ECON 314 Consumption and Consumer Expenditure Lecture 2

ECON 314
MACROECONOMICS II
Lecturer: Dr. (Mrs.) Rebecca Nana Yaa Ayifah
Contact: rnyayifah@ug.edu.gh
Second Semester of 2021/2022 Academic Year

THEORIES OF
CONSUMPTION
ECON 314 Consumption and Consumer

Expenditure: Dr. Rebecca Nana Yaa Ayifah
Theories of Consumption
Life Cycle Hypothesis:
• Franco Modigliani, Albert Ando and Richard
Brumberg (based on their work in the 1950s).
• The model emphasized that income varied

systematically over the life time of an individual
• Consumption depends on a person’s lifetime

income.
Theories of
Consumption
• The origin of the assumption of life-cycle is

retirement since it causes variations in income
• Because of variations in income in each period,
saving helps households to smooth consumption.
• Consumption smoothing takes place over

the lifetime (Try to consume the same amount
each year.
Theories of
Life CycleConsumption
Hypothesis: another illustration of the pattern
of consumption

• Absolute Income Hypothesis vs. the LCH.
• Instead of a single value for the MPC (based on a
psychological rule of thumb), the LCH implies
different MPCs out of permanent income,
transitory income and wealth (based on optimizing
behaviour).

• How do we generalise to the whole population?
• Assume assumptions for both individuals and the
population are stable.
• Add up all the individual consumption functions to get
a stable aggregate function.

• For the entire population, the aggregate consumption

function can be represented as such:
𝑐1 = 𝑘(𝑃𝑉1)
• The challenge is to operationalize the PV term.

• Ando and Modigliani provided an excellent answer.
• They argued that income can be divided into

income from labour (work) and income from
assets and property (wealth)

Theories ofConsumption
•Life Cycle Hypothesis:
• That is, 𝒀 = 𝒀𝑳 + 𝒀𝑷, where Y is income divided

into
• that from labour (𝒀 𝑳 ) and that from property (𝒀𝑷 ).
The PV is defined as:

• A simple illustration of the LCH.
• Suppose an individual starts life at the age of 20,
and plans to work until 65, and will die at 80.
• Suppose 𝑌 𝑃 is initial wealth, and Y is income
from earnings.

• Let R be the number of years an individual expects to
work before retirement.
• Then the individual’s lifetime resources is made up of
initial
wealth, W, and lifetime earnings (R x Y).
• To simplify, we assume r is zero (although if r > 0
then interest on savings will be included).

• The individual’s decision involves ensuring a smooth
consumption path over the remaining life, T.
• Suppose the individual divides their lifetime

resources (W + RY) equally over the remaining
number of years, T.

• We can specify the consumption function as

follows:
𝑪= 𝑾 + 𝑹𝒀 /𝑻
𝟏 𝑹
𝑪= 𝑾+ 𝒀
𝑻 𝑻

Theories of
Consumption
• With R = 45 and T = 60, and the

consumption function as: 𝑪 = 𝑾 + 𝑹𝒀/𝑻.
𝑪= 𝟎. 𝟎𝟏𝟕 𝑾 + 𝟎. 𝟕𝟓 𝒀
• Consumption is dependent on Wealth and Income,

thus yielding two MPCs.

• If every individual in the economy plans to
smooth consumption, then aggregating for the
entire economy, we have the aggregate
consumption function as:
𝑪 = 𝖺 𝑾 + 𝖰𝒀
• Where 𝖺 is the MPC out of wealth, and 𝖰 is the MPC
out of income.
Life Cycle Hypothesis: Implications
• For any given W, the LCH yields a

conventional consumption function (this we
already know).
• But, the intercept of the consumption function is

not fixed; it depends on the level ofwealth. (See
figure below)

Theories of
Consumption

Theories of
Consumption
• The LCH can also solve the consumption puzzle. The
APC is
𝑪 𝑾
=𝖺 +
𝒀 𝒀
𝖰
• But, wealth does not vary proportionately with
income from person to person or from year to year.

• Therefore, we expect to find that high income

corresponds to low APC when looking at data
across individuals or over short periods of
time.
• But, over long periods of time, wealth and income

grow together resulting in a constant W/Y ratio, and
thus a constant APC.
Theories of
Consumption
• A theory of consumption implies a theory

of saving.
• Thus, saving varies over an individual’s

lifetime.
• The young who are working save, whilst the

old who are retired dissave.
Theories of
Consumption
Permanent Income Hypothesis(Theory):
• Milton Friedman.
• The Permanent-Income Hypothesis argues that
consumption is related not to current income but to
a longer-term estimate of income ( what Friedman
termed permanent-income).

