Consumption and GDP

Consumption and GDP

• Consumption constitutes a substantial, yet relatively stable, portion of the Gross Domestic Product
• Consumption makes up about 70% of aggregate demand, surpassing all other sectors combined

Consumption Fluctuation

• Compared to GDP, consumption experiences proportionately smaller fluctuations

Theories of Consumption

• Modern consumption theories connect lifetime consumption with lifetime income
• These theories propose that the marginal propensity to consume out of temporary income should be small

MPC

• The size of the marginal propensity to consume (MPC) is a point of contention in different consumption theories
• Early Keynesian "psychological rule-of-thumb" models suggest a high MPC

Permanent vs Transitory Income

• Modern theories assign different values to the marginal propensity to consume, based on how long income changes are expected to last
• MPC out of permanent income is high
• MPC out of temporary income is close to zero

Quick and Simple Model

• This model illustrates the core idea of modern consumption theory and its potential pitfalls
• Assume a future with two periods: 'now' (this year) and 'later' (the next 99 years)
• An individual earns Ynow this year and Ylater each subsequent year

Quick and Simple Model Example

• Lifetime earnings amount to Ynow + 99 x Ylater
• The goal is to maintain a consistent living standard, represented by consuming C each year
• Lifetime spending equals 100 x C
• Spreading lifetime income across lifetime consumption results in the function C = (Ynow + 99 x Ylater) / 100

Marginal Propensity to Consume Example

• A $1,000 income increase this year (Ynow) leads to just a $10 per year consumption increase
• The short-run marginal propensity to consume would be 0.01, saving the rest for future consumption
• A $1,000 income increase, both 'now' and 'forever' (Ynow and Ylater), raises yearly consumption by the entire $1,000
• The long-run marginal propensity is 1

Empirical Evidence

• Empirical evidence supports both modern theories and simple Keynesian "psychological rule-of-thumb" models when explaining consumption
• The saving rate in the United States is lower than in many other nations

Consumption vs Income Changes (1959-2010)

• Changes in per capita disposable income and per capita consumption are closely related
• Consumption is less volatile than income
• Consumption is not as responsive to positive or negative income spikes (short-term income swings)
• Income swings lasting 5 or 10 years show roughly matching swings in consumption
• Long-term income swings induce changes in consumption
• Short-term spikes do not
• The long-run MPC is high, while the short-run MPC is low

Modern Consumption Meets Tax Policy (1968)

• President Johnson and Congress passed a temporary (1-year) income tax surcharge
• The goal was to cool down an economy temporarily overheated by spending for the Vietnam War
• A temporary tax increase, thus a temporary decrease in disposable income, would have little effect on consumption and aggregate demand
• Modern consumption theory worked, and the tax increase did not have the desired effect

Modern Consumption Meets Tax Policy (2001)

• The Federal government sent out one-time $600 tax rebate checks to American households
• A surprisingly small amount of this temporary windfall was consumed

Current and Lagged Consumption

• Consumption this quarter is almost perfectly predicted by consumption last quarter plus a small allowance for growth
• Equation for the line is Ct = $75.51 + 1.0005Ct-1

Consumption vs Income

• A close relation exists in practice between consumption spending and disposable income
• Consumption rises on average by 96 cents for each additional dollar of disposable income
• This outcome is due to the connection between current consumption and expected future earnings

Keynesian Theories

• Early Keynesian theories and modern consumption theory needs to explain Figures 13-1 and 13-2
• Early Keynesian theories had current consumption and current income moving in lockstep, without differentiating temporary versus permanent changes in income
• In previous chapters, consumption (C) is determined by disposable income (YD) in the linear relation: C = Average Consumption + cYD, where 0 < c < 1

Historical Measurements

• Estimated values for parameters for the line include Average Consumption = -1213.4 and c = 0.96
• The traditional, measured consumption function is C = -1213.4 + 0.96YD
• The measured value of the MPC, 0.96, is quite high

Life-Cycle vs Permanent Income Theories

• The life-cycle and permanent income theories do well at explaining Figures 13-1 and 13-2
• Empirical evidence indicates that the traditional view depicted in Figure 13-3 is still useful
• The earlier, psychological rule-of-thumb theories have much merit

Life-Cycle–Permanent-Income Theory

• Modern consumption theory emphasizes lifetime decision making

Life-Cycle Hypothesis

• Examines decisions on maintaining a stable standard of living when faced with income changes
• Permanent income theory focuses on forecasting the level of income available to a consumer over their lifetime
• These two theories have largely merged
• Rather than relating consumption behavior to income in a given period, individuals plan consumption and savings behavior over long periods

Life-Cycle Theory

• Life-cycle theory (based on maximizing behavior) implies different marginal propensities to consume out of permanent income, temporary income, and wealth
• The key assumption is that most people choose stable lifestyles
• Most individuals try to consume the same amount each year

Life-Cycle Theory Example

• A person starts life at age 20, plans to work until 65, and will die at 80 with an annual labor income (YL) of $30,000
• Lifetime resources equal annual income times years of working life (WL = 65 - 20 = 45), or $30,000 * 45 = $1,350,000
• Spreading lifetime resources over the number of years of life (NL = 80 - 20 = 60), annual consumption = $1,350,000 / 60 = $22,500
• Formula is C = (WL/NL) * YL

Consumption Behavior & Savings

• The marginal propensity to consume is WL/NL
• Consumption and saving patterns can be created with a theory of consumption
• Saving is income minus consumption

Demography & Consumption

• Life-cycle theory helps link consumption and savings behavior to demographic considerations, specifically the population's age distribution
• The marginal propensity to consume out of permanent income (WL/NL) shifts with age
• Exact arguments only work for labor income as WL isn’t relevant to income from investments
• The MPC out of transitory income would increase from 1/60 at age 20 to 1/30 at age 50
• An economy has mixtures of people and life expectancies, so the MPC is a mix of each
• Economies with different age mixtures have different overall marginal propensities to save and consume

Life-Cycle Consumption & Permanent-Income

• Modern consumption theory is largely constructed by Franco Modigliani and Milton Friedman
• The theories from Modigliani and Friedman are similar and referred to as the life-cycle–permanent-income hypothesis
• Both theories carefully consider microeconomic foundations
• While development differed, today they have largely merged and accepted
• Differing on an important methodological lesson creates progress and leads to economists agreeing on 90% of how the economy works

Marginal Propensities to Consume Income

• Marginal propensities to consume can be by considering variations in the income stream
• A permeant increase increases annual consumption to a factor of $3,000
• WL/NL = 45/60 = .75, The marginal propensity to consume out of permanent income
• 1/NL = 1/60 ≈ .017, a transient increase increases annual consumption only to a factor of $3,000
• The marginal propensity to consume out of temporary income
• MPC out of permanent income is large and the MPC out of transitory income is small
• The life-cycle theory implies that the marginal propensity to consume out of wealth should equal the MPC out of transitory income and be very small

Durable goods

• The LC-PIH makes sense for consumption of nondurables and services
• Durable goods provide a stream of utility long after the purchase
• Theory is investment applied to households instead of firms
• Durable goods purchases don't smooth out and are interest rate sensitive

Permanent-Income

• States consumption is not related to current income
• Instead consumption correlates to a longer-term estimate of income, or “permanent income”
• People prefer a smooth consumption flow rather than plenty today and scarcity tomorrow or yesterday
• Permanent income is the steady rate of expenditure a person could maintain for the rest of their life
• C = cYP, where YP is permanent (disposable) income.