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ECN3106 Macroeconomics II

ECN3106 Macroeconomics II. TOPIC 1 CONSUMPTION (part 1). Consumption. Theories of Consumption Behaviour Keynesian Consumption Function Permanent Income Hypothesis and the Life Cycle Hypothesis Explaining Consumption Patterns. ECN3106 MAKROEKONOMI II

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ECN3106 Macroeconomics II

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  1. ECN3106Macroeconomics II TOPIC 1 CONSUMPTION (part 1)

  2. Consumption Theories of Consumption Behaviour Keynesian Consumption Function Permanent Income Hypothesis and the Life Cycle Hypothesis Explaining Consumption Patterns ECN3106 MAKROEKONOMI II Prepared by: Rozita Zainal Abidin, July 09

  3. Learning Objectives Defining consumption, consumer expenditure and saving Understanding the link between consumption and income described by the Keynesian consumption function Using the optimal consumption model to describe how consumption decisions are related to rational utility maximising behaviour Show how the Permanent Income Hypothesis and Life Cycle Hypothesis base consumption decisions on future as well as current income Explain how changes in expectations, interest rates, wealth, credit constraints and uncertainty can account for recent changes in consumption and saving

  4. Aggregate Demand Consumer expenditure (C) by households on goods and services represents the largest part of aggregate demand. (AD) Since 1980, in UK- C exp is 63% of total AD. S imilar figures would be expected for other developed countries. The size of total consumer expenditure- result of choices made by private households. Its counterpart – saving i.e any income not spend. Also used to fund future consumption. ECN3106 MAKROEKONOMI II Prepared by: Rozita Zainal Abidin, July 09

  5. Consumption and Consumer Expenditure • Consumer expenditure - act of purchasing a good or service. • Consumption - the act of deriving a flow of benefits from the usage of those goods or services. • Used interchangeably: • durable goods represent a relatively small proportion of total household expenditure, so the vast majority of consumer expenditure can also be thought of as consumption. • consumer expenditure, and not consumption, plays the central role in the circular flow of income. ECN3106 MAKROEKONOMI II Prepared by: Rozita Zainal Abidin, July 09

  6. Categories of Consumer Expenditure • Consumer expenditure can be broken down into : • A durable goodis one that can be used many times, such as a washing machine, a television, an automobile, and so on. • A non-durable goodis one that is used up in its consumption, for example, food, energy and public transport. • Servicesshare the same characteristics as non-durable goods ECN3106 MAKROEKONOMI II Prepared by: Rozita Zainal Abidin, July 09

  7. Consumer Expenditure, UK

  8. Theories of Consumption Behaviour • Keynesian consumption function: households base consumption decisions solely on current income. • Permanent Income/Life Cycle Hypothesis: households take a much longer term view of income. • Consumption choices is forward-looking, depending on (i) current income and (ii) expectations about future income. ECN3106 MAKROEKONOMI II Prepared by: Rozita Zainal Abidin, July 09

  9. KEYNESIAN CONSUMPTION FUNCTION

  10. The Keynesian Consumption Function • Also known as the absolute income hypothesis(AIP). • Consumption is a function of income: • a = autonomous consumption • c = marginal propensity to consume • Y = aggregate income.

  11. Keynesian Consumption Function C = a + bY a>0 0<b<1

  12. Autonomous Consumption • Autonomous consumption (auto C), a, is consumption independently of income. • includes consuming out of wealth. Eg household stock of financial assets could be used to support consumption regardless of the amount of current income. (i.e., auto C is equal to a proportion of wealth, ). • it determines where the C function intersects the verticalaxis. Anything that leads to a change in this would lead to a shift in the C function.

  13. Marginal Propensity to Consume • marginal propensity to consume, mpc, gives the relationship between changes in consumption and changes in income. MPC = ΔC / ΔYD • It is the change in consumption that would result from a £1 change in income. • Thus, it determines the slope of the C function.

  14. Marginal Propensity to Consume If the mpc were to rise, then the entire C function would pivot upwards, reflecting the change in the slope:

  15. Marginal Propensity to Consume Therefore, the change in consumption following a change in income is simply: Conventionally, the mpc lies between 0 and 1, meaning that consumption moves less than one-to-one with changes in income because saving acts as a counterpart to consumption.

  16. Marginal Propensity to Save marginal propensity to save, mps : tells us how much saving will change when income varies by £1, or Therefore the mps is defined as:

  17. Change in Income Given that all incomeis either consumed or saved, it must be the case that any change in income is equal to the sum of the changes in consumption and saving:

  18. Change in Income Dividing both sides by the change of income results in a very simple rule: So, we can conclude that:

  19. MPC+MPS=1 • The mps and mpc should add up to 1. • This does not preclude the mpc >1, but in this case it would imply that the mps is negative. • This is possible if there is borrowing or dis-saving, as this could fund extra consumption in excess of the change in income.

