Cap 16: Consumo

neoclassical consump- tion model. Individuals choose

consumption at each moment in time to maximize a
lifetime utility function that depends on current and future
consumption. People recognize that income in the future
may differ from income today, and such dif- ferences
influence consumption today.
The Neoclassical Consumption Model
The consumption model is based on two main elements:
an intertemporal bud- get constraint and a utility function
The Intertemporal Budget Constraint

Suppose that as of
this moment Irving has financial wealth equal to ftoday.
For example, this financial wealth would include Irving’s
savings account balance and his holdings of stocks and
bonds. Irving earns labor income ytoday today and yfuture
in the future. Letting c denote consumption, Irving faces
the following two budget constraints:
“consumption equals income less saving.”
future – ftoday
saving for the future—the amount he sets aside to increase
the balance in his financial accounts. The second equation
applies to the future, the second (and last) period of the
model. In this case, Irving earns labor income yfuture but
also earns interest on his financial wealth. Because this is
the last period of life, there is nothing to save for, and
Irving consumes all of his income and wealth at that point.

intertemporal budget
constraint:
This equation says that the present discounted value of
consumption must equal total wealth. That is, Irving’s
consumption is constrained by the total resources that will
be available to him in the present and in the future.
These equations suggest that Irving’s consumption in any
given year can be very different from his income.
Irving is allowed to save for the future, if he desires; but
he can also borrow against his future labor income. What
must be true is that the present value of consumption
equals the present value of lifetime resources.
Utility
We assume that Irving chooses his consumption today and
in the future in order to maximize utility.
a utility function
We also assume that Irving gets more utility whenever his
consumption is higher, but that consumption runs into
diminishing returns.
diminishing marginal utility: each additional unit of
consumption raises utility by a smaller and smaller
amount.

Diminishing marginal
utility is reflected in the curvature of the utility function,
which gets flatter and flatter as consumption increases.
Irving’s lifetime utility depends on how much he
consumes today and how much in the future. The
parameter ! is some number—such as 1.0 or 0.9—that
captures the weight that Irving places on the future,
relative to today. For example, if ! = 1, then Irving treats
utils received today and in the future equally.
Alternatively, if ! < 1, a given flow of utility is worth more
when it occurs today.
Choosing Consumption to Maximize Utility

The model is closed

by assuming that Irving chooses his consumption so as to
maximize utility, subject to his budget constraint:

where we’ve defined X ≡ ftoday + ytoday + 3 yfuture/11 +

R2 4. That is, X denotes total wealth, the sum of financial
wealth and human wealth
If Irving consumes a little more today, the extra utility he
gets is the marginal utility of consumption today, which
we can write as ur1ctoday2. Alternatively, Irving can
consume a little more tomorrow, in which case he gets the
marginal utility of consumption tomorrow (adjusted by the
discount parameter): !ur1cfuture2.
Now recall the logic of the intertemporal budget
constraint. The essence of this constraint is that Irving can
consume 1 unit today or can save that unit and con- sume
1 + R units in the future. If he’s maximized utility, Irving
must be indifferent between consuming today or in the
future. Why? Because if moving consumption from today
to the future (or vice versa) increased utility, then Irving

would not be at a maximum.

Euler equation for consumption.
The Euler equation essentially says that Irving must be
indifferent between con- suming one more unit today on
the one hand and saving that unit and consuming it in the
future on the other.
The fact that these two sides must be equal is what
guarantees that Irving is indifferent to consuming today
versus consuming in the future.
let’s first suppose that ur1ctoday2 were larger than !11 +
R2ur1cfuture2.This means that the marginal utility of
consumption today is higher than the value Irving gets
from consuming the extra unit (plus interest) in the future.
In this case, Irving should reduce consumption in the
future and raise it today. That will increase overall lifetime
utility. This reallocation should occur until Irving is just
indifferent between consuming an extra unit today and
consuming that unit plus interest in the future.
If the marginal utility of consumption today is lower than
it would be in the future, Irving should reduce
consumption today and raise it in the future. That would
increase overall lifetime utility.

