The Demand Side of the Economy:

1. What drives household consumption and savings?

2. What drives business investment decisions?

3. Goods Market Equilibrium

2
Consumption = demand for consumer goods and services by
households

Why Consumption is an important macroeconomic variable?

1. C is the major component of demand (more than 2/3 of GDP in US)

2. Household consumption decision is closely linked to saving

decision. (For given level of disposable income, deciding how much
to consume = deciding how much to save)

We are interested in aggregate levels of Consumption and Saving.

3
Table 1.1.5. Gross Domestic Product
[Billions of dollars] Seasonally adjusted at annual rates
Bureau of Economic Analysis
Last Revised on: December 22, 2022 - Next Release Date January 26, 2023
2022 Q3
Line
Billions of $ % of GDP
1 Gross domestic product $25,724 100%
2 Personal consumption expenditures $17,543 68%
3 Goods $5,989 23%
4 Durable goods $2,196 9%
5 Nondurable goods $3,793 15%
6 Services $11,554 45%
7 Gross private domestic investment $4,579 18%
8 Fixed investment $4,508 18%
9 Nonresidential $3,403 13%
10 Structures $655 3%
11 Equipment $1,352 5%
12 Intellectual property products $1,397 5%
13 Residential $1,105 4%
14 Change in private inventories $71 0%
15 Net exports of goods and services -$891 -3%
16 Exports $3,065 12%
17 Goods $2,141 8%
18 Services $924 4%
19 Imports $3,956 15%
20 Goods $3,270 13%
21 Services $686 3%
22 Government consumption expenditures and gross investment $4,493 17%
23 Federal $1,657 6%
24 National defense $935 4%
25 Nondefense $722 3% 4
26 State and local $2,836 11%
 Keynesian Consumption Function

• Keynes made two basic assumptions:

• 1. The marginal propensity to consume is between 0 and 1 and is relatively
constant
• 2. The average propensity to consume declines with income. Equivalently, the
savings rate rises with income.

• These two assumptions are captured in the following equation:

C = a + b*Yd

a = ‘subsistence’ level of Consumption

b = marginal propensity to consume = MPC= fraction of additional current
income consumed in current period; between 0 and 1.
Key: Consumption is based solely on current income. 5
• Keynesian Consumers

C = a + b*Yd (ignoring Taxes and Transfers: Yd = Y)

Marginal Propensity to consume (MPC) = ΔC/ ΔY=b

Average Propensity to consume (APC)=a/Y+b

• Based on cross-country and long run time series data: a  0 ,

• b=MPC = ΔC/ ΔY  0.90

• Problem: In household level data over short term MPC < 0.90

• People run a regression: ΔC = β0 + β1 ΔY + error.

• With household data β1 around 0.40
6
• Keynesian consumption function does not seem to match short run household
data, although it does match long run country level data.

• Drawbacks of Keynesian Consumption Functions (aside from not matching

data):
– Does not Include Expectations about the future <<this is important!>>
– Does not Distinguish Between Different Types of Income Changes (one-time
increase vs. permanent increase)
– Does not allow for the role of interest rates
– Does not result from optimizing household behavior

• The Lifecycle/Permanent Income Hypothesis theory allows us to look at

household consumption behavior.
7
Milton Friedman/Franco Modigliani:

– Consumers like Smooth Consumption

– Optimize ‘lifetime’ utility over consumption and leisure

Today, you plan your consumption based upon what you

observe today and what you expect to happen tomorrow!

– People like to smooth ‘marginal utility’ across seasons, business

cycles and life cycles.
– Think about it: Retirement, Job Loss, Summer Vacations, etc.
– Does much better at matching data – (although not perfect)
8
• Assumptions:
1. Time horizon = 2 periods (working age and retirement)
2. Current income, future income, and wealth are given
3. Agents can borrow and lend at the same given real interest
rate r = i – π =nominal interest rate - inflation

• Notation:
y = current real income
yf = future real income
a = real assets (wealth) at the beginning of the current
period
af= wealth at the beginning of future period
c = current real consumption
cf = future real consumption
9
• How much the consumer can afford?

