Consumption

Micro foundations of consumption

 Keynesian psychological law of consumption

 Kuznet’s Puzzle

 Fisher’s Inter-Temporal Choice Model

 Life Cycle Hypothesis

 Permanent Income Hypothesis

 Consumption

Classical View – Consumption

 Consumption is the sole end and purpose of all production —Adam Smith

 Smith did not develop a comprehensive economic theory of consumption

 Classical economist concern about the consumption but with respect to production and
growth

 Malthus notion give the impetus to consumption and production as interdependent

 Consumption

Consumption Function : John Maynard Keynes’s General Theory

3 – conjectures

1. MPC
2. APC and MPC (APS & MPS)
3. MPC and Income and Interest rate
 Consumption

1. MPC

Keynes conjectured that the marginal propensity to consume—the amount consumed out of an
additional dollar of income—is between zero and one

“Fundamental psychological law, upon which we are entitled to depend with great
confidence, . . . is that men are disposed, as a rule and on the average, to increase their
consumption as their income increases, but not by as much as the increase in their income.”
 Consumption

Marginal propensity to consume was crucial to Keynes’s policy recommendations

How to reduce widespread unemployment?

 Consumption

Application of MPC

Why does fiscal policy have a multiplied effect on income?

The reason is that, according to the consumption function C = C(Y - T), higher income causes higher consumption. When an
increase in government purchases raises income, it also raises consumption, which further raises income, which further raises
consumption, and so on

DY/DG = 1/(1 - MPC)

For example, if the marginal propensity to consume is 0.6, the multiplier is

DY/DG = 1/(1 - 0.6)
= 2.5.

In this case, a $1.00 increase in government purchases raises equilibrium income by $2.50.
 Consumption

Now consider how changes in taxes affect equilibrium income. A decrease in taxes of DT
immediately raises disposable income Y - T by DT and
therefore, increases consumption by MPC * DT

DY/DT = -MPC/(1 - MPC)

This expression is the tax multiplier, the amount income changes in response to a $1 change in
taxes. (The negative sign indicates that income moves in the opposite direction from taxes.)
For example, if the marginal propensity to consume is 0.6, then the tax multiplier is
DY/DT = -0.6/(1 - 0.6)
= (-1.5)
In this example, a $1.00 cut in taxes raises equilibrium income by $1.50
Consumption

1. MPC
 Consumption

2. APC: Ratio of consumption to income

Average propensity to consume falls as income rises became a central part of early Keynesian
economics

When C = Y …….. APC =1

When C > Y ….. APC >1
When C < Y ……. APC < 1
 Consumption

3. Income is the primary determinant of consumption and that the interest rate does not have an
important role

Current Consumption – Depends on Current Income

Consumption
 Consumption

The average propensity to save (APS) or the savings rate is the ratio of savings to disposable
income

The APS is also known as the savings rate

Individuals in the aggregate save increasing proportions of their incomes.

Consumption
 Consumption
Relation between Consumption and Disposable Income

The APC in this time period was 0.83.

The APC declined from an average of 0.90

during 1980–1981 to 1992–1993 to an average
of 0.77 during 1992–1993 to 2005–2006.
 Consumption

Early Success for Keynesian Consumption Function

 Keynesian consumption function was a good approximation of how consumers behave

 Researchers found that higher-income households saved a larger fraction of their income

 Consumption and income for the period between the two world wars-These data also
supported the Keynesian consumption function.

 during the Great Depression, both consumption and saving were low, indicating that the marginal propensity to consume is between zero and one
 In addition, during those years of low income, the ratio of consumption to income was high, confirming Keynes’s second conjecture.
 Finally, because the correlation between income and consumption was so strong, no other variable appeared to be important for explaining
consumption
 Consumption

Consumption Puzzle

Keynesian consumption function met with early successes: two anomalies soon arose

