Chapter 4 : Theory of Consumption

Introduction

• Consumption tends to be relatively smooth compared to investment.
• Marginal propensity to consume (c₁) significantly determines the multiplier size in the aggregate demand model.
  • Refers to the consumption out of household income on services and goods.
• It will be explained why consumption is expected to be relatively smooth
• This analysis gives insights into determinants of the marginal propensity to consume.

Consumption Smoothing

• Most people prefer similar consumption amounts each month or year.
  • This is preferred over having "more than enough now and too little later".
• Households may save for the future when current income is high.
• Households may borrow if current income is low but is expected to increase later.
• Consumption smoothing: the process of spreading consumption fairly evenly across time periods.
• It involves actions taken to sustain a customary level of consumption.
  • Including borrowing or reducing savings to offset negative shocks like illness or unemployment.
  • It also includes increasing saving or reducing debt in response to positive shocks like promotion or inheritance.

Outline of Lecture

• This lecture covers:
  • The Life Cycle Model
  • Inter-Temporal Choice Model
  • Limits to Consumption Smoothing
  • Volatility of Investment
  • A Quiz

Life Cycle Model

• The desire of households to maintain a constant consumption level is a source of economic stabilization.
• Maintaining this level means households need to plan.
  • This involves considering future income and saving/borrowing to smooth income fluctuations.
• This behavior occurs across agrarian and industrialized societies.
• This behavior is visualised by focusing on predictable life events.

Unexpected events

• People should judge whether an income shock is temporary or permanent.
• If a shock is permanent, people recalculate the long-run consumption level they can maintain under the new income pattern.
• If a shock is temporary, the lifetime consumption plan will not be affected because it makes only a small change to the average lifetime income.

The Life Cycle Model Background

• Franco Modigliani developed the 'life cycle model' of consumption in the early 1960s.
• He was the 1985 Nobel Prize Recipient
• He is best known for the Modigliani-Miller Theorem and his life-cycle consumption theory.
• Modigliani was born in Rome on June 18, 1918, immigrated to the US at the start of WWII, and died on September 25, 2003.

Short-Run Fluctuations

• The Life Cycle Model explains consumption patterns over a lifetime, which is a "long-run" perspective.
• Consumption can be viewed over the business cycle from a "short-run" perspective
  • It was mentioned that consumption remains relatively smooth.
• Output and therefore income can fluctuate over shorter periods of time in months or quarters.
• To understand this, it is necessary to study the theory of consumption and the factors influencing household consumption choices over consumption over time.

Inter-temporal Choice Model

• Lisa's web design business suffered due to the global financial crisis
• Her income decreased forcing her to adjust her living standards.
• Savings she had gathered before the crisis were used to “smooth” her consumption and ensure the survival of basic needs
• During the natural resources boom, Doug and Rob had high incomes
• They expected the boom would not last and both accumulated a large amount of savings.
• This was in anticipation of a possible future in which their income would fall, with the objective to “smooth” their consumption

Consumption-Saving Decisions

• A narrative represents the situations that individuals face over the business cycle.
• Households, firms, and the government see their incomes fluctuate
• This forces them to adjust their consumption and savings decisions.
• Adjustments need to factor the consequences of these decisions and the future wealth.
• Inter-temporal choice is used to make these decisions relating sorts of situations.

Wealth

• Wealth refers to the value of owned items contributing to well-being, also called assets.
• Assets can include property, art, and financial assets like government bonds.
• Wealth can provide income such as the interest from a loan.
• Owning debt means having payments to others, resulting in negative wealth.
• A work of art that appreciated in value is an example asset that can be sold, and provides pleasure.

Income

• Income, also referred to as disposable income, represents payments received net of taxes paid in a given period.
• Income is the maximum amount that can be consumed per period without changing wealth.
• Examples of income include:
  • Wages and Salaries
  • Business and Financial Investment Profits
  • Government transfers like benefits and pensions

The Bathtub Analogy

• Income, measured over time, is a flow variable
• Wealth is a stock variable without time dimension.
• Depreciation is the reduction in the value of wealth over time
• Depreciation acts as a negative flow equal to consumption

Savings

• Saving occurs when consumption is less than net income leading to increased wealth through accumulation.
• Savings can take different forms:
• Putting money into bank deposit accounts
• Buying financial assets like government bonds
• Savings is a way to set aside income and put aside a share of income and earn interest

Assumptions of the Model

• The model introduces Julia, who needs to borrow money.
• The mode is only considered across two time periods: now, and later.
• Julia currently has zero income and wealth
  • Julia will have €100 later.
• Julia's endowment is €0 now, and €100 later.
• If Julia wants to consume now, she will have to borrow money.
• Borrowing is not free: there is an interest rate of 10%, that is 0.10.
  • If Julia borrows €10 now, she will have to pay back €11 later: €10 + €10 × 0.1 = €10 × [1 + 0.10] = €11
• The maximum Julia can borrow depends of the amount she can pay back of €100 later:
  • €100 / (1 + 0.10) = €91
• The graphical model is set up to illustrate Julia's feasible set of outcomes.

Consumption Smoothing

• Consumption smoothing means preferring some consumption both now and later, with no consumption being preferred
• A reason for this powerful motivation is to bring forward buying power to purchase necessities like food, rent, and electricity.
• Diminishing marginal utility of consumption: value of additional consumption declines as more is consumed over time.
• Its desire underlies the desire for regular consumption over large consumption at different times.

