LECTURE FIVE

PART II: SECTORAL DEMAND THEORIES AND

FUNCTIONS

Consumption and Saving

Main references:
1.Branson
2. Mankiw
 Aim of the lecture
 Introduce different theories of consumption
 Keynesian Consumption Theory

• John M. Keynes: Absolute Income Hypothesis

 Fisher’s theory of Intertemporal Choice

 Franco Modigliani: Life Cycle Hypothesis

 Milton Friedman: Permanent Income Hypothesis

 Hall’s random-walk hypothesis

Applicability of the consumption theories to LDCs.

 Consumption and Saving

Consumption is the sole end and purposes of all production (Adam Smith).
3
 5.1. Stylized(common) Facts
 Consumption is an important macro-economic variable:
• Major components of GDP (comprise around 2/3 of GDP).
• Household consumption decision is closely linked to saving
decision and, ultimately therefore of living standards.
• Thus, Consumption decisions affect the way the economy as a
whole behaves both in the long run (since its role in determining
economic growth as saving affects current and future
consumption) and
• In the short run (as determining aggregate demand and hence
changes in consumers‟ spending plans can be a source of shocks
to the economy and that the MPC is a determinant of the fiscal
policy multipliers). 4
 Cont…
• Therefore, examining the consumption theory in more details
and develop thorough explanation of what determines the
aggregate consumption is required.

• There is no topic in macroeconomics that has a longer, deeper, or

more prominent literature than households’ choice of how much
of their income to consume and save.

• As we saw earlier in the course, the theory of consumption is

central to the model of Keynes’s General Theory, which is often
considered to be the origin of macroeconomics.

• In this section, we will discuss the views of prominent economists

to explain what determines consumption.
 5.2 . Keynesian Consumption Theory
 Analytically, in 1936 Keynes made the consumption function
the basic element in the income-expenditure approach to the
determination of national income.
 Based on this, Keynes [Keynesian Theory] argues that
C= Co + cY, with Co > 0 and 0 < c <1
And, APC > MPC , Moreover, the APC should not be a constant if Co is not zero.

 Keynes made conjectures about the consumption function based

on introspection and casual observation.
 The Keynesian conjectures consisting of:
 Marginal Propensity to consume lies b/n 0 and 1, the increase in
consumption is smaller than the increase in disposable income.
 Households spend less than their total income
6
 Cont…
 Average propensity to consume (APC) falls as income rises.
APC (c/ y ) is greater than the MPC.
 The implication is that on average the rich spend less of their income
(or saves more than) than the poor.
 Consumption will rise as disposable income rises.
 Current income is primarily determinants of consumption.
 The higher the income of a household the higher will be
consumption.
 Algebraically, Keynes’s short-run consumption function is

c  c   y ……………. (5.1)
 Where, c is autonomous consumption and  is MPC, which


is greater than 0 but less than 1 (by the 1nd proposition).

9
 Keynesian consumption theory
c
 Cont…..
• As income rises, consumers save a bigger fraction of their
income, so APC falls.

slope = APC The slope equals the rise

over the run = C/Y, or the
Y APC.).
Fig: Keynesian consumption function
11
 Cont....
 Keynes reasoned that:
 As income falls relative to recent levels, people will protect
consumption standards by not cutting consumption
proportionally to the drop in income, and conversely as
income rises, consumption will not rise proportionally.

 In the late 1930s cross-sectional budget studies were

examined to see if Keynes‟ assumption that “rich people save
proportionally more’’ was born out.
 In general, these budget studies seemed to verify the
theory.
12
 Early Empirical Successes: Results from Early Studies
 Keynes‟ followers estimated the consumption function for the
U.S. using the data from 1929-1941:
C = 26.5 + 0.75Yd
Co = 26.5 billion > 0
APC > MPC
• The implication is that on average the rich spend less of their income
(or saves more than) the poor.

 Households with higher incomes:

 consume more  MPC > 0
 save more  MPC < 1
 save a larger fraction of their income
 APC  as Y 
• Very strong correlation between income and consumption 10
 Problems for the Keynesian consumption function:
Secular Stagnation, Simon Kuznets, and the Consumption Puzzle

Based on the Keynesian consumption function, economists

predicted that C would grow more slowly than Y overtime which
could lead to low AD and hence secular stagnation.

Secular stagnation : no economic growth - economy is essentially stagnant.

However, this prediction did not true:

• As income grew, the APC did not fall , and C grew as fast as
income.
• Simon Kuznets showed that C/Y was very stable over long
period.
Consumption puzzle
 Summary
 Thus by 1940s a theory of consumption is expected to
account for three observed facts:
i. Cross-section (budget) studies shows that as Y
increases C/Y declines (or S/Y increase). That is
MPC<APC and APC declines as Y increase.

ii. Business cycle, short-run, data shows the C/Y <

Average in boom and > Average in slum.

