Economics 302It dit M iIntermediate Macroeconomic Theory and Policyyy(Fall 2010)Prof. Menzie ChinnLecture 17, 18,Nov. 8-10, 2010OutlineOutline•Fluctuations in GDP Consumption andFluctuations in GDP, Consumption, and Income•Defects in the Simple KeynesianDefects in the Simple Keynesian Consumption Function•The Forward-Looking Theory of Consumption•The Forward-Looking Theory of Consumption • How Well Does the Forward-Looking Theory Work?Work?• Real Interest Rates, Consumption, and SavingSaving• Consumption and the IS CurveFig. 10.1 updated14 00012,00014,000GDP(Ch05$)10,000,(Ch.05$)8,0006,000Personalconsumption2,0004,000pexpenditures(Ch.05$)Source: BEA, GDP 10Q3 advance release,00070 75 80 85 90 95 00 05 10Long-Run vs Short Run BehaviorLongRun vs. Short Run Behavior•Over the long run, consumptionOver the long run, consumption expenditures and GDP grow at about the same rate, but over short-run business lidicycles, consumption expenditures fluctuate less than GDP.• The relatively smooth behavior of consumption expenditures comparedconsumption expenditures compared with GDP is one of the most important facts of the business cycle.yConsumption 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)7,0006,000SiCh.2005$5,000Services30004,0002,0003,000Nondurables1,000Durables070 75 80 85 90 95 00 05 10.20.25Durables.1505.10.00.05Services-.05NondurablesServices-.15-.10Consumption components, 4 quarter growth rates70 75 80 85 90 95 00 05 10GDP and Personal Disposable Income• Why does consumption fluctuate less than GDP?–Consumption depends on personal disposable–Consumption depends on personal disposable income: When fluctuations in disposable income are small, fluctuations in consumption ,pare small as well.–GDP is about 40 percent greater than personal disposable income.• The difference between GDP and personal disposable income shrinks during recessions and expands during booms.Fig. 10.3 (updated)14,00012,000,GDP(Ch05$)10,000(Ch.05$)8,0006,000Disposable4,000personalincome(Ch.05$)2,00070 75 80 85 90 95 00 05 10The Relation between Real Disposable Income and Consumption• Consumption fluctuates less than real GDP because disposable incomeGDP because disposable income fluctuates less than GDP.Can all consumption behavior be explainedCan all consumption behavior be explained by current personal disposable income, as the simplest consumption function wouldthe simplest consumption function would suggest?Fig. 10.4 (updated)10,0008,0009,000C = -362.8 + 0.97Yd5 0006,0007,000ONS053 0004,0005,000CO1,0002,0003,0002,000 4,000 6,000 8,000 10,000 12,000DIS PINC05The Relation between Real Disposable IdCtiIncome and ConsumptionTh t i ht li f th i fiThe straight line from the previous figure suggests:C 0 97*YdC = 0.97*Yd– This is the simple consumption function; the marginal propensity to consume (MPC)ismarginal propensity to consume (MPC) is 0.97.On average the U S public spends about–On average, the U.S. public spends about 97% of its disposable income on consumption goods and saves 3%.goods and saves 3%.The Relation between Real Disposable IdCtiIncome and Consumption• Consumption is sometimes less and psometimes greater than predicted by the simple consumption function. The errors are given by the equation: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 g(updated).• The simple consumption function seems to give a surprisingly good description ofgive a surprisingly good description of consumption.10.2 DEFECTS IN THE SIMPLE KEYNESIAN CONSUMPTIONKEYNESIAN CONSUMPTION FUNCTION•Although the errors in Figure 10 4 appearAlthough the errors in Figure 10.4 appear small, for some purposes (such as forecasting or policy analysis) they areforecasting or policy analysis) they are actually quite large.– A more revealing picture of the errors is found in the next figure:found in the next figure:Figure 10.5 (Updated)200Error in SimpleConsumption100Function0-100-20070 75 80 85 90 95 00 05Short-Run versus Long-Run Marginal PittCPropensity to Consume•On average consumption is smoothed outOn average, consumption is smoothed out compared with disposable income; consumption fluctuates less thanconsumption fluctuates less than disposable income.– This phenomenon can be detected and illustrated by using the concept of the longrunillustrated by using the concept of the long-run and short-run marginal propensity to consume.consume.Long-Run Marginal Propensity to CConsume•Thelong-run marginal propensity toThe long-run marginal propensity to consume tells us how much consumption increases over the longconsumption increases over the long run when personal disposable income risesrises.• The short-run marginal propensity to consumetells us how muchto consume tells us how much consumption rises over the short run (during one year or one business(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 Friedman1950s by Milton Friedman• Life-cycle theory developed independently at about the same time by Franco Modiglianiabout the same time by Franco Modigliani– The two theories are closely related, and have served as a foundation for most ofhave served as a foundation for most of the rational expectations research on consumption in recent years.pyFORWARD-LOOKING THEORY•Individual consumers are forward-lookingIndividual consumers are forwardlooking decision makers. •Thelife-cycle theoryemphasizes a familyThe life-cycle theoryemphasizes a family looking ahead over its entire lifetime.•Thepermanentincome theory•The permanent-income theorydistinguishes between permanent income, which a family expects to be long lastingwhich a family expects to be long lasting, and transitory income, which a family expects to disappear shortlyexpects to disappear shortly.Intertemporal Budget ConstraintIntertemporal Budget Constraint•The family faces anintertemporal budgetThe