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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 Precautionary savings Mody et al (2012, IMF WP)

COVID precautionary saving in Euro Area:

https://www.ecb.europa.eu/pub/economic-bulletin/focus/2020/html/ecb.ebbox202006_05~d36f12a192.en.html
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 Uncertainty – precautionary savings
• What if the future income is uncertain?
• Assume that the future income is state dependent; for simplicity, we will assume that there
are possible only two states:
• good state - income Ygt+1; probability p
• bad state - income Ybt+1; probability of occurring (1-p)
• Then expected future income is given by:

E(Yt+1)=p*Ygt+1+(1-p) Ybt+1 (1)

• Household maximizes expected utility; implication – expectation operator is introduced to the

Euler equation

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 Uncertainty: implications for consumption
The key insight to understanding the effects of uncertainty is that in general the function of the
expected value is not equal to the expected value of a function.
• A little bit of tedious mathematics, but implications are very important!
• Example:
• Cgt+1=4; Cbt+1=2; p=0.5;
• Assume log utility i.e. Ut=log(Ct); U’{Ct}=1/Ct
• E(Ct+1)=p*Cgt+1+(1-p)*Cbt+1=0.5*2+0.5*4=3;
• Marginal utility of expected consumption =>U’(E(Ct+1))=1/3=0.33;
• E(U’(Ct+1))=0.5*1/2+0.5*1/4=3/8=0.375
• Expected marginal utility =>E(U’(Ct+1)) = 0.375
• Implications: E(U’(Ct+1))>U’(E(Ct+1))

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 Uncertainty – precautionary savings
U’(Ct+1)

A
U’(Cbt+1)
E[U’(Ct+1)
F
U’(E[Ct+1])
E B
U’(C g
t+1 )

Cbt+1 Cgt+1 Ct+1

E[Ct+1]

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 Uncertainty – precautionary savings
U’(Ct+1)

What are the implications of the increased

uncertainty?
U’(Cbt+1,a) D
Recall Euler equation

U’(Cbt+1) A From the graph we can see that higher i

E[U’(Ct+1,a) G

E[U’(Ct+1) F
U’(E[Ct+1])
U’(Cgt+1) E B H
U’(C g
t+1,a) I2

Cbt+1 Cgt+1 Ct+1

Cbt+1,a E[Ct+1] Cgt+1,a

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 Precautionary savings
• Mody et al. (2012) show that there was a significant increase in savings and drop in consumption -
and that at least 40% of savings was due to the precautionary motives.
• There is a very good literature review by Lugilde et al (2019). The conclusion is that in general there is
precautionary savings motive in the data, however, the extent of this differ.
• Guiso, Jappelli and Terlizzese (1992, JME) indicate that precautionary savings accounts for 2 percent of
households net worth.
• For example, Carrol and Samwick (1998) indicate that roughly 40-45% of savings is due to the
precautionary savings;
• For more details please see Lugilde, Bande and Riveiro (2019, Journal of Economic Surveys)
• “In sum, although most of the reviewed works find evidence of precautionary motive for saving there
is not a consensus on the magnitude of this effect, and some works conclude that this motive is nearly
irrelevant.” Lugilde, Bande and Riveiro (2019, Journal of Economic Surveys, p. 507)
• China’s nervous consumers choose saving over spending.
• https://www.ft.com/content/c36c1f9a-c5a1-11e9-a8e9-296ca66511c9

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 Lecture Summary
This chapter 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
• David Laibson: the pull of instant gratification

Keynes => C=f(Current Income)

More recent evidence => C=f(Current Income, Expected Future Income, Wealth, Interest
Rates, Self-Control Mechanisms)

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 Application

Consider the figure on the slide presenting Gross

Disposable Income and Individual Consumption
Expenditure. How would you explain the drastic
drop in consumption in 2020?

Source: https://www.ons.gov.uk/economy/nationalaccounts/uksectoraccounts/articles/coronavirusandtheimpactonukhouseholdsandbusinesses/2020

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Savings in G7 Countries

Source: https://www.ons.gov.uk/economy/nationalaccounts/uksectoraccounts/articles/coronavirusandtheimpactonukhouseholdsandbusinesses/2020

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 Review
1. What variables, in addition to current income, are hypothesized to influence consumption in the:

a. Fisher two-period model?

b. life-cycle model?
c. permanent-income hypothesis?
d. random-walk hypothesis?  
 
