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Advanced Macro (Subject) / VL7 (Lesson)
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- What can demand for goods and services (consumption) depend on? current income (Keynes) life-time income (Fisher) wealth and income (Modigliani) permanent income (Friedman)
- Keynes' assumption Using houshold data, Keynes found that for housholds with higher incomes consumption rises less than proportionally with more income consumption-income ratio falls with more income income is the largest component of consumption
- Keynesian Consumption Function C = C_ + cY MPC = marginal propensity to consume (c): Consumption resulting from an additional unit of income (Y) APC: average propensity to consume: consumption-income ratio C_ = autonomous consumption
- Keynesian Consumption Function C = C_ + cY MPC = marginal propensity to consume (c): Consumption resulting from an additional unit of income (Y) APC: average propensity to consume: consumption-income ratio C_ = autonomous consumption MPC > 0, consume moer MPC < 1 save relatively more and APC goes down
- Problems with the Keynesian Consumption Function it implies that consumption inceases less than proportionally with income, APC decreases. Thus, a rising wedge between consumption and income (and hence between consumption and investments) could potentially lead to stagnation of the economy empirical data show no sign of stagnation since WW2, despite rising income levels APC has remained constant according to Simon Kuznets
- The consumption puzzle Long-run consumption function (constant APC) short-run consumption function (decreasing APC)
- Irving Fisher: Intertemporal Consumption Decisions Fisher assumes that consumers face a dynamic decision tradeoff. They must decide between consumption today and tomorrow (= today's savings) They divide their total income (today's and tomorrows expected income) to maximize their utility - intertemporal budget constraint
- Irving Fisher: Intertemporal Consumption Decisions Fisher assumes that consumers face a dynamic decision tradeoff. They must decide between consumption today and tomorrow (= today's savings) They divide their total income (today's and tomorrows expected income) to maximize their utility - intertemporal budget constraint
- Borrowing Constraints In Fisher's theory the timing of income flows irrelecant as consumers can borrow and save money. But if consumers are subject to borrowing constraints, they cannot increase their current income consumption will evolve according to the keynesian theory
- The Life-cycle Hypothesis (Franco Modigliani) The LCH implies that income changes over the life cycle and that savings allow for consumption smoothing W = wealth, Y = annual income until retirement, R = periods until retirement, T = life-time in years Assumptions: real interest rate = 0 (for simplicity), consumption smoothing is optimal Life-cycle consumption = W + RY C = (W+RY)/T consumption will be spread evenly over the life time (due to consumption smoothing) 1/T = marignal propensity to consume from initial wealth R/T = marignal propensity to consume more income
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- Effects of initial wealth on consumption The LCH consumption function is C = aW + bY, Hence APC = a(W/Y)+b
- Empirical evidence for the LCH-Hypothesis Data shows, that elderly people to not deplete their savings as fast as the LCH would suggest in order to smooth consumption Explanation 1: Precautionary saving due to life-cycle risks and possible unexpected expenditures, however there are insurances (health insucrens, unemployment insurance etc.) Bequest motives
- The permanent income Hypothesis (Friedman) assumes that income flows fluctuate A good education will increase income permanently, while bonus payments are transitory Two components of income: Y = YT+YP (Current income = transitory income + permanent income Consumers save and borrow money to smooth out transitory income, thus PIH assumes that consumption depends on permanent income C = aYP with a being the share of pernenet income that is consumed
- IMplications of the PIH PIH = Permanent income hypothesis APC = C/Y = a*YP/Y APC thus depends on the ration of permanent income to total (current) income For YT>0, APC decreases temporarily, increases otherwise Friedman argues: Shortrun income fluctuation are transitory; Long-run income changes arise from the permanent income component Assumes that Keynesian consumption function uses the wrong explanatory variables