®

CHAPTER 17
Consumption

A PowerPointTutorial
To Accompany

MACROECONOMICS, 7th. Edition

N. Gregory Mankiw
Tutorial written by:
Mannig J. Simidian, modified by meb
B.A. in Economics with Distinction, Duke University 1
Chapter Seventeen
M.P.A., Harvard University Kennedy School of Government
M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management
The consumption function was central to Keynes’ theory of economic
fluctuations presented in The General Theory in 1936.
• Keynes conjectured that the marginal propensity to consume— the
amount consumed out of an additional dollar of income is between
zero and one. He claimed that the fundamental law is that out of
every dollar of earned income, people will consume part of it and save
the rest.
• Keynes also proposed the average propensity to consume, the ratio of
consumption to income falls as income rises.
• Keynes also held that income is the primary determinant of
consumption and that the interest rate does not have an important role.
Chapter Seventeen 2
 C = C + c Y, C > 0, 0 < c <1
C
Consumption
spending by disposable
households marginal income
depends propensity to
on consume (MPC)
C
Y

C determines the intercept on the

vertical axis. The slope of the
Chapter Seventeen consumption function is lower 3case c,
the MPC.
 To understand the marginal propensity to consume (MPC),
consider a shopping scenario. A person who loves to shop
probably has a large MPC, let’s say (.99). This means that for
every extra dollar he or she earns after tax deductions, he or
she spends $.99 of it. The MPC measures the sensitivity of
the change in one variable, consumption, with respect to a
change in the other variable, income.

Chapter Seventeen 4
 The C function exhibits three properties
that Keynes conjectured.
APC = C/Y = C/Y + c (1) the marginal propensity to
consume c is between zero and one.
C (2) the average propensity to
consume falls as income rises.
(3) consumption is determined by
current income Y. Notice that the
APC1 interest rate is not included in this
C equation as a determinant of
APC2 consumption.
11
Y
What Keynes conjectured: at higher values of income, people spend a smaller fraction of
their income. So, as Y rises, the average propensity to consume C/Y falls. Pick a point on the
consumption function; that point represents a particular combination of consumption and
income . Now draw a ray from the origin to that point. The slope of that ray equals the5 APC at
Chapter Seventeen
that point. At higher values of Y, the APC (slope of the ray) is smaller.
 Early Empirical Successes:
Results from Early Studies
• Households with higher incomes:
– consume more
 MPC > 0
– save more
 MPC < 1
– save a larger fraction of their income
 APC  as Y 
• Very strong correlation between income
and consumption
 income seemed to be the main
determinant of consumption
Chapter Seventeen 6
During World War II, on the basis of Keynes’s consumption function,
economists predicted that the economy would experience what they
called secular stagnation—a long depression of infinite duration—
unless the government used fiscal policy to stimulate aggregate demand.
It turned out that the end of the war did not throw the United States
into another depression, but it did suggest that Keynes’s conjecture
that the average propensity to consume would fall as income rose
appeared not to hold.

Simon Kuznets constructed new aggregate data on consumption and

investment dating back to 1869. His work would later earn him a
Nobel Prize. Kuznets discovered that the ratio of consumption to income
was stable over time, despite large increases in income; again, Keynes’s
conjecture was called into question.
Chapter Seventeen 7
This brings us to the puzzle…
The failure of the secular-stagnation hypothesis and the findings of
Kuznets both indicated that the average propensity to consume is fairly
constant over time. This presented a puzzle: Why did Keynes’s
conjectures hold up well in the studies of household data (cross-
sections) and in the studies of short time-series, but fail when long-
time series were examined?
Studies of household data and short
C Long-run consumption time-series found a relationship
function (constant APC) between consumption and income
similar to the one Keynes conjectured—
this is called the short-run consumption
function. But, studies using long time-
Short-run consumption series found that the APC did not vary
function (falling APC)
systematically with income—this
Y relationship is called the long-run 8
Chapter Seventeen
consumption function.
The economist Irving Fisher developed the model
with which economists analyze how rational,
forward-looking consumers make intertemporal
choices—that is, choices involving different periods
of time to maximize lifetime satisfaction. The model
illuminates the constraints consumers face, the
preferences they have, and how these constraints and
preferences together determine their choices about
consumption and saving.