1. SECULAR STAGNATION: during World War II - low consumption would lead to an inadequate demand for goods and
services, resulting in a depression -World War II did not throw the country into another depression
Although incomes were much higher after the war than before, these higher incomes did not lead to large increases in the rate of
saving
Keynes’s conjecture that the average propensity to consume would fall as income rose appeared not to hold

2. KUZNETS PUZZLE: Kuznets constructed new aggregate data on consumption and income - Kuznets assembled these data in
the 1940s - the ratio of consumption to income was remarkably stable from decade to decade
 Consumption

Secular-stagnation hypothesis and the findings of Kuznets both indicated that the average
propensity to consume is fairly constant over long periods of time

Economists wanted to know why some studies confirmed Keynes’s conjectures and others
refuted them

The evidence suggested that there were two consumption functions

 Short time-series, the Keynesian consumption function appeared to work well (Fall in APC)
 Long time-series, the consumption function: A constant average propensity to consume
Consumption

The short-run:
consumption function has a falling APC

The long-run:
consumption function has a constant APC
 Consumption

Consumption Puzzle
 Consumption

Using Keynesian consumption function, find the value for

MPC and Autonomous consumption
 Consumption

What is the slope of this line? (MPC)

slope of a line and a “c" for its vertical intercept: y = C + cY We are given the coordinates of two points on this line, and so

The Change in C =26-14, or 12

The Change in Y = 40-20, or 20.
The MPC is, then 12/20, or 0.6.

To find the vertical intercept (autonomous Consumption), we simply write the equation of the line, substituting the
coordinates of either point for the x and y and substituting 0.6 for the slope, m.
 
C = C + cY
14 = C + 0.6 (20)
14 = 12 + C
C= 2

C = C + cY
26 = C + 0.6 (40)
26 = 24 + C
C= 2
Consumption
 Consumption

What is the Marginal Propensity to Consume?

C (consumption spending) is a linear function of Y (income).
Note the specific form of the function (C = a + bY) with Y being measured along the horizontal axis and C being measured
along the vertical axis. The other symbols take their meaning from the role they play in the equation. The stand-alone term "a" is
the vertical intercept: the coefficient "b" is the slope.

MPC = 12/20, or 0.6.

6B. How much would people spend on consumption goods (C) even if their incomes (Y) fell temporarily to zero?
To find the vertical intercept, we simply write the equation, substituting the coordinates of either point for Y and C and
substituting 0.6 for the slope, b.

C = a + bY
21 = a + 0.6(20)
21 = a + 12
This is the level of consumer spending we would expect to see
a = 21 - 12
even if income has (temporarily) fallen to zero.
a=9
Equivalently: C = a + bY
33 = a + 0.6(40)
33 = a + 24
a = 33 - 24
Consumption
 Consumption

A. Find the MPC for this economy and write the equation that describes consumption behavior.

The MPC is the Marginal Propensity to Consume, which is simply the slope of the consumption equation. To get the slope, we
need to find two points on the equation whose coordinates are known.
The intercept is one such point: Y = 0; C = 6.

The other point is the intersection of the consumption line with the 45-degree line: Y = 15; C = 15 (Remember that the 45-degree
line has a slope of 1.0, which means that, starting from the origin, the Y-distance and the C-distance to any point on that line are
are the same).
So, now we visualize a right triangle with one acute vertex touching the C-intercept and the other touching the intersection with
the 45-degree line. The vertical leg of the triangle, the RISE, is 15-6, or 9; The horizontal leg of the triangle, the RUN, is 15. The
SLOPE is the RISE over the RUN: 9/15 = 0.6.

