Understanding Consumption Theories: Naïve Model to Functional Income Hypothesis

1. Slides for Part III- C Theories of consumption • Outline • The naïve model • Consumption function controversies • The “permanent” income hypothesis • The life-cycle hypothesis • The functional income hypothesis • Poterba on the “wealth effect” • Brown on consumer credit

2. The naïve consumption function Remember our consumption function was specified as follows: Where C is autonomous consumption and c is the marginal propensity to consume

3. The range of possible values of the marginal propensity to consume is based on the the fundamental psychological law of consumption, which can be stated as follows: People are disposed, as a rule and on average, to increase their consumption when their income increases; but not by as much as the increase in income.

4. Definitions • Ave. propensity to consume(APC): Ratio of consumption to real disposable income (YD). That is:APC = C/YD • Ave. propensity to save (APS): Ratio of saving to real disposable income. That is:APC = S/YD. • Marginal propensity to save (MPS): The change in saving resulting from a one unit change in disposable income. That is: MPS = S/  YD.

5. The MPC and the MPS The consumption function is given by:C = 30 + .7YD

6. The graph C C = YD C = 30 + .7YD 300 S 240 C/YD = 1 YD C 100 30 450 0 100 300 YD

7. Slope of the consumption function C Slope = C/YD = 70/100 = .7 C = 30 + .7YD 310 C 240 YD 100 30 450 0 300 400 100 YD

8. Shifts of the consumption function(C) The function could shift due to: C C2 C1 • A change in household wealth • A change in consumer confidence. • Change in price or availability of credit. C0 0 YD

9. Aggregate demand 0 Y1 Y2 Output, income

10. Consumption function controversies • What can explain the long-run stability of the average propensity to consume? • How sensitive is current consumption expenditure to changes in current income? • What can account for cross-sectional differences in the average propensity to consume? • How significant is the “wealth effect”? • Is consumer debt important in explaining shifts of the consumption function?

11. The naïve model predicts a falling APC—but the “long run” data do not bear this out. C C = YD C = 30 + .7YD C/YD = 1 APC decreases as DY increases 100 30 450 0 100 DY

12. The Long Run Average Propensity to Consume Data for consumption and investment in chained 1996 dollars www.bea.gov

13. www.bea.gov

14. The permanent income hypothesis1 Professor Friedman claims thatcurrent C does not depend on current YD (at least not directly). Rather, C depends on what Friedman terms “permanent income.” C=f(YD) 1M. Friedman. A Theory of the Consumption Function, 1957

15. Key points • Permanent income is the flow of monthly or annual income that expected or regarded as normal by the household based on its endowment of wealth (inclusive of human wealth). • Past income flows are one factor that condition the household’s assessment of permanent income. • Current income (YD) affects consumption indirectly--by its affect on the household estimate of permanent income.

16. Example of a “representative household” Occupation: Attorney

17. Positive transitory income (YT) in July ($2,000)—hence, APC falls. • Negative transitory income (YT) in August ($2,000)--hence APC rises APC rises from .7 to 1.17 from July to August Actual income 10,000 YP Income, Consumption 8,000 7,000 C 6,000 Note that: 0 July August Month

18. Moral of the story • C is not as sensitive to changes in current income as the Keynesians would have you believe. • This factor diminishes the size of the MPC and hence the multiplier effect. • The diminished power of the multiplier effect in turn calls into to question to effectiveness of counter-cyclical fiscal policy

19. The life-cycle hypothesis1 Cross-sectional studies of consumer behavior show widevariation in the APC (or APS) among households with the same income. The life-cycle hypothesis can explain this—but is it the right explanation? 1A. Ando and F. Modigliani,” The Life-Cycle Hypothesis of Saving,” American Economic Review, March 1963.

20. DY, C APC falls during peak earning years, and rises during retirement C • 0-18  APS <1 • 18-67  APS > 1 • 67- APS < 1 DY 18 67 Age  Theory implies C is less sensitive to changes in current YD than “naïve” Keynesian model suggests; hence , the multiplier is smaller too.

21. The functional income hypothesis • Key points: • Total consumption expenditure is partly determined by the prevailing distribution of income among various groups. • Higher income households tend to have a higher propensity to save than lower income households. Hence if income is redistributed upward, this will raise the APS and lower the APC. • Policies that have the effect of making income distribution more even tend to raise the propensity to consume (and lower the propensity to save).

