Slides for Part III- C

Outline

1. The naïve model

2. Consumption function controversies

3. The “permanent” income hypothesis

4. The life-cycle hypothesis

5. The functional income hypothesis

6. Poterba on the “wealth effect”

7. Brown on consumer credit

The naïve consumption function

Remember our consumption function was specified as follows:

cYDCC

Where C is autonomous consumption and c is the marginal propensity to consume

The range of possible values of the marginal propensity to consume is based on the the fundamental psychological law of consumption, which can be stated as follows: People are disposed, as a rule and on average, to increase their consumption when their income increases; but not by as much as the increase in income.

•Ave. propensity to consume (APC): Ratio of consumption to real disposable income (YD). That is:

APC = C/YD

•Ave. propensity to save (APS): Ratio of saving to real disposable income. That is:

APC = S/YD.

•Marginal propensity to save (MPS): The change in saving resulting from a one unit change in disposable income. That is:

MPS = S/ YD.

Definitions

YD C S MPC APC MPS APS

0 $30 -$30 -- -- -- --

$100 100 0 .70 1 .30 --

200 170 30 .70 .85 .30 .15

300 240 60 .70 .80 .30 .20

400 310 90 .70 .775 .30 .225

500 380 120 .70 .76 .30 .24

600 450 150 .70 .75 .30 .25

The consumption function is given by:

C = 30 + .7YD

The MPC and the MPS

C = YD

C/YD = 1

C

YD0 100

100

300

240

30

300

S

CYD

C = 30 + .7YD

450

The graph

C

YD0 100

100

240

30

300

C = 30 + .7YD

400

310

YD

C

Slope = C/YD = 70/100 = .7

Slope of the consumption function

450

C1

C0

C2

C

YD0

The function could shift due to:

A change in household wealth

A change in consumer confidence.

Change in price or availability of credit.

Shifts of the consumption function(C)

)1(1

1

)1(1

10

tcC

tcAY

1A

2AC

Y1 Y2 Output, income

0Y

0

Agg

rega

te d

eman

d

Consumption function controversies

•What can explain the long-run stability of the average propensity to consume?

•How sensitive is current consumption expenditure to changes in current income?

•What can account for cross-sectional differences in the average propensity to consume?

•How significant is the “wealth effect”?

•Is consumer debt important in explaining shifts of the consumption function?

C = YD

C/YD = 1

C

DY0 100

100

30

C = 30 + .7YD

450

APC decreases as DY increases

The naïve model predicts a falling

APC—but the “long run” data do not bear

this out.

Period Disposable Income Consumption APC1960-69 2052.6 1853.2 0.9031970-79 3082.8 2713.8 0.8801980-89 4218 3718.3 0.8821990-99 5544.7 5061.9 0.913

The Long Run Average Propensity to Consume

Data for consumption and investment in chained 1996 dollars

www.bea.gov

Disposable Income and Consumption, 1980-99

1,000.0

2,000.0

3,000.0

4,000.0

5,000.0

6,000.0

7,000.0

8,000.0

1,000.0 2,000.0 3,000.0 4,000.0 5,000.0 6,000.0 7,000.0

Disposable Income (billions)

Con

sum

ptio

n (b

illio

ns)

www.bea.gov

The permanent income hypothesis1

1M. Friedman. A Theory of the Consumption Function, 1957

Professor Friedman claims thatcurrent C does not depend on current YD (at least not directly). Rather, C

depends on what Friedman terms “permanent income.”

C=f(YD)

Key points

•Permanent income is the flow of monthly or annual income that expected or regarded as normal by the household based on its endowment of wealth (inclusive of human wealth).

•Past income flows are one factor that condition the household’s assessment of permanent income.

•Current income (YD) affects consumption indirectly--by its affect on the household estimate of permanent income.

Example of a “representative household”

Occupation: Attorney

Expected annual income from legal fees

$89,000

Expected annual income from other sources (rent, dividends, etc.)

7,000

Total $96,000

Annual estimate of YP $96,000

Monthly estimate of YP $8,000

7,000

0

YP

10,000

6,000

Actual income

July August Month

Inco

me,

Con

sum

ptio

n

C

•Positive transitory income (YT) in July ($2,000)—hence, APC falls.

