Intermediate Macroeconomics

(ECB001/ECB501)
Lecture 1: Consumption
Dawid Trzeciakiewicz

Topic 1 Consumption Dawid Trzeciakiewicz 1

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 (no changes in the exogenous
income)!
Hint3. Think of what will happen with the slope of the budget constraint.
Check whether what you get is in line with your intuition!

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 Summary
• Interest rate increase: lender:

• c0 => SE (-); IE (+) => SE + IE = ?

• c1 => SE (+); IE (+) => SE + IE > 0

• Interest rate increase: borrower:

• c0 => SE (-); IE (-) => SE + IE < 0

• c1 => SE (+); IE (-) => SE + IE = ?

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 Homework
• The Euler equation:

• For log utility U=log(Ct)+β*log(Ct+1)

• For we get:
=

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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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The Life-Cycle Hypothesis
• Due to Franco Modigliani (1950s)
• Fisher’s model says that consumption
depends on lifetime income, and
people try to achieve a smooth
consumption pattern (Euler
equation).
• The LCH says that income varies
systematically over the phases of the
consumer’s “life cycle,” and saving
allows the consumer to achieve
smooth consumption.
Topic 1 Consumption Dawid Trzeciakiewicz
• The basic model:
• W = initial wealth
• Y = annual income until retirement
(assumed constant)
• R = number of years until retirement
• T = lifetime in years
• Assumptions:
• zero real interest rate (for simplicity)
• consumption-smoothing is optimal
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The Life-Cycle Hypothesis
• Lifetime resources = W + RY
• To achieve smooth consumption, consumer
divides her resources equally over time:
• C = (W + RY )/T , or (1)
• C = aW + bY (2)
• where
• a = (1/T ) is the marginal propensity
to consume out of wealth
• b = (R/T ) is the marginal propensity
to consume out of income
• Link between wealth and interest
rates?
Topic 1 Consumption Dawid Trzeciakiewicz
•The LCH can solve the consumption puzzle:
• The APC implied by the life-cycle
consumption function is
C/Y = a(W/Y ) + b (3)
• Across households, wealth does not vary as
much as income, so high income
households should have a lower APC than
low income households.
• Over time, aggregate wealth and income
grow together, causing APC to remain
stable.
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 Life cycle hypothesis implications, figure from
Modigliani (1986, AER, p. 300)
Y- annual income;
A – wealth;
N – number of years one works;
L – number of years one lives; The LCH implies that saving varies
C – consumption systematically over a person’s lifetime.

Short-run policy implications:

1. The Monetary Mechanism – wealth in
the consumption function
2. Transitory Income Taxes

Criticism – saving behavior of the elderly:

3. Uncertainty
4. Bequest motive

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 The Permanent Income Hypothesis
• Due to Milton Friedman (1957)
• Y = YP + YT (1)
Where:
Y = current income
Y P = permanent income
average income, which
people expect to persist into
the future
Y T = transitory income
temporary deviations from
average income
Topic 1 Consumption
• Consumers use saving & borrowing to smooth consumption
in response to transitory changes in income.
• The PIH consumption function:
(2)
C = aY P
where a is the fraction of permanent income that
people consume per year.
• The PIH can solve the consumption puzzle:
• The PIH implies
APC = C/Y = aY P/Y (3)
• To the extent that high income households have on average
a higher transitory income than low income households, the
APC will be lower in high income households.
• Over the long run, income variation is due mainly if not
solely to variation in permanent income, which implies a
stable APC.
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 Permanent and Transitory Change in
Income
• What can our simple two period model say about the temporary and
permanent changes in income?
• Recall that Ct=f(Yt, Yt+1, rt)
• Show what will be the impact of a small change in each of the variable:
ΔCt=(∂Ct/∂Yt) ΔYt+(∂C/∂Yt+1) ΔYt+1 +(∂C/∂rt) Δrt (1)

• Assume ΔYt= ΔYt+1 and Δrt=0 then:

A temporary change: A permanent change:

ΔCt/ ΔYt =∂Ct/∂Yt (2) ΔCt/ ΔYt =∂Ct/∂Yt+∂C/∂Yt+1 (3)

Implication => consumption responds more to a permanent change in income

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 PIH vs. LCH
• Both: people try to achieve smooth consumption in the face of changing current
income.
• LCH: current income changes systematically as people move through their life cycle.
• PIH: current income is subject to random, transitory fluctuations.
• Both can explain the consumption puzzle.