2. Which theories put more emphasis on the current income and which put mor emphasis on the
future income?

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 References:
• Banks, J., Blundell, R. and Tanner, S., 1998. Is there a retirement-savings puzzle?. American Economic Review, pp.769-788.
• Bhattarai, K. and Trzeciakiewicz, D., 2017. Macroeconomic impacts of fiscal policy shocks in the UK: A DSGE analysis. Economic Modelling, 61,
pp.321-338.
• Blundell, R., Pistaferri, L. and Preston, I., 2008. Consumption inequality and partial insurance. American Economic Review, 98(5), pp.1887-1921.
• Campbell, J.Y. and Mankiw, N.G., 1989. Consumption, income, and interest rates: Reinterpreting the time series evidence. NBER
macroeconomics annual, 4, pp.185-216.
• Carroll, C.D. and Samwick, A.A., 1998. How important is precautionary saving?. Review of Economics and Statistics, 80(3), pp.410-419.
• Carroll, C., Slacalek, J., Tokuoka, K. and White, M.N., 2017. The distribution of wealth and the marginal propensity to consume. Quantitative
Economics, 8(3), pp.977-1020.
• Galí, J., López-Salido, J.D. and Vallés, J., 2007. Understanding the effects of government spending on consumption. Journal of the european
economic association, 5(1), pp.227-270.
• Guiso, L., Jappelli, T. and Terlizzese, D., 1992. Earnings uncertainty and precautionary saving. Journal of Monetary Economics, 30(2), pp.307-337.
• Hall, R.E., 1978. Stochastic implications of the life cycle-permanent income hypothesis: theory and evidence. Journal of political
economy, 86(6), pp.971-987.
• Havranek, T. and Sokolova, A., 2019. Do consumers really follow a rule of thumb? Three thousand estimates from 144 studies say “Probably
not”. Review of Economic Dynamics.
• Johnson, D.S., Parker, J.A. and Souleles, N.S., 2006. Household expenditure and the income tax rebates of 2001. American Economic
Review, 96(5), pp.1589-1610.

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 References:
• Lugilde, A., Bande, R. and Riveiro, D., 2019. Precautionary Saving: A Review of the Empirical Literature. Journal of Economic
Surveys, 33(2), pp.481-515.
• McManus, R., Ozkan, F.G. and Trzeciakiewicz, D., 2019. Why are fiscal multipliers asymmetric? The role of credit constraints. The
Role of Credit Constraints (forthcoming: Economica).
• Modigliani, F., 1986. Life Cycle, Individual Thrift, and the Wealth of Nations. The American Economic Review, Vol. 76, No. 3 (Jun.,
1986), pp. 297-313
• Mody, A., Ohnsorge, F. and Sandri, D., 2012. Precautionary savings in the great recession. IMF Economic Review, 60(1), pp.114-
138.
• Paxson, C.H., 1993. Consumption and income seasonality in Thailand. Journal of political Economy, 101(1), pp.39-72.
• Shapiro, M.D. and Slemrod, J., 1993. Consumer response to the timing of income: Evidence from a change in tax withholding,
American Economic Review, 85, pp. 274-283
• Shapiro, M.D. and Slemrod, J., 2003. Did the 2001 tax rebate stimulate spending? Evidence from taxpayer surveys. Tax policy and
the economy, 17, pp.83-109.
• Shapiro, M.D. and Slemrod, J., 2009. Did the 2008 tax rebates stimulate spending?. American Economic Review, 99(2), pp.374-79.
• Wilcox, D.W., 1989. Social security benefits, consumption expenditure, and the life cycle hypothesis. Journal of Political
Economy, 97(2), pp.288-304.
• Wolpin, K.I., 1982. A new test of the permanent income hypothesis: the impact of weather on the income and consumption of
farm households in India. International Economic Review, pp.583-594.

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