•Negative transitory income (YT) in August ($2,000)--hence APC rises

8,000

APC rises from .7 to 1.17 from July to August

01

n

i

TY

Note that:

Moral of the story

•C is not as sensitive to changes in current income as the Keynesians would have you believe.

•This factor diminishes the size of the MPC and hence the multiplier effect.

•The diminished power of the multiplier effect in turn calls into to question to effectiveness of counter-cyclical fiscal policy

)1(1

1

tc

The life-cycle hypothesis1

1A. Ando and F. Modigliani,” The Life-Cycle Hypothesis of Saving,” American Economic Review, March 1963.

Cross-sectional studies of consumer behavior show widevariation in the APC (or APS)

among households with the same income. The life-cycle hypothesis can explain this—but is it the right

explanation?

Age

DY, C

18 67

C

DY

APC falls during peak earning years, and rises during retirement

Theory implies C is less sensitive to changes in current YD than “naïve” Keynesian model suggests; hence , the multiplier is smaller too.

•0-18 APS <1

•18-67 APS > 1

•67- APS < 1

The functional income hypothesis

Key points:

1. Total consumption expenditure is partly determined by the prevailing distribution of income among various groups.

2. Higher income households tend to have a higher propensity to save than lower income households. Hence if income is redistributed upward, this will raise the APS and lower the APC.

3. Policies that have the effect of making income distribution more even tend to raise the propensity to consume (and lower the propensity to save).

Example

Family Income Spending APC APS

Rogers $38,000 $37,240 .98 .02

Andersons $225,000 191,250 .85 .15

A transfer of income from the Andersons to the Rogers could boost

the APC.

Sherman & Kolk presentation

•Let W denote labor income from wages, salary, fringe benefits, commissions, etc.

•Let denote “property income”—income from dividends, interest, rent, and (net) income of non-corporate business enterprises.

•Let Y denote national income.

Thus:WY

Also:1

YY

W

(1)

(2)

Equation (2) gives the functional shares in

national income

•Let 1 denote the average propensity to consume out of labor income.

•Let 2 denote the average propensity to consume out of property income.

Thus the consumption function can be written as follows:

21 WC (3)

Example: Let Y = $1 trillion

1 2 W C

1.0 0.1 800 200 820

1.0 0.1 500 500 550

1.0 0.7 700 300 910

1.0 0.7 800 200 940

0.9 0.7 600 400 820

W, , and C are measured in billions

Y (billions)

C (billions

0 1,000

940

910

Change in factor shares in favor of W (at the expense of ) raises the aggregate APC

Share of aggregate income received by U.S. households, 1967-97

Year

9794918885827976737067

Perc

ent

55

50

45

40

35

30

25

20

15

10

5

Top 5 percent

Top 20 percent

Bottom 40 percent

www.census.gov

Mean Household Income of Quintiles, 1997

Source: Bureau of the Census

Income Quintile

HighestFourthThirdSecondLowest

Mean Inco

me (

dollars

)140000

120000

100000

80000

60000

40000

20000

0

122764

57582

37177

22098

8872

Shares of Household Income of Quintiles, 1997

Source: Bureau of the Census

Income Quintile

FifthFourthThirdSecondLowest

perc

ent

of

tota

l in

com

e60

50

40

30

20

10

0

50

23

15

9

4

The wealth effect

•How sensitive is consumer spending to changes in household wealth?

•Does the responsiveness of spending to changes in wealth vary across asset categories—e.g., equities, bonds, home equity, farm land, pension funds?

•Could a substantial “correction” in the U.S. equity market have a powerful negative wealth effect on consumption?

Issues

Change in current consumption per dollar of increase in wealth, assuming consumer are life-cycle planners and do not leave an inheritance. Source: Poterba (2000), p. 104.

After-tax rate of return

Planning Horizon

15 yrs. 30 yrs. 45 yrs.

.01 .074 .038 .027

.03 .081 .050 .040

.05 .092 .062 .053

.07 .103 .075 .069

C that satisfies

T

ttr

CW

0 )1(

Stylized facts about the wealth effect

•The marginal propensity to consume of wealth is not a stable variable—it changes from year-to-year or decade to decade.