Now we know both the vertical intercept (a = 6) and the slope (b = 0.6) and can write the equation describing consumption
behavior:

C = a + bY
C = 6 + 0.6Y
 Consumption

7B. How much do people spend on consumption goods (C) when total income (Y) is 35?
This question calls your bluff: Show me you can actually make use of this equation relating C to Y. You can simply substitute 35 for
Y and solve for C:

C = 6 + 0.6Y
C = 6 + 0.6(35)
C = 6 + 21
C = 27
7C. How much do they save?
There are two ways to calculate the level of saving. The easiest is simply to recognize that saving is what's left of your income
after you're through spending. That is, S = Y - C; S = 35 - 27 = 8

Alternatively, you could write the saving equation by observing the general form: S = -a + (1 - b)Y, and then evaluating for an
income of Y = 35:

S = -a + (1 - b)Y
S = -6 + 0.4Y
S = -6 + 0.4(35)
S = -6 + 14
S= 8
 Consumption

7D. How much would the investment community have to spend for the economy to be in equilibrium with Y = 35?
An income-expenditure equilibrium requires that income be equal to expenditures. For this wholly private economy, we can write
the equilibrium condition as Y = C + I. We know that for an income of 35, consumption spending is 27. So we can write: 35 = 27 +
I. Therefore I = 35 - 27 = 8.

Alternatively, we can recognize that for a wholly private economy, it is always true that Y = C + S. That is, your income has to be
equal to the part of it that you spend plus the part of it that you don't spend. We can now write the equilibrium condition as C + S
= C + I. Subtracting consumption spending from both sides gives us the alternative equilibrium condition for a wholly private
economy: S = I. This means that if S = 8, then that amount needs to be borrowed and spent by the investment community for the
economy to be in macroeconomic equilibrium.

(By the way, if we were dealing with a mixed economy, we would write as our accounting identity: Y = C + S + T. That is, your
income has to be equal to the part of it that you spend plus the part of it that you don't spend plus the part that you don't even
see--because the government took it as taxes before you were given your (after-tax) income. In this case, the alternative
equilibrium would be S + T = I + G.)
 Consumption

Economist gives explanations of these seemingly contradictory finding

1. Irving Fisher: Consumption Smoothing

2. Franco Modigliani : life-cycle hypothesis

3. Milton Friedman: Permanent-income hypothesis

 Consumption

when disposable incomes increase (decrease), this is accompanied by an increase (decrease) in consumption
1986–1987: increase in the percentage change in disposable incomes- the percentage change in consumption declined.
1993–1994 and 1995–1996, despite a drop in disposable income -Consumption actually increased

The variability of disposable income is greater than the variability of consumption

The coefficient of variation in consumption is 18.8 and in disposable income it is 27.4 for the period under consideration
 Consumption

Irving Fisher: Consumption Smoothing

Keynes: relates current consumption to current income

 People consider both the present and the future

 Consumption they enjoy today- the less they will be able to enjoy tomorrow: tradeoff

 Irving Fisher: analyze how rational, forward-looking consumers make intertemporal choices,

 Fisher’s model illuminates the constraints consumers face, the preferences they have, and
how these constraints and preferences together determine their choices about consumption
and saving
 Consumption

Consumption smoothing theory is not a behavioral theory but a preference maximization theory
where individuals are forward looking

Intertemporal analysis is about the trade-offs when the present choices affect the alternatives
available in the future
 Consumption

Intertemporal Constraints and Preferences

How do rational consumers distribute their consumption over time?

1. Intertemporal Budget Constrain

2. Preferences
3. Optimization
 Consumption

1. Intertemporal Constraints

Intertemporal approach focus on how do rational consumer distribute their consumption over
time

Assumes: there are only two time period current and future

C1 and Y1 denote Current consumption and Income

C2 and Y2 denote Future consumption and Income

r denotes rate of interest

Consumption
Consumption
 Consumption

Properties of the Intertemporal Budget Constraint

• It’s downward sloping. Its slope is −(1 + r1), because if you sacrifice one unit of consumption today and put it in the
bank for one period, you get 1+r1 units next period.

• The set of feasible consumption paths (C1,C2) are those inside or at the borders of the triangle formed by the
vertical axis, the horizontal axis, and the intertemporal budget constraint. Points D, E, and F are all feasible
consumption paths.

