Macroeconomics II - CERGE-EIhome.cerge-ei.cz/tlichard/teaching/macroII/L01handout.pdf · Ball, L. and N.G. Mankiw (2011): A New Approach to Intermediate Macroeconomics, Worth Publishers

Info on the courseIntroduction

ConsumptionConclusion

Macroeconomics IILecture 1: Consumption

Tomáš Lichard

IES (Summer 2017/2018)

Tomáš Lichard Macroeconomics II



Contacts

Instructor: Tomáš Lichard

Where to find me: Office 120, CERGE-EI building (Politickýchvězňů 7)When to find me (office hours): Tuesdays 9:30-11:30 or byappointmentHow to contact me: [email protected] website: home.cerge-ei.cz/tlichard/teaching/macroII


mailto:http://home.cerge-ei.cz/tlichard/teaching/macroII



Literature

Primary textbook: N. Gregory Mankiw (2010):Macroeconomics 7e. Worth Publishers.

Other sources:

Ball, L. and N.G. Mankiw (2011): A New Approach toIntermediate Macroeconomics, Worth Publishers.Burda&Wyplosz (2012): Macroeconomics: A European Text6e.Additional reading may be assigned during the course




Grading

The grading will be based on homeworks and a final exam:1 Two homeworks (30% of the grade)2 Final exam (70% of the grade)3 As an insurance, you can obtain bonus 10 points above the

maximum for activity (mainly at exercise sessions)




Introduction

Last semester, you covered economy in the long run

What does it imply about output and prices?

This semester we will cover economy in the short run:

Recessions, depressions: what can we do about them, ifanything?




Consumption & Investment

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

10

20

30

40

50

60

70

Sharesofgrossdomesticproduct:Personalconsumptionexpenditures

Sharesofgrossdomesticproduct:Grossprivatedomesticinvestment

Percent

ShadedareasindicateU.S.recessions Source:U.S.BureauofEconomicAnalysis myf.red/g/iGEU

2530

3540

4550

%

1995q1 2000q1 2005q1 2010q1 2015q1Quarter

Share of private consumptionShare of gross capital formation

Own work based on CSO data

Shares on GDP (Czech Republic)




Consumption and investment

Consumption is the biggest part of GDPInvestment constitutes relatively lower share, but on the otherhand its much more volatile

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

-30

-20

-10

0

10

20

30

40

50

60

70

RealPersonalConsumptionExpenditures

RealGrossPrivateDomesticInvestment

Pe

rce

nt

Ch

an

ge

fro

mY

ea

rA

go

ShadedareasindicateU.S.recessions Source:U.S.BureauofEconomicAnalysis myf.red/g/iHbN

This means that these two variables are an important factorwhen trying to explain business cyclesTomáš Lichard Macroeconomics II



Keynes’ Consumption FunctionBeginnings of Intertemporal Analysis - Fisher ModelLife-cycle Hypothesis (LCH)Permanent Income Hypothesis (PIH)Random-Walk HypothesisBehavioral Views

Keynes’ Basic Arguments

His ideas (based upon introspection and casual observations)were centered around:

1 Marginal Propensity to Consume (MPC) – 0 < c < 12 Average Propensity to Consume (APC) – decreasing with

income3 Income as the primary determinant of consumption, interest

rate has little role

Based on this, we can express Keynes’ idea as:

C = C + cY

where:C > 0, 0 < c < 1

Note that APC = CY =CY + c





Empirical Support

On average, households with higher income really consumemore in absolute terms

They also save more, that would imply that really0 < MPC < 1.

Once controlled for income, interest rate does not have a(big) effect on consumption





But what do you make of this graph?





Failures

Based on the Keynes’ consumption function, householdsshould consume less and less of their income, meaning theywould save more and more, leading to problems withaggregate demand – it predicts secular stagnation

However, after the WWII income rose, but savings didn’t

Kuznets created a dataset containing aggregate data onincome and consumption from 1869 to 1940s -consumption-saving ratio was stable

⇒ There seem to be 2 relationships:1 In the short run, consumption function exhibits falling APC2 In the long run data showed stable APC

So we have to reconcile these two relationships





Intertemporal Budget Constraint

Let’s assume 2 periods:

S = Y1 − C1 (1)C2 = (1 + r)S + Y2 (2)

Combining these two equations we get:

C1 +C2

1 + r= Y1 +

Y21 + r

So in conclusion Fisher model shows that current consumptionis a function of (expected) lifelong income (cf Keynes’ view)

How does it look graphically?





Optimization problem

Consumer wants to maximize his or her “life-time” utility

max U(C1,C2)=u(C1)+βu(C2)

s.t.:

C1 +C2

1 + r= Y1 +

Y21 + r

How does it look graphically?





Comparative statics

What happens if the income increases?