When consumers are deciding how much to consume

today versus how much to consume in the future,
they face an intertemporal budget constraint, which
measures the total resources available for
consumption
Chapter Seventeen today and in the future. 9
 The basic two-period model
• Period 1: the present
• Period 2: the future
Notation
Y1 is income in period 1
Y2 is income in period 2
C1 is consumption in period 1
C2 is consumption in period 2
S = Y1 - C1 is saving in period 1
(S < 0 if the consumer borrows in period 1)
Chapter Seventeen 10
Deriving the intertemporal budget
constraint
• Period 2 budget constraint:

• Rearrange:

• Finally, divide by (1+r ):

Chapter Seventeen 11
 The consumer’s intertemporal
budget constraint

present value of present value of

lifetime consumption lifetime income

Chapter Seventeen 12
Here is an interpretation of the consumer’s budget constraint:
The consumer’s budget constraint implies that if the interest
rate is zero, the budget constraint shows that total
consumption in the two periods equals total income
in the two periods. In the usual case in which the
interest rate is greater than zero, future consumption and future income
are discounted by a factor of 1 + r. This discounting arises from the
interest earned on savings. Because the consumer earns interest on
current income that is saved, future income is worth less than current
income. Also, because future consumption is paid for out of savings
that have earned interest, future consumption costs less than current
consumption. The factor 1/(1+r) is the price of second-period
consumption measured in terms of first-period consumption; it is the
amount of first-period consumption that the consumer must forgo to
obtain 1 unit of second-period consumption.
Chapter Seventeen 13
Here are the combinations of first-period and second-period consumption
the consumer can choose. If he chooses a point between A and B, he
consumes less than his income in the first period and saves the rest for
the second period. If he chooses between A and C, he consumes more that
his income in the first period and borrows to make up the difference.
Consumer’s (intertemporal) budget constraint
C2 showing all combinations of C1 and C2
B that are feasible. The slope equals –(1+r)
Saving
1 Vertical intercept is
(1+r ) (1+r)Y1 + Y2
A Borrowing Horizontal intercept is
Y2
Y1 + Y2/(1+r)
C The slope of the budget line equals -(1+r):
Y1 C1 to increase C1 by one unit,
Chapter Seventeen the consumer must sacrifice 14
(1+r) units of C2.
 The consumer’s preferences regarding consumption in the
two periods can be represented by indifference curves. An
indifference curve shows the combination of first-period and
second-period consumption, C1 and C2, that makes the
consumer equally happy.

Chapter Seventeen 15
 Y Z
X IC2
W IC1
First-period consumption

Higher indifferences curves such as IC2 are preferred to lower ones such
as IC1. The consumer is equally happy at points W, X, and Y, but prefers
point Z to all the others. Point Z is on a higher indifference curve and is
therefore not equally preferred to W, X, and Y.
Chapter Seventeen 16
 The slope at any point on the indifference curve shows how
much second-period consumption the consumer requires in
order to be compensated for a 1-unit reduction in first-period
consumption. This slope is the marginal rate of substitution
between first-period consumption and second-period
consumption. It tells us the rate at which the consumer is
willing to substitute second-period consumption for first-
period consumption.

Chapter Seventeen 17
 Consumer preferences
C2 The slope of an
indifference
curve at any
point equals the
Marginal rate of MRS
substitution (MRS ): 1 at that point.
the amount of C2 MRS
consumer would be
willing to substitute for
one unit of C1. IC1
C1