  20. Global Application 2.1 • The Marginal Propensity to Consume and Aggregate Consumption • Linear consumption function

  21. Global Application 2.1 • Non-linear consumption function • What are the implications for government policy?

  22. Income and disposable income • For consumption decisions, households would be more concerned of disposable income rather than income. • Disposable income, Yd- income that a household can actually use to either save or spend.

  23. Rewriting the Keynesian Consumption Function (I) Incorporating disposable income, where is disposable income.

  24. Link between actual and disposable income • Disposable Income = Actual Income – Taxes + Transfer Payments. • govt takes with one hand (taxation) and give with the other (transfer payments), thus the flows to and from the household sector can be netted out: Net Taxes = Taxes – Transfer Payments • Leaving us with Disposable Income = Actual Income – Net Taxes.

  25. Disposable Income less than Actual Income • Net taxes are usually positive meaning that taxation > transfer payments. Thus, h/hold Yd should be < than actual income. • Figure 2.3 plots the history of GDP per head and h/hold Yd per head for the UK. Over the past two decades, disposable income typically represents between 60-70% of total income.

  26. UK GDP per head and HH disposable income

  27. Lump sum taxes lump sum taxes (T) - a simple way of representing the difference between actual and disposable income Disposable income can now be simply written in terms of actual income as:

  28. Rewriting the Keynesian Consumption Function with Lump Sum Taxes (II) • Using this definition of Yd, the C function can be rewritten in the following way: • Changes in taxes will lead to changes in C through their effects on Yd. Higher taxes will lead to a downward shift in the C function, meaning that at every level of actual income the level of C will be correspondingly lower.

  29. Keynesian Consumption Function

  30. UK household consumption and disposable income per person

  31. Objections to Keynesian Consumption Function • The positive correlation predicted by the Keynesian C function seems to hold true. This offers some evidence that over time changes in C are driven by changes in Yd. • However, there are some objection: • Keynesian model is an incomplete theory of consumer behaviour as it is not clear that consumer behaviour is consistent with rational behaviour, • there is a need for models which allow a much richer set of determinant factors other than current Yd.

  32. The Permanent Income and Life Cycle Hypothesis

  33. The Permanent Income and Life Cycle Hypothesis 33 • Both theories, argue that C decisions will be based on a longer term view of income. • This is the outcome of h/holds trying to maximise their lifetime utility (welfare). • To gain an understanding of the C smoothing nature of the LCH and the PIH, it is necessary to outline the optimal consumption model.

  34. i)Optimal Consumption Model (OCM) 34 • The OCM describes how consumers should choose the path of consumption over time subject to the resource constraints they face in order to maximise their lifetime utility. • Elements of the model: • Optimal Consumption, • Intertemporal Budget Constraint, and • Optimal Choice.

  35. a) Optimal Consumption 35 • Applying utility maximising behaviour to C choices over time can be demonstrated in a simple two period model. • These two periods represent the total lifetime of a household: • period 1 - the current period, and • period 2 - the future. • The objective of the h/hold- choose a C plan for each period that maximises their total lifetime utility.

  36. b) Intertemporal Budget Constraint 36 • 3 characteristics of the intertemporal budget constraint: • Income in each period is given by Y1 and by Y2, respectively. • H/hold can transfer income across periods by borrowing and lending freely at an interest rate of r. • H/hold must reach the end of period 2 without leaving debts, otherwise households would consume an infinite amount.

  37. IBC -Two period budget constraint 37 In period 1, h/hold receives income of Y1 , if it chooses to consume a level of C1; the difference is savings, S, so The maximum second period C must not exceed the total amount of second period resources:

  38. IBC- Two period budget constraint 38 • Substituting in for saving, we can write the period 2 constraint as: • This highlights the trade-off that households face: • Given their income stream, the household can increase current C if they are prepared to consume less in the future. • Likewise, accepting lower current C enables more to be consumed in the future.

  39. Rewriting the I.B.C. 39 intertemporal budget constraint can be rewritten by rearranging (2.5) by dividing both sides by (1+r) and collecting the consumption and income terms together on different sides of the equation: Present discounted value of C cannot exceed present discounted value of income

  40. Intertemporal Budget Constraint 40 • The present discounted value of C cannot exceed the present discounted value of income. • Future values are divided by the interest rate. This is because the same unit of income is worth different amounts in different time periods as income cannot be transferred costlessly over time.

  41. Fig 2.6Intertemporal Budget Constraint 41

  42. Intertemporal Budget Constraint 42 • The area defined by the budget constraint is known as the budget set – • represents all the possible points at which the h/hold can consume over the two periods. • The slope of the budget line is given by –(1+r). The • int rate reflects the cost of transferring C over time, whether it is the rate of return on savings or the cost of borrowing. • When the household is free to borrow and save there is no reason for C to be tied to current income. • The points where the budget constraint meets the axes represent the maximum possible C in each period.

  43. In 2.6 FV divided by int rate because same unit of income is worth different amount in different time periods as income cannot be transferred costlessly over time

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