1

Consumption

Lifetime utility:
T 1
U u (Ct ) with u() 0, u() 0
t 1 (1 )
t 1

Budget constraint:
T 1 T 1
t 1
C t A0 Y
t 1 t
t 1 (1 r ) t 1 (1 r )

Lagrangian:
T
1 T
1 T
1
L t 1
u (Ct )
A0 Y
t 1 t
C
t 1 t
t 1 (1 ) t 1 (1 r ) t 1 (1 r )

(1 ) t 1
F.O.C.: u (C t )
(1 r ) t 1

If r=, then u(Ct) is constant over time, so C is

constant over time

If >r, then u(Ct) is rising over time, so C is falling

over time

If r>, then u(Ct) is falling over time, so C is rising

over time
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2 special cases:

1) u(C) = ln[C] and T=

1 (1 ) t 1

Ct (1 r ) t 1
1 (1 r ) t 1
Ct
(1 ) t 1

1 1 1

t 1 (1 )
t 1
A0
t 1 (1 r )
t 1
Yt

1
1
A0 Yt
1 t 1 (1 r )
t 1

(1 r ) t 1
1
Ct
(1 ) t 0
A
t 1 (1 r )
Y
t 1 t

2) r==0, and T is finite

1 T

Ct A0 Yt
T t 1

Permanent Income Hypothesis (Milton Friedman ): consumption

depends on your permanent income and rises one-for-one with
permanent income.

C=YP

Life-cycle model (Franco Modigliani): people plan consumption

over their lifetimes to maximize the present value of their utility
save in periods in which income is relatively high and dissave in
periods in which income is relatively low
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Transitory income: YT=Y-YP

Savings: S = Y C

Interpreting a simple consumption function

If we looked at a consumption function over long time
periods, consumption is approximately proportional to
income

However, if we looked at consumption at shorter time

horizons or in a cross section of individuals, consumption can
be expressed by the relationship C=a+bY, where a>0 and
0<b<1.

Suppose we estimate Ci=a+bYi+ei.

Cov (Y , C ) Cov (Y P Y T , Y P ) Var (Y P )

b
Var (Y ) Var (Y P Y T ) Var (Y P ) Var (Y T )

a C bY Y P
b(Y P
Y T ) (1 b)Y P
 4

The random walk hypothesis for consumption (Robert Hall)

If future income is uncertain, then consumption should follow a

random walk (perhaps with drift)

random walk: xt=xt-1+et

random walk with drift: xt=xt-1++et

T
1
E[U ] Et u (Ct )
t 1 (1 )
t 1

T
1 T
1
s.t. t 1
Ct A0 Y
t 1 t
t 1 (1 r ) t 1 (1 r )

Suppose consumption in period 1 falls by the amount dCt. This

reduces utility in period 1 by the amount u(Ct)dCt.

This means that consumption in period 2 can be raised by (1+r) dCt,

and the utility of this (in terms of todays dollars) is

1 r
E t [u (C t 1 )]dC t
1

If the individual had previously been maximizing his or her

utility,

1
E t [u (C t 1 )] u (C t ) Euler equation
1 r

Suppose the discount rate = the interest rate

Et [u (Ct 1 )] u (Ct )

Suppose also that utility is quadratic with the following form:

 5

a 2
u (C t ) C t Ct
2
 6

What determines changes in consumption over time?

1
C1 A0 E1 [Yt ]
T

T t 1

1
A1 E 2 [Yt ]
T
C2
T 1 t 2

1 E1 [Yt ]
T T T
C2 A
0 1 1
Y C E [Y ] E [Y ]
T 1 t 2
1 t t 2 2 t
t 2

1
TC1 C1 E2 [Yt ] E1[Yt ]
T T
C2
T 1 t 2 t 2

T
since TC1 A0 Y1 E1[Yt ]
t 2

1 T
E 2 [Yt ] E1[Yt ]
T
C 2 C1
T 1 t 2 t 2
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Tests of the Permanent Income/Random Walk

Hypothesis:

Hall (1978)
Flavin (1981)
regressed current income on lagged income:

yt 1 1 yt 1 2 yt 2 ... p yt p 1t

also ran the following regression for change in

consumption:
ct 2 k ( y t 1 1 y t 1 2 y t 2 ... p y t p )
0 y t 1 y t 1 2 y t 2 ... p 1 y t ( p 1) 2t

term in ( ) is innovation in income. I.e., the

difference between current income and amount
predicted from past income

represents how much an innovation in current

income raises expectations of lifetime income

k represents how much a rise in lifetime income

should raise current consumption

represents normal change in consumption

 8

Found that hypothesis that 0=1=p-1=0 could

be rejected at 0.5% level.

