Consumption Notes

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Consumption
15 November 2010

Topics Reading Key Points
• Consumption • Consumption
• The Keynesian Consumption Function
• Keynesian consumption function
• Two-Period Model - Graphical Analysis
• Two-Period Model - Mathematical Analysis • The Kuznet consumption puzzle
• Life-cycle theory of consumption

Consumption • Permanent income theory of consumption
• Consumption is the biggest component of GDP at about 2/3's • Two period graphical analysis
• In the Solow model we forget about utility maximisation because it makes the model simpler • Two period mathematical analysis
• We assume consumers save a fixed fraction of income • Effect of increase in current income
• Saving is for future consumption
• Effect of increase in future income
• There is a global imbalance based on consumption:
• USA consumes too much • Temporary vs. permanent increase in income
• China consumes too little • Consumption smoothing
• Effect of increase in real interest rate
• We analyze the optimal consumption-saving decision • Linking the two period model to permanent income
• There are two goods: theory
• Current consumption
• Psychology of instant gratification
• Future consumption
• Implications of relation between consumption and
• The Keynesian consumption function is now an out-dated consumption model because it posed a income
problem known as the consumption puzzle
Definitions
The Keynesian Consumption Function
• Beta = how impatient we are
• Keynes (1936) posed two ideas:
• C is related to Y • Life Cycle Theory = Idea of saving for your future
• "The amount of aggregate consumption mainly depends on the amount of aggregate • Life-cycle pattern = Borrow when young (income low),
income" and that this relationship "is a fairly stable function" save during middle age (income high), dis-save during
• "It is also obvious that a higher absolute level of income… lead, as a rule, to a greater old age (retirement)
proportion of income being saved" • The 'pull of instant gratification' = The discount factor
between period 1 and 2 is smaller than the discount
• Consumption Function: factor between future period t and t+1
• Consumption depends on current income • Transitory Shock = Temporary effects to income, but
○
average income will still be almost the same


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

•
• 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
•
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
•

• 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:

• Substitute this into the budget constraint:
• Y is the current income
• A positive intercept -> Falling APC
• Origin intercept -> Constant APC • Where lifetime wealth is
• 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

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