Permanent Income Hypothesis:
• PIH complements Modigliani’s LCH.

• Unlike the LCH, PIH emphasises that individuals
experience random and temporary changes
(Transitory) in their incomes from year to year.

• Permanent income determines the steady rate of

consumption an individual could maintain
for the rest of his/her life, given the
present level of wealth and income earned
now and in the future.

• For this representative individual, we have:
𝑪𝒊 = 𝒇𝒊 𝑷𝑽𝒊 ; where 𝒇𝒊 > 𝟎
• 𝑷𝑽 is the current asset value of the income

stream.

• By multiplying this asset value by the rate of return,

r, it yields Friedman’s permanent income from that
asset value:
𝒚𝒊𝒑 = 𝒓. 𝑷𝑽𝒊

• As in LCH, Friedman assumes that the consumer

wants to smooth his/her actual income stream into
a more or less flat consumption pattern.
• Thus, the level of permanent consumption, 𝒄𝒊

𝒑 ,
is
proportional to permanent income, 𝒚𝒊𝒑.

• This can be stated as: 𝒄𝒊 = 𝒌𝒊 𝒚𝒊
𝒑 𝒑
• 𝒌𝒊 is the ratio of permanent consumption to

permanent income.
• This depends on the interest rate (return on saving),
individual tastes (that shapes the individual’s
indifference curve), and the variability of
expected income.
• If these factors are not associated with income, then
the average k for all income classes will be the same,
equal to the population average k
• Aggregating and generalising, yields: 𝑪 =

𝒄𝒀𝑷, where YP is permanent (disposable)
income.
• Friedman also suggested that current income is

transitory
the sum ofincome:
two components: permanent income
𝒀= 𝒀 + 𝒀𝑷 𝑻
and

Permanent Income Hypothesis: Implications
• On consumption puzzle: PIH argues Keynesian

consumption function uses the wrong variable; use
of current income instead of permanent
income.
• Relating current income to consumption results in

what Friedman termed errors in variables
problem. ECON 314 Consumption and Consumer
• Under PIH, the APC depends on the ratio of
permanent income to current income.
𝑪 𝒄𝒀𝑷 𝒄𝒀 𝑷
APC = = =
𝒀
𝒀
• When current income temporarily rises above
permanent income, the APCExpenditure:
temporarily
ECON falls.
314 Consumption and Consumer
Dr. Rebecca Nana Yaa Ayifah
Theories of
Consumption
• When current income temporarily falls

below permanent income, the APC
temporarily rises.
• Regarding studies using household/cross sectional

data, Friedman reasoned that these data reflected
a combination ofpermanent and transitory
income.

Theories of
Consumption
• Households with high permanent income, have

proportionately high consumption.
• So, if all variations in income came from

permanent income, then the APC will be the same
for all households.

• However, some of the variations are the result

of transitory income, and therefore households
with high transitory income do not have higher
consumption.
• Thus, if increase in current income is due to
transitory income, consumption rises by a
little.

• Therefore, households with high-income, have on

average lower APC.
• In the short-run it is the transitory income which

changes, so the APC falls when income rises.

Theories of
Consumption
• Regarding time series data, Friedman argued that

year-to-year fluctuations in income are dominated
by transitory income.
• Therefore, years of high income should be

years of low APC.

• But over longer periods of time (from decade

to decade), variations in income are the result
of permanent income.
• Therefore, in long time series one should observe

a constant APC.

Other Explanations to Consumption:
• Random Walk Hypothesis.
• The problem of Liquidity Constraints and

Myopia.
• The Pull of Instant Gratification

Theories of
Consumption
Random Walk Hypothesis:
• Robert Hall.
• Combines Irvin Fisher’s assumptions on
forward- looking consumers with rational
expectations.
• What is the idea behind the Random-Walk
Hypothesis of consumption?


• The RWH links income uncertainty and changes in
consumption.
• Hence, changes in consumption must be the result of
surprise changes (random and unpredictable) in
income.
• PIH and rational expectations implies
consumption follows a random walk

Theories of
Consumption
• The famous random walk model is specified

as:  
Ct 1  Ct
  C t 1 
Ct
• Implications for economic policies: where rational

expectations exists, only unexpected policies can
have an effect on consumption.
• Policy changes are therefore effective only when
they
change expectations.

Theories of
Consumption
Explaining Other Aspects of Consumption Behaviour:
Liquidity Constraints and Myopia

• The LCH and PIH do not explain all of
consumption behaviour. Why?
• Other factors, such as liquidity constraints and

myopia can also explain consumption behaviour.
Liquidity Constraints
• This situation occurs when consumers are unable

to borrow to consume at the higher level
predicted by the LCH and PIH permanent income
is higher than current income.

