Microfoundations

1. Microfoundations Consumption and Investment

2. Learning Objectives • Understand the difference between the long-run consumption function and the short-run consumption function. • Understand the logic of the permanent income hypothesis and the life cycle hypothesis. • Know the implications of the PIH and LCH on consumption and the business cycle • Appreciate the strengths and weaknesses of the PIH and LCH as explanations of consumer behavior.

3. Consumption and the Business Cycle • Consumer spending cycles are not as extreme as those of GDP, particularly during recessions. • Consumer spending usually declines by less than GDP. • In 1990-91, consumption declined by more than GDP.

4. Consumption Spending: Selected Facts • Durable goods spending increased 2 to 4 times faster than spending on non-durables and services in expansions. • Durable goods spending declined in every postwar downturn except 1949 and 1953-54. • Nondurable spending declined in only four of the last nine recessions. • Services increased in every recession except for 1980.

5. Consumption Spending • Consumption is defined as all spending done by the household sector on durables, non-durables, and services with the exception of purchases of new housing.

6. Consumption Spending • Consumption spending is determined by two main factors: • The macroeconomic environment of employment and inflation. • Individual consumer purchasing power as reflected in household income, loans, existing savings and other wealth.

7. Early Consumption Theories • The absolute income hypothesis says that consumption is directly related to income. • As income rises, consumption rises but by a smaller amount. This means we can write: • C = a0 + bYd • a0 is subsistence consumption. When Yd = 0, some positive consumption still occurs. • The coefficient b is the marginal propensity to consume (MPC). It tells us by how much consumption changes when disposable income changes.

8. Consumption Function: Review C According to the absolute income hypothesis, consumption spending is directly related to disposable income. The intercept of the consumption function, a0, represents subsistence consumption. The slope of the consumption function, /\C//\Y, is called the marginal propensity to consume. The MPC shows by how much consumption changes as income changes. /\C /\Y a0 0 Yd

9. Consumption • Later, economists collected data to measure the relationship between consumption and GDP and to check its validity. • They discovered that different sets of data generated very different estimates of the marginal propensity to consume. CLR = 0.9Yd CSR = 0.75Yd

10. Consumption Conflict CLR = 0.9Yd C CSR = 0.75Yd a0 0 Y

11. Consumption Functions • Long-run consumption function • When income is zero, subsistence consumption is zero. • Consumption rises by $0.90 for every dollar increase in disposable income. • Short-run consumption function • When income is zero, subsistence consumption is positive. • Consumption rises by $0.75 for every dollar increase in disposable income.

12. Reconciliation • During the 1940s and 1950s, economists determined that there are two separate consumption functions. • The short run function describes how income and consumption are related over short periods of time. • The long run function describes how income and consumption are related over longer periods of time.

13. Forward Looking Theories of Consumer Behavior • Forward-looking expectations are estimates of the future values of economic variables. • They are based on the current and past values of several variables and an economic model that accounts for their behavior. • Consumers are assumed to prefer stable patterns of consumption. • Consequently, they assess whether a change in income is permanent or temporary before they spend it.

14. Two Theories • Two major theories were developed to explain the relationship between the two consumption functions. • The Permanent Income Hypothesis • Milton Friedman • The Life Cycle Hypothesis • Franco Modigliani

15. The Permanent Income Hypothesis • People simultaneously choose how much to consume now and how much to consume in the future. • To make those decisions, they consider how much income they earn now and expect to earn in the future as well as how much savings they have accumulated.

16. Permanent Income Hypothesis • Friedman suggested that people consume a constant fraction (k) of their expected/permanent income. • C = kYP = 0.9($10,000) = $9,000 where k is the individual’s MPC. • k depends on individual tastes and on the variability of income. • YP = YP-1 + j(Y – YP-1) where j is some fraction of the amount by which Y differs from YP-1. • C = kYP-1 + kj(Y – YP-1)= 0.9YP-1 + 0.18(Y – YP-1)

17. Permanent Income Hypothesis C = kYP-1 + kj(Y – YP-1) = C = 0.9YP-1 + 0.18(Y-YP-1) • This equation shows that the PIH is based on a distinction between two concepts of the MPC. • The long-run MPC is simply the coefficient (k) of permanent income or 0.9. • The short-run MPC is the coefficient of a change in actual income, kj, which is equal to the product of the MPC and the fraction of the amount by which actual income differs from permanent income.