• What feasible point the household will choose depends on its preferences

If Consumer spend part of his income, and save some amount for future consumption,

When, C1 < Y1 and saving is Y1 – C1 then earning on that saving would be (1 + r) (Y1 – C1)

Next period Consumption, C2 = (1 + r) (Y1 – C1) + Y2

 Consumption

Dividing throughout by (1 + r) gives

= Y1 – C1 +

Rearranging this expression gives Intertemporal budget Constrain:

C1 +

If there are only two time period then present value of life-cycle consumption = present value of life income

If money is spend rather than to save then opportunity cost of interest will forgone

Given the intertemporal Budget Constrain, consumer needs to maximize consumption utility

Utility function, U = U (C1, C2)

Utility function is used to know the preferences over current and future prefaces, which can be represent by
Indifference Curve
 Consumption

Consumer Preference
C2
 Indifference Curve depicts preferences of an individual for consumption
today versus consumption tomorrows

 The consumer is indifferent between two consumption bundles that lie on

the given indifference curve
Increasing

 The indifference cure that are more to north east represent higher utility Satisfaction

 The slop of indifference curve measures the marginal rate of Substitution

between future and current consumption
B
 MRS presents the rate at which current consumption can be substituted for ∆C2
future consumption with no change in obtained utility I3
∆C1
I2
 The change in utility is expressed by Marginal Utility MUC
I1
 At point B: if we reduce present consumption by ∆C1 then reduction in utility
will be MUC1 (∆C1) C1

 To compensate the individual for future consumption, we raise future

consumption by ∆C2 then increase in future consumption will be MUC2 (∆C2)

https://www.youtube.com/watch?v=iOmDo5jLFw8
 Consumption

δ = Discount rate at which an individual values future consumption relative to current consumption , Assumed δ > 0

Gain in the utility from increased in future consumption : MU c2

For an individual on same indifference curve, value of the gain in utility from the increased future consumption must exactly
offset the loss in the utility from reduction in present consumption: MU C2 = MUc1 (

-= (1 + δ ) =MRTP

Marginal rate of time preference measures rate of time preference for present consumption versus future consumption

If | / | > 1 at point B – Positive time Preference – more unit of consumption in future ( son of business tycoon)

If | / | < 1 at point B –Negative time Preference –Less unit of consumption in future (farmer having bumper crop this year)

If | / | = 1 at point B – Neutral time Preference – Trade off between present and future consumption (ratio is 1:1)
Consumption

Optimization

At the optimum: slope of IC = slope of BL

MRS = 1 + r
 Consumption

How Changes in Income Affect Consumption

the consumer can borrow and lend between

periods, the timing of the income is irrelevant to how
much is consumed today (except that future income
is discounted by the interest rate).

The lesson of this analysis is that consumption

depends on the present value of current and future
income, which can be written as
Present Value of Income = Y1 + Y2/1 + r

Keynes posited that a person’s current consumption

depends largely on his current income. Fisher’s
model says, instead, that consumption is based on
the income the consumer expects over his entire
lifetime.
 Consumption

Changes in the Real Interest Rate Affect Consumption

There are two cases to consider:

1. The case in which the consumer is initially saving

2. The case in which he is initially borrowing

increase in the real interest rate rotates the consumer’s budget line around the point (Y1, Y2) alters
the amount of consumption he chooses in both periods

impact of an increase in the real interest rate on consumption into two effects:
1. Income effect
2. Substitution effect
Consumption

The income effect is the change in consumption

that results from the movement
to a higher indifference curve

Consumer is a saver rather than a borrower (as

indicated by the fact that first-period consumption
is less than first period income

Income effect tends to make the consumer want

more consumption in both periods

The substitution effect is the change in

consumption that results from the change in the
relative price of consumption in the two periods

substitution effect tends to make the consumer

choose more consumption in period two and less
consumption in period one

Hence, depending on the relative size of income

and substitution effects, an increase in the interest
rate could either stimulate or depress saving
 Consumption

Constraints on Borrowing

Fisher’s model assumes that the consumer can borrow as well as save

The ability to borrow allows current consumption to exceed current income: consumes some of
his future income today

How Fisher’s analysis changes if the consumer cannot borrow

The shaded area represents the combinations of first-period

consumption and second-period consumption that satisfy both
constraints
 Consumption

How this borrowing constraint affects the consumption decision

Consumption

the borrowing constraint is not binding

and consumption in both periods depends
on the present value of lifetime income
Y1 + [Y2/(1 + r)].

