Advanced Macroeconomic Theory I

Lecture 1: Basic Consumption Theory

Philipp Grübener

Goethe University Frankfurt

Winter Semester 2022/2023

Course Overview
Course Overview

First part of the core macroeconomics sequence

Topic: Consumption theory

− Mostly theoretical, some empirical applications

Some workhorse models of modern macro

− Stochastic growth model / real business cycle model
− Standard incomplete markets model

Methods
− Dynamic programming
− Some basic numerical methods

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Four Main Blocks
1. Basic consumption theory
− Infinite horizon models
− Life-cycle / overlapping generations models

2. Dynamic programming
− Some underlying theory
− Focus on applying the methods

3. Competitive equilibria
− Complete markets
− Consumption insurance, Ricardian Equivalence

4. Incomplete markets
− Idiosyncratic income shocks and precautionary savings
− General equilibrium incomplete markets models

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Macroeconomics Sequence
1. Advanced Macroeconomic Theory I, Part 1
− Basic methods
− Consumption with complete and incomplete markets

2. Advanced Macroeconomic Theory I, Part 2

− Macro labor: search and matching models
− Macro epidemiology models

3. Advanced Macroeconomic Theory II, Part 1

− Solution, estimation, and analysis of business cycle models
− Real business cycle and New Keynesian models

4. Advanced Macroeconomic Theory II, Part 2

− Models with nominal rigidities, capital market and financial frictions
− Optimal design of monetary and fiscal policy

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Logistics for this Course
11 lectures and 3 sessions to go over problem sets
− October 17 to December 6
− Mondays and Tuesdays 10.15am to 11.45am
− House of Finance E.20 (DZ Bank)

Requirements
− Written exam after the end of the course before the Christmas break
− Problem set solutions have to be handed in, but are not graded
+ Points are deducted from exam score if problem sets not handed in

Materials
− No required textbook
+ Useful textbooks and papers are listed in syllabus
+ Most relevant book: Ljungqvist and Sargent (2018)
− Slides/lecture notes posted on OLAT

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Basic Consumption Theory
Why Start with Consumption?

Data for the U.S. from Bureau of Economic Analysis via FRED

Largest part of GDP ⇒ crucial for understanding macro-economy

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Why Start with Consumption?

Data for the U.S. from Bureau of Economic Analysis (NIPA)

Cons. growth less volatile than inc. growth (std. 0.0194 vs. 0.0233)

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Why Start with Consumption?

Data from Heathcote, Perri, and Violante (2010), based on CEX

Consumption inequality lower than income inequality

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Why Start with Consumption?

Important for understanding aggregate economy

− Largest part of GDP, but less volatile
− Develop theories understanding how consumption is determined

For welfare, in the end we care about consumption inequality

− Consumption inequality lower than income inequality
− Develop theories of risk sharing

Let’s start with the simplest consumption-saving problem

− Consumption under certainty
− Closest textbook treatment: Romer (2019), Chapter 8.1-8.3

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Consumption under Certainty: Assumptions

No uncertainty ⇒ deterministic income stream

Infinite horizon

Rational expectations

No restrictions on borrowing

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Consumption under Certainty: Individual Problem
Individual problem:

∞
X
max
∞
β t u (Ct )
{Ct }t=0
t=0

subject to lifetime budget constraint:

∞  t ∞  t
X 1 X 1
Ct = A0 + Yt
t=0
1+r t=0
1+r

or per-period budget constraint:

1
Ct + At+1 = Yt + At
1+r

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Utility Functions
Typical assumptions on the utility function u (C)
− u′ > 0, u′′ < 0
− Inada conditions:
lim u′ (C) = ∞
C→0

lim u′ (C) = 0
C→∞

Commonly used utility functions

− Constant relative risk aversion (CRRA) utility function
( 1−γ
C −1
1−γ
if γ >= 0, γ ̸= 1
u (C) =
log (C) if γ = 1
′′
⇒ Coefficient of relative risk aversion = − uu′C = γ
− Constant absolute risk aversion (CARA) utility function
u (C) = −eηC
′′
⇒ Coefficient of absolute risk aversion = − uu′ = η

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Budget Constraint
From per-period to lifetime budget constraint:

A1 = (1 + r) A0 + (1 + r) (Y0 − C0 )
A2 = (1 + r) A1 + (1 + r) (Y1 − C1 )
2 2
= (1 + r) A0 + (1 + r) (Y0 − C0 ) + (1 + r) (Y1 − C1 )
...
T −1
T −t
T
X
AT = (1 + r) A0 + (1 + r) (Yt − Ct )
t=0