18. Transitory Income • Transitory income is the difference between actual and permanent income and is not expected to recur. • Transitory income (Yt) is actual income minus permanent income. • Yt = Y – YP = Y – YP-1 – j(Y – YP-1) = (1 – j)(Y – YP-1) • Friedman assumes that the MPC out of Yt is zero. • Therefore, C = 0Yt + kYP = kYP.

19. Reconciling the Consumption Data • According to the cross section data, high-income people had higher saving ratios than low income people, but the long-run saving ratio was nearly constant.

20. Consumption Reconciliation CLR C CSR The saving ratio, S/Y is constant along CLR, but it differs from S/Y on CSR at every point except the intersection of the two consumption functions. 0 Y

21. Consumption Reconciliation CLR C CSR F CSR C0 B A 0 Y YP-1 YP0 Y0

22. Consumption Reconciliation • The ratio C/Y is constant at every point along CLR.. • At point A, where current income equals the last period’s permanent income, the long-run consumption-income ratio just equals the short-run consumption-income ratio and the functions intersect.

23. Consumption Reconciliation • But, if the person’s income rises to Y0, the current estimate of permanent income (YP) rises above the last period’s (YP-1) by a fraction (j) of the excess of actual income over last period’s estimate (YP-1). • YP = YP-1 + j(Y – YP-1) • Consumption rises by k times the increase in permanent income to C0. • C0 = kYP-1 + kj(Y – YP-1)

24. Consumption Reconciliation • At YP0, consumption lies vertically above point A by the fraction kj times the horizontal distance between YP-1 and Y0. • Consumption increases only a small amount, and at point B most of the short-run increase in income is saved.

25. Consumption Reconciliation CLR C CSR CSR F If the change in income is maintained, the short-run consumption function shifts up along the long-run function. A 0 Y

26. The Permanent Income Hypothesis • People try to keep their consumption about the same over their lifetime. • During years in which income is temporarilyhigh, they save most of the temporary portion in case income temporarily dips in the future. • During years in which income is temporarily low, they borrow to maintain their level of spending.

27. The Permanent Income Hypothesis • In the short run, most changes in income and consumption are transitory or temporary. • Therefore, studies that use short run (quarterly) data pick up the transitory changes in income and consumption. • The MPC is low because people are saving most of the temporarily high income.

28. The Permanent Income Hypothesis • In the long run, most changes in transitory income and consumption average to zero. • Therefore, studies that use long run (10 year averages) data pick up permanent income and consumption. • The MPC is high because people have incorporated the higher income into their expectations and have increased consumption.

29. The Life Cycle Hypothesis • People simultaneously choose how much to consume now and how much to consume in the future. • To make those decisions, they consider how much income they earn now and expect to earn in the future as well as how much savings they have accumulated.

30. The Life Cycle Hypothesis • Modigliani argued that people base their consumption decisions on the present value of their lifetime income. • He suggested that consumption, income and saving vary over a person’s lifetime.

31. Life Cycle Hypothesis • During working years people’s income exceeds consumption and people save and accumulate assets. • At retirement, people begin to dissave, drawing down their accumulated assets. • At death all assets have been depleted.

32. Yd Saving C Consumption Dissaving This picture depicts disposable income, consumption and saving during a typical person’s lifetime 0 Working Years Retirement W This picture shows the accumulation of saving during working years and decumulation during retirement. Accumulation Decumulation 0 Working Years Retirement

33. Life Cycle Hypothesis • No initial assets • Total lifetime consumption of C0 per year for L years just equals totally income Y0 per year for R years. • C0L = Y0R or C0 = (R/L)Y0

34. Life Cycle Hypothesis • The simple version of the LCH explains the positive association of saving and income. • A rising GDP per capita, increases both the saving and income of those of working age relative to those who are retired.