Chapter Seventeen 18
 O
IC3
IC2
IC1
First-period consumption

The consumer achieves his highest (or optimal) level of satisfaction

by choosing the point on the budget constraint that is on the highest
indifference curve. Here the slope of the indifference curve
equals the slope of the budget line. At the optimum, the indifference
curve is tangent to the budget constraint. The slope of the indifference
curve is the marginal rate of substitution MRS, and the slope of the
budget line is 1 + the real interest rate. At point O, MRS = 1 + r.
Chapter Seventeen 19
 O IC2
IC1
First-period consumption
An increase in either first-period income or second-period income
shifts the budget constraint outward. If consumption in period one and
consumption in period two are both normal goods - those that are
demanded more as income rises, this increase in income raises
consumption in both periods.
Chapter Seventeen 20
 Keynes vs. Fisher about income
• Keynes:
current consumption depends only on
current income
• Fisher:
current consumption depends only on
the present value of lifetime income;
the timing of income is irrelevant
because the consumer can borrow or lend
between periods.
Chapter Seventeen 21
Economists decompose the impact of an increase in the real interest
rate on consumption into two effects:
- a substitution effect , the change in consumption that results from the
change in the relative price of consumption in the two periods;
- an income effect , the change in consumption that results from the
movement to a higher indifference curve.
Suppose the consumer is a saver (his
C2 New budget
choice is point A). An increase in r
(increase in the slope) rotates the budget
constraint
constraint around the point C, where C is
B (Y1, Y2). As depicted here, the saver goes
Old budget from A to B, reducing first-period
constraint consumption and raising second-period
A
Y IC2 consumption.
Y2 IC1 But for a saver it could turn out
differently…….. !
Chapter Seventeen Y1 C1
22
 How C responds to changes in r
• substitution effect
The rise in r increases the opportunity cost of
current consumption, which tends to reduce C1 and
increase C2.
• income effect
If the consumer is a saver, the rise in r makes him
better off, which tends to increase consumption in
both periods.
• Both effects  C2.
But whether C1 rises or falls depends on the relative
size of the income & substitution effects.

Chapter Seventeen 23
• An answer/exercise for you: do the analysis of an increase in the
interest rate on the consumption choices of a borrower…..

Hint: in that case, the income effect tends to reduce both current and future consumption,
because the interest rate hike makes the borrower worse off. The substitution effect still
tends to increase future consumption while reducing current consumption. In the end,
current consumption falls unambiguously; future consumption falls if the income effect
dominates the substitution effect, and rises if the reverse occurs.

Chapter Seventeen 24
 Keynes vs. Fisher about interest rate

Keynes conjectured that the interest rate matters for consumption

only in theory.

In Fisher’s theory, the interest rate doesn’t affect current

consumption if the income and substitution effects are of equal
magnitude.

Chapter Seventeen 25
• In Fisher’s theory, the timing of income is less important because the
consumer can borrow and lend across periods.
• Example: If a consumer learns that her future income will increase,
she can spread the extra consumption over both periods by borrowing
in the current period.
• However, if consumer faces borrowing constraints
(or liquidity constraints), then she may not be able to increase
current consumption and her consumption may behave
as in the Keynesian theory
even though she is rational & forward-looking

The inability to borrow prevents current consumption from exceeding

current income. A constraint on borrowing can therefore be expressed
as C1 < Y1.
Chapter Seventeen 26
 Constraints on borrowing
C2

The budget
line with no
borrowing
constraints
Y2

C1
Y1

Chapter Seventeen 27
 Constraints on borrowing
C2

The budget
The borrowing line with a
constraint takes borrowing
constraint
the form: Y2
C1  Y1

Y1 C1
The area under the blue line satisfies both budget and borrowing constraints
Chapter Seventeen 28
 Consumer optimization when the
borrowing constraint is not binding
The borrowing constraint is
not binding if the consumer’s C2
optimal C1
is less than Y1.
In this case, the consumer
would not have borrowed
anyway, so his inability to
borrow has no impact on
consumption choices.

Y1 C1
Chapter Seventeen 29
 Consumer optimization when the
borrowing constraint is binding
The optimal choice is at point
C2
D. But since the consumer
cannot borrow, the best he
can do is point E.
In this case, the consumer
would like to borrow to
achieve his optimal
consumption at point D. If he E
faces a borrowing constraint, D
though, then the best he can
achieve is the consumption
plan of point E. Y1 C1
Chapter Seventeen 30
 • If you have a few minutes of class time available, have your students do the
following experiment:
(This is especially useful if you have recently covered Chapter 15 on Government
Debt)
• Suppose Y1 is increased by €1000 while Y2 is reduced by €1000(1+r), so that the
present value of lifetime income is unchanged. Determine the impact on C1
• - when consumer does not face a binding borrowing constraint
- when consumer does face a binding borrowing constraint
• Then relate the results to the discussion of Ricardian Equivalence from Chapter 15.

• Note that the intertemporal redistribution of income in this exercise could be

achieved by a debt-financed tax cut in period 1, followed by a tax increase in
period 2 that is just sufficient to retire the debt.

• The text contains a case study on the high Japanese saving rate that relates to the
material on borrowing constraints just covered.