Solving the Euler Equation: Log Utility

Notice that the left-hand side of this equation is just the

growth rate of consump- tion (plus 1). Equation (16.8),
therefore, says that Irving chooses his consumption so that
the growth rate of consumption is the product of the
discount parameter and the interest rate that he can earn on
his saving. If Irving is very impatient, he places less
weight on future utility (a lower !), and consumption
growth is lower. In contrast, a higher interest rate raises
the return to saving, and consumption growth is faster.
Euler equation
it explains why interest rates and growth rates are often
similar numbers, like 2 percent. In the partial equilibrium
consumption problem that Irving is solving, Irving takes
the value of the real interest rate R as given and chooses
any consumption growth rate he wishes.
in general equilibrium, the real interest rate and the growth
rate of the econ- omy are both endogenous variables, The
Euler equation then explains how these two variables are
related.
In general equilibrium, a Solow/Romer-type model pins
down the growth rate of the economy. The Euler equation
then determines the interest rate that Irving faces.
the Euler equation explains how interest rates and growth
rates are linked.
Solving for ctoday and cfuture: Log Utility and b 5 1

intertemporal budget constraint

in equation
For log utility and ! = 1, then, Irving consumes one-half of
his wealth today and saves the other half. In the future, he
can consume the remainder of his wealth together with the
interest it has earned. Solving the model when ! 2 1 is not
much more difficult; this problem is considered in an
exercise at the end of the chapter.
The Effect of a Rise in R on Consumption
A higher interest rate will reduce this present value,
therefore reducing consumption in the case of log utility.
This force is called the wealth effect of a higher interest
rate, because it works through the total wealth term.
You may also recall from your study of microeconomics
that changes in interest rates often involve both a
substitution effect and an income effect. In the case of log
utility, these effects offset each other, which is why the
interest rate does not appear explicitly in equation
The substitution effect of a higher interest rate is that
current consumption is now more expensive (because
saving will lead to even more consumption in the future),
so consumers will tend to reduce their consumption today.
The income effect says that consum- ers are now richer—
because their current saving leads to more income in the
future—which makes them want to consume more today.
In general, a higher interest rate can either raise or lower
current consumption, because these effects work in
opposite directions.
Lessons from the Neoclassical Model
The Permanent-Income Hypothesis
Milton Friedman’s permanent-income hypothesis.
According to this view, consumption depends on some
average value of income, rather than on current income. In
strong versions of the hypothesis, we said, consumption
might depend on the present discounted value of income.
The intuition behind the permanent-income result is that
consumers wish to smooth their consumption over time.
This desire is embedded in the utility func- tion u1c2. To
begin,suppose ! = 1 and R = 0,and consider Figure
16.2.Suppose Irving could consume c1 today and c2 in the
future or could consume the average of these two values in
both periods. Because of diminishing marginal utility,
Irving prefers to smooth consumption and take the average
in both periods. Now consider what happens if R > 0.
From the Euler equation, we know that this change leads
consumption to grow over time. Because of Irving’s basic
desire to smooth con- sumption, he must be paid a positive
interest rate not to keep consumption constant.
How does Irving respond to a temporary increase in
income? Suppose ytoday rises by $100. Equation (16.9)
implies that Irving’s consumption will rise by only 1/2 as
much as the increase in income, or $50. Irving saves the
remainder and consumes it in the future, smoothing out the
burst of income.
In this simple example, the value of 1/2 is called the
marginal propensity to con- sume: if income temporarily
goes up by $1, consumption rises by 1/2 that amount.
Similarly, the marginal propensity to consume out of
financial wealth is also 1/2.
In other words, if Irving expects to live for another 50
years, the marginal propensity to consume out of another
dollar of income will be something like 1/50. The general
lesson from models in which the permanent-income
hypoth- esis holds is that the marginal propensity to
consume out of income or wealth is relatively small.
Ricardian Equivalence
The essence of the Ricardian approach to the government
is that consumption depends on the present discounted
value of taxes and is invariant to the timing of taxes.
While we did not emphasize it, the proper interpreta- tion
of y is as income after taxes. That is, taxes—both today
and in the future—must be subtracted from the right-hand
side of the intertemporal budget constraint. Lifetime
wealth X is the present discounted value of resources net
of taxes.
The Ricardian equivalence claim is that a change in the
timing of taxes does not affect consumption. A tax cut
today, financed by an increase in taxes in the future, will
not affect consumption, if the Ricardian claim is true.
Borrowing Constraints
A key assumption of the neoclassical model is that Irving
can freely save or borrow at the market interest rate R.
Financial conditions could be bad in the economy as a
whole, or perhaps the individual’s credit history is not
good and no one will provide a loan.

