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## Slides for Part III- C

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**Slides for Part III- C**Theories of consumption • Outline • The naïve model • Consumption function controversies • The “permanent” income hypothesis • The life-cycle hypothesis • The functional income hypothesis • Poterba on the “wealth effect” • Brown on consumer credit**The naïve consumption function**Remember our consumption function was specified as follows: Where C is autonomous consumption and c is the marginal propensity to consume**The range of possible values of the marginal propensity to**consume is based on the the fundamental psychological law of consumption, which can be stated as follows: People are disposed, as a rule and on average, to increase their consumption when their income increases; but not by as much as the increase in income.**Definitions**• Ave. propensity to consume(APC): Ratio of consumption to real disposable income (YD). That is:APC = C/YD • Ave. propensity to save (APS): Ratio of saving to real disposable income. That is:APC = S/YD. • Marginal propensity to save (MPS): The change in saving resulting from a one unit change in disposable income. That is: MPS = S/ YD.**The MPC and the MPS**The consumption function is given by:C = 30 + .7YD**The graph**C C = YD C = 30 + .7YD 300 S 240 C/YD = 1 YD C 100 30 450 0 100 300 YD**Slope of the consumption function**C Slope = C/YD = 70/100 = .7 C = 30 + .7YD 310 C 240 YD 100 30 450 0 300 400 100 YD**Shifts of the consumption function(C)**The function could shift due to: C C2 C1 • A change in household wealth • A change in consumer confidence. • Change in price or availability of credit. C0 0 YD**Aggregate demand**0 Y1 Y2 Output, income**Consumption function controversies**• What can explain the long-run stability of the average propensity to consume? • How sensitive is current consumption expenditure to changes in current income? • What can account for cross-sectional differences in the average propensity to consume? • How significant is the “wealth effect”? • Is consumer debt important in explaining shifts of the consumption function?**The naïve model predicts a falling APC—but the “long**run” data do not bear this out. C C = YD C = 30 + .7YD C/YD = 1 APC decreases as DY increases 100 30 450 0 100 DY**The Long Run Average Propensity to Consume**Data for consumption and investment in chained 1996 dollars www.bea.gov**The permanent income hypothesis1**Professor Friedman claims thatcurrent C does not depend on current YD (at least not directly). Rather, C depends on what Friedman terms “permanent income.” C=f(YD) 1M. Friedman. A Theory of the Consumption Function, 1957**Key points**• Permanent income is the flow of monthly or annual income that expected or regarded as normal by the household based on its endowment of wealth (inclusive of human wealth). • Past income flows are one factor that condition the household’s assessment of permanent income. • Current income (YD) affects consumption indirectly--by its affect on the household estimate of permanent income.**Example of a “representative household”**Occupation: Attorney**Positive transitory income (YT) in July ($2,000)—hence,**APC falls. • Negative transitory income (YT) in August ($2,000)--hence APC rises APC rises from .7 to 1.17 from July to August Actual income 10,000 YP Income, Consumption 8,000 7,000 C 6,000 Note that: 0 July August Month**Moral of the story**• C is not as sensitive to changes in current income as the Keynesians would have you believe. • This factor diminishes the size of the MPC and hence the multiplier effect. • The diminished power of the multiplier effect in turn calls into to question to effectiveness of counter-cyclical fiscal policy**The life-cycle hypothesis1**Cross-sectional studies of consumer behavior show widevariation in the APC (or APS) among households with the same income. The life-cycle hypothesis can explain this—but is it the right explanation? 1A. Ando and F. Modigliani,” The Life-Cycle Hypothesis of Saving,” American Economic Review, March 1963.**DY, C**APC falls during peak earning years, and rises during retirement C • 0-18 APS <1 • 18-67 APS > 1 • 67- APS < 1 DY 18 67 Age Theory implies C is less sensitive to changes in current YD than “naïve” Keynesian model suggests; hence , the multiplier is smaller too.**The functional income hypothesis**• Key points: • Total consumption expenditure is partly determined by the prevailing distribution of income among various groups. • Higher income households tend to have a higher propensity to save than lower income households. Hence if income is redistributed upward, this will raise the APS and lower the APC. • Policies that have the effect of making income distribution more even tend to raise the propensity to consume (and lower the propensity to save).**Example**A transfer of income from the Andersons to the Rogers could boost the APC.