The economics of consumption. From: President Ella Eli To: Yale Students Re: Generous Gift My dear students, I am delighted to report that a generous alumna has made a gift of $1000 per Yale student, available immediately. You can come by the office and pick up your check any time.
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To: Yale StudentsRe: Generous Gift
My dear students,
I am delighted to report that a generous alumna has made a gift of $1000 per Yale student, available immediately. You can come by the office and pick up your check any time.
Professor Nordhaus has requested that you detail how you would spend the funds. Would you please write this down in your notebooks in class today. You will find it instructive as you discuss Consumption in class this week.
With best wishes,
President Ella Eli
P.S. Professor Nordhaus has told me about “elevator quizzes,” which are a great idea. This is not an elevator quiz, but you should hold on to your answers for later reference. EE
1. Consumption is twothirds 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
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 shortrun and crosssectional consumption functions looked very different from the longterm 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. Lifecycle or permanent income approaches (Modigliani, Friedman)
4.Rational expectations (Euler equation) approaches (in Jones)
*We will do in class, but more Fisher in section.
Basic idea:
People have expectations of lifetime income; they determine their consumption stream optimally; this leads consumers to “smooth” consumption over their lifetime.
Assumptions of two period model:
Periods 1 and 2
Income Y1 and Y2
Maximize utility:
Budget constraint:
We will do graphical case now and calculus later.
C1+C2/(1+r)=Y1
[no income in retirement]
C2
Indifference curve between current and future consumption
E*
S1*
C1
Y1
Key result: consumption independent of timing of income!!!
Called “consumption smoothing”
E*
S1*
C1
Y1
Income over life cycle is the major determinant of consumption and saving.
In idealized case, have consumption smoothing over lifetime.
Now move from twoperiod (Fisher model) to multiperiod (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 1 to D.
Earn Y per year for ages 1 to R.
Retire from R to D.
Maximize utility function:
Budget constraint:
Discount rate on utility (δ) = real interest rate (r) = 0 (for simplicity)
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.
Since U’(C1)=U’(C2)=… = λ, C is constant over time.
Note: this assumes diminishing marginal utility or U”(C)<0. Make sure you know what this means.
C1
Lifecycle model:
People plan their consumption over the future
Assumptions:
“Life cycle” for planning from age 1 to D.
Earn constant Y per year for ages 1 to R.
Retire from R to D.
Maximize discounted utility:
For simplicity, assume r = δ = 0.
C, Y, S
Diagram of Life Cycle Model Showing Consumption Smoothing
Income, Y
Consumption, C
Saving, S
age


0
R
D
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
C, Y, S
Income “splash” from tax cut
Income, Y
No C change!
Saving, S’
age


R
D
0
Unanticipated change in permanent income
C, Y, S
Y’ =unanticipated increase; W increases.
Y
C’
C
age


R
D
0
Estimated MPC= 0.25 (+0.04)
Nobel prize in Economics for 2011 won by Chris Sims (Princeton) in part for development of VAR technique.
Vector autoregression (VAR) is a statistical model used to capture the linear interdependencies among multiple time series (vector Yt ):
Yt = A0 + A1Yt1 + A2Yt2 + A2Yt2 + et
Sims emphasized it as “theoryfree estimation.”
Example of short run MPC using VAR:
MPC = 0.16 ( + 0.04)
Smaller than other estimates because of autoregressive properties.
Summary: Econometric estimates of shortrun MPC > lifecycle theory.
Liquidity constraints
Basic idea: That people are not optimizers:
 Draw upon behavioral psychology: anchoring, loss aversion, hyperbolic discounting, and similar phenomena
Realworld examples for all of us:
 Procrastination (as in procrastinate saving for the future).
 Addictive substances (shop until you drop)
Why is it “behavioral”? Because lead to inconsistent decisions that are regretted later
 cheating, hangovers, unwanted pregnancies, jail
Examples from macroeconomics:
 MPC too high; low savings for retirement; subprime mortgages; sticky housing prices; too high discount rate in energy use
for Econ 122
“Raise the tax on the returns for saving, and people will save less. We can argue the magnitude, but to argue that saving does not respond at all is simply to argue that incentives and disincentives are irrelevant to behavior.”
“Of Course Higher Taxes Slow Growth,” J.D. Foster and Curtis Dubay
Important question for economics
A common theme:
 The country need to reduce taxes to increase savings
 Examples: lower marginal tax rates, lower capital gains taxes, move to consumption taxes,
 Mechanism: ra = rb (1τ)
What is the economic theory of this?
What is econometric evidence on this?
CASE I:
Higher interest rate leads to lower saving because income effect outweighs substitution effect.
[Pension example]
E**
E*
C1
Y1
If we estimate the impact of changes in interest rates on consumption, we get paradoxical case (δs/δr < 0):
The impact is essentially zero (and not robust to changes in specifications, samples, etc.)
When the economy is in a liquidity trap and recession, major available policy tool is fiscal policy (remember ISMP)
But, fiscal policy is controversial inside and outside economics:
Purchases (G):
 Controversial because increases size of government
 Long lags (recognition, decision, implementation)
 Infrastructure and other programs have long gestation periods.
Tax Cuts (T) and transfers (T):
 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 shortsighted and/or liquidity constrained, and they will spend a substantial fraction of increased incomes
Wealth effects:
Life cycle model predicts that initial wealth (or surprise inheritances) would be spread over life cycle.
So the augmented life cycle model is
Ct = β0 + β1Ypt + β2 Wt
where Ypt is permanent or expected labor income and Wt is wealth.
Dependent Variable: Real consumption expenditures
Method: Least Squares with AR correction
Sample: 1960.1 2011.2
VariableCoefficientStd. ErrorP
Real Disposable income 0.73 0.025 .0000
Real wealth 0.035 0.0041 .0000
Rsquared 0.9997