CHAPTER-SIX

BEHAVIORAL FOUNDATIONS:
THEORIES OF CONSUMPTION
 The consumption decision is crucial for
short-run analysis because of its role in
determining aggregate demand.
 Consumption has a large share of GDP, so
fluctuations in consumption are a key
element of booms and recessions.
As a result, any analysis of the factors
determining the level of GNP must be
concerned with consumer expenditure at
some point.
 Consumer expenditure is simply assumed to
be a function of income less taxes:
C = C(Y − T)
6.1. THE KEYNESIAN CONSUMPTION FUNCTION

 Keynes’s Conjectures
 Keynes made the following conjectures(guess) about
the consumption function based on introspection and
casual observation.
 First, the marginal propensity to consume (MPC or
ΔC/ ΔY ) -the amount consumed out of an additional
dollar of income is between zero and one.
 That is; when a person earns an extra income, he/she
typically spends some of it and saves some of it.
 Second, average propensity to consume(C/Y), falls
as income rises.
 That is; the rich save a higher proportion of their
income than the poor.
 Third, income is the primary determinant of
consumption and that the interest rate does not
have an important role.
 This conjecture is in contrast to the classical
economists beliefs.
 The classical economists held that a higher
interest rate encourages saving and discourages
consumption.
 Keynes argued that the interest rate could
influence consumption as a matter of theory.
 The short-period influence of the rate of interest
on individual spending out of a given income is
secondary and relatively unimportant.
On the basis of these three conjectures, the
Keynesian consumption function is often
written as: C  C  cY , C> 0, 0 < c <1

where C is consumption, Y is disposable

income, C is a constant (autonomous
consumption) and c is the marginal
propensity to consume.
The autonomous consumption determines
the intercept on the vertical axis,
The MPC determines the slope..
 The Keynesian consumption function

C  C  cY

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

Y
 The Keynesian consumption function

As
As income
income rises,
rises, consumers
consumers save
save aa bigger
bigger
C fraction
fraction of
of their
their income,
income, so
so APC
APC falls.
falls.
C  C  cY

C C
APC    c
Y Y
slope = APC
Y
CHAPTER 16

Consumption
 Keynes consumption function exhibits the three
properties that he posited.
 It satisfies Keynes’s first property because the
marginal propensity to consume c is between zero and
one, so that higher income leads to higher
consumption and also to higher saving.
 This consumption function satisfies Keynes’s second
property because the average propensity to consume
(APC) is:
APC = C/Y = C /Y + c.
 As Y rises, C/Y falls, and so the average propensity to
consume C/Y falls. APC>MPC
 Finally, this consumption function satisfies Keynes’s
third property because the interest rate is not included
in this equation as a determinant of consumption.
 6.1.1.The early empirical successes
 After Keynes proposed the consumption function, economists
began collecting and examining data to test his conjectures.
 The earliest studies indicated that the Keynesian consumption
function was a good approximation of how consumers
behave.
 They found that:
 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
 6.1.2. Secular Stagnation, Simon Kuznets,
and the Consumption Puzzle

