Econ 322 1st edition Final Exam Study Guide Chapters 16 17 19 20 Chapter 16 Understanding Consumer Behavior March 26 April 2 Household s consumption decisions affect the way the economy as a whole behaves both in the long run and the short run Crucial for long run analysis because of its role in economic growth Solow model shows that the saving rate is a key determinant of the stead state capital stock thus the level of economic wellbeing o Savings rate measures how much of its income the present generation is putting aside for its own future and future generations Crucial for short run analysis because of its role in determining aggregate demand o Consumptions is 2 3 of GDP o IS LM model shows that changes in consumer spending plans can be a source of shocks to the economy Initially explained consumption with a simple function that relates consumption to disposable income C C Y T SIX PROMINENT ECONOMISTS SHOW THE DIVERSE APPROACHES TO EXPLAINING CONSUMPTION 1 John Maynard Keynes and the Consumption Function General Theory 1936 Keynes s Conjectures based on introspection and casual observation o Marginal Propensity to Consume the amount consumed out of an additional dollar is between 0 1 When a person earns an extra dollar they typically spend some and save some In Keynesian cross MPC is crucial to Keynes s policy recommendations on how to reduce widespread unemployment o Average Propensity to Consume ratio of consumption to income falls as income rises Saving in a luxury so he expected the rich to save a higher proportion of their income than the poor As countries get richer less of their income goes to consumption Over time consumption decreases and savings increases o Income is the primary determinant of consumption and the interest rate does not have an important role Classical economists believed that higher interest rate encourages saving and discourages consumption Keynes wrote short period influence of the interest rate on individual spending out of a given income is secondary and relatively unimportant Keynesian consumption function is often written as C cY 0 0 c 1 o C is consumption Y is disposable income is a constant and c is the MPC o Graphed as a straight line o determines the intercept on the vertical axis c determines the slope Satisfies all three of Keynes s properties MPC c is between 0 1 higher income leads to higher consumption and higher saving APC C Y Y c As Y rises Y falls so APC C Y falls Interest rates not included in this equation as a determinant of consumption Secular Stagnation Simon Kuznets and the Consumption Puzzle Two anomalies soon arose regarding the Keynesian Consumption Function both concerning the APC conjecture APC falls as income rises o 1st anomaly During WWII economists reasoned that as incomes in the economy grow over time households would consume less and less of their incomes They feared that there would not be enough profitable investment projects to absorb all of the saving If so low consumption would lead to an inadequate demand for goods and services resulting in a depression Secular Stagnation a long depression of indefinite duration However the end of WWII did not throw the US into another depression Although incomes were higher after the war there was not a large increase in the rate of saving o 2nd anomaly Simon Kuznets discovered that the ratio of consumption to income was remarkably stable from decade to decade despite large increases in income over the period o APC is fairly constant over long periods of time Keynes s conjectures held up well in studies of short time series and household data but failed with long time series 2 Intertemporal Choice Consumption Model Irving Fisher 1930 s Irving Fisher developed the model with which economists analyze how rational forward thinking consumers make choices involving different periods of time intertemporal choices The more consumption we enjoy today the less we will be able to enjoy tomorrow The Intertemporal Budget Constraint a measure of total resources available for consumption today and in the future o Budget Constraint The limit consumers face on how much they can spend o People s consumption is constrained by their income o Example Consumer who lives for 2 periods Period 1 youth Period 2 old age S Y1 C1 saving equals income minus consumption in period 1 C2 1 r S Y2 Consumption equals the accumulated saving including the interest earned on that saving plus period 2 income C2 1 r Y1 C1 Y2 1 r C1 C2 1 r Y1 Y2 C1 C2 1 r Y1 Y2 1 r This equation relates consumption in the two periods to the income in the two periods Represents the consumers budget constraint An increase in either Y1 or Y2 shifts the budget constraint outward the higher budget constraint allows the consumer to choose a better combination of first and second period consumption Income effect change in consumption that results from the movement to a higher indifference curve Substitution effect change in consumption that results from the change in the relative price of consumption in the two periods 3 Modigliani and the Life Cycle Hypothesis Modigliani emphasized that income varies systematically over people s lives and that saving allows consumers to move income from those times in life when income is high to those times when it is low o The Hypothesis Because people expect their income to fall when they retire they must save during their working years in order to maintain their level of consumption o o o C W RY T C Consumption W Wealth R Years until retirement Y Income T Expected remaining life expectancy C W Y MPC out of wealth MPC out of income Average propensity to consume C Y W Y Because wealth does not vary proportionately with income from person to person we find high income corresponds to a low average propensity to consume But over long periods of time wealth and income grow together resulting in a constant ratio W Y thus a constant average propensity to consume 4 Milton Friedman and the Permanent Income Hypothesis Milton Friedman 1957 The Hypothesis We view current income as the sum of two components o Permanent Income YP Part of income people expect to persist into the future o Transitory Income YT Part of income people do not expect to persist o Y Y P YT Friedman reasoned that consumption should depend primarily on permanent income because consumers use saving and borrowing to smooth consumption in response to transitory changes in income o Consumption function C YP where is a constant that measures the