Intermediate
Macroeconomics
Lecture 17
Microeconomics behind
Macroeconomics
?Consumption
?Investment
?Money S and D
?Advances in business
cycle model
Consumption
? Keynes & C function
? Fisher & intertemporal choice
? Life-cycle hypothesis
? Permanent hypothesis
? Random-walk hypothesis
? Pull of instant gratification
Keynes & consumption function
① Marginal propensity to consume (0<c<1)
marginal consumption/marginal income
② Average propensity to consume (↓as Y↑)
total consumption/total income
③ Interest does not affect consumption
YcCC ??? ?
Keynes & consumption function
Y
C YcCC ??? ?
APC
MPC
1
1
Keynes & consumption function
? A dire prediction,
as Y grew,households would consume
a smaller and smaller fraction of Y &
save more and more,There might not
be enough profitable investment
projects to absorb S,
Keynes & consumption function
If so,the low C would lead to an
inadequate D for g&s,resulting in
a depression once the wartime D
for the government ceased,
(secular stagnation,long
depression of indefinite duration)
Keynes & consumption function
? Simon Kuznets
Constructed aggregate data on C
and Y from 1869-1940s
Although Y increased dramatically,
APC was stable from decade to
decade
Keynes & consumption function
? The consumption puzzle
Household and SR data (OK)
LR (APC is constant)
1950s,Modigliani & Friedman
Fisher & intertemporal choice
intertemporal choice
111 CYS ??
122 )1( SrYC ???
))(1( 1122 CYrYC ????
2121 )1()1( YYrCCr ?????
r
YY
r
CC
????? 11
2
1
2
1
Fisher & intertemporal choice
? Intertemporal budget constraint
21)1( YYr ??
21)1( YYr ??
1C
2C
Fisher & intertemporal choice
? Is current money more valuable or
the future money?
r
YY
r
CC
????? 11
2
1
2
1
Fisher & intertemporal choice
? Consumer Preferences
Indifference curves,
a curve that shows the
combinations of 1st-pd and 2nd-
pd C that make the consumer
equally happy
Fisher & intertemporal choice
? Indifference curve
1C
2C
IC
IC’
Fisher & intertemporal choice
? Marginal rate of substitution (MRS)
-- measures how much 2nd pd
consumption the consumer
requires in order to be
compensated for a 1-unit
reduction in 1st pd consumption
Fisher & intertemporal choice
1C
2C
IC
1
MRS
Fisher & intertemporal choice
? Consumption optimization
1C
2C
budget
constraint
IC’’
IC IC’
o
Fisher & intertemporal choice
? Change in Y (normal good)
1C
2C
IC IC’
Fisher & intertemporal choice
? Keynes,
--- C depends largely on current Y
? Fisher,
--- C depends on the resources
one expects over his/her lifetime
Fisher & intertemporal choice
? Change in r
1C
2C
IC
IC’
Fisher & intertemporal choice
? Income effect,
r ↑ ? total Y↑
? C moves to a higher IC
? Consume more in both periods
? Substitution effect,
r ↑? relative price of C in 1st pd ↑
? T1 save more & T2 consume more
? Consume less C1 & more C2
Fisher & intertemporal choice
? Therefore,
increase in r does not necessarily ↑S
?Does not necessarily↑C2 &↓C1
?Depends on the relative size of
income and substitution effects
Fisher & intertemporal choice
? Constraints on borrowing
1C
2C
Y1
Modigliani & life-cycle hypothesis
Income varies systematically over
people’s lives and that savings allows
consumers to move income from
those time in life when income is high
to those times when it is low
Modigliani & life-cycle hypothesis
W,wealth
R,years before retiring
Y,income
T,years to live
TRYWC /)( ??
Modigliani & life-cycle hypothesis
? What is enough?
W=0,R=30,T=15,C ? Y
Modigliani & life-cycle hypothesis
房,稍微像样,包括装修,50万
车,1500× 12月 × 30年＋ 15万 × 3＝ 100万
孩子,一个孩子到大学毕业,30万
父母,300× 4人 × 12月 × 30年＝ 43.2万
家庭开支,3000× 12月 × 30年＝ 108万
休闲,一年 1万，不会太土匪吧?!
10000× 30年＝ 30万
退休金,2000× 12月 × 15年＝ 36万
总计,397.2万元 (每月要有 11033元收入 !!!)
Modigliani & life-cycle hypothesis
Y
C
YW
TRYWC
????
??
??
/)(
Wealth
Modigliani & life-cycle hypothesis
TRYWC /)( ??
TRYTWYC /// ??
?? ??? )/(/ YWYC
Life-cycle model solves the C puzzle,
For individual or over the SR,W does not
vary proportionately with Y ? high Y
corresponds to low APC,
Over the LR,W & Y grow together ?
constant ratio of W/Y ? constant APC
Modigliani & life-cycle hypothesis
? However,the prediction of negative
savings of the elderly is not true in
real life
? Precautionary saving
a) living longer than expected
b) Illness and large medical bills
(annuity & medicare may explain)
? Leave bequest to children
Friedman & permanent-Y hypothesis
Life-cycle,income follows a regular
pattern over a person’s lifetime
Permanent-income,people experience
random and temporary changes in
their incomes from year to year
Friedman & permanent-Y hypothesis
? C depends primarily on permanent
income
? Saving and borrowing are used to
smooth consumption in response to
transitory changes in income
TP YYY ??
Friedman & permanent-Y hypothesis
? Implications
? Household data,
high permanent Y – high APC
high transit Y – low APC
In all,high Y – low APC
? Time-series data,
SR,high Y – low APC
LR,high Y – high APC (constant)
YYYCA P C P // ???
Hall & random-walk hypothesis
permanent income hypothesis
+
rational expectation
? Changes in C over time should be
unpredictable
Hall & random-walk hypothesis
? Implication,
Only unpredicted policy changes
influence C,because policy
changes take effect when they
change expectations,
Laibson & the Pull of Instant
Gratification
? Would you prefer
A) 1 Haagen Datz today
B) 2 Haagen Datz tomorrow
? Would you prefer
(A) 10 Haagen Datz on May 1st?
(B) 11 Haagen Datz on May 2nd?
Laibson & the Pull of Instant
Gratification
? People are
? not rational
? imperfect decision-makers
? more patient in the LR than in
the SR
? time consistent
? hard to resist the desire for
instant gratification
Summary
? Consumption
= f (current income)
= f (current income,wealth,
expected future income,interest
rate,transitory income changes,
psychological factors )