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272 SECTORALDEMAM>FUNCTIONS ANO EXTENSIONS OF THE STATIC MODEL
0
,;_j
.., Comparison o~uation (40):giving the MPC and ~uation (39) giving the. . ;\ ~
~
.
CONSUMPTION AND C0NSUMER EXPENOIT\JRE 273
~ · APC shows that in the short run, with previous . . .peak mcome. fixed, "the Due- _,_; "--... • ~ sumption-path that is tied to 3R expected inco-me stream and is somewhat
senberry model implies MPC.'< APC. • •. .. . .. ; ~~ inse.nsi1ive r~·temporary fluctuations in income, is penu~. The Hall model
This combinatit>n of short-run and Jong-run behavior of consumptJon :l •- .~ is the most modem and uses ex~tions in a fully rational way. It is supported •.
gives us the ratchet effect shown in Figure 1_2-11. A~ inco~~ gro~s aloni ,rend, ·::~ _- .. by the intuition that. wil)l·expected lifclime wealth availa~ only information
r and y move up along the topg_:.run funcuon of F1gure 12-11. With a constant ,. i, ~ influencing this expectation can affect consumption. On- the other hand, it is
c/y ratio. But if, at some point like co,J'o, income falls off and the economy , '-- useful to know what does cause fluctuations in current consumptjon, and the
goes•into a recession, c and ymove down along a short-run function CoCo with ~- Ando-Modigliani model has a n:lative sarength in its explicit inclusion of cur-
a slope given by the MPC in equation ( 40). Recovery of income back to its ·;j - rent income and assets in the explanation of consumption. Perhaps the best
• 'j ~- --··· compromise is to explain consumption using the Ando-Modigliani model,
tre~d _J~vel, which_ is also the pi:c~_ous peak_, will ·take c and y-back up coe~ to
the 1mtial c0 .y0 pomt, where trend growth resumes-along the long-run function. but with reservations in cases of temporary income and asset tluctuatiom as
If another recession occurs'at c,,y.. consumption and income will fall back l . •suggested .by the permanent income hypothesis. •• •
~
along c 1c 1 ~ and rise back to c 1,y1 during the recovery. Thus. Duesenberry's
:!-
·1
model implies a ratchet effect in that when income falls off. consumption _ _l'II'-' CHOICE STRUCTURE AND DISEOUIUBRNJM
drops less than it rises as income grows along trend. We might note that
-1 - In Chapter 6 we modeled the worker-consumer as making a constrained op-
this mechanism is fonnally the same as that suggested by wage rigidity in
~;l t' _ timal choice between income and leisure, given tastes and skills. the wage rate
Chapter I 0.
W, and the Cllpected price level r. Thus, in deriving the economy's supply
This completes our survey of the principal theories of the consumption curve, we had a worker choosing. under the usual constraints, a level of'income
function. Each theory improves our understanding of the consu-mption-saving- y• • w'( r- S) (see equation ( 12), p. 116]. Now, in analyzing consumption
income relationships. The theories of-Ando-Modigliani and Friedman, with and saving behavior, we take as given the income-leisure choice. so that con-
the rational expectations extension by Halt, seem to be more su~ful than sumption and saving depend on income..
Duescnberry's, in tenns of their present acceptance among economis~ The Implicit in this treatment of income as predetermined in the consumption
strength of Friedman ·s theory is related to the acceptance by many economists function is a model of the choice structure of the worker-conswner illusttated
of the proposition that people base current consumption-saving decisions on in Figure 12-12. Given·ti~. tastes, skills. prices, and wages detcnnincd by
more than just current and past values of income and assets. The notion, the market, the worker makes a work-leisure decision. This was the starting°
common to both Ando-Modigliani and Friedm·an, of a basic pennanent con- point ofChaptei 6. This decision will not be revised often. In the institutional
context of most industrial economies, with union membership, long-term
contracts, and skill and educational background "locking'• people into labor
C market decisions for extended periods of time, the fundamental labor market
·-. ~ decision is not going to be reviewed nearly as often as the saving-consumption
decision.
~. .~!
The work-leisure decision yields a value for permanent i•onw that is
.r 6
then split ( after taxes. of coune) into consumption and saving. This saving
~· 1

decision can be reviewed frequently. As the worker-consumer is occasionally

surprised by the labor market outcome as national income Ductuatcs. we sec
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Time 7H: w..t.;~lennaneal--CC111llilunptiun~
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-=...a......
..
· Skill!' . Savi,,_ ) v....
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11 Y1