Estimated coefficients: 0=.355, 1=.071,2=.049

 9

Campbell and Mankiw (1989)

hypothesized that a fraction, , of consumers spend
their current income and the remaining (1- of
consumers behave according to Halls theory

Ct Ct 1 (Yt Yt 1 ) (1 )et
Ct Yt (1 )et

C t Z t t
where Z t Yt
t (1 )et

et represents the change in consumers estimates of

their permanent income between t-1 and t. Treated as
a random error.

Test for Halls model is test that =0

Estimated equation: C t Z t ~t

C t Z
t (Z t Z
t ) t
C t Z
t ~
t
~
where ( Z Z )
t t t t

Shea (1995) examined change in spending by workers covered

by long-term union contracts

Souleles (1999) examined income tax refunds

 10

Hsieh (2003) examined payments to Alaska residents from oil

royalties

Parker, Souleles, Johnson, and McClelland (2013) examined

consumer spending resulting from stimulus package of 2008.
Single taxpayers generally received $300-$600, and couples
generally received $600-$1200. In addition, households received
$300 per child who qualified for the child tax credit. Timing of
receipt was based on last two digits of SSN.
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Liquidity Constraints

Test for liquidity constraints:

1) Zeldes (1989)
1 rit
Euler equation: u (C it )
1 i
E t [u (Ci ,t 1 )]

If an individual is liquidity constrained in period t,

then
1 rit
u (Cit ) Et [u (Ci ,t 1 )] it
1 i

2 period model
1
Max u (Cit ) Et [u (Ci , t 1 )]
1 i
s.t. Ci , t 1 ( Ait Yit Cit )(1 rit ) Yi , t 1
s.t. Cit Ait Yit

1
L u (Cit ) Et [u (( Ait Yit Cit )(1 rit ) Yi , t 1 )]
1 i
it ( Ait Yit Cit )

dL 1
0 u (Cit ) Et [u (( Ait Yit Cit )(1 rit ) Yi , t 1 )(1 rit )]
dCit 1 i
it

1 rit
u (Cit ) Et [u (Ci , t 1 )] it
1 i
 12

2) Shea (1995)

Time-inconsistent preferences (hyperbolic discounting)

Consumption and Risky Assets

Assume individual can reduce consumption in period t by

an infinitesimal amount and use it to buy a risky asset, i.
Let P represent the price of the asset and D , D ,
t
i i
t 1
i
t 2

represent the future stream of payoffs, which are uncertain.

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1
u (Ct ) Pt i Et u (Ct k ) Dtik for all i
k 1 (1 )
k

Suppose assets are held for one period.

Di
Then rti1 t i 1 1
Pt

Et (1 rt i1 )u (Ct 1 )
1
u (Ct )
1
for all i

u (Ct )
1
Et 1 rti1 Et u(Ct 1 ) Cov 1 rti1 , u(Ct 1 )
1
for all i

With quadratic utility, u(Ct 1 ) 1 aCt 1

u (Ct )
1
Et 1 rti1 Et u(Ct 1 ) aCov1 rti1 , Ct 1
1

Note that the risk of the asset does not appear in the above
equation

Optimal holding of an asset depends on the correlation of

the assets return and consumption

Home country bias

Consumption CAPM
 14

Et 1 rti1 (1 )u(Ct ) aCov1 rti1 , Ct 1

1
Et u(Ct 1 )

The higher an assets covariance with consumption, the

higher its expected return must be.

Let rt 1 represent the rate of return on a risk-free asset

(1 )u (Ct )
1 rt 1
Et u (Ct 1 )

aCov1 rti1 , Ct 1
Et rti1 rt 1
Et u (Ct 1 )

Equity Premium Puzzle

Let represent the coefficient of relative risk aversion,

assuming CRRA utility function,

Ct1
U (Ct ) .
1

Then it can be demonstrated that

E[r i ] E[r ] Cov(r i r , g c ) ,

where gc represents the growth in consumption.

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From 1890-1979, the difference between the average return

on the stock market and the return on short-term
government securities averaged about 6%, and the
covariance between consumption growth and the excess
return on the market was 0.0024.

Implies that =25.