University of Illinois at Urbana Champaign Department of Economics Econ 303 Intermediate Macroeconomics Lecture Note 2 Prof Ricardo Bebczuk Spring 2024 Short Run Macroeconomics Who Spends Private Consumption s r o t c e S l a n o i t u t i t s n I Households Businesses Government Rest of the World Private Consumption Theories Keynesian Hypothesis Permanent Income Hypothesis Life Cycle Hypothesis Expectations Saving Expectations and Shocks Saving and Uncertainty Saving by Institutional Sector Composition and Substitutions Consumption Saving and Interest Rate Consumption Keynesian Consumption Theory Keynes 1936 C c0 c1 Y C Consumption c0 Autonomous consumption independent of income c1 Marginal propensity to consume MPC C Y Y Current disposable income after taxes subsidies dividends and interest Example c0 2 000 c1 0 7 Y 5 000 Pitfalls of this theory If our income next month goes down all the way to zero would we be happy with a total consumption of just 2 000 C 5 500 million would we really want to consume 7 002 000 And if in two months time we win the lottery and get 10 Question Where does c0 2 000 come from Permanent Income Theory Friedman 1957 Consumers seek to smooth consumption that is avoid large fluctuations in their consumption levels from one period to the next With this goal in mind in deciding their consumption level individuals take into account not only their current income but also their permanent income i e the discounted sum of their lifetime income Quick Review Intertemporal discounting Are 1 000 received today worth the same as 1 000 to be received one year from now No because if we get the money today we can always put the money into a bank account and earn some interest r on it For example if r 20 1 000 received today are equivalent to 1 200 received in one year s time 1 000 1 0 2 1 200 By the same logic X 1 0 2 1 000 X 1 000 1 2 833 3 1 000 to be received one year from now are equivalent to 833 today Consumption Smoothing Three forces at play In favor of the equality between present and future consumption Diminishing marginal utility Most people are better off by having a steady consumption over time in comparison to consuming too much now and too little tomorrow or vice versa In favor of present consumption Rate of time preference RTP Most people prefer spending today over saving to spend tomorrow In favor of future consumption Interest rate The interest rate is an incentive to sacrifice consumption today and achieve a larger consumption tomorrow Diminishing Marginal Utility and Consumption Smoothing Utility U Marginal utility U C Consumption Utility Marginal Utility U C U C 1 2 3 4 5 6 7 8 9 90 170 240 300 350 390 420 440 450 90 80 70 60 50 40 30 20 10 Utility Gain 10 90 80 CPresent CFuture Consumption C Intertemporal Budget Constraint IBC Two periods 1 present and 2 future Let s first assume that r 0 1 2 1 2 The sum of consumption over time must be equal to the sum of income over time Two questions On what grounds can we rule out the and inequalities in the IBC above Does the IBC mean that 1 1 and 2 2 Permanent Income and Consumption Decisions Keeping the assumption that r 0 if we aim to smooth consumption then 1 2 2 1 2 Y1 2 000 Y2 4 000 C 3 000 Numerical example In period 1 C Y1 In period 2 C Y2 Questions Can these inequalities be reversed If so how should the numerical value change Key model assumption There s a financial market where you can borrow and lend as much as you want Optimal Consumption 1 1 1 2 2 1 1 2 2 1 1 1 Discount rate 1 1 where is the RTP B1 Borrowing in period 1 B1 0 Consumer takes on debt borrower B1 0 Consumer saves and lends lender U C U C Marginal utility 1 1 2 1 2 1 1 1 Euler Equation First order condition Along the optimal path Marginal cost Marginal benefit 1 1 2 1 2 1 1 1 The forces for present and future consumption cancel each other out Optimal Consumption If r then 1 r 1 u C1 u C2 C1 C2 Permanent Income Theory A Graphical Exposition Income Consumption Income Consumption Borrowing or dissaving Debt repayment Unlike the Keynesian model Time consumption does not track current disposable income Permanent Income and Consumption Decisions If r 0 and recalling the concept of discounting 1 2 1 1 2 1 1 2 1 1 1 1 1 2 1 Example Y1 2 000 Y2 4 000 r 10 C 2 952 Keynes versus Friedman Who s right Answer They are both partially right Why Financial constraints Income Consumption Keynesian Consumption permanent income Time Household saving and borrowing with financial institutions in of respondents by income country group 55 Saved at a financial institution Borrowed from a financial institution 19 11 7 21 9 High income Low income Middle income 60 50 40 30 20 10 0 Source Global Findex Database 2017 Survey with 150 000 adults age 15 and above respondents from 140 countries Life Cycle Hypothesis Modigliani and Brumberg 1954 Income Y Consumption C Adulthood prime age workers C Age Childhood Old age Y People seek to smooth consumption by spending above current income early and late in life when income is low and saving during their prime earning years when income is high Life Cycle Theory International Evidence Source IMF 2017 https www imf org external pubs ft fandd 2017 03 lee htm A Few Remarks I The permanent income PIH and the life cycle hypotheses LCH are closely related to the point that they can be considered to be the same model The main difference is that the LCH focuses on the demographic factors cohorts behind the consumption saving choice whereas the PIH is more general and applies to individuals at any given moment in life Utility maximization would imply that people die with zero wealth why In real life that rarely happens Why People may want to leave inheritance bequest to their descendants not only their own consumption enters their utility functions People don t know exactly when they are going to die and neither do they know how much they ll need to spend on health while old Fun fact 1 Both Friedman 1976 and Modigliani 1985 were awarded the Nobel Prize in Economics Professor here at U of I Fun fact 2 Modigliani developed the Life Cycle Hypothesis while a A few remarks II The life cycle hypothesis LCH is the analytical backbone of all the policy debates around the financial sustainability of pension systems With some differences across regions the world is going through an ageing process by which the share of elderly individuals rises and that of young individuals declines This is a very positive outcome in that it reflects an