Consumption

Nguyễn Việt Hưng

Basic contents

• Consumption
– Keynesian Consumption Function

– The life-cycle theory of consumption

– The permanent income hypothesis

2
Consumption

Consumption
• Keynesian
45o
consumption function
C = a + bYd
C = a + bYd,

in which a > 0,

0<b<1

Disposable income, Yd

3
Consumption

• The average propensity to consume, (APC)

C a
APC = = +b
Yd Yd
−a
APS = + (1 − b )
Yd

4
Consumption

• The empirical evidence supports for this function

– The positive value of intercept

– The marginal propensity to consume lies in the range (0, 1)

– APC exceeded MPC

– A time series analysis shows that APC declines as income rises

– A cross-section analysis shows that APC of low-income

households tend to be higher than APC of high-income
households

5
Consumption

• The decline in APC or the rise in APS when income rises

led some economists to worry about stagnation in the
economy
– The consumption ratio declines and if other components of
aggregate demand do not grow to compensate, AD would fall
short of full-employment output

– The empirical evidence shows that APC does not decline but be
relatively constant over decades

6
Consumption

APC in the period 1869-1928 (5

decades) ranged between 0.83 and
0.90 though income rose over seven
times. So, it did not vary significantly.
This raised the question about the
appropriateness of Keynesian
function!

7
Consumption

• Kuznets data Consumption

suggest that the 45o

long-run C = 0.9Yd
relationship
between
consumption and
income is a
proportional one.
– MPC = APC

Disposable income, Yd

8
Consumption

• Gardner Ackley examined 22 quarter-to-quarter changes

in C and Y
– In 5 quarters, changes in C and Y were in opposite direction

– In 10 quarters, changes in C and Y are in the same direction, but

change in consumption exceeded the change in income

– In only 7 quarters, the movements in C and Y are consistent with

a short-run MPC lying in the range (0, 1)

9
Consumption

• Arthur Smithies reconciled with Keynes’ theory

by using a time trend, which caused the function
to shift overtime

• Smithies estimates yielded the equation

C = 76.58 + 1.15 ( t − 1922 )  + 0.76Yt

*
t
*

10
Consumption

Reasons for shifts:

• Migration from farms to
cities (buy goods more)
• Greater equality (poorer
save less)
• Rise in the perceived
“standard of livings”
(luxuries become
necessities)
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Consumption

• Life-cycle hypothesis (LCH)

– Developed by Franco Modigliani, Albert Ando, and Richard
Brumberg (1954, 1963)

– “…consumption and saving decisions of households at each

point of time reflect a more or less conscious attempt at
achieving the preferred distribution of consumption over the life
cycle, subject to the constraint imposed by the resources
accruing to the household over its lifetime.”

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Consumption

• Consumption depends not just on current

income but also, and more importantly, on long-
term expected earnings.
1
C = Yt + ( N − 1) Y + At 
e

T
or C = b1Yt + b2Y + b3 At
e

T: life expectancy of T years Yt: labor income in the current time period
N: number of working-years Ye: average labor income expected over the
At: value of presently held assets future (N-1) years 13
Consumption

• If T = 50 and N = 40, then what would happen to

current consumption if
– There is a one-time or transient change in current
income of $100?

– There is a permanent increase in income of $100?

14
Consumption

• Young workers have low income and low

savings rates (possibly dissaving)

• Middle-age workers have higher income, so the

saving rate increases

• Retirement brings a fall in come and might be

expected to begin a period of dissaving

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Consumption

Income and Consumption over the Life Cycle

16
Consumption

• Ando and Modigliani assume that expected

average future labor income is just a multiple of
current labor income:

Y e =  Yt
So, the new consumption function becomes

C = ( b1 + b2  ) Yt + b3 At

17
Consumption

• A representative statistical estimate of the equation is the

following:

Ct = 0.72Yt + 0.06 At
According to LCH, the relationship between consumption and current
income would be non-proportional.
The intercept measures the effect of wealth(0.06), but the intercept is not
constant overtime. As wealth grows, the short-run consumption functions
shift upward.
The shifting short-run consumption functions traces out a long-run
consumption function 18
Consumption

