Intermediate Macroeconomics

(ECB001/ECB501)
Lecture 1: Consumption
Dawid Trzeciakiewicz

Topic 1 Consumption Dawid Trzeciakiewicz 1

 The Composition of GDP 2018 USA

Gross domestic product 20580 100.0%

Personal consumption expenditures 13999 68.0%
Durable goods 1475.6 7.2%
Nondurable goods 2889.2 14.0%
Services 9633.9 46.8%
Gross private domestic investment 3628.3 17.6%
Nonresidential 2786.9 13.5%
Residential 786.7 3.8%
Change in private inventories 54.7 0.3%
Government cons. and inv. 3591.5 17.5%
Net exports of goods and services -638.2 -3.1%
Exports 2510.3 12.2%
Imports 3148.5 15.3%

Source: BEA https://apps.bea.gov/iTable/iTable.cfm?reqid=19&step=2#reqid=19&step=2&isuri=1&1921=survey

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 Lecture overview
This lecture surveys the most prominent work on consumption:
• John Maynard Keynes: consumption and current income
• Irving Fisher: intertemporal choice
• Franco Modigliani: the Life-Cycle Hypothesis
• Milton Friedman: the Permanent Income Hypothesis
• Robert Hall: the Random-Walk Hypothesis
• Borrowing constraints
• Precautionary savings

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 Reading / References
• Mankiw, N. G. (2019), Macroeconomics, Macmillan International, 10th ed.
Chapter 19
• Mankiw, N. G., Taylor, M. P. (2014), Macroeconomics European Edition,
Worth Publishers, 2th ed. Chapter 18
• Williamson, S.D. (2018), Macroeconomics, Pearson Education Limited, 6th
ed. Chapter 9
• Garin, J., Lester, R., Sims, E. (2018), Intermediate Macroeconomics.
Available at: https://www3.nd.edu/~esims1/gls_int_macro.pdf Chapter
9.
• Chamberlin, G., Yueh, L., Y., (2006), Macroeconomics, Thomson Learning.

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Keynes’s conjectures

MPC – slope of the 1. 0 < MPC < 1

C
consumption function
C=+MPC*Y 2. Average propensity
to consume (APC)
falls as income rises.
MPC APC
1
(APC = C/Y)
1

APC 3. Income is the main

Slope = APC determinant of
1
APC=C/Y= /Y+MPC consumption.

0 Y

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 The Keynesian consumption function
Initially empirical research supported the Keynesian
consumption function
Long-run consumption
C
function – APC remains
Problems: Based on the Keynesian consumption function, constant
economists predicted that C would grow more slowly
than Y over time.

This prediction did not come true:

 As incomes grew, the APC did not fall, and C grew
just as fast. Short-run consumption
 Simon Kuznets showed that C/Y was very stable function – APC decreases
in long time series data.

0 Y

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 Application 1
a) On the 7th September 2021 Prime Minister Boris Johnson announced an increase to
National Insurance Contributions. The change is to take effect from April 2022.
Explain when and how this tax cut would impact consumer spending according to the
Keynesian consumption function?
b) Caroll et al. (2017, QE) write about the MPC in the following manner: “Indeed, some
of the dispersion in MPC estimates from the microeconomic literature (where
estimates range up to 0.75 or higher) might be explainable by the model’s implication
that there is no such thing as “the” MPC—the aggregate response to a transitory
income shock should depend on details of the recipients of that shock in way that the
existing literature may not have been sensitive to (or may not have been able to
measure).” What do you think authors mean by saying that the MPC depends on the
details of recipients?

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 Thus Far:
Keynesian consumption theory
• Keynes’ conjectures
– MPC is between 0 and 1
– APC falls as income rises
– current income is the main determinant of current consumption

• Empirical studies
– in household data & short time series: confirmation of Keynes’ conjectures
– in long time series data:
APC does not fall as income rises

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 Lecture overview
This lecture surveys the most prominent work on consumption:
• John Maynard Keynes: consumption and current income
• Irving Fisher: intertemporal choice
• Franco Modigliani: the Life-Cycle Hypothesis
• Milton Friedman: the Permanent Income Hypothesis
• Robert Hall: the Random-Walk Hypothesis
• Borrowing constraints
• Precautionary savings

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 Irving Fisher and Intertemporal Choice
• The basis for much subsequent work on consumption.

• Assumes consumer is forward-looking and chooses consumption for the present and
future to maximize lifetime satisfaction.

• Consumer’s choices are subject to an intertemporal budget constraint,

a measure of the total resources available for present and future consumption

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 Intertemporal Choice; The Basic Model
1. Two time periods => t=0, 1
2. Real Income => y0, y1
3. Real Consumption Expenditure => c0, c1
4. Real savings => s0
5. Real interest rate on bonds => r; the same for lending and borrowing
6. Real budget constraint at time 0 => c0+s0=y0
7. Real budget constraint at time 1 => c1=y1+(1+r)s0
8. If s>0 =>?
9. If s<0 =>?

