Macroeconomics II

Macroeconomics II, Econ-2032

Credit hour 3
Pr-erequeste econ 2031
 Chapter one; Behavioural Foundaions:
Theories of Consumption
 Content
1.1 the Keynesian consumption Function
1.2 the early empirical successes
 1.3 secular Stagnation, Simon Kuznets and the
consumption puzzle
1.4 Irvin Fischer’s Model
 1.5 Modigiani’s Life cycle Hypothesis model
 1.6 Friedman’s permanent income Hypothesis
 1.7 Hall’s Random Walk model Rational
expectations Adaptive expectations Naïve
 1.1. The Keynesian
Consumption Function
consumption spending or consumption
expenditure is defined as the total
amount of income spent on either
durable or non-durable consumption
goods such as food, shelter (rent), clothes
and cars or transportation. This spending,
however, can be considered at
macroeconomic or individual level.
The study of consumption spending at
macroeconomic level is mainly concerned
 Keynes in his “General theory”, published in
1936, laid the foundations of modern
macroeconomics.
 The concept of consumption function
plays an important role in Keynes’ theory
of income and employment.
 According to Keynes, of all the factors it
is the current level of income that
determines the consumption of an
individual and also of society.
Keynes laid stress on the absolute size of
current income as a determinant of
consumption, his theory of consumption is also
known as absolute income theory of
consumption. Keynes put forward a
psychological law of consumption,
according to which, as income increases
consumption increases but not by as much
as the increase in income. In other words,
marginal propensity to consume is less
than one. 1> MPC>0
While Keynes believed that there are many
other factors including interest rate and
 THREE CONJUCTURES
About consumption behaviour, Keynes makes three
points.
 First, he suggests that consumption expenditure
depends mainly on absolute income of the current
period, that is, consumption is a positive function of the
absolute level of current income.
The more income in a period one has, the more is likely to be
his consumption expenditure in that period. In other words, in
any period the rich people tend to consume more than the
poor people do.
 Secondly, Keynes points out that consumption
expenditure does not have a proportional relationship
with income.
According to him, as the income increases,
consumption increases but not in the same
proportion.
The proportion of consumption to income is
called average propensity to consume
(APC). Thus, Keynes argues that average
propensity to consume (APC) falls as
income increases.
The Keynes’ consumption function can be
expressed in the following form C = a + bYd
where C is consumption expenditure and Yd is
the real disposable income which equals gross
national income minus taxes, a and b are
constants, where a is the intercept term, that is,
 The parameter b is the marginal propensity to
consume (MPC) which measures the increase
in consumption spending in response to
per unit increase in disposable income.
Thus MPC = ΔC/ΔY
Since the average propensity to consume falls
as income increases, the marginal
propensity to consume (MPC) is less than
the average propensity to consume (APC).
The Keynesian consumption function is depicted
in Figs. below. In Figer we have shown a linear
consumption function with an intercept term.
 In this form of linear consumption function,
The straight line OB drawn from the origin
indicating average propensity to consume at
higher income level Y2 has a relatively less
slope than the straight line OA drawn from the
origin to point A at lower income level Y1.
The decline in average propensity to
consume as the income increases implies
that the proportion of income that is saved
increases with the increase in national
income of the country. This result also follows
from the studies of family budgets of various
families at different income levels.
AS income increase APC start declines,
Fig.1.1.consumption function;
declining APC
Third, 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 classical economists held that a higher
interest rate encourages saving and
discourages consumption. Keynes admitted
that the interest rate could influence
consumption as a matter of theory. Yet he wrote
 Consumption and Aggregate Demand: Their Relationship

 The study of consumption spending at

macroeconomic level is mainly concerned with
its importance in the aggregate demand. But,
dear learner, how do you think consumption is related
to aggregate demand?
In very simple terms, aggregate demand is the total
amount of goods and services demanded in an
economy.
The economy can be taken as the combination of
several sectors, namely the household sector, the
business sector, the government sector and the
All of the sectors demand goods and
services from the economy. The household
sector demands consumption goods and
services desired for life. The business
sector demands investment goods
required for business. The government
sector demands both consumption and
investment goods to facilitate public
services, build infrastructure, etc.

Residents of the rest of the world also

demand the nation’s goods and services,
and so the nation does theirs. The former
The total amount of goods and services
demand by all of these sectors is known as
aggregate demand.

