The economics of consumption

1. The economics of consumption

2. Midterm Grading will probably be ready for sections next week. Midterm makeup: - Bring your Dean’s excuse to the exam. - We will schedule the exam for this week in the evening. Meet after class today to schedule it.

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

4. Growth in C and GDP

5. 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) But, fiscal policy is controversial inside and outside economics: Purchases: - Controversial because increases 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 Deficit hawkism: Today, many economists and others worry about impact of stimulus on government debt Here is where we need to study carefully the economics of consumption.

6. 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.

7. Short-run v. Long-run Consumption Function Mankiw, p. 499.

8. 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.

9. Consumption and Disposable Income

10. 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 (for simplicity)

11. 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.

12. Initial Solution C, Y, S Diagram of Life Cycle Model Showing Consumption Smoothing Income, Y Consumption, C Saving, S age | | 0 R D

13. Anticipated change in timing of income C, Y, S Income “splash” (Y’) with no W increase Income, 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. Consumption, C’=C Saving, S’ age | | R D 0

14. Unanticipated change in permanent income C, Y, S Y’ =unanticipated increase; W increases. • Unanticipated windfall of ΔY. • Leads to smoothing the windfall over remaining lifetime. • one time splash: MPC = ΔY/(D-z). For life expectancy of 40 years, would be MPC = .025. • Permanent income increase: MPC = ΔY(R-z)/(D-z) = .6 to .8 Y C’ C age | | R D 0

15. Taxes and Consumption 1. Theory of temporary tax cuts: • What is the impact if taxes are anticipated and paid back during lifetime? No impact! MPC from taxes = 0. • Barro (Ricardian) model extends this to future generations 2. Empirical estimates • Actual evidence definitely shows substantial MPC (0.3 to 0.7) • Evidence from random assignment of 2008 tax cut; MPC perhaps 0.5 in the first two quarters 3. Why discrepancy? • Liquidity constraints on low-income • “Behavioral economics”

16. Example of consumption smoothing: the 2008 tax rebate Estimated MPC= 0.46 (0.19)

18. Behavioral economics Basic idea: That people are not optimizers (make mistakes) Real-world examples for all of us: - procrastination - dealing with addictive substances Why is it “behavioral”? Because lead to inconsistent decisions that are regretted later - bad grades, hangovers, addictions, drug wars Examples from macroeconomics: - MPC too high; low savings for retirement; subprime mortgages; sticky housing prices; too high discount rate

19. 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.

20. Major result of LCM: consumption smoothing Y: Entrepreneur Y: professor C of both! D age R

21. Taxes and Consumption 1. Theory of temporary tax cuts: • What is the impact if taxes are anticipated and paid back during lifetime? No impact! MPC from taxes = 0. • Barro (Ricardian) model extends this to future generations 2. Empirical estimates • Actual evidence definitely shows substantial MPC (0.3 to 0.7) • Evidence from random assignment of 2008 tax cut; MPC perhaps 0.5 in the first two quarters 3. Why discrepancy? • Liquidity constraints on low-income • “Behavioral economics”

22. Further Extensions Liquidity constraints • Case of Yale students where income growing rapidly • Here consumption is limited by borrowing constraint. • Is this reason for MPC higher than life cycle prediction? (Partially, but cannot explain response of non-constrained consumers)

23. 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 Ypt + β2 Wt where Ypt is permanent or expected labor income and Wt is wealth.

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

25. 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 Ypt + β2 Wt standard estimates are that β2 = .03 - .06 (example in a minute) • Effect in the “Roaring 90s” and the housing crash today.

26. Regression Dependent Variable: Real consumption expenditures Method: Least Squares Sample: 1960.1 2010.2 VariableCoefficientStd. ErrorP Real Disposable income 0.78 0.009 .0000 Real wealth 0.029 0.0014 .0000 R-squared 0.9993

27. Wealth and Consumption through Two Bubbles

28. Loss of wealth and savings rate increase

29. Key ideas • Consumption derived from consumer maximization • Pure model leads to consumption smoothing • All kinds of fun predictions • But impediments to pure model • Remember the wealth effect • Big open issue: how big is the short-run MPC?