REED ECONOMICS 314 - Theories of Consumption and Saving (28 pages)

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Theories of Consumption and Saving



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Economics 314 Coursebook 2008 Jeffrey Parker 16 THEORIES OF CONSUMPTION AND SAVING Chapter 16 Contents A Topics and Tools 2 B The Kuznets Paradox 4 C Relative Income Hypothesis 6 D Life Cycle Model and Permanent Income Hypothesis 9 Life cycle model 9 Permanent income hypothesis 11 Permanent vs temporary changes in income 12 The dangers of ignoring macroeconomists A policy faux pas 14 E Understanding Romer s Chapter 7 15 Empirical consumption functions 16 Uncertainty rational expectations and consumption 17 Quadratic utility 18 F Empirical Tests of the Random Walk Hypothesis 19 Testing the random walk hypothesis 21 Later tests and excess sensitivity of consumption to income 24 G Suggestions for Further Reading 27 Classic studies of consumption 27 Some recent advances 27 H Works Cited in Text 28 A Topics and Tools There is no topic in macroeconomics that has a longer deeper or more prominent literature than households choice of how much of their income to consume and save As we saw earlier in the course the theory of consumption is central to the model of Keynes s General Theory which is often considered to be the origin of macroeconomics Since then it has been the subject of countless theoretical and empirical studies Keynes treated consumption on a very common sense level Like most other economists of his day his methodology included neither abstract mathematical theory nor detailed econometrics Rather he relied almost entirely on intuition as he demonstrates when he introduces the central principle of his consumption theory in Chapter 8 The fundamental psychological law upon which we are entitled to depend with great confidence both a priori from our knowledge of human nature and from the detailed facts of experience is that men are disposed as a rule and on the average to increase their consumption as their income increases but not by as much as the increase in their income Keynes 1936 Keynes gives no basis for his theory in terms of utility maximization nor



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