Macroeconomists are always concerned with

equilibrium level of output which is that level of
output at which quantity of output supplied is
equal to the quantity demanded.
 As consumption is the largest component
of desired aggregate expenditure, the
factors affecting the consumption are also
the most important determinants of
As you may understand from the above
aggregate demand function, any change in the
factors determining consumption that produce
increase/decrease in consumption expenditure
will also increase/decrease aggregate demand
in the economy.
Consumption function explains the relationship
between consumption and income. One of the
popular consumption theories that explain such
relationship is known as the Keynesian
absolute income hypothesis.
According to this theory when income
 1.2. The Early Empirical Successes
Soon after Keynes proposed the consumption
function, economists began collecting and
examining data to test his conjectures.
 The earliest studies indicated that the
Keynesian consumption function was a good
approximation of how consumers behave. In
some of these studies, researchers surveyed
households and collected data on consumption
and income.
They found that households with higher income
consumed more, which confirms that the
marginal propensity to consume is greater
than zero. They also found that households
Thus, these data verified Keynes’s
conjectures about the marginal and
average propensities to consume. In other
studies, researchers examined aggregate data
on consumption and income for the period
between the two world wars. In years when
income was unusually low, such as during the
depths of the Great Depression, both
consumption and saving were low, indicating
that the marginal propensity to consume is
between zero and one.
In addition, during those years of low
income, the ratio of consumption to
income was high, confirming Keynes’s
 Secular Stagnation, Simon Kuznets,
and the Consumption Puzzle
Although the Keynesian consumption function
met with early successes, two anomalies soon
arose. Both concern Keynes’s conjecture
that the average propensity to consume
falls as income rises.

The first anomaly became apparent after

some economists made a dire and, it
turned out, erroneous—prediction during
World War II.
On the basis of the Keynesian consumption
They feared that there might not be enough
profitable investment projects to absorb all this
saving. If so, the low consumption would lead to an
inadequate demand for goods and services, resulting in
a depression once the wartime demand from the
government ceased.

In other words, on the basis of the Keynesian

consumption function, these economists predicted that
the economy would experience what they called secular
stagnation—a long depression of indefinite duration—
unless the government used fiscal policy to expand
aggregate demand.
Fortunately for the economy, but unfortunately
for the Keynesian consumption function, the
end of World War II did not throw the country
into another depression.
Although incomes were much higher after
the war than before, these higher incomes
did not lead to large increases in the rate
of saving. Keynes’s conjecture that the
average propensity to consume would fall
as income rose appeared not to hold.
The second anomaly arose when
economist Simon Kuznets constructed
new aggregate data on consumption and
He discovered that the ratio of consumption to
income was remarkably stable from decade to
decade, despite large increases in income over
the period he studied. Again, Keynes’s
conjecture that the average propensity to
consume would fall as income rose
appeared not to hold
The failure of the secular-stagnation
hypothesis and the findings of Kuznets
both indicated that the average propensity
to consume is fairly constant over long
periods of time.

Figure 17-2 illustrates the puzzle. The evidence
suggested that there were two consumption
functions(short-run and long-run).
For the household data and for the short
time-series, the Keynesian consumption
function appeared to work well. i.e APC
Declines as income increase
Yet for the long time-series, the
consumption function appeared to exhibit a
constant average propensity to consume.
Economists needed to explain how these two
consumption functions could be consistent with
each other.
In the 1950s, Franco Modigliani and Milton
Friedman each proposed explanations of these
seemingly contradictory findings. Both economists
later won Nobel Prizes, in part because of their
work on consumption.