 Although the Keynesian consumption function met with early

successes, two inconsistencies soon arose.
 Both concern Keynes’s conjecture that the average propensity to
consume falls as income rises.
 The first inconsistency became apparent after some economists
made prediction during World War II.
 On the basis of the Keynesian consumption function, these
economists reasoned that as incomes in the economy grew over
time, households would consume a smaller and smaller fraction
of their incomes.
 They feared that there might not be enough profitable investment
projects to absorb all this saving.
 If so, the low consumption would lead to an inadequate demand
for goods and services, resulting in a depression once the wartime
demand from the government ceased.
In other words, these economists predicted
that the economy would experience what they
called secular stagnation-a long depression of
indefinite duration-unless the government used
fiscal policy to expand aggregate demand.
However, the end of World War II did not
throw the country into another depression.
Although incomes were much higher after the
war than before, these higher incomes did not
lead to large increases in the rate of saving.
Keynes’s conjecture that the average
propensity to consume would fall as income
rose appeared not to hold.
The second inconsistency arose when
economist Simon Kuznets constructed new
aggregate data on consumption and income
dating back to 1869.
Kuznets assembled these data in the 1940s.
He discovered that the ratio of consumption
to income was remarkably stable from
decade to decade, despite large increases in
income over the period he studied.
Again, Keynes’s conjecture that the average
propensity to consume would fall as income
rose appeared not to hold.
 The failure of the secular-stagnation hypothesis
and the findings of Kuznets both indicated that
the average propensity to consume is fairly
constant over long periods of time.
 This fact presented a puzzle that motivated
much of the subsequent research on
consumption.
 Economists wanted to know why some studies
confirmed Keynes’s conjectures and others
refuted them.
 That is, why did Keynes’s conjectures hold up
well in the studies of household data and in the
studies of short time-series but fail when long
time-series were examined?
 In general, after late 1940s it was clear that a theory of
consumption must account three observed phenomena:
1. Cross-sectional budget studies show s/ y increases as y
rises, so that in cross sections of the population,
MPC < APC.
2. Business cycle, or short-run, data show that the c / y ratio
is smaller than average during boom periods and greater
than average during recession, so that in the short run, as
income fluctuates,
MPC < APC.
3. Long-run trend data show no tendency for the c / y ratio to
change over the long run, so that as income grows along
trend,
MPC = APC.
 In addition, a theory of consumption should be able to
explain the apparent effect of wealth on consumption that
was observed after World War.
Irving Fisher and Intertemporal Choice
The consumption function introduced by Keynes
relates current consumption to current income.
However, people make decisions on how much to
consume and how much to save, they consider
both the present and the future.
Fisher developed the model with which
economists analyze how rational, forward-looking
consumers make intertemporal choices-that is,
choices involving different periods of time.
Consumer’s choices are subject to an
intertemporal budget constraint, a measure of
the total resources available for present and future
consumption.
The Intertemporal Budget Constraint
 Normally, consumption is constrained by consumers’ income.
 In other words, consumers face a limit on how much they can
spend, called a budget constraint.
 When they are deciding how much to consume today versus
how much to save for the future, they face an intertemporal
budget constraint, which measures the total resources
available for consumption today and in the future.
 To keep things simple, we examine the decision facing a
consumer who lives for two periods.
 Period one- consumer’s youth age, and
 Period two- consumer’s old age.
 The consumer earns Y1 and consumes C1 in period one, and
earns Y2 and consumes C2 in period two. (All variables are
real)
 Because the consumer has the opportunity to borrow and
save(lend), consumption in any single period can be either
greater or less than income in that period.
 Consider how the consumer’s income in the two
periods constrains consumption in the two periods.
 In the first period, saving equals income minus
consumption. That is,
S = Y1 − C1
 S < 0 if the consumer borrows in period 1.
 S>0 if consumption is less than income in first
period
 In the second period, consumption equals the
accumulated saving, including the interest earned on
that saving, plus second-period income. That is,
C2 = (1 + r)S + Y2
 NB. The variable S can represent either saving or
borrowing.
Deriving the intertemporal budget constraint

 Period 2 budget constraint:

C 2  Y 2  (1  r ) S
 Y 2  (1  r )(Y1  C 1 )
 Rearrange terms:
(1  r ) C 1  C 2  Y 2  (1  r )Y1
 Divide both sides by (1+r )
 The intertemporal budget constraint

C2 Y2
C1   Y1 
1r 1r

present value of present value of

lifetime consumption lifetime income

The above equation relates consumption in the two periods

to income in the two periods.

It is the standard way of expressing the consumer’s

intertemporal budget constraint.
 The intertemporal budget constraint

C2
C2 Y2
C1   Y1 
1r 1r

(1  r )Y1 Y 2
Consump =
Saving income in
The
The budget
budget both periods
constraint
constraint shows
shows
all
all combinations
combinations Y2
of
of CC11 and
and C
C22 that
that Borrowing
just
just exhaust
exhaust the
the
consumer’s
consumer’s C1
resources. Y1
resources.
Y1 Y 2 (1  r )
 The intertemporal budget constraint

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

Y2

C1
Y1
 Consumer preferences

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

IC1
C1
The slope at any point on the indifference
curve shows how much second-period
consumption the consumer requires in order
to be compensated for a 1-unit reduction in
first-period consumption.
This slope is the marginal rate of substitution
between first-period consumption and second-
period consumption.
It tells us the rate at which the consumer is
willing to substitute second-period
consumption for first-period consumption.
 Consumer preferences

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

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

C1

At the optimal point( O), the slope of the indifference

curve (MRS) equals the slope of the budget line (1+r).
 How C responds to changes in Y

C2 An
An increase
increase
Results:
in
in YY11 or
or YY22
Provided they are
shifts
shifts the
the
both normal goods,
budget
budget lineline
C1 and C2 both outward.
outward.
increase,
…regardless of
whether the
income increase
occurs in period 1
or period 2. C1
 Keynes vs. Fisher
Keynes:
 Current consumption depends only on current income.
Fisher:
 Current consumption depends only on the present value
of lifetime income. That is;
Present Value of Income = Y1 + Y2/1+r

 The timing of income is irrelevant because the consumer

can borrow or lend between periods.
 Regardless of whether the increase in income occurs in
the first period or the second period, the consumer
spreads it over consumption in both periods.
 This behavior is sometimes called consumption
smoothing.
How C responds to changes in r
Economists decompose the impact of an
increase in the real interest rate on
consumption into two effects:
substitution effect , the change in
consumption that results from the change in
the relative price of consumption in the two
periods;
income effect , the change in consumption
that results from the movement to a higher
indifference curve.
How C responds to changes in r
substitution effect
The rise in r increases the opportunity cost of
current consumption, which tends to reduce C1 and
increase C2.
income effect
If the consumer is a saver, the rise in r makes him
better off, which tends to increase consumption in
both periods.
Both effects  C2.

