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### Consumption Notes

This is a sample of our 6 page long **Consumption** notes, which we sell as part of the **Macroeconomic Principles Notes** collection, a 2.1 package written at LSE in 2011 that contains ** 260 pages** of notes across **32 different documents.**

### Consumption Revision

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**Macroeconomic Principles Notes**. This text version has had its formatting removed so pay attention to its contents alone rather than its presentation. The version you download will have its original formatting intact and so will be much prettier to look at.Consumption 15 November 2010

Topics

• Consumption

• The Keynesian Consumption Function

• Two-Period Model - Graphical Analysis

• Two-Period Model - Mathematical Analysis

Reading

Consumption

• Consumption is the biggest component of GDP at about 2/3's

• In the Solow model we forget about utility maximisation because it makes the model simpler

• We assume consumers save a fixed fraction of income

• Saving is for future consumption

• There is a global imbalance based on consumption:

• USA consumes too much

• China consumes too little

• We analyze the optimal consumption-saving decision

• There are two goods:

• Current consumption

• Future consumption

• The Keynesian consumption function is now an out-dated consumption model because it posed a problem known as the consumption puzzle

Key Points

• Consumption

• Keynesian consumption function

• The Kuznet consumption puzzle

• Life-cycle theory of consumption

• Permanent income theory of consumption

• Two period graphical analysis

• Two period mathematical analysis

• Effect of increase in current income

• Effect of increase in future income

• Temporary vs. permanent increase in income

• Consumption smoothing

• Effect of increase in real interest rate

• Linking the two period model to permanent income theory

• Psychology of instant gratification

• Implications of relation between consumption and income

Definitions The Keynesian Consumption Function

• Keynes (1936) posed two ideas:

• C is related to Y

• "The amount of aggregate consumption mainly depends on the amount of aggregate income" and that this relationship "is a fairly stable function" lead, as a rule, to a greater

• "It is also obvious that a higher absolute level of income…

proportion of income being saved"

• Consumption Function:

• Consumption depends on current income

○

• This the simplest way of stating consumption, however it is now old and out-dated

• Keynes made two claims with his consumption function:

• and are constants

• Average propensity to consume (APC) is falling as income increases

APC = C/Y = a/Y + b

Since a>0, when Y increases, APC falls

Average propensity to save: APS = 1-APC

□ So falling APC implies rising APS

• Beta = how impatient we are

• Life Cycle Theory = Idea of saving for your future

• Life-cycle pattern = Borrow when young (income low), save during middle age (income high), dis-save during old age (retirement)

• The 'pull of instant gratification' = The discount factor between period 1 and 2 is smaller than the discount factor between future period t and t+1

• Transitory Shock = Temporary effects to income, but average income will still be almost the same

Formulae

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Consumption Puzzle

• Data on C and Y do not show a consistent and stable relationship

• Across households at a point in time, they found that APC was falling

• i.e. Keynes was correct

• This is microeconomics

• But within a country over time, APC was constant

• So macro disagrees with Keynes

• Both of these cannot occur together

○ This is called Kuznets consumption puzzle Graphical representation of the consumption puzzle

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• APC = C/Y = a/Y + b

• At optimal point:

• Average propensity to save: APS = 1-APC

• Current period budget constraint:

• Derive marginal utility:

• Find FOC as:

○

• Future period budget constraint:

• Lifetime utility for T-period model:

• Y is the current income

• A positive intercept -> Falling APC

• Origin intercept -> Constant APC

• It is important to be able to explain this graph

Solving the Consumption Puzzle

• Two theories developed in the 1950s

• Milton Friedman: Permanent income theory of consumption

• Franco Modigliani: Life-cycle theory of consumption

• Life Cycle Theory = Idea of saving for your future

• Transitory Shock = Temporary effects to income, but average income will still be almost the same

• Saving is for future consumption Life-Cycle Theory of Consumption

• Income varies systematically over the phases of the consumer's "life cycle"

• They plan over entire lifetime to achieve smooth consumption

• Consumption therefore depends on life-time income

• Saving is used to achieve smooth consumption

Course Notes Page 24

• Substitute this into the budget constraint:

• Where lifetime wealth is

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