Chapter 8
Theory of
Consumption &
Saving
01
0
10
20
30
40
90 91 92 93 94 95 96 97 98 99 00
Topics to be Discussed
? 8.1 Keynesian consumption function
? 8.2 A simple two-period model
? 8.3 Consumption theory after Keynes
? Permanent–income Hypothesis
? Life-style Hypothesis
? 8.4 Real interest & decision-making
between consumption and saving
8.1 Keynesian Consumption
Function
?household consumption is mainly decided by its
disposable income Yd;;
?Consumption increases slower than income
（ 0<b<1）
dYbaC ??
8.1 Keynesian Consumption
Function
?Deficiency of Keynesian theory
?Only consider the influence of present income
?Ignore the influence of household wealth to
present consumption
8.2 A Simple Two-period
Model
?Two-period model
?Consider present & future
?Fix the foundation of Permanent–income
Hypothesis and Life-style Hypothesis
8.2 A Simple Two-period Model
?Assumption of the model
?Life is made up of two periods,the youth and
the aged
?Income is made up of two parts, wealth &
wages,with no positive wealth at the beginning
and the end
?Optimal objects,
?Given the present income & future income,
decide the consumption of the present and the
future to maximize their intercourse inter-
temporal utility
8.2 A Simple Two-period
Model
? inter-temporal constraint
C1,C2 is respectively the first-period & the
second-period consumption； Q1,Q2 is
respectively the periods’ wages
? inter-temporal utility function
U（ C1,C2）（ convex）
）（ r1
QQ
r1
CC 2
1
2
1 ????? )(
8.2 A Simple Two-period
Model
? Debit consumption
? Save for future
consumption
period2
period1
Q2
Q1 C1
C2
Q2
Q1 C1
C2
period1
period2
A B E
E
8.3 Consumption Theory After
Keynes
? Permanent Income Hypothesis
? Milton Friedman,1957,,a theory of consumption
function,
? Permanent income
? Observe household average income in a long run,In a two-
period model,permanent income is a weighted average for
present income & future income,
）（ r1
QQ
r1
YY 2
1
p
p ????? )( ??
?
??
?
???
??
）（ r1
QQ
r2
r1Y 2
1p )(
)(
8.3 Consumption Theory After
Keynes
?Significance of permanent income
? Income variable is relatively steady
? Permanent or long-term income will make the individual
adjust his consumption behavior
?Deficiency of permanent income hypothesis
? Decide whether income change belongs to permanent
phenomena by adaptable anticipation
8.3 Consumption Theory After
Keynes
? Life Cycle Hypothesis
?Modigliani & Brumberg,1954,,utility analysis
& consumption function,
?Core idea
?An individual’s saving is due to the phase of his life,
The consumption is stable while the income may
fluctuate severely,
8.3 Consumption Theory After
Keynes
Income &
consumption
saving
Negative saving Negative saving
20 40 60 65 80 age
8.3 Consumption Theory After
Keynes
?Significance of life-style hypothesis
?Display the relation between national saving
and national age structure for a country,when
the quantity of middle age is more than that of
the youth ＆ the aged,the national saving ratio
may increase
?Saving ratio is also related to the maturity of
social insurance, a mature insurance may
decrease the saving ratio,
8.3 Consumption Theory After
Keynes
America Japan Germany England Canada
National
saving
16.3 31.6 22.5 16.6 20.7
Government
saving
-2.1 4.9 2.0 0.1 -1.6
Individual
saving
18.5 26.8 20.5 16.4 22.2
International difference of saving ratio
Why？
8.3 Consumption Theory After
Keynes
? The reason for the high saving ratio of Japan,
?Endowment motive
?High anticipation of life
?Income increase fast,the anticipation for future
consumption will also increase
?The price of real estate is too high
8.4 Real Interest & Decision-making
Between Consumption and Saving,
?Income effect
?The increase of interest will change the real income of
household,For the lender,income will increase while for the
borrower,income will decrease,
?Substitution effect
?For a higher interest,to abandon some present
consumption means to get more consumption in the future,
Thus household will make new choice between the two
periods,
The Influence of Higher Interest for
Household Saving
borrower lender
Income
effect + +
Substitution
effect +
—
General
effect +
？
Chapter 8
The End
01
0
10
20
30
40
90 91 92 93 94 95 96 97 98 99 00
Theory of
Consumption &
Saving
01
0
10
20
30
40
90 91 92 93 94 95 96 97 98 99 00
Topics to be Discussed
? 8.1 Keynesian consumption function
? 8.2 A simple two-period model
? 8.3 Consumption theory after Keynes
? Permanent–income Hypothesis
? Life-style Hypothesis
? 8.4 Real interest & decision-making
between consumption and saving
8.1 Keynesian Consumption
Function
?household consumption is mainly decided by its
disposable income Yd;;
?Consumption increases slower than income
（ 0<b<1）
dYbaC ??