But whether C1 rises or falls depends on the

relative size of the income & substitution effects.
Constraints on borrowing
C

The budget
line with no
borrowing
constraints

Y2

C
Y1
1
 Constraints on borrowing
The area under the blue line satisfies both budget and borrowing constraints

C

The borrowing The budget line

constraint takes with a
borrowing
the form: constraint

C1  Y 1
Y2

C
Y1
1
 Consumer optimization when the
borrowing constraint is not binding
C

2
The borrowing constraint is
not binding if the consumer’s
optimal C1
is less than Y1.
In this case, the consumer
would not have borrowed
anyway, so his inability to
borrow has no impact on
consumption choices.
C
Y1
1
 Consumer optimization when the
borrowing constraint is binding
C

2
The optimal choice is at point
D. But since the consumer
cannot borrow, the best he can
do is point E.
In this case, the consumer
would like to borrow to
achieve his optimal E
consumption at point D. If he D
faces a borrowing constraint,
though, then the best he can
achieve is the consumption C
Y1
plan of point E. 1
Life-Cycle Hypothesis
 Inthe 1950s, Franco Modigliani, Albert Ando, and
Richard Brumberg used Fisher’s model of consumer
behavior to study the consumption function.
 One of their goals was to study the consumption puzzle.
 According to Fisher’s model, consumption depends on a
person’s lifetime income.

Modigliani emphasized that income varies systematically
over people’s lives and that saving allows consumers to
move income from those times in life when income is
high to those times when income is low.
 This interpretation of consumer behavior formed the
basis of his life-cycle hypothesis.
The Life-Cycle Hypothesis
Fisher’s model says that consumption
depends on lifetime income, and people
try to achieve a smooth consumption
pattern.
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.
The basic model:
W = 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
Lifetime resources = W + RY
To achieve smooth consumption, consumer
divides her resources equally over time:
C = (W + RY )/T , or
C = aW + bY
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
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 or in the short-run, wealth does not
vary as much as income, so high income households
should have a lower APC than low income households
 similar to Keynes
• Over time, aggregate wealth and income grow together,
causing APC to remain stable  Simon Kuznets puzzle
solved.
 Implications of the Life-Cycle
Hypothesis
€

The LCH Wealth

implies that
saving varies
systematically
Income
over a person’s
lifetime. Saving

Consumption Dissaving

Retirement End
begins of life
The Permanent Income Hypothesis
 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 behavior 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.
 Friedman suggested that we view current income Y as the
sum of two components, permanent income YP and
transitory income YT.
The Permanent Income Hypothesis
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)
Consumers use saving & borrowing to
smooth consumption in response to
transitory changes in income Y T.
The PIH consumption function:
C = aY P
where a is the fraction of permanent
income that people consume per year.
The PIH can solve the consumption puzzle:
• The PIH implies
APC = C/Y = aY P/Y
• To the extent that high income households have on
average a 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.  policy changes will affect
consumption only if they are permanent.
PIH vs. LCH
In both cases, 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.
The Random-Walk Hypothesis
 Robert Hall was first to derive the implications of
rational expectations for consumption.
 He showed that if the permanent-income hypothesis
is correct, and if consumers have rational
expectations, then changes in consumption over time
should be unpredictable.
 When changes in a variable are unpredictable, the
variable is said to follow a random walk.
 According to Hall, the combination of the permanent-
income hypothesis and rational expectations implies
that consumption follows a random walk.
The Random-Walk Hypothesis
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.
If consumers obey the PIH and have
rational expectations, then policy changes
will affect consumption only if they are
unanticipated.
The Psychology of Instant Gratification
 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 behavioral economics.
 Harvard’s David Laibson notes that many consumers
judge themselves to be Imperfect decision makers.
 Consumers’ preferences may be time- inconsistent:
they may alter their decisions simply because time
passes.
Consumers consider themselves to be
imperfect decision-makers.
◦ e.g., in one survey, 76% said they were not
saving enough for retirement.
The “pull of instant gratification” explains
why people don’t save as much as a
perfectly rational lifetime utility
maximizer would save.
Two Questions and Time Inconsistency
1. Would you prefer
(A) a chocolate bar today, or
(B) two chocolate bars tomorrow?
2. Would you prefer
(A) a chocolate bar in 100 days, or
(B) two chocolate bars 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 and to select A.  People are more patient in the long-
run than in the short-run. Time inconsistency.
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
Keynesian consumption theory
• Keynes’ conjectures
– MPC is between 0 and 1
– APC falls as income rises
– current income is the main determinant of current
consumption
• Empirical studies
– in household data & short time series: confirmation
of Keynes’ conjectures
– in long time series data:
APC does not fall as income rises
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.
Modigliani’s Life-Cycle Hypothesis
• Income varies systematically over a lifetime.
• Consumers use saving & borrowing to smooth
consumption.
• Consumption depends on income & wealth
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.
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.
Laibson and the pull of instant gratification
• Uses psychology to understand consumer behaviour.
• The desire for instant gratification causes people to
save less than they rationally know they should.
END!