T
Divide both sides by (1 + r)

T −1 T −1
AT X Ct X Yt
T
+ t = A0 + t
(1 + r) t=0 (1 + r) t=0 (1 + r)

−t
and let T → ∞ and use transversality condition limt→∞ (1 + r) At = 0
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Consumption under Certainty: Lagrangian

Lagrangian

∞ ∞ 
" t  t #
X
t
X 1 1
L= β u (Ct ) + λ A0 + Yt − Ct
t=0 t=0
1+r 1+r

First order condition

 t
t ′ 1
β u (Ct ) = λ
1+r

Dividing the FOCs for t + 1 and t yields the Euler equation.

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Consumption under Certainty: Euler Equation

Euler equation

u′ (Ct ) = β (1 + r) u′ (Ct+1 )

Effect of increase in r on current consumption?

− Substitution effect: Consumption falls
− Income effect: Positive for net lender, negative for net borrower

Special case: β (1 + r) = 1

u′ (Ct ) = u′ (Ct+1 ) ⇒ Ct = C̄ ∀ t

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The Permanent Income Hypothesis

With β (1 + r) = 1: constant consumption

Use lifetime budget constraint to compute the consumption level

∞  t ∞  t
X 1 X 1
C̄ = A0 + Yt
t=0
1+r t=0
1+r
∞ 
" t #
r X 1
⇒ C̄ = A0 + Yt
1+r t=0
1+r

Consumption is annuity value of total wealth or permanent income

− Financial wealth
− Human capital: future incomes

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Consumption under Uncertainty
Individual problem:

∞
X
max
∞
E0 β t u (Ct )
{Ct }t=0
t=0

subject to lifetime budget constraint

∞  t ∞  t
X 1 X 1
E0 Ct = A0 + E0 Yt
t=0
1+r t=0
1+r

or per-period budget constraint:

1
Ct + At+1 = Yt + At
1+r

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Consumption under Uncertainty: Lagrangian

Individual maximizes
∞
X
max Et β i u (Ct+i )
{At+i+1 ,Ct+i }∞
i=0
i=0
s.t.At+i+1 ≤ (1 + r) (Yt+i + At+i − Ct+i )

Lagrangian
(∞ )
X
i
L = Et β {u (Ct+i ) + λt+i [(1 + r) (Yt+i + At+i − Ct+i ) − At+i+1 ]}
i=0

where λt+i are the Lagrange multipliers

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Consumption under Uncertainty: Euler Equation
First order conditions in period t are then given by:

Ct : β 0 u′ (Ct ) − β 0 λt (1 + r) = 0
At+1 : −λt + βEt [λt+1 ] (1 + r) = 0

Solving first FOC for λt yields

1
λt = u′ (Ct )
1+r

and solving one period forward

1
Et [λt+1 ] = Et [u′ (Ct+1 )]
1+r

Plug these into second FOC to get:

u′ (Ct ) = β (1 + r) Et [u′ (Ct+1 )]

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The Random Walk Hypothesis
A special case again
− Assumption 1: β (1 + r) = 1
− Assumption 2: Quadratic utility
b2 2
u (C) = b1 C − C
2
b1 > 0, b2 > 0, C < b1 /b2 such that u is strictly increasing

Euler equation

Ct = Et Ct+1

Random walk hypothesis: optimal consumption is a martingale

Hall (1978)

Expected consumption growth is zero

Et [∆Ct+1 ] = Et [Ct+1 − Ct ] = 0
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Optimal Consumption
Start from budget constraint and set Et Ct+i = Ct ∀i:

∞  i "∞  i #
X 1 X 1
Et Ct+i = At + Et Yt+i
i=0
1+r i=0
1+r
∞  i "∞  i #
X 1 X 1
⇔ Ct = At + Et Yt+i
i=0
1+r i=0
1+r
"∞  i #
1 X 1
⇔ 1 Ct = At + Et Yt+i
1 − 1+r i=0
1+r
" "∞  i ##
r X 1
⇔ Ct = At + E t Yt+i
1+r i=0
1+r

∞
1
ai =
P
Note: convergence of inf. geometric sequence 1−a if 0 < a < 1
i=0

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Terminology Again

" "∞  i ##
r X 1
Ct = At + Et Yt+i
1+r i=0
1+r

∞  i 
1
P
Human capital: Et 1+r Yt+i
i=0

Total net worth = sum offinancial and human capital:

∞  i
1
P
At + Et 1+r Yt+i
i=0

Permanent
 income
 ∞ = annuity value
 of total net worth:
i
r 1
P
1+r At + Et 1+r Yt+i
i=0

Consumption equals permanent income

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More Implications
Have already derived first testable prediction
− Expected consumption growth is zero

Let’s derive more implications for consumption dynamics

Let’s find an expression for ∆Ct+1 using

" "∞  i ##
r X 1
Ct = At + E t Yt+i
1+r i=0
1+r
" "∞  i ##
r X 1
Ct+1 = At+1 + Et+1 Yt+1+i
1+r i=0
1+r
1
At = At+1 − Yt + Ct
1+r

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Consumption Dynamics: Derivation
" "∞  i ##
r 1 X 1
Ct = At+1 − Yt + Ct + Et Yt+i
1+r 1+r i=0
1+r
" "∞  i ##
r r 1 X 1
Ct = Ct + At+1 − Yt + Et Yt+i
1+r 1+r 1+r i=0
1+r
" "∞  i ##
1 r 1 X 1
Ct = At+1 − Yt + Et Yt+i
1+r 1+r 1+r i=0
1+r
" "∞  i ##
r X 1
Ct = At+1 − (1 + r)Yt + (1 + r)Et Yt+i
1+r i=0
1+r
" "∞  i ##
r X 1
Ct = At+1 − (1 + r)Yt + (1 + r)Yt + (1 + r)Et Yt+i
1+r i=1
1+r
" "∞  ##
 i
r X 1
Ct = At+1 + (1 + r)Et Yt+i
1+r i=1
1 + r
" "∞  i ##
r X 1
Ct = At+1 + Et Yt+1+i
1+r i=0
1+r

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Consumption Dynamics

∆Ct+1 = Ct+1 − Ct
" "∞  i # "∞  i ##
r X 1 X 1
= Et+1 Yt+1+i − Et Yt+1+i
1+r i=0
1+r i=0
1+r

Consumption does not change in response to predicted inc. change

Transitory income shock: small consumption response

Permanent income change: fully passed through to consumption

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Consumption Growth vs. Income Growth

Assume quarterly aggregate income growth follows an AR(1):

∆Yt+1 = α + ρ∆Yt + ϵt+1

− ϵt+1 ∼ iid 0, σ 2 and 0 ≤ ρ < 1

If α = ρ = 0, then income follows a random walk:

∆Yt+1 = ϵt+1 ⇔ Yt+1 = Yt + ϵt+1

Assume ρ = 0 and Yt = Yb
− Et (Yt+1 ) = Yb , Et (Yt+2 ) = Yb , . . .

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Consumption Growth vs. Income Growth
Shock hits in period t + 1: Yt+1 = Yb + ϵ

For all periods i ≥ 1 it holds that:

Et (Yt+i ) = Yb
Et+1 (Yt+i ) = Yb + ϵ

Change in annuity value of exp. total net worth: ϵ

Change in consumption equal to this, i.e. equal to income change

Volatility of consumption and income growth equal

With ρ > 0: Consumption growth more volatile than income growth

− Change in permanent income is larger than change in actual income

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Testable Implications

1. Expected consumption growth equals zero

2. Consumption growth more volatile than income growth

3. Consumption growth does not react to predicted income changes

4. Transitory income changes: low marginal propensity to consume

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Empirical Tests
Let’s look at three papers empirically studying these implications

John Y. Campbell and N. Gregory Mankiw (1989). “Consumption,

income, and interest rates: Reinterpreting the time series evidence”.
NBER Macroeconomics Annual 4, pp. 185–216
− Is consumption growth predictable?

Sydney C. Ludvigson and Alexander Michaelides (2001). “Does

buffer-stock saving explain the smoothness and excess sensitivity of
consumption?” The American Economic Review 91.3, pp. 631–647
− Is consumption growth more volatile than income growth?
− Is consumption growth predicted by lagged income growth?

David S. Johnson, Jonathan A. Parker, and Nicholas S. Souleles

(2006). “Household expenditure and the income tax rebates of
2001”. The American Economic Review 96.5, pp. 1589–1610
− How large is consumption response to transitory income changes?