• For given resources, current consumption affects future consumption!

• Current resources: y + a
• Leftover after consumption: y + a – c
• Wealth in the future: af = (y + a – c)*(1 + r)
• Total resources in the future: (y + a – c)*(1 + r) + yf

• The future period is the last period, then consume all resources!

cf = (y + a – c)*(1 + r) + yf

• This is the budget constraint = combination of current and future consumption

that the agent can afford for given current, future income and wealth. 10
 cf

cf = (y + a – c)*(1 + r)+ yf

Slope=– (1 + r)

Downward sloping: trade-off between current and future c

Slope = -(1 + r ) One unit increase in current consumption reduces

savings by 1 unit and hence future consumption by (1 + r) units 11
• A given amount of money is always more valuable sooner than later since
this enables one to take advantage of investment opportunities.

• Because of this present values are smaller than corresponding future

values .

• The present value of R dollars to be delivered t years in the future is the

amount you need to pay today, at current interest rates, to ensure that you
end up with R dollars t years from now.

• PV= R /(1+i)t

12
• If payments are measured in nominal terms you use the nominal interest rate i,
if in real terms (as in our model) then you use r

• Let’s define:
• PVLR = present value of lifetime resources,
• PVLR = a + y + yf/(1+r)

• PVLC = present value of lifetime consumption

• PVLC = c + cf /(1+r)

• The budget constraint can be rewritten as

• PVLC = PVLR
13
 cf

c + cf /(1+r) = y + a + yf /(1+r)

PVLR c

PVLR = current consumption if you consume everything today!

c = PVLR if cf = 0
14
• Given the available combinations of current and future consumption,
what is the one preferred by the agent?

• Utility describes the satisfaction of an agent!

• U(c , cf) represents the utility the agents gets from consuming c units of
current consumption and cf units of future consumption

• For simplicity forget about leisure

The Individual will choose current and future to maximize utility.

Max U=f(C,Cf)
s.t. c + cf /(1+r) = y + a + yf /(1+r) 15
The best consumption combination is the one such that
16
the budget line is tangent to the indifference curve
▪ The effect on consumption of a change in income (current or
future) or wealth depends only on how the change affects the PVLR

▪ An increase in current income

▪ Increases PVLR, so shifts budget line out parallel to old budget
line
▪ If there is a consumption-smoothing motive, both
current and future consumption will increase
▪ Then both consumption and saving rise because of the
rise in current income
17
18
▪ The effect on consumption of a change in income (current or future) or wealth
depends only on how the change affects the PVLR
▪ An increase in future income
▪ Same outward shift in budget line as an increase in
current income.
▪ Again, with consumption smoothing, both current and future consumption
increase
▪ Now saving declines, since current income is unchanged and current
consumption increases.
▪ An increase in wealth
▪ Same parallel shift in budget line, so both current and future consumption
rise.
▪ Again, saving declines, since c rises and y is unchanged. 19
• Preferences

• U(c, cf) =ln(c) + β ln (cf) (log utility - for simplification)

Discount Factor = β≤1 : how much you like eating today versus tomorrow

• Budget constraint

• cf = (y + a - c) (1 + r) + yf

• Simple optimization:

maximize U(c, cf)

subject to cf = (y + a - c) (1 + r) + yf
20
• Example: assume that β = 1 and r = 0 (for simplicity, not realism)

• Solution: c = cf (Households want equal consumption each period).

• Suppose: y = 1, yf = 9, a = 0: What is Optimal c, cf?

• We know that c is smoothed over time (optimizing behavior)

• We also know that cf = (a + y - c) (1 + r) + yf (budget constraint)

• Solve, we get c = (a+ y + yf)/ 2 = PVLR/2 = 5

21
 Period 1 2

Income 1 9
Consumption 5 5
Saving -4 4

• Expected Income Increase is already included in Today’s

consumption plan:

– Only news today (about today or the future) affects our

consumption plan!!!!
– The fact that income rises from 1 to 9 between periods 1 and 2 is
already included in my consumption plan.
– Unexpected News about income, life spans, etc WILL affect
22
consumption decisions.
• Suppose today (period 1) I find out that my income is higher by $2. What
is the new consumption plan?