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Application 1
Assume you are a 50-year old who expects to work for additional 25 years and then
enjoy 15 years of retirement. If you behave according to the life-cycle/permanent
income hypothesis, how would your current consumption change if:
• You win £1,000,000 in the lottery this year.
• You win in the lottery £10,000 paid each year by the end of your life.
Assume that interest rate is 0 percent. Can we draw any policy implications based on
this example?
Compare to Keynesian consumption function.

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 Application 2
In response to COVID pandemic, BoE cut the interest rates (
https://www.ft.com/content/05b2be14-6367-11ea-a6cd-df28cc3c6a68).
Explain the impact on consumption in line with LCH and Keynesian
consumption function.

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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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 The Random-Walk Hypothesis
• Due to Robert Hall (1978)
• based on Fisher’s model & PIH, in
which forward-looking consumers
base consumption on expected future
income
• Hall adds the assumption of rational
expectations, that people use all
available information to forecast
future variables like income.
Topic 1 Consumption Dawid Trzeciakiewicz
• If PIH is correct and consumers have
rational expectations, then consumption
should follow a random walk: changes in
consumption should be unpredictable.
• A change in income or wealth that was
anticipated has already been factored
into expected permanent income, so it
will not change consumption.
• Only unanticipated changes in income
or wealth that alter expected
permanent income will change
consumption.
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 Theory meets the empirical evidence
• How can we test PIH and LCH?
• How should people respond to an anticipated change in income?
• According to this theories, there should be no response due to smoothing.
• How should people react to unanticipated transitory and permanent
shocks?
• The MPC out of a transitory shock should be small
• The MPC out of a permanent shock should be close to 1.
• For a review of the literature please see: Jappelli and Pistaferri (2010,
Annual Review of Economics)

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 Anticipated Changes in Income
• Income increases: Wicox (1989, JPE), Shapiro and Slemrod (1995, 2003,
2009), Johnson, Parker, and Souleles (2006, AER)
• Income decreases: retirement Banks, Blundell and Tanner (1998, AER)
• Leisure and consumption are substitutes
• Increase in home production
• “On substance, there is by now considerable evidence that consumption
appears to respond to anticipated income increases, over and above what
is implied by standard models of consumption smoothing (…) Indeed,
consumption appears much less responsive to anticipated income
declines” Jappelli and Pistaferri (2010, Annual Review of Economics)
• The role of borrowing constraints.

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 Unanticipated Changes in Income
• Wolpin (1982, IER), Paxton (1993, JPE), Blundell, Pistaferri, Preston (2008)
• “consumption reaction to permanent shocks is much higher than that to
transitory shocks. There is also evidence, at least in the United States,
that consumers do not revise their consumption fully in response to
permanent shocks.” Jappelli and Pistaferri (2010, Annual Review of
Economics)
• The role of precautionary savings

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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

Topic 1 Consumption Dawid Trzeciakiewicz 20

 The borrowing constraint
C1
C1
The budget constraint
with no borrowing
constraints
The budget
constraint
The borrowing with a
Y1 A constraint takes borrowing
the form: Y1 B
constraint
F C0  Y 0

Y0 C0
C0
Y0

Topic 1 Consumption Dawid Trzeciakiewicz 21

 Consumer optimization when the borrowing
constraint is not binding and is binding
The borrowing The optimal
C1 constraint is not C1 choice is at point
binding if the D.
consumer’s
optimal C0 But since the
consumer cannot
is less than Y0. borrow, the best
F he can do is point
E.
E
E
D

Y0 C0 Y0 C0

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Application 3
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. In a
two period model show on a graph the impact of such transfer on
consumption. Assume two scenarios (two graphs needed): one in
which households face binding borrowing constraints and one in
which households face non-binding borrowing constraints.
Households receive checks immediately.

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 Application to business cycles: McManus, Ozkan,
Trzeciakiewicz (2021, Economica)
• Two types of households: Patient and Impatient (credit constrained
households). The Euler equations for both are given by:
(1)
(2)

The Impatient households maximize their utility subject to the budget

constraint but also the borrowing constraint and denotes a Lagrange
multiplier on the borrowing constraint. (3)

When it can be shown that for Impatient households:

(4)

Implications?
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Dynamics of credit-constrained households
McManus, Ozkan, Trzeciakiewicz (2021, Economica)

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 Application 4
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. When would consumers adjust their consumption
spending according to:
• The Keynesian consumption function;
• The Fisher two-period model with binding borrowing constraints;
• The random -walk hypothesis with no binding borrowing constraints.

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