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Campbell and Mankiw (1989)

Random walk hypothesis: change in consumption is unpredictable

Alternative theory: two types of consumers

− First group behaves according to permanent income theory
− Second group spends current income (rule of thumb consumers)

Denote with λ fraction of consumption by rule of thumb consumers

Ct − Ct−1 = λ (Yt − Yt−1 ) + (1 − λ) et
≡ λZt + νt
− et : change in estimate of permanent income

Estimate with OLS? Zt and νt most likely correlated

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Campbell and Mankiw (1989) (cont.)

IV strategy
− Residual reflects new information between t − 1 and t
− Any variable known as of t − 1 uncorrelated with residual
− Instruments: lagged income and consumption growth rates

Estimates for λ across specifications around 0.5

− Violation of random walk hypothesis
− But: estimates also clearly below 1

Two-agent model still widely used in macro research today

Debortoli and Galı́ (2018), Bilbiie, Primiceri, and Tambalotti (2022)

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Ludvigson and Michaelides (2001)

Is consumption growth more volatile than income growth?

− Consumption growth about half as volatile as agg. income growth
− Excess smoothness puzzle

Is consumption growth predicted by lagged income growth?

− Consumption growth is positively correlated with lagged income
− Excess sensitivity puzzle

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Johnson, Parker, and Souleles (2006)

How large is consumption response to transitory income changes?

− Economic Growth and Tax Relief Reconciliation Act of 2001
− Retroactive reduction of federal income tax for lowest tax bracket
− Advance tax rebate between July and September 2001
− Announced in June 2001
− $300 per adult for most households ($38 billion in total)
− Timing of payment based on last two digits of social security number
− Special module added to CEX on timing and amount of rebate

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Johnson, Parker, and Souleles (2006) (cont.)
X
∆cit = β0s months + β1′ Xi,t−1 + β2 Rit + εit
s

− ∆cit : change in nondurable expenditures of household i in quarter t

− months : time dummy; Xi,t−1 : vector of demographics
− Rit : dollar value of the rebate received by household i in quarter t

Rebate coefficient β2 around 0.25

− Cannot be directly interpreted as MPC, but requires significant MPC

Other estimation strategies confirm large MPC

− Lottery winnings (Fagereng, Holm, and Natvik 2021)
− Hypothetical questions (Fuster, Kaplan, and Zafar 2021)

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Taking Stock

Influential predictions from basic consumption theory

− Permanent income hypothesis / random walk hypothesis

Empirically, strict forms of the hypotheses are rejected

So far: consumption-savings problems with an infinite horizon

Next slide set: life-cycle problems

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References

Bilbiie, Florin, Giorgio E. Primiceri, and Andrea Tambalotti (2022). “Inequality and Business
Cycles”. Working Paper.

Campbell, John Y. and N. Gregory Mankiw (1989). “Consumption, income, and interest rates:
Reinterpreting the time series evidence”. NBER Macroeconomics Annual 4, pp. 185–216.

Debortoli, Davide and Jordi Galı́ (2018). “Monetary policy with heterogeneous agents: Insights
from TANK models”. Working Paper.
Fagereng, Andreas, Martin B. Holm, and Gisle J. Natvik (2021). “MPC heterogeneity and
household balance sheets”. American Economic Journal: Macroeconomics 13.4, pp. 1–54.

Fuster, Andreas, Greg Kaplan, and Basit Zafar (2021). “What would you do with $500? Spending
responses to gains, losses, news, and loans”. The Review of Economic Studies 88.4,
pp. 1760–1795.

Hall, Robert E. (1978). “Stochastic implications of the life cycle-permanent income hypothesis:
theory and evidence”. Journal of Political Economy 86.6, pp. 971–987.

Heathcote, Jonathan, Fabrizio Perri, and Giovanni L. Violante (2010). “Unequal we stand: An
empirical analysis of economic inequality in the United States, 1967–2006”. Review of
Economic Dynamics 13.1, pp. 15–51.

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References (cont.)

Johnson, David S., Jonathan A. Parker, and Nicholas S. Souleles (2006). “Household expenditure
and the income tax rebates of 2001”. The American Economic Review 96.5, pp. 1589–1610.
Ljungqvist, Lars and Thomas J. Sargent (2018). Recursive macroeconomic theory. MIT Press.

Ludvigson, Sydney C. and Alexander Michaelides (2001). “Does buffer-stock saving explain the
smoothness and excess sensitivity of consumption?” The American Economic Review 91.3,
pp. 631–647.

Romer, David (2019). Advanced Macroeconomics. New York: McGraw-Hill.

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