',)
•
--r
[ W,F"' J l.riwlt' ...__..,
Figura 12-11 The "ratchet effect•• in c:onsump. J flgln 12-12 ~ Choice structure.
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. SECTORAL DEMAND FUNCTIONS AMJ EXTENSIONS OF THE STATIC M00EL CONSUMPTION AND CONSUMER EXPENOfflJRE
271
~
270
I.,,
( .. ,. , • . , .. tryi~g to keep up with a ~tiont:1~ avg.age consumption,standard witlMt bclow-
avera;e income. 0n-·tbe other hand,.an-individual with an above-average in-
!' y 1', come witi h~ve a lower Cj y' ratio' ~use it taJces a smaller proportion of his
_
~
C income to buy the standard basket ·of co_ns~~r goods.
e
!! - · This provides the explanation of both the era.sectio nal result that
MPC < APC and the long-run constancy of c/y. If, as income g,ows along
0
J
C
trend, the relative distribution of income is stabl~. there will be no reason for
Flgw• 12-10 Uquldity-:eonstralned lfe c/y to change. As people earn more along trend, they can inaease their con-
T cycle. -I~ sumption proportionately to maintain the same ratio between their consump-
;
t~on and the national average. ,
•"tt
'
follow income in Figure 12-10 up to point A where·c·, ;=; y,. From 'the,e on it
would foJlow the life-cycle path of Figure 12-6. In a cross section of the pop-
j·~ Duesenberry's second hypothesis is that present consumption is not in-
fluenced merely by present levels of absolute and relative income, but also by
ulation; we would expect to ftnd liquidity constraints most binding among the
young. This expectation is borne out by ·empirical studies, such as the research
of Hubbard and Judd. It also implies that the effect of cyclical fluctuations in
income on consumption- is feJt most sharply by the younger segments of the
working population.

I .:t
~~- ';

levels of consumption attained in previous periods. It is much more difficult.

