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The economics of consumption

Notes on the mid-term exam The midterm examination is Wednesday October 21, 11:35 – 12:50. All information posted on the course web site. Coverage: It will cover all materials through the material on Consumption (which will be covered through October 19). Format (the following is indicative only):

There will be three parts.First section will be “shorties”: definitions, true-false, compare, or

the like.The other sections will be problems and thought questions.

 Sample midterm and solution will be posted

Review sessions:A schedule will be posted onlineProf review session here on Friday.

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Logistics

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Econ122a. Midterm logistics

Date Time Place Name

review 16-Oct 11:35-12:50 pm DL220 Nordhausreview 19-Oct 2:30 - 3:30 pm BCT CO31 Federicoreview 19-Oct 5:30 - 6:30 pm BCT CO31 Chrisreview 19-Oct 6:30 - 7:30 pm WLH 117 Melanie

review 20-Oct 5 - 9:00pm WLH208 All

exam 21-Oct 11:35-12:50 pm LC102 A - Lexam 21-Oct 11:35-12:50 pm DL220 M - Z

Importance of consumption in macro

1. Consumption is two-thirds of GDP – understanding its determinants is major part of the ball game.

2. Consumption is the entire point of the economy:

3. Consumption plays two roles in microeconomics:a. It is a major part of AD in the short run: recall IS curve in which Y = C(Yd) + I + G + NXb. What is not consumed is saved and influences national investment and economic growth

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Growth in C and GDP

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-.04

-.02

.00

.02

.04

.06

.08

1970 1975 1980 1985 1990 1995 2000 2005 2010

ConsumptionGDP

Rate of growth per year

The importance of fiscal policy today

When the economy is in a liquidity trap and recession, major available policy tool is fiscal policy (remember IS-LM and Summers quote)

But, fiscal policy has multiple problems:Purchases:

- Controversial because increase size of government- Long lags (recognition, decision, implementation)- Infrastructure and other programs have long gestation periods.

Tax Cuts:- One view: people will smooth consumption, and even anticipate a future tax increase, and there will be little or no response.- Other view: people are short-sighted and/or liquidity constrained, and they will spend a substantial fraction of increased incomes

Here is where we need to study carefully the economics of consumption.

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Alternative Theories of Consumption

The basic Keynesian insight is that consumption depends fundamentally on personal income (“consumption function”)

This enters into the Keynesian models as C = α + βYd

On a closer look, a major puzzle: the short-run and cross-sectional consumption functions looked very different from the long-term consumption function.

Short-run v. Long-run Consumption Function

8Mankiw, p. 499.

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Alternative Theories of Consumption

The basic Keynesian insight is that consumption depends fundamentally on personal income (“consumption function”)

This enters into the Keynesian models as C = α + βYd

On a closer look, a major puzzle: the short-run and cross-sectional consumption functions looked very different from the long-term consumption function.

There are four major approaches in macroeconomics:*1. Fisher's approach: sometimes called the neoclassical model 2. Keynes original approach of the consumption function*3. Life-cycle or permanent income approaches (Modigliani,

Friedman) 4.Rational expectations (Euler equation) approaches (Hall,

Barro,...)

*We will sketch the life cycle model in class; Fisher in Mankiw and section.

Consumption and Disposable Income

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0

2,000

4,000

6,000

8,000

10,000

0 2,000 4,000 6,000 8,000 10,000

Real personal disposable income

Rea

l per

sona

l con

sum

ption

exp

endit

ure

s

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Basic Assumptions of Life Cycle Model

Basic idea:People have expectations of lifetime income; they determine

their consumption stream optimally; this leads consumers to “smooth” consumption over their lifetime.

Assumptions:“Life cycle” for planning from age 0 to D.Earn Y per year for ages 0 to R.Retire from R to D.Maximize utility function:

Budget constraint:

Discount rate on utility (δ) = real interest rate (r) = 0

Y)(1 C)(1 zz-

D

0 zz

z-D

0 z

rr

D. to 0z ages for 1 max0

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),C( U)() , ..., C, CV(C z

D

z

zD

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Techniques for Finding Solution

1. Two periods:

Maximizing this leads to U’(C1)=U’(C2). This implies that C1 = C2 , which is consumption smoothing. The Cs are independent of the Ys.