.Both Modigliani’s life-cycle hypothesis and

Friedman’s permanent-income hypothesis
rely on the theory of consumer behavior proposed
much earlier by Irving Fisher.
 1.4. Irvin Fischer’s Model
The consumption function introduced by
Keynes relates current consumption to
current income. This relationship, however, is
incomplete at best. When people decide how
much to consume and how much to save,
they consider both the present and the
future. The more consumption they enjoy
today, the less they will be able to enjoy
tomorrow.
In making this trade-off, households must look
ahead to the income they expect to receive in
the future and to the consumption of goods and
Fisher’s model illuminates the constraints
consumers face, the preferences they have,
and how these constraints and
preferences together determine their
choices about consumption and saving.
 1.4.1. The Intertemporal Budget
Constraint
Most people would prefer to increase the quantity or quality
of the goods and services they consume—to wear nicer
clothes, eat at better restaurants, or see more movies.
The reason people consume less than they desire is that
their consumption is constrained by their income. In other
words, consumers face a limit on how much they can
spend, called a budget constraint.
When they are deciding how much to consume today
versus how much to save for the future, they face an
intertemporal budget constraint, which measures
the total resources available for consumption today
and in the future. Our first step in developing Fisher’s
model is to examine this constraint in some detail.
To keep things simple, we examine the decision
facing a consumer who lives for two periods.
Period one represents the consumer’s youth,
and period two represents the consumer’s old
age. The consumer earns income Y1 and consumes
C1 in period one, and earns income Y2 and
consumes C2 in period two.
(All variables are real—that is, adjusted for inflation.)
Because the consumer has the opportunity to
borrow and save, consumption in any single period
can be either greater or less than income in that
period.
Consider how the consumer’s income in the two
periods constrains consumption in the two
periods. In the first period, saving equals
income minus consumption. That is S
= Y1 − C1, ;where S is saving.
In the second period, consumption equals
the accumulated saving, including the
interest earned on that saving, plus second-
period income. That is,
C2 = (1 + r)S + Y2, where r
is the real interest rate.
 For example, if the real interest rate is 5
percept, then for every $1 of saving in period
Note that the variable S can represent either
saving or borrowing and that these equations
hold in both cases.
 If first-period consumption is less than first-
period income, the consumer is saving, and S is
greater than zero.
If first-period consumption exceeds first-period
income, the consumer is borrowing, and S is
less than zero. For simplicity, we assume that
the interest rate for borrowing is the same as
the interest rate for saving.
To derive the consumer’s budget constraint, combine the two
preceding equations.
Substitute the first equation for S into the second equation to
obtain
C2 = (1 + r)(Y1 − C1) + Y2.
 To make the equation easier to interpret, we must rearrange
terms. To place all the consumption terms together, bring (1 +
r)C1 from the right-hand side to the left-hand side of the
equation to obtain
(1 + r)C1 + C2 = (1 + r)Y1 + Y2.
 Now divide both sides by 1 + r to obtain C1 + = Y1 + . This
equation relates consumption in the two periods to income
in the two periods. It is the standard way of expressing
the consumer’s intertemporal budget constraint
The consumer’s budget constraint is easily
interpreted. If the interest rate is zero, the
budget constraint shows that total
consumption in the two periods equals
total income in the two periods.
Similarly, 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
 1.5. Franco Modigliani and the Life-
Cycle Hypothesis I
In a series of papers written in the 1950s,
Franco Modigliani and his collaborators Albert
Ando and Richard Brumberg used Fisher’s model
of consumer behaviour to study the
consumption function.
 One of their goals was to solve the
consumption puzzle—that is, to explain the
apparently conflicting pieces of evidence that
came to light when Keynes’s consumption
function was confronted with the data.
According to Fisher’s model, consumption
depends on a person’s lifetime income.
One important reason that income varies over a
person’s life is retirement. Most people plan to stop
working at about age 65, and they expect their incomes to
fall when they retire. Yet they do not want a large drop in
their standard of living, as measured by their consumption.
To maintain their level of consumption after retirement,
people must save during their working years. Let’s see
what this motive for saving implies for the consumption
function.
Consider a consumer who expects to live another T years,
has wealth of W, and expects to earn income Y until she
retires R years from now. What level of consumption
will the consumer choose if she wishes to maintain a
The consumer’s lifetime resources are composed of initial
wealth W and lifetime earnings of R × Y. (For simplicity, we
are assuming an interest rate of zero; if the interest rate were
greater than zero, we would need to take account of interest
earned on savings as well.)

