Economics 302 Intermediate Macroeconomic Theory and Policy Spring 2010 Prof Menzie Chinn Lecture 17 18 Mar 17 22 2010 Outline 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 Curve Fig 10 1 updated 14 000 GDP Ch 05 12 000 10 000 8 000 6 000 Personal consumption expenditures Ch 05 4 000 2 000 70 75 80 Source BEA GDP 09Q4 2nd release 85 90 95 00 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 7 000 in Ch 05 6 000 Services 5 000 4 000 3 000 Nondurables 2 000 1 000 Durables 0 70 75 80 85 90 95 00 05 20 15 10 05 Services 00 Nondurables 05 Durables 10 15 70 75 80 85 90 Consumption components 4 quarter growth rates 95 00 05 GDP 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 14 000 in Ch 05 12 000 GDP 10 000 8 000 6 000 Personal disposable income 4 000 2 000 70 75 80 85 90 95 00 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 Fig 10 4 updated 10 000 9 000 C 3 6 2 8 0 9 7 Y d 8 000 CONS05 7 000 6 000 5 000 4 000 3 000 2 000 1 000 2 000 4 000 6 000 8 000 D IS P IN C 0 5 1 0 0 00 12 000 The Relation between Real Disposable Income and Consumption The 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 Yd and are measured by the vertical distances between 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 Figure 10 5 Updated 200 Error in Simple Consumption Function 100 0 100 200 70 75 80 85 90 95 00 05 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 theory distinguishes 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 year Intertemporal 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 Consumption The 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 Smoothing The MPC out of Temporary versus Permanent Changes in Income How does consumption change when disposable income changes For forward looking consumers the answer depends on how long the change in income will last in particular whether the change is viewed as temporary or permanent