•Households as a group are more sensitive to changes in the value of non-financial wealth than financial wealth—a counterintuitive result.

•The effect of changes in the value of financial wealth is diminished by the fact that ownership stocks and bonds is tightly concentrated among households.

•An much larger proportion of equity wealth is held indirectly(through mutual funds, pensions, insurance policies) today as compared with 1972.

Composition of Household Net Worth in the U.S.

Year

199919951989

50000

45000

40000

35000

30000

25000

20000

15000

10000

5000

0

Asset Category

Tangible assets

Financial assets

minus equities

Market value of

equities

Net worth

42048

30241

26959

13332

6730

3683

21617

1716915634

139411179612184

Source: Poterba (2000)

Billions of 1999 dollars

Percen-tage of owners

Common stock

excluding pensions

All Commo

n Stock

Non-Equity Financial Assets

Housing equity

NetWorth

Top .5percent

41.4 37.0 24.2 10.2 25.6

Next.5 Percent

11.8 10.7 7.8 4.6 8.4

Next 4 percent

27.7 27.2 26.2 20.5 23.4

Next 5 percent

10.3 11.3 14.0 15.4 11.4

Next 10percent

7.2 9.8 13.9 20.1 12.8

Bottom 80 percent

1.7 4.1 14.0 29.3 18.5

Percent of Assets Owned by U.S. Households, 1998

Source: Poterba (2000), based on 1998 Survey of Consumer Finances

 

If the MPC out of stock market

wealth is

Then 2000 consumer spending would be this much higher as a result of the stock market change

from:

Dec. 89-Dec. 99

Dec. 95-Dec. 99

Dec. 97-Dec. 99

.01 96.5(1.5%) 66.0(1.0%) 37.4(0.6%)

.03 289.5 (4.5%)

196.0 (3.0%) 112.3 (1.7%)

.05 482.4 (7.4%)

330.1 (5.1%) 187.1 (2.9%)

Poterba’s estimate of the “stock market wealth effect” on consumer spending in 2000 (billions of dollars)

Source: Poterba (2000)

The role of consumer debt

•Does the build-up, on an unprecedented scale, of mortgage, revolving, and non-revolving debt on household balance sheets constitute at threat to the continued robust growth of payrolls and personal income in the United States?

Macroeconomic effects of widened credit availability

Pl a

nned

ex p

endi

t ure

(A

D)

Real GDP (Y)0

AD1

AD2

AD = Y

Y1 Y2

Liberalization of credit standards, by augmenting the spending power of middle and lower income households, reacts on the propensity to consume is the same way as a downward redistribution of income would.

Effects of household debt deflation

•Debt deflation is an episode wherein households on average allocate a sharply increased proportion of current income to debt servicing.

•Debt deflation tends to occur at the terminal point of a lengthy business cycle expansion.

Consequences of household “debt deflation”P

l ann

ed e

x pen

dit u

re (

AD

)

Real GDP (Y)0

AD1

AD2

AD = Y

Y1 Y2

Explained in the income –expenditure framework, debt deflation is manifest in a decrease in autonomous consumption--C

450

Figure 1

Consumer Credit Outstanding in the U .S.

End of June each year

Source: Federal Reserve Board

Y ear

199919971995199319911989

Bil

lio

ns

of

do

lla

rs 14001300120011001000

900800700600500400300200100

Total

Revolving

Nonrevolving

Figure 2

Consumer Debt to Income Ratio, 1993-99

Total consumer deb t divided by personal disposable income

Source: Federal Reserve of St. Louis

www.stls.frb/org/fred/data

Y ear/Qua rter

99.198.398.197.397.196.396.195.395.194.394.193.393.1

De

bt

to I

nc

om

e

.22

.21

.20

.19

.18

.17

.16

Source: Trans Union Credit Research Center

Supposition

A given rate of increase of household indebtedness is likely to be sustainable so long proportion of after-tax income claimed by the minimum debt servicing remains constant as the economy moves forward along the time axis.

It follows that the rate of increase of indebtedness is not sustainable if the proportion of income claimed by debt service is rising.