For other consumers, the borrowing

constraint
binds, and the consumption function is
C1 = Y1 and C2 = Y2.
Hence, for those consumers who
would like to borrow but cannot,
consumption depends only on current
income
 Consumption

Franco Modigliani: Life-Cycle Hypothesis

In a series of papers written in the 1950s, Franco Modigliani, Albert Ando and Richard Brumberg

Attempt to solve the consumption puzzle: Using Fisher’s Model

According to Fisher’s model, consumption depends on a person’s lifetime income

Modigliani emphasized that income varies systematically over people’s lives and that saving
allows consumers to move income from those times in life when income is high to those times
when it is low.

This interpretation of consumer behavior formed the basis for his life-cycle hypothesis
 Consumption

The Hypothesis

income varies over a person’s life is retirement

consumer who expects to live another T years

wealth of W,
expects to earn income Y per year
he retires R years from now

What level of consumption will the consumer choose if he wishes to maintain a smooth level of
consumption over the course of his life?
 Consumption

C = (W + RY)/T

Person’s consumption function as C = (1/T)W + (R/T)Y

if the consumer expects to live for 50 more years and work for 30 of them, then
T = 50 and R = 30, so his consumption function is
C = 0.02W + 0.6Y

consumption depends on both income and wealth. An extra $1 of income per year raises
consumption by $0.60 per year, and an extra $1 of wealth raises consumption by $0.02 per year

C = aW + bY, where the parameter a is the marginal propensity to consume out of wealth, and
the parameter b is the marginal propensity to consume out of income.
Consumption

Implications

the intercept of the consumption

function, which shows
what would happen to consumption if
income ever fell to zero, is not a fixed
Value

According to the life-cycle consumption

function, the average propensity to
consume is

C/Y = a(W/Y) + b.
 Consumption

In the long run, as wealth increases, the consumption function shifts upward, This upward shift
prevents the average propensity to consume from falling as income increases. In this way,
Modigliani resolved the consumption puzzle posed by Simon Kuznets’s data
Consumption

Adulthood with no wealth, he will

accumulate wealth during his working
years and then run down his wealth during
his retirement years
 Consumption

The Consumption and Saving of the Elderly

Elderly do not dis-save as much as the LCH predicts

1. Concerned about unpredictable expenses

2. Precautionary saving
3. Property for next generation
 Consumption

Milton Friedman: The Permanent-Income Hypothesis

In a book published in 1957, Milton Friedman explain consumer behavior

Friedman’s permanent income hypothesis complements life-cycle hypothesis

the permanent-income hypothesis emphasizes that people experience random and temporary
changes in their incomes from year to year
 Consumption

The Hypothesis

Friedman suggested current income Y as the sum of two components

(Y = YP + YT)

Permanent income is average income

Transitory income is the random deviation from that average

Friedman concluded that we should view the consumption function as approximately

C = aYP
where a is a constant that measures the fraction of permanent income consumed
The permanent-income hypothesis, as expressed by this equation, states that consumption is
proportional to permanent income
 Consumption

Implications
According to the permanent-income hypothesis, consumption depends on permanent income YP
Many studies of the consumption function try to relate consumption to current income Y

what Friedman’s hypothesis implies for the average propensity to consume. Divide both sides of
Consumption function by Y to obtain APC = C/Y = aYP /Y

When current income temporarily rises above permanent income, the average propensity to
consume temporarily falls; when current income temporarily falls below permanent income, the
average propensity to consume temporarily rises
 Consumption

3 Case Studies

1. The 1964 Tax Cut

 The permanent-income hypothesis can help us interpret how the economy responds to
changes in fiscal policy