Indifference Curves

• Economics uses the term "Preferences" to describe how people decide between different options.
• Preferences are reflective of cost and benefit evaluations.
• Indifference curves show combinations of consumption in different periods (C1 and C2) that provide the same level of consumer happiness.
• The Marginal Rate of Substitution (MRS) measures a slope of an indifference curve, representing the tradeoff between consumption now and consumption in the future.
• When future consumption is high and present consumption is low, an additional unit of present consumption brings more utility, giving the indifference curve a steep slope.
  • The MRS falls and the curve becomes flatter as additional units of present consumption is consumed.

Analysis

• Permanent income is the aggregate income obtained between two periods.
• Distribution of income across periods is not that important.
• The total measure leads to important implications.

Saver or a Borrower

• Julia is endowed with Y1 now and Y2 later.
• Depending on how much Julia wants to spend, she will be either a lender or borrower.
• A saver values C1 < Y1: S1 = (Y1 – C1) >0
  • Savings will earn her interest for consumption Y2 + S1 x [1+r] > Y1
• A borrower values C1 > Y1: S1 = (Y1 – C1) < 0
  • She is borrowing, and has to pay back the borrowed amount.
  • Final value: Y2 + S1 x (1+r)
• Individuals, households, firms, and governments can smooth consumption when income follows the business cycle.
• When current income is low but is expected to increase, they can borrow now to sustain consumption.
• When current income is high but is expected to fall, they can save current income to keep consumption stable.

Historical Context

• Irving Fisher is credited with modelling household preferences over consumption now versus later as two different goods
• Irving Fisher is known for his "The Theory of Interest," "The Quantity Theory of Money," and "The Fisher Equation"
• Milton Friedman is credited with consumption smoothing and the permanent income hypothesis.
• Friedman was a 1976 Nobel Prize recipient known for permanent income hypothesis, monetarism, and Natural Rate of Unemployment.

Limits to Consumption Smoothing

• Consumption is not perfectly smooth (constant) over the business cycle.
• The limitations of the assumptions made by the consumption-smoothing model are examined.
• Households might be unable to consumption smooth because of:
  • Credit constraints
  • Present bias (or time inconsistency), and
  • Limited co-insurance.

Types of Limitations to Consumption Smoothing

• Credit constraints means not everyone can borrow or any amount they like.
• Credit constraints arise because banks do not lend to people they may think may not repay the debt.
• Credit constrained households cannot smooth consumption.
• Present bias results in the failure to consider future challenges when committing to current plans.
  • Households may want to avoid a sudden drop in consumption when income falls.
  • Alternatively the desire to postpone a fall in living standards (present bias) leads to not reacting which results in maintaining high consumption until income sharply falls.

Co-insurance

• This policy is enacted through citizens paying income tax to support individuals who are temporarily unemployed as a form of economic wide shock
• During the 2007-2009 global financial crisis in Germany, a significant volume of firms saw a demand for their product fall.
  • This resulted in workers' hours being cut.
  • There were government policies and agreements amongst firms and employees to ensure few German jobs were lost.
• Many were paid whilst not working their full contracted hours
• Although aggregate income fell, both unemployment and consumption did not significantly increase.

Limited Co-insurance

• Limited co-insurance is caused by limited coverage of government assistance and is often uninsurable and can be caused:
  • Lack of health insurance
  • Lack of unemployment benefit
  • Lack of insurance against natural disasters
  • Lack of basic social security transfers.
• There Risks cannot accessed by a household to insurance/ credit, there is no market for firms to offer the related insurance, creating greater volatility in middle-income countries over high-income countries
• Empirical constraints lead to the observation that credit constraints, present bias, and limited co-insurance lead to income changes resulting in consumption changes.
  • This combination is because of more widespread limits on credit access and the prevalence of limited government-based co-insurance programs.

Investment

• Households try to smooth consumption when able.
  • The drive for firms to smooth investment spending is not the same.
• To increase profit, firms increase their stock of machinery and equipment and build new premises when they identify an opportunity.
• Investment can be potentially postponed, so clusters of investment projects are produced at certain times.

New Technologies

• When driverless trucks are introduced firms can
• Create output a lower cost
• Create a high quality product
• Failing to comply with the new production method will result in their businesses to close (inability to make profits) Firms invest through new machinery due to this new tech, resulting in an investment boom

Herding Behaviour

• The machinery and equipment that needs to happen is amplified which will lead meet extra demand
• Higher demands = increased investments = even greater demand = additional investment
• Investment in 1 firm presses other to invest as the former will otherwise lose market share. One firms investment can pull others to invest by helping to increase their market + potential profits

Coordination Problems

• Demand problems and the investment that follows:
  • Low expected demand from output decreases investment and is caused by a "lack of incentives."
  • High Expected demand allows for higher use of output and increased profitability: increases the firms investment

Uncertainty and Credit Constraints

• Credit constraints also restrict firms, resulting in clustering and volatilization of investment
  • When they find profits high, it's to to borrow money to invest. -Periods of economic distress (recessions) are associated with high squeezes on firms' profits, making it challenging to borrow/invest.
  • Uncertainty about the future prospect of the economy is also an additional potential deterrent.
  • Therefore, invest if they expect economic growth

Wrapping Up

Today we analyzed two business cycles of the economy

• Consumption is smooth
• Investment is volatile

Learn about consumption smoothing and its impact on aggregate demand. Understand how households manage consumption over time by saving during high income and borrowing during low income periods. Gain insights into the determinants of the marginal propensity to consume.