of
whether the
income increase
occurs in period 1
or period 2. C1

slide 20
 Keynes vs. Fisher
 Keynes:
current consumption depends only on
current income
 Fisher:
current consumption depends on
the present value of lifetime income;
the timing of income is irrelevant
because the consumer can borrow or lend
between periods.

slide 21
 How C responds to changes in r
C2
An increase in r
pivots the budget
line around the
point (Y1,Y2 ).
B

As depicted here, A
C1 falls and C2 rises.
Y2
However, it could
turn out differently… C1
Y1

slide 22
 How C responds to changes in r
C2
An increase in r
pivots the budget
line around the
point (Y1,Y2 ).
B

As depicted here, A
C1 falls and C2 rises.
Y2
However, it could
turn out differently… C1
Y1

slide 23
 How C responds to changes in r
 income effect
If consumer is a saver, the rise in r makes him
better off, which tends to increase consumption in
both periods.
 substitution effect
The rise in r increases the opportunity cost of
current consumption, which tends to reduce C1 and
increase C2.
 Both effects  C2.
Whether C1 rises or falls depends on the relative
size of the income & substitution effects.

slide 24
 Constraints on borrowing
 In Fisher’s theory, the timing of income is irrelevant
because the consumer can borrow and lend across
periods.
 Example: If consumer learns that her future income will
increase, she can spread the extra consumption over both
periods by borrowing in the current period.
 However, if consumer faces borrowing constraints (aka
“liquidity constraints”), then she may not be able to
increase current consumption
 and her consumption may behave as in the Keynesian
theory even though she is rational & forward-looking

slide 25
 Constraints on borrowing

C2

The budget
line with no
borrowing
constraints
Y2

Y1 C1

slide 26
 Constraints on borrowing

The borrowing C2
constraint takes the
form:
The budget
C1  Y1
line with a
borrowing
constraint
Y2

Y1 C1

slide 27
 Consumer optimization when the borrowing
constraint is not binding

C2

The borrowing
constraint is not
binding if the
consumer’s
optimal C1
is less than Y1.

Y1 C1

slide 28
 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 do is point E
E. D

Y1 C1

slide 29
 The Life-Cycle Hypothesis

 due to Franco Modigliani (1950s)

 Fisher’s model says that consumption depends on
lifetime income, and people try to achieve smooth
consumption.
 The LCH says that income varies systematically over the
phases of the consumer’s “life cycle,”
 and saving allows the consumer to achieve smooth
consumption.

slide 30
 The Life-Cycle Hypothesis
 The basic model:
Wt = wealth in time t
Yt = annual disposable income until retirement
(income net of taxes)
R = number of years until retirement
T = lifetime in years
 Assumptions:
– zero real interest rate (for simplicity)
– consumption-smoothing is optimal

slide 31
 The Life-Cycle Hypothesis
 Lifetime resources R
Wt  Yt   Yt 1
 To achieve smooth consumption, consumer
t 1 divides her
resources equally over time:

1 R
Ct  [Wt  Yt 
T
Y
t 1
t 1 ]

If we assume constant income, we can write:

C = aW + bY

a = (1/T ) is the marginal propensity to

consume out of wealth
b = (R/T ) is the marginal propensity to consume out
of income
slide 32
 Implications of the Life-Cycle Hypothesis
The Life-Cycle Hypothesis can solve the consumption
puzzle:
 The APC implied by the life-cycle consumption
function is
C/Y = a(W/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.
 Over time, aggregate wealth and income grow
together, causing APC to remain stable.

slide 33
 Implications of the Life-Cycle Hypothesis
$
The LCH
implies that
saving varies Wealth
systematically
over a person’s
lifetime. Income

Saving

Consumption Dissaving

Retirement End
begins of life
slide 34
Implications of the Life-Cycle Hypothesis
 Implications