Fiscal policy—the tax cut of 1964

It was announced as being a major and permanent reduction in tax rates
This policy change lead to stimulation to the economy
 Consumption

2. 1968 Tax Surcharge

 The tax surcharge of 1968 arose in a very different political climate

 the increase in government spending from the Vietnam War had excessively stimulated
aggregate demand
 To offset this effect, they recommended a tax increase
 But Policymakers were aware that the war was already unpopular, feared the political
repercussions of higher taxes
 He finally agreed to a temporary tax surcharge—in essence, a one-year increase in taxes

The tax surcharge did not seem to have the desired effect of reducing aggregate demand.
Unemployment continued to fall, and inflation continued to rise
 Consumption
3. The Tax Rebates of 2008

Severe financial crisis in 2008, the economy was heading into a recession
To counteract the recessionary forces, Congress passed the Economic Stimulus Act, which provided
$100 billion of one-time tax rebates to households

Single individuals received $300 to $600, couples received $600 to $1,200, and families with children
received an additional $300 per child

Most important, because sending out many millions of checks was a long process, consumers received
their tax rebates at different times

The timing of receipt was based on the last two digits of the individual’s Social Security number,
which is essentially random.

By comparing the spending behavior of consumers who received early payments to the behavior of
those who received later payments, researchers could use this random variation to estimate the effect
of a transitory tax cut
 Consumption
The Tax Rebates of 2008

Researchers who did the study: We find that on average households

spent about 12 to 30 percent of their stimulus payments, depending
on the specification, on nondurable consumption goods and services
(as defined in the consumer expenditure survey) during the three
month period in which the payments were received. This response is
statistically and economically significant.

We also find a significant effect on the purchase of durable goods and

related services, primarily the purchase of vehicles, bringing the
average response of total consumption expenditures to about 50 to
90 percent of the payments during the three-month period of receipt
 Consumption
The Tax Rebates of 2008

If households were smoothing their consumption over time, as the permanent-income

hypothesis assumes, they would have spent only a small fraction of the tax rebate in a three-
month period, but the data show a large impact of the rebate on spending
 Consumption

 The permanent-income hypothesis, however, predicts that consumption responds only to

changes in permanent income

 Therefore, transitory changes in taxes should have only a negligible effect on consumption
and aggregate demand
 Consumption

Robert Hall: the Random-Walk Hypothesis

The permanent-income hypothesis is based on Fisher’s model of intertemporal choice

The permanent-income hypothesis highlights the idea that consumption depends on people’s
expectations

The rational-expectations assumption states that people use all available information to make
optimal forecasts about the future
 Consumption

Random-Walk Hypothesis

 The economist Robert Hall was the first to derive the implications of rational expectations for
consumption

 He showed that if the permanent-income hypothesis is correct, and if consumers have

rational expectations, then changes in consumption over time should be unpredictable

 When changes in a variable are unpredictable, the variable is said to follow a random walk.

 According to Hall, the combination of the permanent-income hypothesis and rational

expectations implies that consumption follows a random walk
 Consumption

Implications

If consumers obey the permanent-income hypothesis and have rational expectations, then only
unexpected policy changes influence consumption. These policy changes take effect when they
change expectations
 Consumption
David Laibson: the Pull of Instant Gratification

Keynes called the consumption function: fundamental psychological law

consumption theory based on rational expectation: Irving Fisher to Robert Hall

Harvard professor David Laibson: behavioral economics, real human beings whose behavior can
be far from rational

Raises the possibility that consumers’ preferences may be time-inconsistent: they may alter their
decisions simply because time passes, gratification may induce him to change his mind
 Consumption

Six prominent economists, we have seen a progression of views on consumer behavior

Consumption = f(Current Income)

Consumption = f(Current Income, Wealth, Expected Future Income, Interest Rates)

 Consumption

Question

Gabe and Gita both obey the two-period Fisher model of consumption. Gabe earns $100 in the
first period and $100 in the second period. Gita earns nothing in the first period and $210 in the
second period. Both of them can borrow or lend at the interest rate r.