8.1 Keynesian Consumption
Function
?Deficiency of Keynesian theory
?Only consider the influence of present income
?Ignore the influence of household wealth to
present consumption
8.2 A Simple Two-period
Model
?Two-period model
?Consider present & future
?Fix the foundation of Permanent–income
Hypothesis and Life-style Hypothesis
8.2 A Simple Two-period Model
?Assumption of the model
?Life is made up of two periods,the youth and
the aged
?Income is made up of two parts, wealth &
wages,with no positive wealth at the beginning
and the end
?Optimal objects,
?Given the present income & future income,
decide the consumption of the present and the
future to maximize their intercourse inter-
temporal utility
8.2 A Simple Two-period
Model
? inter-temporal constraint
C1,C2 is respectively the first-period & the
second-period consumption； Q1,Q2 is
respectively the periods’ wages
? inter-temporal utility function
U（ C1,C2）（ convex）
）（ r1
r1
CC 2
1
2
1 ????? )(
8.2 A Simple Two-period
Model
? Debit consumption
? Save for future
consumption
period2
period1
Q2
Q1 C1
C2
Q2
Q1 C1
C2
period1
period2
A B E
E
8.3 Consumption Theory After
Keynes
? Permanent Income Hypothesis
? Milton Friedman,1957,,a theory of consumption
function,
? Permanent income
? Observe household average income in a long run,In a two-
period model,permanent income is a weighted average for
present income & future income,
）（ r1
r1
YY 2
1
p
p ????? )( ??
?
??
?
???
??
）（ r1
r2
r1Y 2
1p )(
)(
8.3 Consumption Theory After
Keynes
?Significance of permanent income
? Income variable is relatively steady
? Permanent or long-term income will make the individual
adjust his consumption behavior
?Deficiency of permanent income hypothesis
? Decide whether income change belongs to permanent
phenomena by adaptable anticipation
8.3 Consumption Theory After
Keynes
? Life Cycle Hypothesis
?Modigliani & Brumberg,1954,,utility analysis
& consumption function,
?Core idea
?An individual’s saving is due to the phase of his life,
The consumption is stable while the income may
fluctuate severely,
8.3 Consumption Theory After
Keynes
Income &
consumption
saving
Negative saving Negative saving
20 40 60 65 80 age
8.3 Consumption Theory After
Keynes
?Significance of life-style hypothesis
?Display the relation between national saving
and national age structure for a country,when
the quantity of middle age is more than that of
the youth ＆ the aged,the national saving ratio
may increase
?Saving ratio is also related to the maturity of
social insurance, a mature insurance may
decrease the saving ratio,
8.3 Consumption Theory After
Keynes
America Japan Germany England Canada
National
saving
16.3 31.6 22.5 16.6 20.7
Government
saving
-2.1 4.9 2.0 0.1 -1.6
Individual
saving
18.5 26.8 20.5 16.4 22.2
International difference of saving ratio
Why？
8.3 Consumption Theory After
Keynes
? The reason for the high saving ratio of Japan,
?Endowment motive
?High anticipation of life
?Income increase fast,the anticipation for future
consumption will also increase
?The price of real estate is too high
8.4 Real Interest & Decision-making
Between Consumption and Saving,
?Income effect
?The increase of interest will change the real income of
household,For the lender,income will increase while for the
borrower,income will decrease,
?Substitution effect
?For a higher interest,to abandon some present
consumption means to get more consumption in the future,
Thus household will make new choice between the two
periods,
The Influence of Higher Interest for
Household Saving
borrower lender
Income
effect + +
Substitution
effect +
—
General
effect +
？
Chapter 8
The End
01
0
10
20
30
40
90 91 92 93 94 95 96 97 98 99 00