 The saving rate changes over the life-time of

the consumer
 Consumption is not very responsive to
changes in current income
 Consumption may change even if current
income does not
 Important role for expectations
 The Permanent Income Hypothesis
 due to Milton Friedman (1957)
 The PIH views current income Y as the sum of
two components:
permanent income Y P
(average income, which people expect to
persist into the future)
transitory income Y T
(temporary deviations from average income)

slide 37
 The Permanent Income Hypothesis

 Consumers use saving & borrowing to smooth

consumption in response to transitory
changes in income.
 The PIH consumption function:
 C = aY P
where a is the fraction of permanent income
that people consume per year.

slide 38
 The Permanent Income Hypothesis
 Current income differs from permanent income
 Yt = Yt P + Yt T
Yt = current income in time t
Y P = permanent income
expected (in time t) average yearly income from
human capital (earnings) and wealth
Y T = transitory income
transitory deviations of current income from
permanent income
 The Permanent Income Hypothesis
 Consumers have to somehow estimate the amount of
permanent income
 Friedman assumed an adaptive formula

Yt perm
Y perm
t -1  j (Yt - Y perm
t -1 ), 0  j 1

 Consumers correct their previous estimates of permanent

income by the j amount of deviation of current income
from previous period estimated permanent income
 The Permanent Income Hypothesis

The PIH can solve the consumption puzzle:

 The PIH implies
APC = C/Y = aY 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.

slide 41
 PIH vs. LCH
 In both, people try to achieve smooth
consumption in the face of changing current
income.
 In the LCH, current income changes systematically
as people move through their life cycle.
 In the PIH, current income is subject to random,
transitory fluctuations.
 Both hypotheses can explain the consumption
puzzle.
 In applied work, reseraches often use PILCH (an
approach that combines both theories)

slide 42
 The Random-Walk Hypothesis

 due to Robert Hall (1978)

 based on Fisher’s model & PIH, in which forward-
looking consumers base consumption on expected
future income
 Hall adds the assumption of rational expectations, that
people use all available information to forecast future
variables like income.

slide 43
 The Random-Walk Hypothesis
If PIH is correct and consumers have rational
expectations, then consumption should follow a
random walk: changes in consumption should be
unpredictable.
• A change in income or wealth that was anticipated
has already been factored into expected permanent
income, so it will not change consumption.
• Only unanticipated changes in income or wealth
that alter expected permanent income will change
consumption.

slide 44
 Implication of the R-W Hypothesis

If consumers obey the PIH

and have rational expectations, then policy
changes will affect consumption
only if they are unanticipated.

slide 45
 The Psychology of Instant Gratification

 Theories from Fisher to Hall assumes that

consumers are rational and act to maximize
lifetime utility.
 Famous studies by David Laibson and others
consider the psychology of consumers.

slide 46
 The Psychology of Instant Gratification

 Consumers consider themselves to be

imperfect decision-makers.
 E.g., in one survey, 76% said they were not saving
enough for retirement.

 Laibson: The “pull of instant gratification”

explains why people don’t save as much as a
perfectly rational lifetime utility maximizer
would save.

slide 47
 Two Questions and Time Inconsistency
1. Would you prefer
(A) a candy today, or
(B) two candies tomorrow?
2. Would you prefer
(A) a candy in 100 days, or
(B) two candies in 101 days?
In studies, most people answered A to question 1, and B to
question 2.
A person confronted with question 2 may choose B.
100 days later, when he is confronted with question 1, the
pull of instant gratification may induce him to change his
mind.
slide 48
 Summing up
 Keynes suggested that consumption depends
primarily on current income.
 More recent work suggests instead that
consumption depends on
 current income
 expected future income
 wealth
 interest rates
 Economists disagree over the relative importance of
these factors and of borrowing constraints and
psychological factors.
slide 49
 Summing up
2. Fisher’s theory of intertemporal choice
 Consumer chooses current & future consumption to
maximize lifetime satisfaction subject to an
intertemporal budget constraint.
 Current consumption depends on lifetime income,
not current income, provided consumer can borrow
& save.
3. Modigliani’s Life-Cycle Hypothesis
 Income varies systematically over a lifetime.
 Consumers use saving & borrowing to smooth
consumption.
 Consumption depends on income & wealth.
slide 50
 Summing up
4. Friedman’s Permanent-Income Hypothesis
 Consumption depends mainly on permanent
income.
 Consumers use saving & borrowing to smooth
consumption in the face of transitory fluctuations in
income.
5. Hall’s Random-Walk Hypothesis
 Combines PIH with rational expectations.
 Main result: changes in consumption are
unpredictable, occur only in response to
unanticipated changes in expected permanent
income.
slide 51
 Chapter summary
6. Laibson and the pull of instant gratification
 Uses psychology to understand consumer behavior.
 The desire for instant gratification causes people to
save less than they rationally know they should.

