Chapter 16: ConsumptionChapter 16: Consumption

John M. Keynes: Absolute Income Hypothesis

Consumption is a linear function of disposable personal income,

C = C + cY

C = consumption expenditureY = disposable incomeC = autonomous consumption (intercept of the line)c = marginal propensity to consume (slope of the line)

Properties of Consumption Function

Consumption is determined by current income

Marginal propensity to consume (MPC = ΔC/ΔY) is between zero and one (0<c<1)

Average propensity to consume (APC = C/Y) falls as income rises

Short-run Consumption Function

Disposable income

Consumption expenditure

C = C + cY

C

c

Constant APC

Empirical Evidence

High income families have a higher marginal propensity to save (MPS = 1 – MPC)

High income families have a higher average propensity to save (APS = 1 – APC); APC falls with the level of income

In the long-run, autonomous consumption falls to zero (C = 0)

Long-run Consumption Function

C = ćY

Ĉ

ć

Variable APC; Ĉ = 0

Consumption expenditure

Disposable income

Irving Fisher: Intertemporal Choice

Consumption decisions are based on current and future income

Current period income = current income plus present value of future income: Y1 + Y2 / (1 + r), where r is a discount rate

Future period income = future income plus future value of current income: Y2 + (1 + r)Y1

The Intertemporal Budget Line

A

B

C

Y1

Y2

C1

C2

C1

C2

Current Period

Future Period

The Intertemporal Budget Line

Along BC, there is a trade-off between current and future consumption spending

Along AB, C1<Y1, but C2>Y2: consumers would save in current period to finance consumption in second period

Along AC, C1>Y1, but C2<Y2: consumers would borrow in current period and will pay off debt in future period

Consumer Preferences

Consumer preferences are shown by a family of indifference curves

Any combination of current and future consumption along an indifference curve provides the same level of satisfaction for the consumer

A higher indifference curve yields combinations with greater satisfaction

Consumer PreferencesFuture Period

Current Period

A

B

Combination B is preferred to combination A because it yields more in both periods

The Consumer’s Optimum

Consumer equilibrium is achieved at the tangency of the highest attainable indifference curve and the budget line

The tangency determines the optimum allocation of consumption spending in both periods; i.e. highest level of satisfaction within the budget

The Consumer’s Optimum

B

C1c

C1f

Future Period

Current Period

A

Higher income shifts the budget line up, positioning the consumer on a higher indifference curve and consumer’s optimum

C2f

C2c

Franco Modigliani: Life Cycle Hypothesis

Consumption depends on income and wealth

C = Consumption expenditureW = Consumer wealthR = Length of productive life timeT = Years of life

Consumption Function

C = (W + RY)/T = (1/T)W + (R/T)YDefine:

α = 1/T is the MPC out of wealthβ = R/T is the MPC out of income

C = αW + βY

Consumption Function

C = αW + βY

β

For the United States, α = 0.02 and β = 0.60.

1

αW

Consumption expenditure

Disposable income

Consumption Function

Increased wealth shifts the consumption function upward.

αW1

αW2

Consumption expenditure

Disposable income

Consumer Behavior over Life Time

Consumption spending is a stable function of income

Consumers save their leftover income

Consumers accumulate wealth during the productive lifetime

Consumer finance retirement by dissaving and selling-off their assets

Consumer Behavior over Life Time

$

T

Wealth

Income

Consumption Dissaving

Saving

R Years

Milton Friedman: Permanent Income Hypothesis

Measured income consists of permanent and transitory income; Y = YP + YT

Permanent income is the average income we make during years of productive life

Transitory income is the random variation from the average

Consumption Function

Consumption is a function of permanent income

C = αYP

Consumers use saving and borrowing to smooth consumption in response to transitory changes in income

Determinants of Consumption

Combining all the theories, we can conclude that consumption depends on

Current incomeExpected future incomeWealthInterest rate