How are consumption and savings related with income?
Burak Uras
Macro 3: Consumption & Savings
today: overview consumption theories Keynes Fisher (intertemporal choice) Modigliani (life-cycle hypothesis) Friedman (permanent income hypothesis) Hall (random walk hypothesis) Laibson (behavioural economics) next week: model (based on life cycle hypothesis)
Burak Uras
Macro 3: Consumption & Savings
Keynes ¯ + cY Keynesian consumption function: C = C consumption primarily determined by current income interest rate relatively unimportant (contrast classical economists) 0 < marginal propensity to consume (MPC) < 1 MPC crucial for power of fiscal policy to reduce Keynesian unemployment average propensity to consume falls as income rises as at ¯ + cY . C=C Keynesian consumption function worked well in short time-series but in long time-series: average propensity to consume constant Kuznets puzzle and the Secular stagnation. Burak Uras
Macro 3: Consumption & Savings
Fisher Keynes: consumption based on current income Fisher: Intertemporal choice. Consumption not only depends on current income but also the future income. rational, forward-looking behaviour consumers make optimal choices = maximize intertemporal utility given an intertemporal budget constraint
Burak Uras
Macro 3: Consumption & Savings
budget assume consumer lives two periods S = Y1 − C1 C2 = (1 + r )S + Y 2 C2 = (1 + r )(Y1 − C1 ) + Y2 (1 + r )C1 + C2 = (1 + r )Y1 + Y2 C1 +
C2 1+r
= Y1 +
Y2 1+r
intertemporal budget constraint
present value consumption = present value income C1 < (>)Y1 : saving (borrowing) slope intertemporal budget constraint: 1 + r Burak Uras
Macro 3: Consumption & Savings
preferences indifference curves C1 , C2 slope: marginal rate of substitution C1 , C2 MRS MRS: how much C2 for 1 unit C1 MRS falls when C1 /C2 rises
Burak Uras
Macro 3: Consumption & Savings
optimum: indifference curve tangent to budget line slope indifference curve = slope budget line: MRS = 1 + r timing income irrelevant (given present value income) consumption smoothing: consumers spread extra income in one of the periods over C1 and C2 so: consumption not determined by current income (Keynes) but by expected lifetime income.
Burak Uras
Macro 3: Consumption & Savings
the real interest rate and consumption if r rises the budget line become more steep leads to new optimum utility may rise, but also fall budget line rotates around Y1 , Y2 utility savers rise, utility borrowers may fall
Burak Uras
Macro 3: Consumption & Savings
impact change r can be split up in: substitution effect income effect net effect on savings depends on sum two effects substitution effect: C2 less expensive → consume more C2 = save more income effect: depends on saving/borrowing.
Burak Uras
Macro 3: Consumption & Savings
assume Y2 = 0 → only savers income effect: given S > 0 possible to consume more C2 if r rises. as a result utility rises as r rises. smooth consumption = save less substitution effect: save more, C2 is less expensive as r rises. net effect with positive S: ambiguous Cobb-Douglas or logarithmic utility: income and substitution effect cancel out: S independent r
Burak Uras
Macro 3: Consumption & Savings
with Y2 > 0: borrowing possible S < 0 income effect: given S < possible to consume less C2 utility falls smooth consumption = borrow less (= save more) substitution effect: save more so for borrower: net effect on S positive
Burak Uras
Macro 3: Consumption & Savings
borrowing constraints constraint: C1 ≤ Y1 saver: constraint not binding, no effect "borrower": constraint binding, C1 = Y1 → consumption determined by current income borrowing constraint (eg for housing) can be explanation for high saving in countries (eg Japan) compared to countries where borrowing is less restricted (eg US) many other factors important (eg social security)
Burak Uras
Macro 3: Consumption & Savings
Modigliani: life-cycle hypothesis application of intertemporal model Fisher stresses that income, and therefore savings, vary over the lifetime stresses role of wealth for consumption example: current wealth: W remaining lifetime: T income: Y until retirement (in R years) assume r = 0 total wealth: W + RY smooth consumption perfectly: C = (1/T )W + (R/T )Y Burak Uras
Macro 3: Consumption & Savings
So: consumption depends on income and wealth average propensity to consume = constant + constant x wealth/income wealth varies proportionally with income in long run, but not in short run explains Kuznets puzzle
Burak Uras
Macro 3: Consumption & Savings
retirement saving optimal consumption smoothing: consume less than income (= save) during working life = accumulate wealth during working life (pension funds) dissave during retirement = decumulate wealth empirical tests: support model problem: elderly do not dissave enough
Burak Uras
Macro 3: Consumption & Savings
reasons for low dissaving: 1. precautionary saving for: large medical expenses et cetera (health insurance?) living longer than expected (annuities?) 2. bequests → dynastic model (week 5)
Burak Uras
Macro 3: Consumption & Savings
Friedman: permanent income hypothesis builds on Fisher’s intertemporal model Y = YP + YT C = αY P C/Y = αY P /Y short run: fluctuation income dominated by changes in Y T high income = low C/Y long run: changes in income dominated by changes in Y P C/Y does not change solves Kuznets puzzle helps understanding effects tax changes Burak Uras
Macro 3: Consumption & Savings
Hall: random walk hypothesis intertemporal choice model: consumption based on expected future income rational expectations: consumers use all available information to forecast income so: consumption based on all available information hence: changes unpredictable random walk only news / unexpected events (eg unexpected policy changes) affect consumption not only actual policy important, but also expectations of policy. empirical research: consumption does react to predictable changes in income. So: consumers are either “not perfectly rational” or they are “borrowing-constrained”. Burak Uras
Macro 3: Consumption & Savings
Laibson: behavioural economics consumers not always as rational as theory assumes behavioural economics: bring in elements from psychology example: consumers are more patient in long run than in short run implies time inconsistency many other examples experimental economics: observe behaviour in lab real incentives)
Burak Uras
Macro 3: Consumption & Savings
(with
Conclusion consumption not only function of current income, but intertemporal decision based on: wealth expected future income interest rates and other factors such as: psychological effects borrowing constraints model reader: based on life-cycle model
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