slide 52
 Saving motives in Poland

Florczak & Jabłonowski, 2016

https://www.nbp.pl/publikacje/materialy_i_studia/252_en.pdf
 Research on consumption
 Johnson & Parker & Souleles (2006); „Household
expenditure and the income tax rebates of 2001”; Am.
Econ. Rev. 96:
 They study the US large income tax rebate program
provided by the Economic Growth and Tax Relief
Reconciliation Act of 2001.
 The program sent tax rebates, typically $300 or $600 in
value, to approximately two-thirds of U.S. households.
 According to the PI hypothesis, a single rebate would have
little effect on spending. Furthermore , in the absence of
liquidity constraints, spending should increase as soon as
consumers begin to expect the tax cut, and not increase
only after they actually have received the rebate check.
 The rebate checks were mailed out over a 10-week period
from late July to the end of September 2001. The
particular week in which a check was random.
 Research on consumption

 This randomization allows the authors to identify the

causal effect of the rebate by comparing the spending
of households that received the rebate earlier with the
spending of households that received it later.
 The authors find that the average household spent
20%–40% of its 2001 tax rebate on nondurable goods
during the three-month period in which the rebate was
received.
 The authors also find that the expenditure responses
are largest for households with relatively low liquid
wealth and low income, which is consistent with
liquidity constraints
 Research on consumption

 A paper that stands in contrast to these is Browning & Callado (2001)

„The response of expenditures to anticipated income changes: Panel
Data Estimates” AER, vol.91(3)
 They use Spanish micro data to examine the consumer response to
the payment of institutionalized June and December extra wage
payments to full-time workers & compare it to consumption of
workers witouht the extra wage payments.
 Browning & Collado detect no evidence of excess sensitivity – there is
no significant difference in consumption profiles of both groups
 They argue that the reason why earlier researchers found a large
response of consumption to predicted income changes is because of
bounded rationality:
 Consumers tend to smooth consumption and follow the theory when
expected income changes are large but are less likely to do so when
the changes are small
 Ricardian equivalence approach
 The focus is on the effects of budget deficits on
consumption and private savings
 Assumptions:
 fully rational consumers
 Infinite time horizon
 Taxes are lump-sum
 Conclusion: the timing of taxes does not matter for
consumption
 Private consumption is not on by way that that government
spending is financed (by taxes or by public borrowing)
 Hence, tax cuts (keeping government spending unchanged)
do not make any difference
 Two period model
1. Private budget constraint
C2 (Y2 - T2 )
C1   (Y1 - T1 ) 
(1  r ) (1  r )
2. Government’s budget constraint
G1  G 2  rB2  T1  T2
G1  G 2  r (G1 - T1 )  T1  T2
G2 T2
G1    T1 
(1  r ) (1  r )

Plug 2 into 1 to get the private sector’s budget constraint

C2 Y2 G2
C1   Y1  - G1 -
(1  r ) (1  r ) (1  r )
 Intuition
 Let’s assume that government spending are unchanged, but the
government cuts taxes
 Will private consumption change?
 Current disposable income increases, but future disposable income
decreases, as the government will have to increase taxes in the future
to pay back the public debt
 Rational consumers, expecting an increase in taxation will not
increase consumption, but will increase savings (they will save the
current increase in income)
 Current decrease in taxation does not have any effect on total,
disposable income, so it does not affect consumption
 Ricardian equivalence approach
 Conclusions: when the government cuts taxes and runs a
budget deficit, the government saving falls
 In the same time, private sector savings increases, implying
that:
 Total amount of savings does not change
 Consumption is not affected;
 Aggregate demand is not affected