Theories of Consumption

Structure of Consumption Lecture

1. Introduction: Why study consumption?
2. Stylized facts of consumption
3. Theories of consumption
3.1 Keynesian theory of consumption
3.2 The General Formulation (Micro Foundation): Intertemporal
Optimization of consumption
3.3 The Ando-Modigliani Approach [LC Hypothesis]
3.4 The Friedman Approach [PI Hypothesis]
3.5 The Duesenenberry Approach [RI Hypothesis]
Introduction: Why study consumption?
1. It is the largest component of AD (over 75% of GDP)
2. Changes in the propensity to consume are often the
dominant source of changes in AD
3. Consumption is a basic determinant of economic
welfare (that is why we study the golden rule of capital)
4. Since saving is the basis for capital accumulation
(hence economic growth) and saving is income minus
consumption, theory of consumption is relevant for theory
of economic growth.
2. Stylized facts of consumption
Cross-section studies show that as Y increases C/Y declines (or
S/Y increase), that is, the rich save a larger fraction of their
current income than the poor.
Business cycle, short-run, data shows that C/Y is below trend
(long run average) during Boom; and above trend during slum
C/Y>Trend in Slum & C/Y<Trend in boom
This means that consumption is countercyclical
 Macroeconomic time series data for most countries (long-run
data) indicate that C/Y is roughly constant over the long run
 A consumption theory should thus explain these stylized facts
 Theories of consumption
3.1 Keynesian theory of consumption

Keynes’ theory of consumption is based on the following

three conjectures:
1) Consumption during period t, Ct, is mainly determined by
real disposable income Yt during that period: Ct=C(Yt)
2) Marginal propensity to consume (MPC) is positive but
less than 1: 0<dCt/dYt=MPC<1
3) Average propensity to consume (APC) will decrease with
the level of income (or average propensity to save will
rise with income).
The Keynesian function having the above properties is:
Ct=a+bYt
The Keynesian function indicates that:
Current consumption is a function of current income only
MPC=b (proportion of additional unit of income consumed or an additional
consumption due to additional unit of income)
APC=a/Y+b (proportion of unit of income consumed or the ratio of consumption to
income)
 APC declines as income rises. This prediction leads to the secular stagnation hypothesis
(a long depression of infinite duration); unless government spending or investment rises as
income rises over time, the economy will stagnate
APC>MPC
Criticism of the Keynesian theory of consumption
1. Not theory based: why should an optimizing consumer depend only on current
income and not on other factors such as interest rate, future expected income
and wealth
2. Though the Keynesian theory is consistent with HH data and short time series
data (short run consumption), APC is stable in the long time series data, i.e.,
long run consumption fn (failure of secular stagnation)
 3.2 The General Formulation (Micro Foundation):
Intertemporal Optimization of consumption
Assumption: two periods
Period 1: the present
Period 2: the future
1. Lifetime utility U (utility from consumption over two periods, C1
and C2)
U (C2 ) ' ''
U  U (C1 )  , U  0,U  0, 0    
1
Where θ is a parameter capturing a consumer’s impatience about
the future (rate of time preference).
θ>0 means that current consumption is more valued.
θ<∞ means that the consumer is not indifferent about the future
2. The intertemporal budget constraint
Assumption: capital markets are perfect in the sense that the consumer
can freely lend and borrow as much as he likes at the going market
interest rate
a. Period 1 constraint:
C1=V1+Y1-T1. This implies that S1=V1+Y1-T1-C1
where V1 is the initial interest bearing wealth of a consumer, Y1 labor income in period
1, T1 income tax in period 1. The consumer can be a borrower or lender
b. Period 2 constraint:
C2=(1+r)S1+Y2-T2 where r market interest rate and Y2 and T2 are income and
income tax in period 2 respectively
c. Intertemporal budget constraint: substitute S1 in period 2 constraint to get
C2=(1+r)(V1+Y1-T1-C1)+Y2-T2
C2 Y2  T2
C1   V1  Y1  T1   V1  H1
1 r 1 r
where V is financial welth and H total expected labor income
3. Optimization
U (C2 ) C2
max U (C1 )  s.t C1   V1  H1
C1 ,C 2 1 1 r
U ((1  r )(V1  H1  C1 )
max U (C1 )  by substitution
C1 1
dU ' 1 r '
 U (C1 )  U ((1  r )(V1  H1  C1 ))  0
dC1 1
' 1 r '
U (C1 )  U (C2 )
1
U ' (C1 )
'
 1 r
U (C2 )
1
MRS (C2 : C1 )  1  r
 Interpretation
The consumer optimizes where MRS(C2:C1) is equal to 1+r which is the
relative price of present consumption.
Current consumption C1 depends on wealth (V), after-tax expected labor
income (H), interest rate (r) and rate of time preference (θ)
 Consumption smoothing (C1=C2) occurs if r=θ, that is, when the consumer’s
impatience θ is exactly offset by the capital market reward r for postponing
consumption

U ' (C1 ) 1  r
'
 , C1  C2 (consumption smoothing) occurs if r  
U (C2 ) 1  

The role of capital markets

If there were no capital market allowing saving and dissaving (lending and
borrowing) consumption would have to equal income within each period.
Capital markets enable consumers to decouple current consumption from
current income and to spread their consumption more evenly overtime
 3.3 The Ando-Modigliani Approach [Life Cycle
Hypothesis - LCH]