35. Life Cycle Hypothesis • The simple version of the LCH also explains the long-run constancy of S/Y • S/Y is constant if the population in each historical era is divided into the same proportions of working and retired people, and if each age group has the same saving behavior.

36. Life Cycle Hypothesis • The role of assets • If a person has an initial endowment of assets, A, and plans to spend those assets over his or her lifetime rather than leave an inheritance, consumption can be higher and saving lower in any period since the asset endowment provides more spending power. • The consumption function becomes: • C1L = A + Y0R or C1 = A1/L + R/LY0

37. Life Cycle Hypothesis • Modigliani was the first to point out the importance of assets for consumption decisions. • Empirical work indicates that the marginal propensity to consume out of accumulated assets is roughly 0.03 to 0.06 cents out of every $1 increase in wealth.

38. Consumption and the Business Cycle • There are two reasons why consumption spending is less volatile than GDP. • The PIH and LCH suggest that consumption spending does not fully reflect changes in disposable income. • When income rises (falls), consumption spending rises (falls) by less.

39. Consumption and the Business Cycle • Disposable income is less volatile than GDP because of the automatic stabilization properties of fiscal policy. • Progressive taxation and transfers dampen the fall in disposable income during recessions.

40. PIH, LCH and Policy • The PIH and LCH have two policy lessons: • Permanent policies will have more impact on the economy than temporary policies. • Monetary policy, through its effect on the value of people’s wealth, can affect consumption.

41. Summary • The short run and long run consumption functions differ. • The short run consumption function has a positive intercept and a lower MPC than the long run function. • The long run consumption function has no positive intercept.

42. Summary • According to the PIH and LCH, the short run consumption function has a lower MPC and a positive intercept because short term movements in income are dominated by transitory changes.

43. Summary • The PIH and LCH assume that people try to smooth their consumption over their lifetime by saving transitory increases in income and dissaving to maintain consumption during transitory decreases in income.

44. Does the LCH Fit the Facts? • The LCH suggests the following: • Elderly people dissave. • People smooth their consumption over time.

45. Dissaving among the Elderly • The retired elderly do dissave on average, but they do not dissave as much as the life cycle model predicts. Why? • A person’s lifespan is uncertain and the elderly may be hesitant to dissave too quickly and run out of money. • The elderly want to leave an inheritance to their heirs. • Some research supports this idea; other research indicates that most inheritances result from sudden death.

46. Consumption Smoothing • People do not tend to smooth their consumption as much as predicted. • According to the LCH, the MPC from transitory income is about 5 to 10 percent as large as the MPC from permanent income. • The data show that the MPC from transitory income is about 30 percent as large as the MPC from permanent income.

47. Consumption Smoothing • The early work on these hypotheses suggested that people base their estimates of future income on past income using simple rules of thumb such as the average income over the past several years. • Robert Hall suggested that people form expectations about future income using rational expectations.

48. Rational Expectations and Consumption • Rational expectations means that people use all available information, avoid systematic mistakes, and know the economic model that is generating their lifetime income. • Anticipated changes in income, then, would not change consumption. Only unexpected changes in income would affect consumption decisions as people update their expectations of their permanent income.

49. Rational Expectations and Consumption • Hall’s theory means that because people are rational, only random changes in income are not anticipated. • Therefore, changes in consumption are also unexpected and random. • Hall’s theory does not fit the data. • Changes in aggregate consumption are not random. • When income rises even if it is expected, consumption also rises.

50. Rational Expectations and Consumption • Hall concluded that either people did not form expectations about future income rationally or they are unable to borrow against future income to finance their present consumption. • Of the two possibilities, economists favor the liquidity constraint hypothesis. • Even if people could perfectly anticipate their lifetime earnings, it is unlikely that they could borrow enough from future income to completely smooth consumption over their lifetimes.