SymbolsSERVICEt Debt service in quarter t ;DPIt (Nominal) personal disposable income in quarter t ;t SERVICEt DPIt ;Revolvet Revolving consumer debt outstanding in quarter t ;Nrevolvet Non-revolving consumer debt outstanding in quarter

t ;CDEBTt The sum of Revolvet and Nrevolvet ;MDEBTt Mortgage debt outstanding in quarter t ;Interestt Minimum interest owed in quarter t ;Principlet Minimum principal owed in period t ;MaturityC Average maturity of outstanding consumer debt

obligations (measured in quarters); MaturityM Average maturity of outstanding mortgage debt

Obligations (measured in quarters) ; RC1 Average interest rate paid on revolving consumer

debt ; RC2 Average interest rate paid on non-revolving

consumer debt ,and;RM Average interest rate paid on mortgage debt.

Methodology

•The growth of consumer and mortgage debt is forecasted using a (linear) trend projection obtained from quarterly observations for each variable for a six year period (1993.1 to 1999.1).

•Having forecasted the value of outstanding debt in future quarters, the next step is to estimate quarterly debt service--that is, the minimum principal and interest payable in each quarter.

Thus we have:

SERVICEt = Interestt + Principlet [1]

The following equation was used to estimate quarterly interest payments:

Interestt =RevolvetRc1+ NrevolvetRc2 + MDEBTtRM/4 [2]

The estimate of minimum principal owed was obtained from the following equation:

Principlet = CDEBTt ÷ MaturityC + MDEBTt ÷ MaturityM [3]

Equations [2] and [3] were substituted into [1] to estimate quarterly debt service.

Table 1Assumptions of the Forecasts

Forecast DPIta Mc(QTRs) MM(QTRs) RC1(%) RC2(%) RM(%)

1 Trendb 14.8 67.5 15.65 9.5 7.75

2 Trend 14.8 67.5 16.15 10.00 8.253 0 14.8 67.5 15.65 9.5 7.754 2.5 14.8 67.5 15.65 9.5 7.755 -1.0 14.8 67.5 15.65 9.5 7.756 -1.0 14.8 67.5 16.15 10.00 8.25

a Expressed in percent per year.b Approximately 3.9 percent.

Table 2

Forecasted Values of t

YR/QTR Forecast 1 Forecast 2 Forecast 3 Forecast 4 Forecast 5 Forecast 6

2000/1 0.191 0.196 0.193 0.191 0.198 0.2032000/2 0.192 0.197 0.196 0.193 0.202 0.2072000/3 0.193 0.197 0.199 0.194 0.205 0.2102000/4 0.194 0.199 0.202 0.197 0.208 0.2142001/1 0.195 0.199 0.208 0.198 0.212 0.2182001/2 0.196 0.200 0.211 0.199 0.216 0.2212001/3 0.197 0.201 0.214 0.201 0.219 0.2252001/4 0.197 0.202 0.217 0.203 0.223 0.228

Figure 3

Income Claimed by Debt Service, 2000-2001

Forecasts 1, 2, and 3

Ratio of quarterly debt service to quarterly personal disposable income

Year/Quarter

01/401/301/201/100/400/300/200/1

Deb

t Ser

vice

to D

ispos

able

Inco

me

.220

.215

.210

.205

.200

.195

.190

.185

.180

Forecast 1

Forecast 2

Forecast 3

Figure 4

Income Claimed by Debt Service, 2000-2001

Forecasts 4, 5, and 6

Ratio of quarterly debt service to quarterly disposable income.

Year/Quarter

01/401/301/201/100/400/300/200/1Debt S

evi

ce to D

isposa

ble

Inco

me

.240

.235

.230

.225

.220

.215

.210

.205

.200

.195

.190

.185

.180

Forec ast 4

Forec ast 5

Forec ast 6

Figure 5

Debt Repa yments to Inco me Ratios by Fa mily Inc ome, 1995

Source: Kennickell et al. (1997), Table 14, p. 21

Family Income (1995 dollars)

Above 100,000

50,000-99,999

25,000-49,999

10,000-24,999

Less than 10,000

All families

Perc

ent

30

25

20

15

10

5

0

Repayments to Income

Above 40 percent