• c = cf = 6 <<still smooth consumption across periods>>

• s1 = -3, s2 = 3

• Consumption increases by a little today (and in future), saving

increases today!

– Saving increases today so consumption tomorrow will be higher

•
(transfer some of the transitory income shock towards the future)
23
MPC = ΔC (today) / ΔY (today) = ½ = 0.5
• Suppose today I find out that my wealth increased by $2 prior to
period 1 (a one-time unexpected stock market gain). What is the new
consumption plan associated with this unexpected increase in a?

• c = cf = 6

• s1 = -5 (y – c), s2 = 3 (increase in PVLR due to wealth = 2)

• Consumption increases today (and in future), and saving falls.

• One time increases in wealth are identical to one time (transitory)

changes in income.
24
• Suppose today I find out that my income will permanently increase by $2 (in
both period 1 and period 2). What is the new consumption plan?

• c = cf = 7

• s1 = -4, s2 = 4

• Consumption increases today and in future (more than in the case of a

transitory shock), and saving remains constant!

• MPC = ΔC (today) / ΔY (today) = 2/2 = 1

With permanent changes in income, consumption and income move 1 for 1.

25
▪ Different types of changes in income
▪ Temporary increase in income: y rises and yf is unchanged
▪ Permanent increase in income: Both y and yf rise

▪ Permanent income increase causes bigger increase in PVLR than a

temporary income increase
▪ So current consumption will rise more with a permanent income
increase
▪ So saving from a permanent increase in income is less than from
a temporary increase in income

26
▪ Different types of changes in income

▪ This distinction between permanent and temporary income changes

was made by Milton Friedman in the 1950s and is known as the
permanent income theory.

▪ Permanent changes in income lead to much larger changes in

consumption
▪ Thus permanent income changes are mostly consumed, while
temporary income changes are mostly saved

27
• Business Cycles are likely to be associated with temporary shocks to
income.

– We find consumption to be more stable than income over the business

cycle.
– And the saving rate is procyclical.

• Micro studies find the MPC out of income changes to be much less than 0.9 (C
does not track Y one for one)

• Micro Studies find a MPC out of changes in wealth of about 0.05.

(Unexpected capital gains in housing/securities are like one time increases in
income).
• Household consumption responds more to permanent shocks to income 28
▪ Life-cycle model was
developed by Franco
Modigliani and
associates in the 1950s

▪ Looks at patterns of
income, consumption,
and saving over an
individual’s lifetime

29
▪ Real income steadily rises over time until near retirement; at retirement, income
drops sharply
▪ Lifetime pattern of consumption is much smoother than the income pattern
▪ In reality, consumption varies somewhat by age
▪ For example, when raising children, household consumption is higher than
average
▪ The model can easily be modified to handle this and other variations
▪ Saving has the following lifetime pattern
▪ Saving is low or negative early in working life
▪ Maximum saving occurs when income is highest (ages 50 to 60)
▪ Dissaving occurs in retirement

30
▪ Bequests and saving
▪ What effect does a bequest motive (a desire to leave an inheritance) have
on saving?
▪ Simply consume less and save more than without a bequest motive
▪ Ricardian equivalence
▪ We can use the two-period model to examine Ricardian equivalence
▪ The two-period model shows that consumption is changed only if the PVLR
changes
▪ Suppose the government reduces taxes by 100 in the current period, the
interest rate is 10%, and taxes will be increased by 110 in the future period
▪ Then the PVLR is unchanged, and thus there is no change in consumption

31
Caveats to Ricardian Equivalence:

1. Myopia: In practice, people may be too short-sighted to see that future

taxes will rise if taxes are cut today; then a tax cut leads to increased
desired consumption and reduced desired national saving.

2. Selfishness: Maybe people don’t care what happens after they die

3. Imperfect Capital Markets: Maybe Government and household face

different interest rates, and the person might experience an overall
increase in the present value of lifetime resources.