C
LCF
SCF2
SCF1

SCF0

Yd 19
Consumption

• In US,
– the ratio of labor income to disposable income has been
approximately 0,88

– the ratio of wealth to disposable income is approximately 4,75

• Substitution of these expressions in the estimated

consumption function

Ct = 0.72 ( 0.88Yd ) + 0.06 ( 4.75Yd ) = 0.92Yd

0.92 is approximately the average value of the APC over
the post-WW II period! 20
Consumption

• LCH also explains the evidence from cross-

sectional studies
– A larger proportion of high-income families might be
expected to be those in their peak-earning years, so
saving rate is higher

– Low-income families would have a high proportion of

new entrants and retirees, groups that tend to
dissave, so saving rate is lower
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Consumption

• LCH also can explain why quarter-to-quarter

movements in consumption do not closely mirror
quarter-to-quarter movements in income
– This is a transient income change rather than change
in lifetime average income, which have little impact on
consumer behavior according to the LCH.

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Consumption

• Critics of LCH
– Assumptions are unrealistic
• Family’s future size and composition, life expectancy

• Entire lifetime profile of the income from work of each

member

• Present and future extent and terms of any credit available to

it (liquidity constraints)

• Future emergencies, opportunities, and social pressures

• The importance of bequest

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Consumption

• Policy implications of the LCH

– A change in the current income itself has little
influence on consumer behavior.

– But if expected lifetime income is proportional to

current income, then there would be s strong
response of consumption to current income

– Temporary tax changes may have strong effects if

liquidity constraints are important
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Consumption

• Policy implications of the LCH

– Monetary policy affects household wealth and
consumption
• Change the quantity of money, a component of
household net wealth

• Affecting interest rate, and consequently the

market value of other assets

25
Consumption

• The Permanent Income Hypothesis

– Suggested by Milton Friedman (1957)

– The hypothesis has in common with the LCH the

property that long-term income is assumed to be the
primary determinant of consumption.

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Consumption

• Consumption (permanent rather than transitory

consumption) is proportional to permanent income

Y = Y +Y p t
C = Y p

Permanent income (Yp) is expected average long-term income

from both “human and nonhuman” wealth, that is both expected
labor income and expected earnings from asset holdings!
Transitory income (Yt) may be either positive or negative.

27
Consumption

• Friedman assumed that permanent income is revised

from period to period in the following manner:

Yt = Y + j (Yt − Y
p p
t −1
p
t −1 ), 0  j 1
So, the consumption function becomes

Ct =  Yt −1 + j (Yt − Yt −1 ) 
 p p

Ct =  (1 − j ) Yt −1 +  jYt
p

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Consumption

• This relationship is non-proportional in the short-

run
– {(1 – j)Ypt-1} implies the intercept in the function

29
Consumption

p
Ct Y
APC = =  (1 − j ) + j t −1

Yt Yt
When actual income is low relative to permanent income, then
APC will be relatively high, and vice versa!
• High-income families are more likely to have positive
transitory income flows, so actual income is high relative to
permanent income, so APC would be lower!

30
Consumption

• Over the long-run, permanent and actual income will on

average be equal,, so APC simplifies to
p
Ct Y
APC = =  (1 − j ) + jt −1

Yt Yt
APC =  (1 − j ) +  j = 
So, the long-run consumption function is a
proportional relationship!
31
Consumption

• Quarter-to-quarter income changes will contain

many transitory income changes, to which
consumption does not respond.

• There is a transitory component to consumption

that is not related to income.

32
Consumption

Ct
MPC = = j
Yt

If the estimate of permanent income is less responsive to a

change in current income, i.e. j is small, then MPC is small
(despite  being high), and the tax policy may be ineffective.

33
Consumption

• Rational expectation
– Friedman assumed the form of backward-looking
manner to estimate permanent income

– Other new classical economists suggest the forward-

looking, or rational expectation, i.e. using all available
relevant information intelligently to estimate
permanent income

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Consumption

• Rational expectation
– Then, changes in consumption will come only as the
result of unanticipated changes in income, that
cause changes in estimated permanent income.

– Later studies were not favorable to this hypothesis

• The excessive sensitivity of consumption to changes in
actual income may be due to liquidity constraints

• The consumption responds less to unanticipated changes in

income than the rational expectation points out.
35