In this case, the intertemporal budget

constraint is no longer the correct con- straint. Instead, the
constraint on consumption for individuals with no
financial wealth and no access to credit is much simpler:
Irving’s consumption is constrained by the lack of
borrowing opportunities to be no greater than his income.
Consumption as a Random Walk
What happens if Irving’s income is uncertain?
In the presence of uncertainty, the neoclassical model
implies that consumption today depends on all information
the consumer has about the present value of lifetime
resources. Clearly, there is no way for the consumer to
know if she will win the lottery 25 years from now.
However, she may know that she is currently under
consideration for a big promotion and will likely be
earning substantially more income in the future than she is
today. This information—and all other available
information—should be reflected in her current
consumption.
random walk view of consumption.4 Because all known
information should be incorporated into current
consumption, changes in con- sumption should be
unpredictable. Apart from the general trend in
consumption associated with the interest rate in the Euler
equation, consumption should be equally likely to move
up or down over time, at least if the permanent-income
hypothesis is correct. When an expected promotion
arrives, the effect on consump- tion should be relatively
small—after all, the promotion was expected, and so the
extra future income should already be reflected in current
consumption. In contrast, an unexpected job loss may have
a much larger effect on current consumption, particularly
if the unemployment spell is expected to be long.
Consumption versus Expenditure
that consumption should not change when a long-
anticipated event comes to pass.
one would expect consumption to remain relatively
unchanged when people retire.
Precautionary Saving
consumers may save to hedge against the possibility of a
large drop in income, perhaps asso- ciated with
unemployment or disability. This type of saving is called
precaution- ary saving. Notably, such a consumer might
save even when income and wealth are temporarily low,
when the basic permanent-income hypothesis would
suggest borrowing. Why? As long as the possibility
remains that income could fall even further, consumers
may engage in precautionary saving to insure themselves
against that outcome.
their consumption may be especially sensitive to their
current income, just as in the case of a borrowing
constraint. Precautionary saving and borrowing
constraints, then, are two explanations for why the
marginal propensity to consume out of income can be
higher than the permanent-income hypothesis would
dictate.
Empirical Evidence on Consumption
Evidence from Individual Households
The marginal propensity to consume out of a temporary
income shock is low, and consumption smoothing is
effective for these households.
Second, there are also many households, especially those
with low income and wealth, that behave as if they are
borrowing-constrained or engaging in precau- tionary
saving. For these households, consumption tracks income
well, and the marginal propensity to consume from a
temporary boost in income is high.
The third and final lesson from the extensive research on
household consump- tion is that there are many anomalies
and departures from the neoclassical con- sumption model
—and even from the basic view of households as rational
economicagents, for that matter. One of the most active
areas of economic research in the past decade is
behavioral economics. This research blends insights from
psychol- ogy, neuroscience, and economics in an effort to
create a better understanding of how individuals make
economic decisions. We discuss it in more detail in the
accompanying case study.
Behavioral Economics and Consumption
Laibson considers the possibility that people are
particularly concerned about the present. That is, they may
be especially impatient when faced with decisions
involving today versus the future (as opposed to compar-
ing two different moments in the future). Laibson shows
that under this assumption, consumption will be more
sensitive to movements in income than the permanent-
income hypothesis predicts. Such departures have been
observed empirically. For example, some people seem to
borrow excessively, using credit cards that have very high
interest rates. Others may have trouble exerting the self-
control required to save in response to large, temporary
boosts in income.
Some of the most compelling evidence on the importance
of behavioral consider- ations comes from 401(k)
retirement plans.
SUMMARY
1.
Theneoclassicalconsumptionmodelisbasedonrationali
ndividualswhochoose the time path of their
consumption to maximize a utility function subject to
their intertemporal budget constraint.
2. 3.
Thesolutiontothisbasicproblemisaversionoftheperman
ent-incomehypoth- esis: consumption in each period
is a fraction of total wealth, where total wealth
includes financial resources, current income, and the
present discounted value of future income.
3. 4.
ThissolutioncanalsobeexpressedintermsoftheEulerequ
ationforconsump- tion. This equation says that
individuals are indifferent between consuming a little
more today, on the one hand, and saving a little more
and consuming the proceeds in the future, on the
other.
4. 5. A key implication of this result is that individuals
will seek to smooth out any shocks to current and
future income, suggesting that the marginal pro-
pensity to consume out of a temporary increase in
current income is likely to be small.
5. 6. There are two forces that may counterbalance this
 low marginal propensity to consume, however.
Individuals who are constrained from borrowing in
credit markets such individuals may engage in
precautionary saving to insure themselves against the
possibility of unemployment or disability and may,
therefore, have a high marginal propensity to
consume.
6. 7. Empirical evidence, consistent with this theory,
suggests that while the permanent-income model is a
good benchmark for describing the consump- tion of
well-off individuals, there are also many poorer
consumers with a high marginal propensity to
consume.
7. . Aggregate evidence on consumption during the
1980s and 1990s shows a rise in debt as a ratio to
income and a decline in the personal saving rate.