32
▪ Application: How consumers respond to tax rebates
▪ The government provided tax rebates in recessions of 2001 and 2007-2009,
hoping to stimulate the economy.

▪ Research by Shapiro and Slemrod suggests that consumers did not increase
spending much in 2001.

▪ New research by Agarwal, Liu, and Souleles finds that even though
consumers originally saved much of the tax rebate, later they increased
spending and increased their credit-card debt.

▪ People getting the tax rebates initially made additional payments on their
credit cards, paying down their balances; but after nine months they had
increased their purchases and had more credit-card debt than before the tax
33
rebate.
▪ Application: How consumers respond to tax rebates

▪ Younger people, who were more likely to face binding borrowing constraints,
increased their purchases on credit cards the most of any group in response
to the tax rebate.

▪ People with high credit limits also tended to pay off more of their balances
and spent less, as they were less likely to face binding borrowing constraints
and behaved more in the manner suggested by Ricardian equivalence.

▪ New evidence on the tax rebates in 2008 and 2009 was provided in a research
paper by Parker et al.
▪ Consumers spent 50%-90% of the tax rebates
▪ Inconsistent with Ricardian equivalence 34
If the PIH theory is true, consumption of the economy should not respond that
much during recessions. Why?

1. recessions have little effect on our lifetime incomes

2. we should prepare for recessions and as a result, have savings to buffer

our low income.

In contrast to the predictions of the PIH, consumption does vary a lot with
temporary income changes!

There seems to be excess sensitivity of consumption to changes in current

income
This could be due to short-sighted behavior
Or it could be due to borrowing constraints 35
36
▪ Excess sensitivity and borrowing constraints:
▪ Liquidity constraints mean people can’t borrow as much as they want to smooth
consumption because lenders may worry that a consumer won’t pay back the
loan, so they won’t lend.

▪ If a person wouldn’t borrow anyway, the borrowing constraint is said to be

nonbinding, but if a person wants to borrow and can’t, the borrowing constraint
is binding.

▪ When Y is high, households look like PIH households as the borrowing

constraint is nonbinding. Liquidity constraints prevent borrowing NOT saving.

▪ If Y is temporarily high, households would want to save some of that income. 37

• In recessions, in order to smooth consumption, households who receive a
negative income shock either have to draw down savings or borrow. If they
are prevented from borrowing, household will have no choice but to cut their
consumption.

• As a result, C will fall during recessions.

• A consumer with a binding borrowing constraint spends all income and

wealth on consumption
• So an increase in income or wealth will be entirely spent on consumption
as well
• This causes consumption to be excessively sensitive to current income
changes ( as in the Keynesian Theory)

38
• Liquidity constraints make households look Keynesian when income
falls (C falls when Y falls – for those with no savings and who cannot
borrow).

• Hence, the main difference between Keynes and the PIH can be interpreted
as reflecting different assumptions about the importance of borrowing
constraints.

• How prevalent are borrowing constraints? Perhaps 20% to 50% of the U.S.
population faces binding borrowing constraints
• https://www.magnifymoney.com/blog/news/paycheck-survey/

39
• The real interest rate affects the consumption/saving
decision

• The price of current consumption in terms of future

consumption is 1 + r

• If you increase consumption today by 1 unit you are saving 1

unit less and you will be consuming 1 + r units less in the
future.

40
When the real interest rate rises,
one point on the old budget line is
also on the new budget line: the
No-borrowing, no-lending point

The slope of new budget line is

steeper

Now current consumption is

more expensive! (Price = 1 + r )

41
Substitution effect:

• A higher real interest rate makes future consumption cheaper relative to current
consumption.

• Suppose a person is at the no-borrowing, no-lending point when the real interest
rate rises.