Chapter Seventeen 31
Europa: Austria,Belgio,Danimarca, Finlandia, Francia, Germania, Grecia,Irlanda, Italia, Norvegia, Olanda,Portogallo,
UK,Spagna,Svezia, Svizzera. (OECD, IMF,Eurostat).

Per alcuni l’elevata crescita del Giappone nel dopoguerra deriva dall’elevato tasso di
risparmio (nel modello di crescita di Solow vedremo che il risparmio determina il livello di
reddito di stato stazionario). Per altri la lunga recessione degli anni’90 è causata dall’elevato
tasso di risparmio (basso consumo e bassa domanda aggregata).
Chapter Seventeen 32
In the 1950s, Franco Modigliani, Albert Ando, and Richard Brumberg
used Fisher’s model of consumer behavior to study
the consumption function. One of their goals was to study
the consumption puzzle. According to Fisher’s model,
consumption depends on a person’s lifetime income.
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 income is low.
This interpretation of consumer behavior formed the basis of his
life-cycle hypothesis.

Chapter Seventeen 33
 The Life-Cycle Hypothesis
• due to Franco Modigliani (1950s)
• Fisher’s model says that consumption
depends on lifetime income, and people try to
achieve a smooth consumption pattern.
• The LCH says that income varies
systematically over the phases of the
consumer’s “life cycle,”
and saving allows the consumer to achieve
smooth consumption.

Chapter Seventeen 34
 The Life-Cycle Hypothesis
• The basic model:
W = initial wealth
Y = annual income until retirement
(assumed constant)
R = number of years until retirement
T = lifetime in years
• Assumptions:
– zero real interest rate (for simplicity)
– consumption-smoothing is optimal
Chapter Seventeen 35
 The Life-Cycle Hypothesis
• Lifetime resources = W + RY
• To achieve smooth consumption, consumer
divides her resources equally over time:
C = (W + RY )/T , or
C = aW + bY
where
a = (1/T ) is the marginal propensity to
consume out of wealth
b = (R/T ) is the marginal propensity to consume
out of income
Chapter Seventeen 36
 Implications of the Life-Cycle
Hypothesis
The Life-Cycle Hypothesis can solve the
consumption puzzle:
• The APC implied by the life-cycle consumption function is
C/Y = a(W/Y ) + b
• Across households or in the short-run, wealth does not vary
as much as income, so high income households should have
a lower APC than low income households  similar to
Keynes
• Over time, aggregate wealth and income grow together,
causing APC to remain stable  Simon Kuznets puzzle
solved.
Chapter Seventeen 37
 Implications of the Life-Cycle
€ Hypothesis

Wealth
The LCH
implies that
saving varies Income
systematically
over a person’s Saving
lifetime.
Consumption Dissaving

Retirement End
begins of life
Chapter Seventeen 38
In 1957, Milton Friedman proposed the permanent-income hypothesis
to explain consumer behavior. Its essence is that current consumption is
proportional to permanent income. Friedman’s permanent-income
hypothesis complements Modigliani’s life-cycle hypothesis: both use
Fisher’s theory of the consumer to argue that consumption should not
depend on current income alone. But unlike the life-cycle hypothesis,
which emphasizes that income follows a regular pattern over a person’s
lifetime, the permanent-income hypothesis 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.
Chapter Seventeen 39
 The Permanent Income
Hypothesis
• due to Milton Friedman (1957)
• The PIH views current income Y as the
sum of two components:
permanent income Y P
(average income, which people expect to
persist into the future)
transitory income Y T
(temporary deviations from average
income)
Chapter Seventeen 40
 The Permanent Income
Hypothesis
• Consumers use saving & borrowing to
smooth consumption in response to
transitory changes in income Y T.
• The PIH consumption function:
C = aY P
where a is the fraction of permanent
income that people consume per year.
Chapter Seventeen 41
 The Permanent Income
Hypothesis
The PIH can solve the consumption puzzle:
• The PIH implies
APC = C/Y = aY P/Y
• To the extent that high income households have on
average a higher transitory income than low income
households, the APC will be lower in high income
households.
• Over the long run, income variation is due mainly if not
solely to variation in permanent income, which implies a
stable APC.  policy changes will affect consumption
only if they are permanent.
Chapter Seventeen 42
 PIH vs. LCH
• In both cases, people try to achieve
smooth consumption in the face of
changing current income.
• In the LCH, current income changes
systematically as people move through
their life cycle.
• In the PIH, current income is subject to
random, transitory fluctuations.
• Both hypotheses can explain the
consumption puzzle.
Chapter Seventeen 43
Robert Hall was first to derive the implications of rational expectations
for consumption. He showed that if the permanent-income hypothesis
is correct, and if consumers have rational expectations, then changes
in consumption over time should be unpredictable. When changes in a
variable are unpredictable, the variable is said to follow a random walk.
According to Hall, the combination of the permanent-income
hypothesis and rational expectations implies that consumption follows
a random walk.