22. Example A transfer of income from the Andersons to the Rogers could boost the APC.

23. Sherman & Kolk presentation • Let W denote labor income from wages, salary, fringe benefits, commissions, etc. • Let  denote “property income”—income from dividends, interest, rent, and (net) income of non-corporate business enterprises. • Let Y denote national income. Thus: (1) Also: (2)

24. Equation (2) gives the functional shares in national income • Let 1 denote the average propensity to consume out of labor income. • Let 2 denote the average propensity to consume out of property income. Thus the consumption function can be written as follows: (3)

25. Example: Let Y = $1 trillion W, , and C are measured in billions

26. Change in factor shares in favor of W (at the expense of ) raises the aggregate APC C (billions 940 910 0 1,000 Y (billions)

27. www.census.gov

30. The wealth effect Issues • How sensitive is consumer spending to changes in household wealth? • Does the responsiveness of spending to changes in wealth vary across asset categories—e.g., equities, bonds, home equity, farm land, pension funds? • Could a substantial “correction” in the U.S. equity market have a powerful negative wealth effect on consumption?

31. Change in current consumption per dollar of increase in wealth, assuming consumer are life-cycle planners and do not leave an inheritance. Source: Poterba (2000), p. 104. C that satisfies

32. Stylized facts about the wealth effect • The marginal propensity to consume of wealth is not a stable variable—it changes from year-to-year or decade to decade. • Households as a group are more sensitive to changes in the value of non-financial wealth than financial wealth—a counterintuitive result. • The effect of changes in the value of financial wealth is diminished by the fact that ownership stocks and bonds is tightly concentrated among households. • An much larger proportion of equity wealth is held indirectly(through mutual funds, pensions, insurance policies) today as compared with 1972.

33. Billions of 1999 dollars Source: Poterba (2000)

34. Percent of Assets Owned by U.S. Households, 1998 Source: Poterba (2000), based on 1998 Survey of Consumer Finances

35. Poterba’s estimate of the “stock market wealth effect” on consumer spending in 2000 (billions of dollars) Source: Poterba (2000)

36. The role of consumer debt • Does the build-up, on an unprecedented scale, of mortgage, revolving, and non-revolving debt on household balance sheets constitute at threat to the continued robust growth of payrolls and personal income in the United States?

37. Macroeconomic effects of widened credit availability Liberalization of credit standards, by augmenting the spending power of middle and lower income households, reacts on the propensity to consume is the same way as a downward redistribution of income would. AD = Y AD2 AD1 Planned expenditure (AD) 0 Y1 Y2 Real GDP (Y)

38. Effects of household debt deflation • Debt deflation is an episode wherein households on average allocate a sharply increased proportion of current income to debt servicing. • Debt deflation tends to occur at the terminal point of a lengthy business cycle expansion.

39. Consequences of household “debt deflation” Explained in the income –expenditure framework, debt deflation is manifest in a decrease in autonomous consumption--C AD = Y AD2 AD1 Planned expenditure (AD) 450 0 Y1 Y2 Real GDP (Y)

42. Source: Trans Union Credit Research Center

43. Supposition • A given rate of increase of household indebtedness is likely to be sustainable so long proportion of after-tax income claimed by the minimum debt servicing remains constant as the economy moves forward along the time axis. • It follows that the rate of increase of indebtedness is not sustainable if the proportion of income claimed by debt service is rising.

44. SymbolsSERVICEt Debt service in quarter t ; • DPIt  (Nominal) personal disposable income in quarter t ; • t SERVICEt DPIt ; • Revolvet  Revolving consumer debt outstanding in quarter t ; • NrevolvetNon-revolving consumer debt outstanding in quarter t ; • CDEBTt The sum of Revolvetand Nrevolvet; • MDEBTt Mortgage debt outstanding in quarter t ; • Interestt Minimum interest owed in quarter t ; • Principlet Minimum principal owed in period t ;MaturityC Average maturity of outstanding consumer debt obligations (measured in quarters); • MaturityM Average maturity of outstanding mortgage debt • Obligations (measured in quarters) ; • RC1  Average interest rate paid on revolving consumer debt ; RC2  Average interest rate paid on non-revolving consumer debt ,and; • RM Average interest rate paid on mortgage debt.

45. Methodology • The growth of consumer and mortgage debt is forecasted using a (linear) trend projection obtained from quarterly observations for each variable for a six year period (1993.1 to 1999.1). • Having forecasted the value of outstanding debt in future quarters, the next step is to estimate quarterly debt service--that is, the minimum principal and interest payable in each quarter.

46. Thus we have: SERVICEt = Interestt+ Principlet [1] The following equation was used to estimate quarterly interest payments: Interestt =RevolvetRc1+ NrevolvetRc2 + MDEBTtRM/4 [2] The estimate of minimum principal owed was obtained from the following equation: Principlet =  CDEBTt÷ MaturityC +  MDEBTt ÷ MaturityM [3] Equations [2] and [3] were substituted into [1] to estimate quarterly debt service.

48. The results