• An increase in the real interest rate unambiguously leads the person to increase
future consumption and decrease current consumption

• The increase in saving, equal to the decrease in current consumption, represents the
substitution effect

• Think of people saving more to reap the higher return, or people borrowing less b/c
it is more expensive. Higher interest rate today, makes saving more beneficial (price
of future consumption falls). 42
c’ c

43
Income effect:

• If a person is planning to consume at a different point than the no-

borrowing, no-lending point, there is also an income effect

1. Net Savers: for every dollar saved, you get higher income. When richer,
you buy more of the things you like. As a result, consumption today
increases, consumption tomorrow increases, and savings today falls.

The income effect works in the opposite direction of the substitution effect,
since more future income increases current consumption. so saving may
increase or decrease. Both effects increase future consumption

44
 Net Saver
Substitution effect: D=>P
consume less, save more today

Income effect: P => Q consume

more both today and tomorrow, save
less.

Total Effect: D=>Q In this example

the substitution effect dominates on
savings

Evidence: Some studies find the

substitution effect stronger, but the
increase in savings is small.

45
Income effect:

• If a person is planning to consume at a different point than the no-

borrowing, no-lending point, there is also an income effect

2. Net Borrowers: they have to pay higher interest payments. They are
poorer. Then Consumption today will fall, consumption tomorrow
will fall and Savings today will increase.
The income effect works in the same direction as the substitution effect,
since less future income reduces current consumption further, so saving
definitely increases but the effect on future consumption is ambiguous

46
• Current Income (Both PIH and Keynesian Theories)
• Expectations of Future Income (Only PIH theory)
• Wealth
• Tax Policy
• Interest rates (slightly)
• Time Preferences (Beta)

• The magnitude of the results depend on whether consumers follow

Keynesian or PIH consumption rules and whether or not liquidity
constraints exist.
47
Investment = purchase or construction of capital goods (residential and non-
residential buildings + equipment + software) and additions to inventory
stocks.

Why Investment is an important macroeconomic variable?

1. Fluctuates sharply over the business cycle: more than any other
spending component! Only 1/6 of total GDP, but in the typical recession
accounts for more than ½ of total decline in spending

2. Plays a crucial role in determining the long-run productive capacity of

the economy (K affects Y* and MPN)
48
49
• K increases through investment, I, in a process called physical capital
accumulation.

• An equation for physical capital accumulation:

• Kt+1 = Kt - KDEPRECIATED + It

• Assuming a constant depreciation rate (δ), the physical capital

accumulation becomes:

• Kt+1 = (1-δ) Kt + It

• Tomorrow’s capital is increased by investing today (less depreciation) 50

• Net investment = gross investment (I) minus depreciation: Kt+1 – Kt = It – δKt
where net investment equals the change in the capital stock

• If firms can change their capital stocks in one period, then the desired capital
stock (K*) = Kt+1
• Gross Investment: It = δ Kt + K* – Kt

• Two components:
1. Investment needed to replace depreciated capital δ Kt
2. Desired net increase in the capital stock over the year K* – Kt
• The first part is determined by the depreciation rate and the initial level of
capital
• The second part depends on everything that affect the desired capital
stock K*
51
52
• User Cost of Capital = expected real cost of using a unit of capital for a
period. Capital is long lived so user costs include not only current, but future
costs

• Nominal Purchase Price of capital per unit = PK

• Real Interest Rate (cost of Funds). Usually have to borrow to buy equipment.
If you do not borrow and instead use retained earnings, you give up the
interest payments you would have received if you invested that money
instead of buying new equipment. (Assume borrowing rates = lending rates =
r = real interest rate).
• Depreciation Rate (percentage that depreciates, on average, per year) = δ
• User Cost (per period) = real interest cost + depreciation

• UC = r*PK + δ* Pk= PK (r+ δ)

53
• Expected Profits= PYf – WN – pK (r + δ )K
• First order condition from profit maximization:

* MPKf = PK (r + δ ) MPKf = (r + δ )(PK/P) MPKf = (r + δ )pK

• Benefits of investing are more output tomorrow – so, it is the future MPK
that is important.