• Therefore, current consumption cannot exceed

current income as suggested in the Fisher model.
This creates a borrowing constraint:
C 1  Y1

• Therefore, current consumption cannot exceed

current income as suggested in the Fisher model.
This creates a borrowing constraint:

• In the figure, the consumer must satisfy both the

intertemporal budget constraint and borrowing
constraint.
• Two possibilities regarding the liquidity constraint can

be illustrated.

• The implication is that there are two consumption

functions:
• (1)for those facing liquidity constraints
• (2) for those unconstrained by borrowing.

Theories of
Consumption
Liquidity Constraints: Implications
• According to the LCH (and PIH), consumption should
not
rise much when income rises, so long as the increase
in income was expected.
• Because of liquidity constraints consumption will be
more
closely related to current income than is predicted
by the LCH and PIH. ECON 314 Consumption and Consumer
Theories of
Consumption
Myopia:
• Here consumers simply aren’t as forward-looking as
the theories argue.
• Rational habits assume that consumers are aware of the

effect of their current consumption decisions on their
future marginal rates of substitution.

Myopia:
• Therefore, with myopia, any expectation of a rise

in income does not change consumption until
the actual increase in income takes place.

Myopia:
• What accounts for the lag in the response of
consumption to expected increases in income?
1. Because such individuals do not have assets to

enable them adjust to spending before actual
payments (liquidity constraint)

Myopia:
2. Because they fail to pay attention to the
announcements of the expected increases
(myopia)
3. Because they do not believe the announcements

of expected increases in future income.

The Pull of Instant Gratification:

• According to David Laibson, consumers regard
themselves to be imperfect decision-makers.
• Consumption decisions are influenced by psychological
factors, in contrast to the rational utility maximisation
presumption. Preferences become time-inconsistent.


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ECON 314

Second Semester of 2021/2022 Academic Year

ECON 314 Consumption and Consumer

• The model emphasized that income varied

• Consumption depends on a person’s lifetime

• The origin of the assumption of life-cycle is

• Consumption smoothing takes place over

ECON 314 Consumption and Consumer

ECON 314 Consumption and Consumer

ECON 314 Consumption and Consumer

• For the entire population, the aggregate consumption

ECON 314 Consumption and Consumer

• Ando and Modigliani provided an excellent answer.

• They argued that income can be divided into

ECON 314 Consumption and Consumer

• That is, 𝒀 = 𝒀𝑳 + 𝒀𝑷, where Y is income divided

ECON 314 Consumption and Consumer

ECON 314 Consumption and Consumer

ECON 314 Consumption and Consumer

• Suppose the individual divides their lifetime

ECON 314 Consumption and Consumer

• We can specify the consumption function as

ECON 314 Consumption and Consumer

• With R = 45 and T = 60, and the

• Consumption is dependent on Wealth and Income,

ECON 314 Consumption and Consumer

• For any given W, the LCH yields a

• But, the intercept of the consumption function is

ECON 314 Consumption and Consumer

ECON 314 Consumption and Consumer

ECON 314 Consumption and Consumer

• Therefore, we expect to find that high income

• But, over long periods of time, wealth and income

• A theory of consumption implies a theory

• Thus, saving varies over an individual’s

• The young who are working save, whilst the

ECON 314 Consumption and Consumer

• PIH complements Modigliani’s LCH.

ECON 314 Consumption and Consumer

• Permanent income determines the steady rate of

ECON 314 Consumption and Consumer

• For this representative individual, we have:

𝑪𝒊 = 𝒇𝒊 𝑷𝑽𝒊 ; where 𝒇𝒊 > 𝟎

• 𝑷𝑽 is the current asset value of the income

ECON 314 Consumption and Consumer

• By multiplying this asset value by the rate of return,

ECON 314 Consumption and Consumer

• As in LCH, Friedman assumes that the consumer

• Thus, the level of permanent consumption, 𝒄𝒊

ECON 314 Consumption and Consumer

• 𝒌𝒊 is the ratio of permanent consumption to

• Aggregating and generalising, yields: 𝑪 =

• Friedman also suggested that current income is

ECON 314 Consumption and Consumer

• On consumption puzzle: PIH argues Keynesian

• Relating current income to consumption results in

• When current income temporarily falls

• Regarding studies using household/cross sectional

ECON 314 Consumption and Consumer

• Households with high permanent income, have

• So, if all variations in income came from

ECON 314 Consumption and Consumer