The consumer can divide up her life time resources among her
T remaining years of life. We assume that she wishes to
achieve the smoothest possible path of consumption over her
lifetime.
Therefore, she divides this total of W + RY equally
among the T years and each year consumes C=
(W + RY)/T.
We can write this person’s consumption
function as
C = (1/T)W + (R/T)Y.
For example, if the consumer expects to live for
50 more years and work for 30 of them, then T
= 50 and R = 30, so her consumption function is
C = 0.02W + 0.6Y
This equation says that consumption
depends on both income and wealth. An
extra $1 of income per year raises consumption
In particular, aggregate consumption depends
on both wealth and income. That is, the
economy’s consumption function is
C = aW + b Y, where the parameter a is the
marginal propensity to consume out of wealth,
and the parameter b is the marginal propensity to
consume out of income.
 Implications
Implications Figure 17-10 graphs the relationship between
consumption and income predicted by the life-cycle
model. For any given level of wealth W, the model yields a
conventional consumption function similar to the one shown in
Figure 17-1.
Notice, however, that the intercept of the consumption
function, which shows what would happen to consumption if
income ever fell to zero, is not a fixed value, as it is in Figure
17-1. Instead, the intercept here is aW and, thus, depends on
the level of wealth.
This life-cycle model of consumer behavior can solve
the consumption puzzle. According to the life-cycle
consumption function, the average propensity to
consume is C/Y = a(W/Y) + b .
Because wealth does not vary
proportionately with income from person
to person or from year to year, we should
find that high income corresponds to a low
average propensity to consume when
looking at data across individuals or over
short periods of time.
But over long periods of time, wealth and
income grow together, resulting in a constant
ratio W/Y and thus a constant average
propensity to consume.
To make the same point somewhat
differently, consider how the consumption
function changes over time. As Figure 17-10
shows, for any given level of wealth, the life-
cycle consumption function looks like the one
Keynes suggested.
 But this function holds only in the short run
when wealth is constant. In the long run, as
wealth increases, the consumption
function shifts upward, as in Figure 17-
11. This upward shift prevents the
Most important, it predicts that saving varies over
a person’s lifetime. If a person begins adulthood
with no wealth, she will accumulate wealth during
her working years and then run down her wealth
during her retirement years.
Figure 17-12 illustrates the consumer’s income,
consumption, and wealth over her adult life.
According to the life-cycle hypothesis,
because people want to smooth consumption
over their lives, the young who are working
save, while the old who are retired dissave.
 Milton Friedman and the
Permanent-Income
Hypothesis
In a book published in 1957, Milton Friedman proposed
the permanent-income hypothesis to explain
consumer behavior.
Friedman’s permanent-income hypothesis complements
Modigliani’s life-cycle hypothesis: both use Irving
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.
 The Hypothesis
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 + Y T.

Permanent income is the part of income that people

expect to persist into the future.
Transitory income is the part of income that people
do not expect to persist. Put differently, permanent
income is average income, and transitory income is
the random deviation from that average.
The permanent income hypothesis is a theory
of consumer spending stating that people will
spend money at a level consistent with
their expected long-term average income.

A worker will save only if their current

income is higher than the anticipated level
of permanent income, in order to guard
against future declines in income.
The permanent income hypothesis states that
individuals will spend money at a level that is
consistent with their expected long-term average
income.
Milton Friedman developed the permanent income
hypothesis, believing that consumer spending is a result
of estimated future income as opposed to consumption
that is based on current after-tax income.
Under the theory, if economic policies result in increased
income, it will not necessarily translate into increased
consumer spending.
An individual's liquidity is a factor in their management of
income and spending.
 Implications
The permanent-income hypothesis solves the
consumption puzzle by suggesting that the standard
Keynesian consumption function uses the wrong variable.
According to the permanent-income hypothesis,
consumption depends on permanent income YP ; yet
many studies of the consumption function try to relate
consumption to current income Y.
Friedman argued that this errors-in-variables problem
explains the seemingly contradictory findings.
Let’s see what Friedman’s hypothesis implies for
the average propensity to consume. Divide both
sides of his consumption function by Y to obtain
APC = C/Y = aYP /Y.
According to the permanent-income
hypothesis, the average propensity to
consume depends on the ratio of
permanent income to current income.
 When current income temporarily rises
above permanent income, the average
propensity to consume temporarily falls;
when current income temporarily falls
below permanent income, the average
propensity to consume temporarily rises.
Now consider the studies of household data.
Friedman reasoned that these data reflect a
 Robert Hall and the Random-
Walk Hypothesis
The permanent-income hypothesis is based on Fisher’s model of
intertemporal choice. It builds on the idea that forward-looking
consumers base their consumption decisions not only on their
current income but also on the income they expect to receive.
The economist Robert Hall was the 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.
Thank you