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 Intertemporal budget constraint
• Budget constraint at time 0 => c0+s0= y0
• Budget constraint at time 1 => c1=y1+(1+r)s0
• From budget constraint at time 1 we get:
s0=(c1-y1)/(1+r) (1)

• Therefore the lifetime budget constraint is:

(2)
c0+(c1-y1)/(1+r)= y0
• Or:
(3)
c0+c1/(1+r)= y0 +y1/(1+r)=W

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Intertemporal budget constraint
C1 , Y 1 The intertemporal budget
constraint:
A c0+c1/(1+r)= y0 +y1/(1+r)=W
(1+r)
W
Can be written as:
c0+c1/(1+r)=W

Or:
C1 E
c1= -(1+r)c0 +(1+r)W
Budget constraint
Slope = -(1+r)
If c0 =0 then c1 =(1+r)W
(1+r) D If c1 =0 then c0 =W
0 C0 W C0, Y0
Shift of the budget constraint?

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Endowment
C1 , Y 1
Example endowment points
A Endowment point
(1+r) determines exogenous
W income at time 0 and at
B Y0=Y1 time 1.
Y1
Summarize budget
Y1 E constraint thus far

C
Y1

45° D
0 Y0 Y0 Y0 W C0, Y0

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Preferences
Assumptions:
C1 , Y 1 Indifference curves 1. More is better
2. Preference for
diversity
3. Consumption today
and tomorrow are
B F normal goods
Slope of I1 at point A and B = -MRSc0,c1

Indifference curve
I3
I2 MRSc0,c1 - marginal rate
A
I1 of intertemporal
substitution
0 C0, Y0

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Optimal choice
Indifference curves At optimal point the
C1 , Y 1 slope of the budget
constraint is equal to the
A slope of the indifference
(1+r)
W B curve, i.e. (1+r) =
MRSc0,c1
Budget constraint

In other words: a rate at

G which consumer is
C1 willing to give up future
F
consumption in order to
I3
get a unit of current
I2
C consumption is equal to
D I1 the rate prevailing in the
market.
0 C0 W C0, Y0

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Optimal choice 1
At optimal point the slope of
C1 , Y 1 the budget constraint is equal
Endowment point
to the slope of the indifference
A curve, i.e. (1+r) = MRSc0,c1
(1+r) Optimal allocation
W Y E
1 0Y0 => income at time 0
0C0 => consumption at time 0
Y0C0 = C0-Y0 => borrowing/lending
C1 G
0Y1 => income at time 1
0C1 => consumption at time 1
I2 C1Y1 => borrowings + interest/
savings + interest
D
Borrower/Lender
0 Y0 C0 W C0, Y0

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 Application 2
The $1.9 trillion economic stimulus (The American Rescue Plan Act of
2021) signed into law by President Joe Biden on March 11, 2021
included among others $1,400 direct payments to individuals.
1. In a two period model show on a graph the impact of such
transfer on consumption.
2. Reflect on your result and consider how would your answer differ
if rather than 2 periods, you would consider 3, 4 or many, many
more periods (months/quarters/years)…
3. Compare your answer in point 2 with the Keynesian consumption
function.

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Application 3
Many economists expect an increase of the interest rate in 2022 in the US (
https://www.ft.com/content/0a7a4edd-b656-4d6a-b608-454241d0288e).
In a two period model show the impact of such change on lenders.
Comment on your result. How does this compare to the Keynesian
consumption function?
Hint1. Given this is a lender think of where the optimal point will be placed
with respect to the endowment point.
Hint2. Notice, that the budget constraint after the change in the interest
rate will have to go through the endowment point!
Hint3. Think of what will happens with the slope of the budget constraint.

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Application 4
Many economists expect an increase of the interest rate in 2022 in the US (
https://www.ft.com/content/0a7a4edd-b656-4d6a-b608-454241d0288e).
In a two period model show the impact of such change on borrowers.
Comment on your result. How does this compare to the Keynesian
consumption function?

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 Summary
• Interest rate increase: lender:

• c0 => SE (-); WE (+) => SE + WE = ?

• c1 => SE (+); WE (+) => SE + WE > 0

• Interest rate increase: borrower:

• c0 => SE (-); WE (-) => SE + WE < 0

• c1 => SE (+); WE (-) => SE + WE = ?

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 Thus far:
Keynesian consumption theory
• Keynes’ conjectures
– MPC is between 0 and 1
– APC falls as income rises
– current income is the main determinant of current consumption
• Empirical studies
– in household data & short time series: confirmation of Keynes’ conjectures
– in long time series data:
APC does not fall as income rises

Fisher’s theory of intertemporal choice

• Consumer chooses current & future consumption to maximize lifetime satisfaction subject
to an intertemporal budget constraint.
• Current consumption depends on lifetime income, not current income, provided consumer
can borrow & save.

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 Homework
• Derive the Euler Equation and Consumption Function
• Utility is given by:
• The budget constraint is given by:
• Steps:
1. Form Lagrangian:
2. Find derivative with respect to and . Note: Derivative of utility with respect to
consumption is simply marginal utility; you can denote marginal utility of with .
3. Combine the two derivatives to get Euler equation with marginal utility of
consumption on the LHS and all the remaining terms on the RHS.
4. Now assume that the utility takes the following form: U=log(Ct)+β*log(Ct+1)
5. Calculate the Euler equation. Hint:
6. Find the consumption function. Hint: use Euler Equation and the intertemporal budget
constraint to present: Ct=f(Yt, Yt+1, rt).

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