• Rationale: Investment decisions today have effects on the capital stock

tomorrow. It takes time to build, install, train workers, etc. Since investment
becomes capital stock with a lag, the benefit of investment is the future
marginal product of capital (MPKf)
• If User Cost of Capital > MPKf, then it is profitable to decrease the capital
stock Kf: Invest less than what necessary to replace the depreciated capital
• If User Cost of Capital < MPKf, then it is profitable to increase the capital
stock Kf: Invest more than necessary to replace the depreciated capital.
54
55
▪ Changes in the desired capital stock

▪ Factors that shift the MPKf curve or change the user cost of
capital cause the desired capital stock to change

▪ These factors are changes in the real interest rate,

depreciation rate, price of capital, or technological
changes that affect the MPKf

56
57
58
Application: measuring the effects of taxes on investment

▪ With taxes, the return to capital is only (1 – t) MPKf

▪ The desired Capital Stock equates the AFTER-TAX MPKf to the user cost of
capital, or MPKf = (r + δ)pk/(1-t) = tax-adjusted real user cost of capital

▪ Do changes in the tax rate have a significant effect on investment?

▪ A 1994 study by Cummins, Hubbard, and Hassett found that after major tax
reforms, investment responded strongly; elasticity about –0.66 (of
investment to user cost of capital)
59
 Assume t’ > t = 0
MPKf/
User
Cost

User Cost (r, δ, t‘>0)

User Cost (r, δ, t=0)

MPKf (Af,Nf)

Kf
K*

60
61
• Investment takes time to plan.

• Investment tends to be ‘irreversible’ (costly to change if you over invest).

• Firms - like individuals - are forward looking. If interest rates fall today, I may
not invest today because I believe interest rates can be even lower tomorrow.

• Investment returns are uncertain (returns are in the future - which is unknown).
As economic uncertainty increases, investment decisions can become
delayed.

• Firms, like individuals, may be financially constrained.

The role of banks in the economy may be important. Financial constraints

means that it is costly to access external finance. 62
• So far, focus on business fixed investment (I by firms in structure,
equipment and software)

• Other two components of Investment:

1.Inventory Investment = increase in firms’ inventories of unsold

goods, unfinished goods or raw material
2.Residential Investment = construction of housing

• Same concepts of future marginal product and user cost of capital apply

• Example: apartment building

Future marginal product = real values of rents – taxes and operating
costs
User cost of capital = depreciation + interest cost (mortgage
63
payment)
• C is a function of PVLR (Y, Yf, Wealth), taxes, expectations, liquidity constraints…

• I is a function of r, δ, Af, K, expectations, investment taxes…

• G is government spending (we will discuss fiscal policy later in the class)

• NX we will model this at the end of the course (for the U.S., NX is small)

• We are moving towards a model of Goods Aggregate Demand: C(.) + I(.)

+ G + NX

• In the previous lectures we have studied the Goods Aggregate Supply,

that is what determines the total output produced: Y = AF(K,N) 64

• The Good Market is in equilibrium when the quantity of goods supplied
is equal to the quantity of goods demanded:

(1) Y = C + I + G + NX

• For the moment assume a closed economy NX = 0

• Recall the definition of national savings:

(2) S =Y – C – G

• From (1) and (2) the equilibrium in the goods market can be represented
by: S = I
• The real interest rate will adjust to bring the market in equilibrium. 65
 S(Y,G,C(.))

r*

I (Af, Nf,K)

I*=S* I,S

The interest rate adjust to guarantee the equilibrium: I=S

66
Example: increase in Af

S(Y,G,C(.))

r’

r*

I (Af, Nf,K)

I* I’ I,S

▪ Investment curve shifts right due to a fall in the effective tax rate
or a rise in expected future marginal productivity of capital
▪ Result of increased investment: higher r, higher S and I
67
 Example: increase in G

S(Y,G,C(.))

r’
r*

I (Af, Nf,K)

I’ I* I,S

▪ Saving curve shifts right due to a rise in current output, a fall in expected future
output, a fall in wealth, a fall in government purchases, a rise in taxes (unless
Ricardian equivalence holds, in which case tax changes have no effect)
▪ Example: Temporary increase in government purchases shifts S left
68
▪ Result of lower savings: higher r, causing crowding out of I