What happens if the interest rate increases?

Substitution vs. income effect

Income effect: movement to a higher indifference curveSubstitution effect: movement along the indifference curve





Liquidity constraint

However, in real world it is not that easy to borrow against apromise of higher future income (students are familiar withthis)

What happens if you are liquidity constrained?

In the most extreme scenario C1 = Y1

Two cases:1 Constraint is not binding2 Constraint is binding





LCH — Basic Idea

Modigliani, Ando & Brumberg: people like to smooth theirconsumption - they move income from periods when it is highto periods when it is low

If W is current wealth, and consumer lives for T additionalyears and works for R of them, then annual consumption is:

C = (W+RY )/T

This implies that the aggregate consumption function is:

C = αW + βY

APC then is: C/Y = α (W /Y ) + β





LCH

The above solves the conflict between long-run and short run:

in the short run the wealth is almost fixed, so APC isdecreasingin the long run the wealth changes with income, so APC isconstant





Empirically...

Elderly dissave much less than what would be predicted byLCH. Possible reasons:

1 Precautionary saving (but people can insure against manyrisks)

2 Bequests (altruism towards their children)

Kopczuk&Lupton (2007) estimated that approximately half ofthe positive net worth at time of death in their sample is dueto a bequest motive, rest is precautionary saving





PIH — Basic Idea

Developed by Milton Friedman, extension of the LCH

People experience random and temporary changes in theirincome from year to year

Y C = Y P + Y T

Change in income can be caused by changes in Y P or Y T

(Compare a farmer with a macroeconomics lecturer)

Consumption depends on permanent income, because peoplewill smooth consumption during transitory changes in income

⇒ C = αY P





PIH — Basic Idea

Friedman’s conclusion: Keynes’ function uses the wrongvariable:

APC =C

Y=αY P

Y

How does this explain our graph?





Random-Walk Hypothesis – Hall (1978)

If PIH holds and consumers have rational expectations, theconsumption should only change with unexpected shocks:

Ct+1 = Ct + εt+1

where εt+1 follows an iid process with zero mean independentof Ct – in that case the equation is an example of what instatistics is called a random walk

this implies that Et (Ct+1) = Et (Ct) + Et (εt+1) = Ct

In other terms, consumption should be a martingale process:Et (Ct+1 | Ct ,Ct−1...C0) = Et (Ct+1 | Ct) = Ct





One-dimensional random walk – example





Random-Walk Hypothesis – Hall (1978)

This gives us a testable hypothesis—Hall (1978) tested it:1 Past real disposable income (Yt) has no predictive power for

Ct+12 Indeces of stock prices have predictive power for Ct+1, which

violates pure PIH

Conclusion: evidence supports a modified version of PIH

However, since this study researchers have found more casesof deviation from PIH

1 consumers do not have rational expectations2 consumers are credit constrained

But some research shows (Havranek&Sokolova, 2016) that ifyou account for liquidity constraints, PIH is not a baddescription of reality





Time-inconsistent Plans

Behavioral economics: people are rational only boundedly;they may have what is called present bias

They may change plans as time passes (think of: “I will startgoing to gym/stop smoking/etc tomorrow”)

Example:1 Q1: Would you prefer $10 today or $20 in one week?2 Q2: Would you prefer $10 in 100 days or $20 in 107 days?

Rational model: pick the first or the second option in bothcases

However, a lot of subjects in experiments choose first optionin Q1 and second option in Q2 - this is often called hyperbolicdiscounting





Hyperbolic discounting

0 10 20 30 40 500

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

Time

Insta

nta

neous u

tilit

y

βt

1/(1+β × t)

This can pose a problem for voluntary pension systems, saving,health care systems... (see Thaler&Sunstein (2008): Nudge.)




What have we learnt?

Consumption is an important component of GDP, thereforethey are crucial for understanding business cycles

We took a look at how consumption is determined accordingto various hypotheses:

Keynes: depends on current income (constant MPC,decreasing APC)Intertemporal choice: consumers take into account their futureincomeLife-cycle hypothesis: consumers spend according to the stageof the life cycle they are inPermanent income hypothesis: consumer spend according totheir lifelong (permanent) income

Random-walk: if PIH is true, consumption should be arandom walk, which is partially observed


Info on the courseIntroductionConsumptionKeynes' Consumption FunctionBeginnings of Intertemporal Analysis - Fisher ModelLife-cycle Hypothesis (LCH)Permanent Income Hypothesis (PIH)Random-Walk HypothesisBehavioral Views

Conclusion

Documents

Macroeconomics II - CERGE-EIhome.cerge-ei.cz/tlichard/teaching/macroII/L01handout.pdf · Ball, L. and N.G. Mankiw (2011): A New Approach to Intermediate Macroeconomics, Worth Publishers