Module 3:

Consumption
and Investment
Manish Chauhan
Consumption Function
This includes the most prominent work of

John Maynard Keynes: consumption and current income (1930)

Irving Fisher and Intertemporal Choice (1930): Contrary of Keynes

consumption at only current period (Developed this theory in his book
Theory of Interest in )

Franco Modigliani: Life-Cycle Hypothesis(early 1950s): Develop his

collaborators Albert Ando and Richard Brumberg used Fishers model of
consumer behaviour to study the consumption function.

Milton Friedman: the Permanent Income Hypothesis (1957): He

complements Modiglianis life-cycle hypothesis: both use Irving Fishers
theory of the consumer to argue that consumption should not depend on
current income alone.

Robert Hall: the Random-Walk Hypothesis (1978): He uses Euler

John Maynard Keynes and the
Consumption Function
Keynes conjecture
Due to lack of technical help and sophisticated data, Keynes made conjectures on consumption function.

1. Marginal Propensity to consume (MPC): the amount consumed out of an additional rupee incomeis
between zero and one.

fundamental psychological law, upon which we are entitled to depend with great confidence, . . . 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

2. Average Propensity to consume (APC): APC is ratio of consumption to Income. It fall as income rises.

3. Income is the primary determinant of consumption: Keynes thought that income is the primary
determinant of consumption and that the interest rate does not have an important role. This conjecture
stood in stark contrast to the beliefs of the classical economists who preceded him.
The Keynesian Consumption Function

C = C + cY

c = MPC
c
= slope of the
1 consumption
function
The Keynesian Consumption
Function
C
C = C + cY

APC = __ ___________

slope = APC
Y
As income rises, the APC falls (consumers save a slid
bigger fraction of their income). e5
Empirical Evidence
Based on data collected on consumption and researcher, they found

1. Households with higher income consumed more : confirms that the marginal propensity to
consume is greater than zero.

2. Households with higher income saved more: confirms that the marginal propensity to
consume is less than one.

3. Higher-income households saved a larger fraction of their income: confirms that the average
propensity to consume falls as income rises.

4. Low consumption and income at the time Depression and during the period of low income,
consumption to income ratio was high: This confirm the second conjecture

5. High correlation between consumption and income: Third conjecture that income is the
primary determinant of how much people choose to consume.
Problems Associated with Keynes Consumption
Function
Based on the Keynesian consumption function, economists predicted
secular stagnation unless the government use expansionary fiscal policy

This prediction did not come true:

As incomes grew, the APC did not fall, and C grew just as fast.
(because after the world war, countries experience higher income but
not experience fall in consumption).

Simon Kuznets showed that C/Y was very stable in long time series
data.
The Consumption Puzzle
Consumption function from long time
C series data (constant APC )

Consumption function from cross-

sectional household data
(falling APC )

Y
Irving Fisher and Intertemporal
Choice
The basis for much subsequent work on consumption.

Assumes consumer is forward-looking and chooses consumption for the

present and future to maximize lifetime satisfaction.

Two Period basic Model:

Period 1: the present

Period 2: the future

Notations

Y1 is income in period 1 Y2 is income in period 2

C1 is consumption in period 1 C2 is consumption in period 2

 Saving S = Y1 - C1

Period 1 Budget Constraint C 1 = Y1 - S

Period 2 Budget Constraint C2 = Y2 + (1+r) S

Rearrange to put C terms on one side and Y terms on the other:

(1+r) C1 + C2 = (1+r)Y1 + Y2

Finally, divide through by (1+r ):

The intertemporal budget
constraint
C +
C
= Y +
Y2 2
1 1
1 + r 1 + r

present value of present value of

______________ _____________

slid
e 11
The intertemporal budget
C Y2
constraint
The budget C C2
+
1+r
= 1
2
Y1 +
1+r
constrain
shows all Consump = income
combinations _____ in both periods

of C1 and C2 Y2
_______
that just
exhaust the
consumers Y1 C1
resources. slid
e 12
The intertemporal budget
C Y2
constraint C C +
2
1+r
= 1
2
Y1 +
1+r
The slope of
the budget
line equals 1
_________ ) (1+r )
Y2

Y1 C1
slid
e 13
Consumer preferences
C2
Higher
indifference
curves
represent Y

higher levels Z
X IC2
of happiness.
W
IC1
C1
slid
e 14
Consumer preferences The slope of an
C2 indifference
curve at any
Marginal rate of point equals
substitution (MRS ): the MRS
the amount of C2 1 at that point.
MRS
consumer would be
-----------------------
IC1
So the MRS is the (negative) of the
C1
___________________________.
Optimization
C2
The optimal (C1,C2) At the
is where the budget optimal point,
line just touches __________
the highest O
indifference curve.

C1
slid
e 16
How C responds to changes in Y
C2

An increase in Y1 or Y2

shifts the budget line

outward.
C1
slid
e 17
How C responds to changes in r
C2
An increase in r pivots
the budget line around
the
point (Y1,Y2 ).
B

A
Y2

Y1 C1
slid
e 18
The Life-Cycle Hypothesis
Income varies systematically over peoples lives

: Saving allows consumers to move income from those time in life when income is
high to those times when it is low

The basic model:

W =Initial Wealth Y = Income per year (assumed constant)

R = number of years until retirement T = lifetime in years

Assumptions: (1)Zero real interest rate (for simplicity)

(2)Consumption-smoothing is optimal
 She divides this total of W + RY equally among the T years and each year consumes

C = (W + RY )/T

We can write this persons consumption function as

C = (1/T)W + (R/T)Y

If every individual in the economy plans like this, then the aggregate consumption will become

C = aW + bY

Average Propensity to consume will be

C/Y = a(W/Y) + b
Implications of the Life-Cycle
$
Hypothesis
The LCH
implies that Wealth
saving varies
systematicall Income
y over a
Saving
persons
lifetime. Consumption Dissaving

Retirement End
begins of lifeslid
e 21
The Permanent Income
Hypothesis
Friedman emphasizes that people experience random and temporary changes in their incomes
from year to year.

Friedman suggested that we view current income Y as the sum of two components, permanent
income YP and transitory income YT. That is,

Y = YP + YT.

Permanent income is average income, and transitory income is the random deviation from that
average.

According to Friedman Consumption function will be

C = a YP

According to the permanent-income hypothesis, the average propensity to consume depends

on the ratio of permanent income to current income.
Random Walk Hypothesis
If permanent income hypothesis is correct and consumers have rational
expectations, then consumption should follow a random walk. When
change in a variable is unpredictable then the variable is said to follow a
random walk.

Implication: If consumers obey the permanent-income hypothesis and

have rational expectations, then only unexpected policy changes influence
consumption. These policy changes take effect when they change
expectations.
 Pull of Instant Gratification
Consumers consider themselves to be imperfect decision-makers.

E.g., in one survey, 76% said they were not saving enough for retirement.

Laibson: The pull of instant gratification explains why people dont save as much as a perfectly
rational lifetime utility maximizer would save.

Two Questions and Time Inconsistency

1.Would you prefer (A) a candy today (B) two candies tomorrow?

2. Would you prefer (A) a candy in 100 days (B) two candies in 101 days?

In studies, most people answered A to question 1, and B to question 2.

A person confronted with question 2 may choose B. 100 days later, when he is confronted with
question 1, the pull of instant gratification may induce him to change his mind.