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ECN3106 Macroeconomics II. TOPIC 1 CONSUMPTION (part 2). Consumer Preferences. 2. A lifetime utility function : tells us how much happiness or satisfaction a household will achieve from their lifetime pattern of consumption. This is given by:.
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ECN3106Macroeconomics II TOPIC 1 CONSUMPTION (part 2)
Consumer Preferences 2 • A lifetime utility function : tells us how much happiness or satisfaction a household will achieve from their lifetime pattern of consumption. • This is given by:
Law of diminishing MU of C 4 • The shape of the utility function is concave - as C rises, TU rises at a diminishing rate. This is due to the law of diminishing MU of C. MU=∆U/∆C • the MU from an extra unit of C is much lower at high levels of C than at low levels.
Global Applications 2.3 5 How’s Life? Is Consumption the Source of Welfare? Health Status, Employment Status, Family Status, Education, Age, Religious Activity, Voluntary Organisations, Trust, Governance Measures, Individual and National Incomes
MU of consumption 6 explains how TU changes when C changes by one unit. It is given by the ratio of the change in total utility and the change in consumption:
Fig 2.8 Total Utility function : two period model As C of either or both period Rises TU will rise at decreasing rate TU generated by different range of different C plans 7
Fig 2.9 Indifference Curves There are different set if Ics for every level of TU Moving to higher IC is assoc with moving to higher level of TU 8
Because of law of diminishing MU, IC are convexThus h/hold Consumption Choices: prefer average patterns than extremes Fig 2.10 Convexity of the indifference curve 9
Household Maximisation The objective of h/hold- • to find the pattern of C which delivers the highest level of utility and feasible given lifetime resources, or • To find the pattern of C that enables the highest IC to be reached staying within the budget set
Fig 2.11Household Maximisation Optimal C is at C*1, C*2 I2 tangent to BC Other C plan: Feasible but lower utility High utility but noy feasible Given IBC 11
Consumption Smoothing 12 • What are the predictions of the utility maximising h/hold model for agg C? 1. the link between current income and C strongly advocated by the Keynesian C function is broken. • Maximising h/hold would base C on longer term view of lifetime income resources • Consumer not constrained by current income but by the present discounted value of lifetime income
we expect to see evidence of consumption smoothing. • This is a consequence of the law of diminishing MU of C which pushes the h/hold to prefer averages over extremes. The h/hold would find it optimal to use borrowing and saving to achieve this end
Fig 2.12 : Net saver h/hold have very high income period 1, very low income period 2 C on current Y:TU on I1 h/hold can achieve higher TU within BC at C*1,C*2 Net saver- S=Y1-C*1 achieve higher C future Eg invest for retirement 14
Fig 2.13: Net borrower h/hold have very low income period 1, very high income period 2 Smoothing C : h/hold move to higher TU within BC at C*1,C*2 Require h/hold to borrow-C*1-Y1 Eg. Young professionals borrow to maintain current C 15
The Life Cycle Hypothesis 17 • Franco Modigliani applies the C smoothing result to the pattern of lifetime consumption and income. • In terms of income, a lifetime can be split into three distinct periods. • First- young age when little or no income is earned. • A relatively long period of working life when income tends to rise with experience and seniority. • Before death there is a retirement period when income once again drops to nothing or near zero.
FIG 2.14 The Life Cycle Hypothesis 18
The Life Cycle Hypothesis • If C follows lifetime income swings, C would be sub optimal • h/holds could smoot out C by borrowing and saving to increase welfare. It justifies borrowing while young and investing in pension plans during working life as a provision for retirement • LCH predicts C smoothing will occur over the life cycle.
The Permanent Income Hypothesis 21 Milton Friedman’s important contribution argues that measured income consists of two parts, permanent income and transitory income:
The Permanent Income Hypothesis The main predication of the PIH is that the h/hold uses borrowing and saving to smooth out transitory income fluctuations, so C decisions will only be based on permanent income:
Predictions of the PIH The theory predicts that the mpc out of permanent income will be much higher thanthe mpc out of measured income, with empirical estimates suggesting that The SR C function (based on measured income) is much flatter than the LR C function (based on permanent income).
2.6 EXPLAINING CONSUMPTION PATTERNS
Explaining Consumption Patterns • Changes in Current Income • Other Factors Determining Consumption • Changes in Future Income • Interest rates: Substitution & Income effects • Financial Market Constraints • Financial Markets Deregulation • Wealth • Uncertainty and Precautionary Saving
1. Saving ratio An often used, statistic for analysing consumer behaviour is the saving ratio. It is the proportion of income that is saved. Or S/Y If income is either consumed or saved, then it must be true that:
1. Saving ratio • Thus, the saving ratio is: • An analysis of the saving ratio enables us to observe changes in C other than those generated by changes in current income. • Eg- If C rises with no changes in Y, then saving ratio will fall
2. Changes in Future Income, Yf • It will have exactly the same effects on the IBC as changes in current income. • Increase in Yf will cause IBC shift outward and raise current C (fig 2.6) • A good indicator is the unemployment rate- • Movement in saving ratio seem to pre-empt movements in U suggest C falls in response to expectation of higher future U
3. Interest rates The effect of interest rate changes are easily predicted using our two period consumption model. Interest rates represent the costs of borrowing and the returns to saving, and can be thought of as the price of moving income or resources over time.
3. Change in Interest rates • Higher interest rate: • Cause borrowing more expensive and reduce present discounted value to future income. Max amt to consume in period 1 will fall • But will generate higher returns from saving thus period 2 C will rise. • This opposite effect cause the IBC to pivot
3. Change in Interest rates CHANGE IN INTERES RATE WILL CAUSE BUDGET CONSTRAINT TO PIVOT
Change on interest rate: Impact on consumption • Substitution effect: The i/r represents the price of current consumption in terms of future consumption. • As int rate rise future C is cheaper than current C since the cost of borrowing and returns to saving are both greater. • h/holds substitute current for future C
Change on interest rate: Impact on consumption • Income effect: the direction depends on whether the consumer is initially a net borrower or a net saver. net borrower : worse off as cost of servicing the existing amt of borrowing rise. This cause negative income effect net savers: better off as return to savings will increase. This cause a positive income effect. • overall effect of int rates on C will therefore depend on whether the household is initially a net borrower or a net saver.
Effect of change in interest rate increase: Net Saver IE and SE works in Opposite direction SE-reduce C IE-increase C IE>SE, C increase
Effect of interest rate increase : Net borrower IE and SE works in The same direction Current C falls Net borrower will always Be made worse off
Empirical Evidence • int rate changes have small substitution effects on the timing of C, and therefore the income effect is usually dominant. Thus, a rise in int rates would increase the current C of net savers but reduce that of net borrowers. • saving ratio and the int rate share a positive association. This indicates that most h/holds are net borrowers, so current C will respond inversely to int rate changes.
4. Financial Market Constraints • The presence of borrowing constraints has two interesting implications for the determination of C. • even though h/holds may be rational optimisers, the pattern of C will follow the predictions of the Keynesian model in being fairly tied to current income. Credit constrained households may wish to borrow against future income to increase current C but cannot. They will only be able to consume more when their current income increases. • changes in the laws and regulations governing credit creation may lead to sudden large jumps in C
5. Wealth If a h/hold, in addition to their income, also has some initial wealth, this can be added to the intertemporal constraint:
