Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, StartzSlides prepared by Dr Monica Keneley.

12-1

Chapter 12Consumption and Saving


12-2

Objectives

• Evaluate modern theories of consumption which link lifetime consumption to lifetime income

• Consider consumption under uncertainty

• Investigate further aspects of consumption behaviour

• Explain the Barro-Ricardo problem


12-3

Chapter Organisation

12.1 The Life-Cycle–Permanent-Income Theory of Consumption and Saving

12.2 Consumption under Uncertainty: the Modern Approach

12.3 Further Aspects of Consumption Behaviour


12-4

12.1 Consumption and Saving

• Consumption accounts for more than 61% of aggregate demand.

• A simple model of consumption was outlined in Chapter 7.

• It assumed that consumption was determined by disposable income in a simple linear relation.

(12.1)


12-5

12.1 The Life-Cycle Theory

• Life-cycle (LC) hypothesis– Individuals plan their consumption and savings

behaviour over long periods with the intention of allocating consumption over their entire lifetime.

• A key assumption is individuals choose to consume at about the same level every period.

• This implies that the MPC will vary over the life-cycle of the individual.


12-6

The Life-Cycle Theory

• Modern consumption theories consider the way in which individuals plan and make choices over an extended period of time.

• Two theories explain consumption patterns:– The life-cycle hypothesis– The permanent income theory.

• These two models focus on different aspects of consumption planning.

• Today, these two theories have largely merged.


12-7


• Example– Assume a person starts work at 20, plans to work

until they are 65, expects to die at 80, and earns – $30 000 a year (YL).– The person’s lifetime resources would be YL times

working life (WL) or $30 000 (65 – 20) = $1.35m.– Spreading the lifetime resources over the lifespan (NL)

gives an annual C of $22 500.– C = (WL/NL) YL = $1.35m/(80 – 20) = $22 500


12-8


• Example– C = (WL/NL) YL– So the MPC is WL/NL = (65 – 20)/(80 – 20) = 0.75

• Consider now a permanent increase in Y of $3000:– The extra Y times 45 working years spread over 60 years

of life would increase annual consumption by +$3000 (45/60) = +$2250

– The MPC out of permanent Y would still be: WL/NL = 45/60 = 0.75


12-9


• Consider now a transitory increase in Y of $3000 for 1 year only:

– The extra Y spread over 60 years would increase annual consumption by +$3000 (1/60) = +$50

– The MPC out of transitory Y would be 1/NL = 1/60 = 0.017

– The MPC out of permanent Y is large while the MPC out of transitory Y is small.


12-10

Permanent-Income Theory

• The Permanent-Income hypothesis (PIH) claims C is not related to current Y but rather longer-term estimates of Y.

• Permanent-Income is:– The steady rate of C a person could maintain for the

rest of his or her life– Given the present level of wealth and the Y earned

now and in the future.


12-11

Permanent-Income Theory

• This implies that consumption is proportional to permanent Y.

• C = cYP (12.2)

• Where YP is permanent (disposable) Y.

• Transitory Y is assumed not to have any substantial affects on consumption.


12-12


12.1 The Life-Cycle–Permanent-Income Theory of Consumption and Saving




12-13


• The modern version of the LC-PIH links income uncertainty and changes in consumption.

• Changes is consumption arises from surprise changes in Y.

• Without surprises, maximising consumers equate consumption over all periods.


12-14

Consumption under Uncertainty: the Modern Approach

• Any reallocation of consumption from the optimum will reduce total utility.

• A person enjoys utility u from consumption C in period t: u(Ct).

• Lifetime utility (LU) is the sum of period-by-period utilities.


12-15


– Starting at period t until the final period T

LU = u(Ct) + u(Ct + 1) + ….. + u(CT - 1) + u(CT)

• The lifetime budget constraint (LBC) is the sum of the period-by-period consumption

LBC = Ct + Ct + 1 + ….. + CT - 1 + CT

= wealth +YLt +YLt+1 + …..+YLT - 1+YLT (12.3)


12-16


• Equation 12.3 states that consumers choose consumption each period:

– To maximise lifetime utility

– Subject to total lifetime resources.

• The optimal choice is the C path that equates the marginal utility of C across periods:

– MU(Ct + 1) = MU(Ct)

– No reallocation over time can increase total utility.