Chapter Seventeen 44
 The Random-Walk Hypothesis
• due to Robert Hall (1978)
• based on Fisher’s model & PIH, in which
forward-looking consumers base consumption
on expected future income
• Hall adds the assumption of rational
expectations, that people use all available
information to forecast future variables like
income.
Chapter Seventeen 45
 Implication of the R-W
Hypothesis
If consumers obey the PIH
and have rational expectations,
then policy changes
will affect consumption
only if they are unanticipated.

Chapter Seventeen 46
Recently, economists have turned to psychology for further explanations
of consumer behavior. They have suggested that consumption decisions
are not made completely rationally. This new subfield infusing
psychology into economics is called behavioural economics. Harvard’s
David Laibson notes that many consumers judge themselves to be
Imperfect decisionmakers. Consumers’ preferences may be time-
inconsistent: they may alter their decisions simply because time passes.
Pull of Instant
Gratification

Chapter Seventeen 47
 The Psychology of Instant
Gratification
• Theories from Fisher to Hall assumes that
consumers are rational and act to maximize
lifetime utility.
• recent studies by David Laibson and others
consider the psychology of consumers.

Chapter Seventeen 48
 The Psychology 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 don’t save as much as a
perfectly rational lifetime utility maximizer
would save.
Chapter Seventeen 49
Two Questions and Time Inconsistency
1. Would you prefer
(A) a chocolate bar today, or
(B) two chocolate bars tomorrow?
2. Would you prefer
(A) a chocolate bar in 100 days, or
(B) two chocolate bars 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 and to select A.  People are more patient in the
long-run than in the short-run. Time inconsistency.
Chapter Seventeen 50
 Summing up
• Keynes suggested that consumption depends
primarily on current income.
• More recent work suggests instead that
consumption depends on
– current income
– expected future income
– wealth
– interest rates
• Economists disagree over the relative
importance of these factors and of borrowing
constraints and psychological factors.
Chapter Seventeen 51
 Chapter summary
1. Keynesian consumption theory
• Keynes’ conjectures
– MPC is between 0 and 1
– APC falls as income rises
– current income is the main determinant of current
consumption
• Empirical studies
– in household data & short time series:
confirmation of Keynes’ conjectures
– in long time series data:
APC does not fall as income rises

Chapter Seventeen 52
 Chapter summary
2. Fisher’s theory of intertemporal choice
• Consumer chooses current & future consumption
to maximize lifetime satisfaction subject to an
intertemporal budget constraint.
• Current consumption depends on lifetime income,
not current income, provided consumer can borrow
& save.
3. Modigliani’s Life-Cycle Hypothesis
• Income varies systematically over a lifetime.
• Consumers use saving & borrowing to smooth
consumption.
• Consumption depends on income & wealth.
Chapter Seventeen 53
 Chapter summary
4. Friedman’s Permanent-Income Hypothesis
• Consumption depends mainly on permanent
income.
• Consumers use saving & borrowing to smooth
consumption in the face of transitory fluctuations in
income.
5. Hall’s Random-Walk Hypothesis
 Combines PIH with rational expectations.
 Main result: changes in consumption are
unpredictable, occur only in response to
unanticipated changes in expected permanent
income.

Chapter Seventeen 54
 Chapter summary
6. Laibson and the pull of instant gratification
• Uses psychology to understand consumer
behaviour.
• The desire for instant gratification causes people to
save less than they rationally know they should.

Chapter Seventeen 55
Marginal propensity to consume
Average propensity to consume
Intertemporal budget constraint
Discounting
Indifference curves
Marginal rate of substitution
Normal good
Income effect
Chapter Seventeen
Substitution effect
Borrowing constraint
Life-cycle hypothesis
Precautionary saving
Permanent-income hypothesis
Permanent income
Transitory income
Random walk
56