# Macro economics

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Macroeconomics ECO 403
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LESSON 37
CONSUMPTION
John Maynard Keynes and the Consumption Function
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.
The Consumption Function
C = C + cY
income
depends
Marginal
consumption
on
Propensity to
spending by
consume (MPC)
households
Autonomous
consumption
C
C = C + cY
C
Y
This consumption function exhibits three properties that Keynes conjectured.
1. The marginal propensity to consume c is between zero and one.
2. The average propensity to consume falls as income rises.
3. Consumption is determined by current income.
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Average Propensity to Consume
APC = C/Y = C/Y + c
As Y rises, C/Y falls, and so the average propensity to consume C/Y falls. Notice that the
interest rate is not included in this function.
C
APC1
C
APC2
1
1
Y
Marginal Propensity to Consume
·  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 rupee he or she earns after tax deductions, he or
she spends 99 paisas of it.
·  The MPC measures the sensitivity of the change in one variable (C) with respect to a
change in the other variable (Y).
Secular Stagnation and Simon Kuznets
·  During World War II, on the basis of Keynes' consumption function, economists
predicted that the economy would experience what they called secular stagnation, a
long depression of infinite duration-- unless fiscal policy was used to stimulate
aggregate demand.
·  It turned out that the end of the war did not throw the U.S. into another depression, but
it did suggest that Keynes' 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 and whose work would later earn a Nobel Prize.
·  He discovered that the ratio of consumption to income was stable over time, despite
large increases in income; again, Keynes' conjecture was called into question.
·  This brings us to the puzzle...
Consumption 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' conjectures hold up well in the studies of household data and in
the studies of short time-series, but fail when long time series were examined?
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Studies of household data and short time-series found a relationship between consumption
and income similar to the one Keynes conjectured-- this is called the short-run consumption
function.
But, studies using long time-series found that the APC did not vary systematically with income-
-this relationship is called the long-run consumption function.
C
Long-run consumption function
(constant APC)
Short-run consumption
function (falling APC)
Y
Irving Fisher and Intertemporal Choice
·  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.
·  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 today and in the future.
Consumer's Budget Constraint
·
Consider the decision facing a consumer who lives for two periods (representing youth &
age)
·
He earns Income Y1, Y2 and consumes C1, C2 in both periods respectively (adjusted for
inflation)
·
The savings in the first period will be
S = Y1 ­ C1
·
In the second period
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C2 = (1 + r) S + Y2
Where r is the real interest rate.
·
Remember S can represent either saving or borrowing and the equations hold in both
cases.
­ If C1 < Y1
consumer is saving
S>0
­ If C1 > Y1
consumer is borrowing
S<0
·
Assume:
r (borrowing) = r (saving)
Combining the two equations:
C2 = (1 + r)(Y1 ­ C1) + Y2
Rearranging
(1 + r)C1 + C2 = (1 + r) Y1 + Y2
·
Dividing both sides by 1 + r
C2
Y2
C1 + r
+
1+r
= Y1 +
1
So we can say that
·  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.
Here are the combinations of first-period and second-period consumption the consumer can
choose.
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Second-
period
consumption
Consumer's budget
constraint
B
Saving
Vertical intercept is
(1+r)Y1 + Y2
A
Borrowing
Y2
Horizontal intercept is
C
Y1 + Y2/(1+r)
Y1
First-period consumption
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.
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