Economics 302Intermediate Macroeconomic Theory and Policy(Spring 2010)Prof. Menzie ChinnLecture 17, 18Mar. 17, 22, 2010Outline• Fluctuations in GDP, Consumption, and Income• Defects in the Simple Keynesian Consumption Function• The Forward-Looking Theory of Consumption • How Well Does the Forward-Looking Theory Work?• Real Interest Rates, Consumption, and Saving• Consumption and the IS CurveFig. 10.1 updatedSource: BEA, GDP 09Q4 2ndrelease2,0004,0006,0008,00010,00012,00014,00070 75 80 85 90 95 00 05GDP(Ch.05$)Personalconsumptionexpenditures(Ch.05$)Long-Run vs. Short Run Behavior• Over the long run, consumption expenditures and GDP grow at about the same rate, but over short-run business cycles, consumption expenditures fluctuate less than GDP.• The relatively smooth behavior of consumption expenditures compared with GDP is one of the most important facts of the business cycle.Consumption vs. Consumption Expenditure• Consumption of durables is more spread out over time and is smoother than expenditure on them.• For services and nondurable items, there is no meaningful distinction between consumption and expenditure: When we purchase a haircut, we consume it at the same time.• Because consumption of durables fluctuates less than expenditure on durables, total consumption has smaller fluctuations than total consumption expenditures.Fig. 10.2 (updated)01,0002,0003,0004,0005,0006,0007,00070 75 80 85 90 95 00 05NondurablesServicesDurablesin Ch.05$Consumption components, 4 quarter growth rates-.15-.10-.05.00.05.10.15.2070 75 80 85 90 95 00 05DurablesNondurablesServicesGDP and Personal Disposable Income• Why does consumption fluctuate less than GDP?– Consumption depends on personal disposable income: When fluctuations in disposable income are small, fluctuations in consumption are small as well.– GDP is about 40 percent greater than personal disposable income.• The difference between GDP and personal disposable income shrinks during recessions and expands during booms.Fig. 10.3 (updated)2,0004,0006,0008,00010,00012,00014,00070 75 80 85 90 95 00 05GDPPersonaldisposableincomein Ch.05$The Relation between Real Disposable Income and Consumption• Consumption fluctuates less than real GDP because disposable income fluctuates less than GDP.Can all consumption behavior be explained by current personal disposable income, as the simplest consumption function would suggest?1,0002,0003,0004,0005,0006,0007,0008,0009,00010,0002,000 4,000 6,000 8,000 10,000 12,000DIS PINC05CONS05C = -362.8 + 0.97YdFig. 10.4 (updated)The Relation between Real Disposable Income and ConsumptionThe straight line from the previous figure suggests:C = 0.97*Yd– This is the simple consumption function; the marginal propensity to consume (MPC) is 0.97.– On average, the U.S. public spends about 97% of its disposable income on consumption goods and saves 3%.The Relation between Real Disposable Income and Consumption• Consumption is sometimes less and sometimes greater than predicted by the simple consumption function. The errors are given by the equation:Error = C + 326.2 - 0.97*Ydand are measured by the vertical distancesbetween the line and the dots in Figure 10.4 (updated).• The simple consumption function seems to give a surprisingly good description of consumption.10.2 DEFECTS IN THE SIMPLE KEYNESIAN CONSUMPTION FUNCTION• Although the errors in Figure 10.4 appear small, for some purposes (such as forecasting or policy analysis) they are actually quite large.– A more revealing picture of the errors is found in the next figure:-200-100010020070 75 80 85 90 95 00 05Error in SimpleConsumptionFunctionFigure 10.5 (Updated)Short-Run versus Long-Run Marginal Propensity to Consume• On average, consumption is smoothed out compared with disposable income; consumption fluctuates less than disposable income.– This phenomenon can be detected and illustrated by using the concept of the long-run and short-run marginal propensity to consume.Long-Run Marginal Propensity to Consume• The long-run marginal propensity to consume tells us how much consumption increases over the long run when personal disposable income rises.• The short-run marginal propensity to consume tells us how much consumption rises over the short run (during one year or one business cycle) when disposable income rises.10.3. THE FORWARD-LOOKING THEORY OF CONSUMPTION• Permanent-income theory developed in the 1950s by Milton Friedman• Life-cycle theory developed independently at about the same time by Franco Modigliani– The two theories are closely related, and have served as a foundation for most of the rational expectations research on consumption in recent years.FORWARD-LOOKING THEORY• Individual consumers are forward-looking decision makers. • The life-cycle theory emphasizes a family looking ahead over its entire lifetime.• The permanent-income theorydistinguishes between permanent income, which a family expects to be long lasting, and transitory income, which a family expects to disappear shortly.Intertemporal Budget Constraint• The family faces an intertemporal budget constraint that limits its consumption over the years.• Assets at the beginning of next year = Assets at the beginning of this year+ Income on assets this year + Income from work this year - Taxes paid this year - Consumption this yearIntertemporal Budget Constraint• At= Assets at the beginning of year t• R = Interest rate on assets• Et= Income from work during year t• Tt= Taxes during year t• Ct= Consumption during year t.The intertemporal budget constraint can be written as follows: At+1= At+ RAt+ Et- Tt- Ct. (10.3)Preferences: Steady Rather than Erratic Consumption• A consumption plan is feasible if it does not involve an impractical asset position at any time in the future.• Many different consumption plans are feasible. As long as the family is careful not to consume too much, it has a wide choice about when to schedule its consumption.Preferences: Steady Rather than Erratic ConsumptionThe forward-looking theory of consumption assumes that most people prefer to keep their consumption fairly steady from year to year.Given the choice between consuming $10,000 this year and $10,000 next year, as against $5,000 this year and $15,000 next year, people generally choose the even split.Consumption SmoothingThe MPC out of Temporary versus Permanent Changes in Income• How does consumption change when