You observe both Gabe and Gita consuming $100 in the first period and $100 in the second
period. What is the interest rate r
Consumption

Questions
 Consumption

Questions

Suppose the interest rate increases. What will happen to Gabe’s consumption in the first
period?
Is Gabe better off or worse off than before the interest rate rise? (show it diagrammatically)
Consumption

Questions
 Consumption

Questions

What will happen to Gita’s consumption in the first period when the interest rate increases?

Is Gita better off or worse off than before the interest rate increase?
Consumption
 Consumption

Questions

The chapter uses the Fisher model to discuss a change in the interest rate for a consumer who
saves some of his first-period income. Suppose, instead, that the consumer is a borrower. How
does that alter the analysis? Discuss the income and substitution effects on consumption in both
periods
Consumption

Questions

The increase in the real interest rate causes the budget line to
rotate around the point (Y1, Y2)

The income effect is the change in consumption that results from

the movement to a different indifference curve

the consumer is a borrower, the increase in the interest rate

makes the consumer worse off—that is, he or she cannot achieve
as high an indifference curve -reduce both C1 and C2

The substitution effect is the change in consumption that results

from the change in the relative price of consumption in the two
periods

second-period consumption relatively less expensive

the consumer choose more consumption in the second period

and less consumption in the first period.
 Consumption

Questions

The chapter analyzes Fisher’s model for the case in which the consumer can save or borrow at an
interest rate of r and for the case in which the consumer can save at this rate but cannot borrow
at all.
Consider now the intermediate case in which the consumer can save at rate rs and borrow at rate
rb, where rs < rb

On a single graph, show the two budget constraints from parts (a) and (b). Shade the area that
represents the combination of first period and second-period consumption the consumer can
choose
Consumption

Questions
 Consumption

Questions

Now add to your graph the consumer’s indifference curves. Show three possible outcomes:
1. one in which the consumer saves
2. one in which he borrows
3. one in which he neither saves nor borrows
Consumption

Questions
 Consumption

Questions

Explain whether borrowing constraints increase or decrease the potency of fiscal policy to
influence aggregate demand in each of the following cases.
a. A temporary tax cut
b. An announced future tax cut
 Consumption

Questions

The potency of fiscal policy to influence aggregate demand depends on the effect on
consumption:
If consumption changes a lot, then fiscal policy will have a large multiplier.
If consumption changes only a little, then fiscal policy will have a small multiplier.
That is, the fiscal-policy multipliers are higher if the marginal propensity to consume is higher
 Consumption

Questions

Consider a two-period Fisher diagram. A temporary tax cut means an increase in first-period disposable income Y1
. Figure 16–8(A) shows the effect of this tax cut on a consumer who does not face a binding borrowing constraint, whereas Figure
16–8(B) shows the effect of this tax cut on a consumer who is constrained
Consumption

Questions

The consumer with the constraint would have liked to

get a loan to increase C1,but could not.

The temporary tax cut increases disposable income: as

shown in the figure, the consumer’s consumption rises
by the full amount that taxes fall.

The consumer who is constrained thus increases first-

period consumption C1 by more than the consumer
who is not constrained—that is, the marginal
propensity to consume is higher for a consumer who
faces a borrowing constraint.

Therefore, fiscal policy is more potent with binding

borrowing constraints than it is without them.
Consumption

Questions

Again, consider a two-period Fisher diagram. The

announcement of a future tax cut increases Y2
. Figure 16–9(A) shows the effect of this tax cut on a consumer
who does not face a binding borrowing constraint, whereas
Figure 16–9(B) shows the effect of this tax cut on a consumer
who is constrained.

The consumer who is not constrained immediately increases

consumption C1 . The consumer who is constrained cannot
increase C1, because disposable income has not changed.
Therefore, the announcement of a future tax cut has no effect
on consumption or aggregate demand if consumers face
binding borrowing constraints: fiscal policy is less potent.