2. Lagrangean maximization (advanced math econ):

Maximizing implies that U’(C1)=U’(C2)=λ. This implies that

which again is consumption smoothing independent of Y.

z

D D D-z -z -z

1 D z z z{C } z = 0 z = 0 z = 0

max L C ,...,C = (1+δ) U(C ) + λ (1+r) C - (1+r) Y

1 2 1 1 2 1maxz{C }

U(C ) U(C ) U(C ) U(Y Y - C )

tC C

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age

C, Y, S

Income, Y

R D| |

Consumption, C

0

Saving, S

Diagram of Life Cycle Model Showing Consumption Smoothing

Initial Solution

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age

C, Y, S

Income, Y

R D| |

Consumption, C’=C

0

Saving, S’

Anticipated change in timing of income

Income “splash” with no W increase (Y’)

Anticipated income change of ΔY. Because it is anticipated, no change in lifetime income, so no change in (smoothed) consumption. MPC = 0; MPS = 1.

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age

C, Y, S

Y

R D| |

C

0

Unanticipated change in permanent income

Y’ =unanticipated increase; W increases.

C’

Unanticipated windfall of ΔY.

Leads to smoothing the windfall over remaining lifetime.

(a) one time splash: MPC = ΔY/(D-z). For life expectancy of 40 years, would be MPC = .025.

(b) Permanent income increase: MPC = ΔY(R-z)/(D-z) = .6 to .8

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Example of the Life Cycle Model at Work:

• How would the consumption and saving of people with volatile or stable income streams look?

• See figure for Entrepreneur Ghates and Professor Nerd.

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Major result of LCM: consumption smoothing

Y: professor

C of both!

R D

Y: Entrepreneur

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Further Extensions

1. Liquidity constraints

– Case of Yale students where income growing rapidly

– Here consumption is limited by borrowing constraint

2. The impact of taxes:

– What is the impact if taxes are anticipated and paid back during lifetime? No impact! MPC from taxes = 0.

• see 2008 temporary tax cut

– Barro (Ricardian) model extends this to future generations.

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Example of consumption smoothing: the 2008 tax rebate

-400

-200

0

200

400

600

800

06M01 06M07 07M01 07M07 08M01 08M07

CDYS

Changes in C, DY, and S

Estimated MPC= 0.07 (0.04)

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Further Extensions

3.Wealth effects:

Examples: How would you spend an unanticipated inheritance of $1m? What is MPC of “trust-fund babies”? What would be the effect of stock-market decline or housing bubble and burst?

- Life cycle model predicts that initial wealth (or surprise inheritances) would be spread over life cycle.

• Intuition: an inheritance is just like an income splash.

- So the augmented life cycle model is

Ct = β0 + β1 Yp

t + β2 Wt

where Ypt is permanent or expected labor income and Wt

is wealth.

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0

10

20

30

40

50

1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Price-earnings ratios, US

Roar

ing 2

0s

Road

ing 9

0s

What is the Effect of Stock Market Booms and Busts on Consumption?

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The stock market, the housing market, and consumption

• Economists think that the bursting of the stock market bubble in 2000 or the housing market today contributed to recessions.

• Reasons? Decline in consumption (today) and investment (later)

• Rationale: the “wealth effect” on consumptoin• Analysis in the life-cycle model:

– In augmented life-cycle model Ct = β0 + β1 Yp

t + β2 Wt

standard estimates are that β2 = .03 - .06 (example in a minute)

– Effect in the “Roaring 90s” and the housing crash today.

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Regression

Dependent Variable: Real consumption expenditures

Method: Least SquaresSample: 1952.1 2009.2

Variable Coefficient Std. Error P

Real Disposable income 0.63 0.026 .0000

Real wealth 0.024 0.0032 .0000

R-squared 0.9983

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Wealth and Consumption through Two Bubbles

-16,000

-12,000

-8,000

-4,000

0

4,000

8,000

12,000

-200

-100

0

100

200

300

400

500

98 99 00 01 02 03 04 05 06 07 08 09

Change in real HH wealth (left scale)Change in consumption (right scale)

Tech stock bubble

Burst of housingbubble; financialcrisis

Billions of 2005 $

Key ideas

1. Consumption derived from consumer maximization

2. Pure model leads to consumption smoothing3. All kinds of fun predictions4. But impediments to pure model5. Remember the wealth effect6. Big open issue: how big is the short-run MPC?

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