**Sherman & Kolk presentation**• Let W denote labor income from wages, salary, fringe benefits, commissions, etc. • Let denote “property income”—income from dividends, interest, rent, and (net) income of non-corporate business enterprises. • Let Y denote national income. Thus: (1) Also: (2)**Equation (2) gives the functional shares in national income**• Let 1 denote the average propensity to consume out of labor income. • Let 2 denote the average propensity to consume out of property income. Thus the consumption function can be written as follows: (3)**Example: Let Y = $1 trillion**W, , and C are measured in billions**Change in factor shares in favor of W (at the expense of**) raises the aggregate APC C (billions 940 910 0 1,000 Y (billions)**The wealth effect**Issues • How sensitive is consumer spending to changes in household wealth? • Does the responsiveness of spending to changes in wealth vary across asset categories—e.g., equities, bonds, home equity, farm land, pension funds? • Could a substantial “correction” in the U.S. equity market have a powerful negative wealth effect on consumption?**Change in current consumption per dollar of increase in**wealth, assuming consumer are life-cycle planners and do not leave an inheritance. Source: Poterba (2000), p. 104. C that satisfies**Stylized facts about the wealth effect**• The marginal propensity to consume of wealth is not a stable variable—it changes from year-to-year or decade to decade. • Households as a group are more sensitive to changes in the value of non-financial wealth than financial wealth—a counterintuitive result. • The effect of changes in the value of financial wealth is diminished by the fact that ownership stocks and bonds is tightly concentrated among households. • An much larger proportion of equity wealth is held indirectly(through mutual funds, pensions, insurance policies) today as compared with 1972.**Billions of 1999 dollars**Source: Poterba (2000)**Percent of Assets Owned by U.S. Households, 1998**Source: Poterba (2000), based on 1998 Survey of Consumer Finances**Poterba’s estimate of the “stock market wealth effect”**on consumer spending in 2000 (billions of dollars) Source: Poterba (2000)**The role of consumer debt**• Does the build-up, on an unprecedented scale, of mortgage, revolving, and non-revolving debt on household balance sheets constitute at threat to the continued robust growth of payrolls and personal income in the United States?**Macroeconomic effects of widened credit availability**Liberalization of credit standards, by augmenting the spending power of middle and lower income households, reacts on the propensity to consume is the same way as a downward redistribution of income would. AD = Y AD2 AD1 Planned expenditure (AD) 0 Y1 Y2 Real GDP (Y)**Effects of household debt deflation**• Debt deflation is an episode wherein households on average allocate a sharply increased proportion of current income to debt servicing. • Debt deflation tends to occur at the terminal point of a lengthy business cycle expansion.**Consequences of household “debt deflation”**Explained in the income –expenditure framework, debt deflation is manifest in a decrease in autonomous consumption--C AD = Y AD2 AD1 Planned expenditure (AD) 450 0 Y1 Y2 Real GDP (Y)**Supposition**• A given rate of increase of household indebtedness is likely to be sustainable so long proportion of after-tax income claimed by the minimum debt servicing remains constant as the economy moves forward along the time axis. • It follows that the rate of increase of indebtedness is not sustainable if the proportion of income claimed by debt service is rising.**SymbolsSERVICEt Debt service in quarter t ;**• DPIt (Nominal) personal disposable income in quarter t ; • t SERVICEt DPIt ; • Revolvet Revolving consumer debt outstanding in quarter t ; • NrevolvetNon-revolving consumer debt outstanding in quarter t ; • CDEBTt The sum of Revolvetand Nrevolvet; • MDEBTt Mortgage debt outstanding in quarter t ; • Interestt Minimum interest owed in quarter t ; • Principlet Minimum principal owed in period t ;MaturityC Average maturity of outstanding consumer debt obligations (measured in quarters); • MaturityM Average maturity of outstanding mortgage debt • Obligations (measured in quarters) ; • RC1 Average interest rate paid on revolving consumer debt ; RC2 Average interest rate paid on non-revolving consumer debt ,and; • RM Average interest rate paid on mortgage debt.**Methodology**• The growth of consumer and mortgage debt is forecasted using a (linear) trend projection obtained from quarterly observations for each variable for a six year period (1993.1 to 1999.1). • Having forecasted the value of outstanding debt in future quarters, the next step is to estimate quarterly debt service--that is, the minimum principal and interest payable in each quarter.**Thus we have:**SERVICEt = Interestt+ Principlet [1] The following equation was used to estimate quarterly interest payments: Interestt =RevolvetRc1+ NrevolvetRc2 + MDEBTtRM/4 [2] The estimate of minimum principal owed was obtained from the following equation: Principlet = CDEBTt÷ MaturityC + MDEBTt ÷ MaturityM [3] Equations [2] and [3] were substituted into [1] to estimate quarterly debt service.