he argues. for a family to red~ a level of consumpti on once attained than
to reduce the portion of its income saved in any period. This assumption
suggests that the aggregate ratio of saving to income depends on the level of
present income relative to previo.us peak income, j. Mathematically, in Due-
senbcrry's formulation,
~. s y
The Duesenberry Approach: Relative Income
,1 ~
I,
- =Do+ a,-;. (38)
;:,i y y
The model developed by Duesenberry in 1949 differs considerably from all I
,l • where y is real disposable income. As present income rises relative to its pre-
the models we have presented in this chapter in that it docs not begin with an ,)
I
'I
vious peak. s/y increases. and vice versa. We can convert this Duesenbe ny
entirely private utility function independent of the consumption of other per- saving function into a consumption function by observing that ify is disposable
hy- •-~'
sons. Instead, Duescnbcrry•s analysis is based on two relative income • ;J income, c/y = I - (s/y), so that from (3&) we can obtain
potheses. . I ,j
y
The fim hypothesis is essentially that consumers arc not so much con-
C
- = ( 1 - Do) - a, -; . (39)
y
cerned about their absolute level of consumption as they arc with their con- 'I
y
sumption relative to that of the rest of the populatjon. The Fishcrian model '
As income grows a1ollg trend, previous pealc income will always be last
is based on the solution to the problem of consumer choice when the consumer
year"s income, so that y/j would be equal to I + g, where g, is the growth
tries to maximize u = u(co, •••• c,, ... , c 7 ) subject to a present value con- .! rate of real income. If y grows at 3 percent along trend. y I j will be 1.03 and
strai_nt. In that case, only the absolute level of the individual's consumption 't
y, however, writes the utility function c/y win be conslanlt as required by the long-nm data of Kuznets.
enters the utility function. Duesenberr
. But as income fluctuates around trend. the f / y ratio wiU vary inversely
as •1
J
1
·,
with incmne, owing to the negative coefficient of y/j iP (39). To compute
U -= (
co•• . c, '
er ,I,
the MPC. we can multiply the c/ y ratio of ( 31) by y to oblain
<37>
U Ro• ... • R, ' ••• 'RT) ' ;)·:1 yZ
c = ( I - ao)1 - a, -:-
y
.
where the R•s are a weighted avc,age of the rest of the population's consump- ·1:
tion. This says that utili~in ~ only if the individual 's consumpti'on rises
1
The MPC. the partial derivative of c with respect toy. is then
J
:,\
relative (o that of the average.
j ac ,. (40)
This assumption leads to the result that the individual's c/y ratio will .I MPC- cly = (I - ao)_- 2a, j"
depend on his position ,in the incom~ distribution..A person with an income .i
( ~ t h e avera~e will tend to ~vc a h!gh c/yratio because, mentially, he is :j '
.. "
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.
-
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268
SECT~AL DEMAND F U ~ ~EXTE-OF ~ST~TIC ~~L :'. · .: ; •· •• •••
period and add transitory consumption c:., to both si~es of it to get an equa- ; ~
- . . _c.._ CONSUMP'TION ~[) C0NSUMEA EXPENDITURE 211
• • c,+1 =),cf+ k(l - ~)y, + c~. (34)" ..
. .
Here {)le lagged· ~al_u~ ~ ;. ~e-~~n-ts •the ~aptive, ra!h~~- than rational. ex- • tomorrow, or can.bo_rrow.k>day to.c.onsu.me.agains) fulvre income. The second
~aji_ons ~U~!Q~• ~vmg -1t ~ut of the regressi~n ·wou~d introduce ~on- _,. · •case is the one itlustrated in. Figure 12-4~ Both saving (lending) and borrowing
-Aandomness m the estimated error terms uni~ the tune senes of y were·1tself ~ ·are assumed to be PoSSible at the same rate of interest. It ·is·obvious, jusi from
random. • ~~ everyday experience. that this.assumpcion docs not hold &e'1Cnµ)y at the level-
_Hall's work adds the rational expectations ~umption to the basic Fish- ~ of the individual household. Many households cannot· borrow freely for con-
sumption against future income. They are constrained in thcirronsumption
erian intertemporal model underlying both Ando-Modigliani and Friedman. ~ -~ decisions by cunent liquidity-current income pJus existing assets. Thus. the
This ·gives us a reduced.:fonn forecasting equation 'for cons~mptio~ in the • ~- - term liquidity const,ainl.
form of (33 ). This equation is,_ of cou~, consistent with t~e basic structural. •• • ·- _. There are two basic causes ofJiquidity constraints in the form of banks•
relationship of this whole bo4y of theory: cu'rrent consumption depends on • ·u._ unwillingness to lend for consumption agains, repayment out of future income.
the present value of the entire future income stream. This is the common ~~ One is the uncertainty that both bank and borrower feel about .future income.
starting point for all the variants we have discussed. The jury is still out on ~---· Th~ second is the risk of default by the borrower. The combination ~f these
the role of rationat expectations, howevp C::: _ ~ uncertainties causes banks to place credit limits on borrowers, so that they
cannot bom>w fieely against future income. It may be possible to borrow
against the purchase of durable goods. such as houses and cars. because they
TWO ALTERNATIYES IN CONSUMPTION THEORY provide collateral. The bank owns the item until the loan is paid off. Banks
will lend apinst education because in many cases the government guarantees
The approaches to consumption theory set out in the last section an started repayment of the loan. In this case public policy is attempting to break the
from the intertemporal maximization model. The assumptions of that model liquidity constraint on investment in education.
are not sacrosanct, however. Their empirical validity is open to question and Generally, however. these limits apply to how far you can go in borrowing
to econometric verification. The consumption literature includes two major to consume. If the borrower goes beyond a reasonable limit in committing
alternatives to the pure intertemporal maximizing model, which we will discuss uncertain future income to repayments. he or she faces the possibility of bank-
here. The first alternative ·modifies the budget constraint of equation (3 ). It ruptcy. Once faced with that situation, the borrower may as weU go broke on
is generally referred to as a "liquidity-constraint" model. The second introduces a grand scale, enjoying life in the short run. This pombility adds to banks"
an alternative utility function to equation (2) that recognizes that individuals reluctance to lend for consumption.
Tbc~xtternc case ofliquidity constraint would be characterized by a level
care about their relative position in the income distribution and their relative } of consumption limited by current liquidity. For these consumers. the budget
consumption levels, as weU as the absolute level of consumption. James Due- I
\. constraint would be
senberry developed ~ theory built on this idea in the l 940s. It can be traced
to Thorstein Veblen's ideas about conspicuous consum~tion which date from C: sy;+a:. (35)
the beginning of the 1900s. Let's begin with liquidity constraints. ·, where y, is CWTCDI net income (net of past repayment obligations). In an
economy with a mixture of consumers. some constrained by liquidity as in
The Role of Uq·uidity Constraints
( 35) and some under the usual intencmporal constraint of equation ( 3 ), the
aggregate ~onsumpuoa function would then resemble that of Ando and M~
In discussing both the two-period and many-period intertemporal maximizing dig)iani: •
model, we made heavy use of the intertempotal budget constraint of equa- c, • aoY, + a 1a,, with a0 , a, < l. (36)
tion (3 ).:
Pervasive liquidity constraints would therefore lead us back to a ..Keynesian"
T C, T y, coosumption function with an imponant role for current wealth.
f (I +r)'= f-o +r)'. The existence of liquidity constraints would not eliminate life-cycle pat-
terns in coasumplion and saving. since the consuaint is C>Ae-sided. It would
This budget constraint assumes that the consumer can in fact move resources constrain borrowina at the yo11ng end of the life--cyc>e. But saving in the middle
through time in both directions. He or she can save today for consumption years for miRJMDI woutd still be oprimal. So the consumption path would
.
A~
158
~-r~ 159
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