12-17


• Now consider uncertainty.– Future marginal utility is unknown at time t.– The consumer must estimate the expected value of

tomorrow’s t + 1 utility: E [MU(Ct + 1)].

– The optimum time path of consumption is where

E[MU(Ct + 1)] = MU(Ct).

– If the (marginal) utility function is one-to-one with C, then: E (Ct + 1) = Ct.


12-18


• Now consider uncertainty.– E (Ct + 1) = Ct

– If observed C is expected C with a random surprise Ct + 1 = E (Ct + 1) +

– Then substituting for the expected value derives a simple random-walk model of consumption

Ct + 1 = E (Ct + 1) +

= Ct +


12-19


• The random walk model suggests that changes in consumption should not be predictable.

• Consumption is assumed to be based on future expected income as well as current income.

• The predictions of the random walk model appear to be fairly accurate.


12-20

LC–PIH: The Traditional Model Strikes Back

• Empirical evidence suggests:– Both the simple consumption function and the LC–PIH

help explain consumption behaviour.– Campbell and Mankiw (1989) found that 1/3 of household

consumption can be explained by current Y rather than permanent Y.

– Consumption behaviour exhibits excess sensitivity (C responds strongly to predictable changes in Y) and excess smoothness (C responds sluggishly to surprise changes in Y).


12-21

Liquidity Constraints and Myopia

• Why doesn’t LC–PIH fully explain consumption behaviour?

• Three reasons may account for this shortfall:– Liquidity constraints– Myopia– Uncertainty and buffer stock saving.


12-22


• Liquidity constraints– Represent constraints on borrowing– A consumer may not be able to borrow to sustain current

consumption in the expectation of higher future Y– Example: Students cannot obtain a large loan now

merely on the basis of expected higher future Y.


12-23


• Myopia– Consumers may not be as forward looking as

suggested by the LC–PIH – They take a short-sighted approach– Example: An announcement that social security

benefits will be increased in 6 weeks' time– Doesn’t increase consumption (until benefits are

paid) because the recipients do not have the available assets to increase consumption (liquidity constraint), or

– They do not pay attention to the announcement (myopia), or they don’t believe it.


12-24

Uncertainty and Buffer-Stock Saving

• Some saving is precautionary (buffer-stocks) to guard against times when income is low.

– Y fluctuations create considerable risk for the consumer.– The pain caused by a large drop in spending is greater

than the pleasure caused by an equal-size increase in spending.

– Consumers may avoid having to cut C sharply in bad times if they have a buffer-stock.


12-25


12.1 The Life-Cycle-Permanent-Income Theory of Consumption and Saving




12-26


• The Barro-Ricardo Problem (Ricardian equivalence)

– Claims that a reduction in taxes does not increase consumption.

– Households save the additional disposable income, with unchanged consumption spending.

– Debt financing of the budget deficit by bond issue will require future increases in taxes.

– So households increase their savings now to pay for the future tax increase.


12-27

Further Aspects of Consumption Behaviour

• Objections to the Ricardian equivalence– People have finite lives, so later generations pay for the

debt that the present generation enjoys.– For a given tax cut now, people increase their

consumption now, as the tax cut eases their liquidity constraints.

– They do not save now for the future increase in taxes as their liquidity constraints imply they are consuming less now then their optimal consumption level.


12-28

International Differences in Savings Rates

• Gross national savings – The sum of private sector and public sector savings.

• Public sector savings– Includes total government saving and savings of public

sector enterprises and financial institutions.

• Private sector savings– Includes personal (household) and business savings.


12-29



12-30


• From Figure 12.5:– Significant declines in both private and public sector

savings in the early 1990s contributed to national savings reaching a post-war low of around 15.5% of GDP in late 1992.

– Since then, national savings has increased to 18.9% of GDP.

– This has been entirely due to increased public savings.– Private savings have continued to decline.


12-31



12-32


• Table 12.1 shows that Australia had an average gross national savings rate in the 1990s of 18.5%.

• This rate is similar to Canada’s (17.5%).

• This rate is higher than the rates for the US (16.5%) and the UK (15.7%).

• However, national saving is considerably lower than Japan’s (31%).


12-33


• What underlies the trend of savings in Australia and internationally?

– Large budget deficits imply reduced saving in the public sector.

– Changing demographics (such as a larger senior citizen population) account for some of the changes in saving rates over time.

– Australia and other OECD economies find it easier to borrow than most other nations.

Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

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