Due to Franco Modigliani, Albert Ando, and Richard

Bloomberg
Income varies systematically over the phases of the
consumer’s life cycle and saving allows the consumer to
achieve smooth consumption.
 Assumes that each representative agent knows that:
 has V initial wealth, works r number of years and earns y
annual income until retirement. Assuming zero interest rate
for simplicity, lifetime resources=V+ry
 will die after T lifetime in years
The consumer smooths consumption expenditure over
his/her life, spending 1/T of his/her life-time resources each
period
C=(V+ry)/T=(1/T)V+(r/T)y=αV+βy

 The constraint is that her/his life time consumption doesn‘t

exceed the present value of his/her total income.
The LC is consistent with C/Y evidences. APC=C/Y=αV/Y+β
falls in cross sectional data since the rich have low V/Y but
the poor have high V/Y as wealth is constant in the short run;
Over time, aggregate wealth and income grow together
hence APC stable.
In general, for a representative consumer i, if PV of
lifetime resources rises, C rises more or less
proportionately. That is,
Cti=ki(PVi) where 0<ki<1
 ki=fraction of PV that the consumer wants to consume
in period t
 ki depends on:
(a) shape of the indifferent curve embodied in the utility
function [see the micro foundation in the previous section)
(b) the market interest rate (r), and
(c) the personal discount rate (θ)
 3.4 The Friedman Approach [Permanent income
Hypothesis - PIH]
Due to Milton Friedman
Assumptions:
– Perfect certainty about: Future receipts; Future interest
rates; Future prices, etc.
– People save to reduce fluctuations in expenditures
– People are immortal (or leave bequests)
Like Modigliani and Ando noted consumption shouldn‘t
depend on current income alone.
Unlike Life-Cycle Hypothesis (which hold income follows
regular pattern) the PIH hold that people face random and
temporary changes to their income from year to year
 Friedman holds that current income (Y) could be
divided between permanent income (Yp) and transitory
income (YT), that is, Y=YP + YT
Permanent Income (Yp): part of the income people
expect to persist into the future/average income.
Transitory Income (YT): part of income that is not
expected to persist (is random: deviation from the
average)
Friedman maintained consumption primarily depends
on YP & consumers use saving/borrowing to smooth
consumption in response to transitory shocks.
The PIH consumption function is:
𝐶 = 𝛼𝑌𝑃 where α is constant and represents a fraction of permanent
income that people consume per year
→ consumption is proportional to permanent income.
Implications:
C YP YP
APC   
Y Y YT  YP

When current income temporary rises above permanent, APC declines

Rich (poor) households have YT high (low) then APC falling cross-
sectionally
Over time YT is negligible and variation in income comes from the
permanent component hence the APC is almost constant
3.5 The Duesenenberry Approach [Relative Income
Hypothesis - RIH]

Due to James Duesenberry (1949) and is based on two

relative income related hypotheses:
1. Consumers base their consumption relative to the rest of the
population (the consumer vs other households around the
consumer)
2. Consumption is influenced by level of consumption attained in
the previous period/its own past income (habit persistence or
habit formation)
1. The hypothesis of the consumer versus the rest
He used the following utility function to show how consumers base
their consumption decisions in view of others around them

 C0 C C 
U  u  .... t ... ... T 
 R0 Rt RT 

Where R is the weighted average of the rest of population’s consumption

In this formulation U increase only if individuals consumption

relative to the average increase. Thus individuals APC depends on
her position in the income distribution. That is,
 Individuals with income <average tend to increase C/Y [to keep up]
Individual with income > average will have lower C/Y [takes a small portion
of his income to buy consumption basket]
2. The hypothesis of habit persistence
Duesenberry (1947) noted that in 1935 dissaving grew as a percentage of
income.
 Dissaving was greater in1935 than in the relatively prosperous year 1941.
 Why? Households must sacrifice saving to “defend” (attempt to maintain) their standard of living.
it is difficult for a family to reduce consumption in the face of declining income than to
reduce the proportion of income [to be] saved
Duesenberry assumes that consumers defend their highest level of
consumption. Thus:  
St Y
 F t 
Yt Ypeak 
For no other reason than simplicity, he assumes linearity:
.
St  Yt 
 a  b 
Yt Y
 peak 
This can be expressed in consumption

Ct  Y    Yt  
 (1  a )  b  t  Ct  1  a  b   Yt
Yt Ypeak   Ypeak  

Yt Yt
If Y grows steadily, then Ypeak

Yt 1
 k, and

Ct  (1  a  bk )Yt , or
Ct  Yt , with   (1  a  bk )

  Yt  
Short run: Ct  1  a  b   Yt
 Ypeak  

Long run: Ct  (1  a  b)Yt since Yt  Ypeak in the long run

3.6 The Random-Walk Hypothesis of Consumption

• Due to Robert Hall (1978)

• Based on Fisher’s model (intertemporal 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.
• If PIH is correct and consumers have rational expectations, then
consumption should follow a random walk: changes in
consumption should be unpredictable.
• Consumption will change only when consumers learn something
new about the future. Since news about the future cannot be
predicted, changes in consumption are highly random.
• 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.

Random walk model: Ct=Ct-1+Ut

Implication of the random walk hypothesis

If consumers obey the PIH and have rational

expectations, then policy changes will affect consumption
only if they are unanticipated.
Summary
Keynes suggested that consumption depends primarily on
current income.
 Recent work suggests instead that consumption depends on:
– current income
– expected future income
– wealth
– interest rates
– rate of time preference
Economists disagree over the relative importance of these
factors and of borrowing constraints and psychological factors.