[As income fluctuate MPC < APC].

i. Long-run data show no tendency for C/Y ratio to
change over time. [So, as Y grows along trend
MPC=APC].
18
5.3. Irving Fisher and Intertemporal Optimizing Model

The Irving Fisher‟s intertemporal choice is :

The basis for much subsequent work on consumption.
Assumes consumer is forward-looking (assume a rational
optimizing agent) and chooses consumption for the present
and future to maximize lifetime satisfaction.
Basis on micro foundation.
Consumer’s choices are subject to an intertemporal budget
constraint, a measure of the total resources available for
present and future consumption.
 Intertemporal Optimizing Model
Fisher’s model illuminates the constraints consumers face, the
preferences they have, and how these constraints and
preferences together determine their choices about
consumption and saving.
For simplicity we assume a single consumer lives for two
periods, i.e. two-period model.
 Period one: the present
 Period two: the future
The consumer earns income Y1 and consumes C1 in period
one, and earns income Y2 and consumes C2 in period two.
Let consider how the consumer’s income in the two periods
constrains consumption in the two periods.
 Intertemporal Optimizing Model
• In period one , S=Y1-C1 where S is saving (S<0 if the consumer
borrows in period 1).
• In the second period, consumption equals the accumulated
saving, including the interest earned on that saving, plus
second period income.
• That is, C2 =(1+r)S+Y2……………period 2 budget constraint
where r is interest rate
C2=Y2+(1+r)(Y1-C1)
• After the rearrangement,
(1+r) C1+ C2 = Y2+(1+r) Y1
Finally, divide through by (1+r)
 The intertemporal budget constraint

C2 C2 Y2
C1   Y1 
1r 1r

(1  r )Y1 Y 2
Consump =
Saving income in
The budget
both periods
constraint shows all
combinations Y2
Borrowing
of C1 and C2 that just
exhaust (use) the
C1
consumer’s Y1
resources. Y1 Y 2 (1  r )
 Irving Fisher and Intertemporal choice
(1+r) is the slope of budget line.
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.

Consumer Preferences
The consumer’s preferences regarding consumption in the two
periods can be represented by indifference curves.
Intertemporal Optimizing Model
 Intertemporal Optimizing Model
• Consumer equilibrium is achieved at the tangency of the highest
attainable indifference curve and the budget line.
•The tangency determines the optimum allocation of consumption spending in
both periods; i.e. highest level of satisfaction within the budget
• Optimization : the consumer achieves his highest level of satisfaction by
choosing the point on the budget constraints, i.e. on the highest indifference
curve. Graphically,
 How C responds to changes in Y
• Assume an increase of income they are given both normal
goods,
 Irving Fisher and Intertemporal choice

• How changes in interest rate affects consumption?

Keynes vs. Fisher
• Keynes: current consumption depends only on current
income.
• Fisher: current consumption depends on the present
value of lifetime income; the timing of income is
irrelevant because the consumer can borrow or lend
between periods.
 How C responds to changes in r

C2
An increase in r pivots
As depicted here,
(turn) the budget line
C1 falls and C2 rises. around the
However, it could turn point (Y1,Y2 ).
out differently… B

A
Y2

Y1 C1
 How C responds to changes in r
• Income effect: If consumer is a saver, the rise in r makes him
better off, which tends to increase consumption in both periods.
• Substitution effect: The rise in r increases the opportunity cost
of current consumption, which tends to reduce C1 and increase
C2. Both effects  C2.

• Whether C1 rises or falls depends on the relative size of the

income & substitution effects.

• Note:
• Keynes conjectured that the interest rate matters for
consumption only in theory.
• In Fisher’s theory, the interest rate doesn’t affect current
consumption if the income and substitution effects are of
equal magnitude.
 5.4 The Life-Cycle Hypothesis ( Ando-Franco Modigliani)
 Due to Franco Modigliani (1950s).
 Used Fisher’s model of consumer behavior to study C function.
 This model assumes that each representative agent will die, and
knows when he/she will die, how many periods T he/she will live,
and how much his/her life-time income will be.
 Fisher’s model says that consumption depends on lifetime income,
and people try to achieve smooth consumption.
 The LCH says that income varies systematically over the phases of
the consumer’s “life cycle,” and saving allows the consumer to
move income from those times in life when income is high to those
times when it is low.
 The Life-Cycle Hypothesis
 This interpretation of consumer behavior formed the basis for
his life-cycle hypothesis achieve smooth consumption.
 The constraint is that her/his life time consumption
doesn‘t exceed the present value of his/her total income.
 According to this hypothesis, the typical individual has an
income stream that is relatively low at the beginning and end
of her/his life.
 This model suggests that:
 In the early years of a person’s life, the first shaded portion of the
figure, the person is a net borrower.

 In the middle years, she/he saves to repay debt and provide

for retirement.
 In the late years, the second shaded portion of the figure,
she/he dissaves. 27
 The Life-Cycle Hypothesis …contd

28
 The life-cycle hypothesis
• Basic model:
• Lifetime resources = W+RY , where W is initial wealth, Y is annual
actual income until retirement (assumed constant) and R is number of
years until retirement.
• Assumptions of the model:
• zero real interest rate
• consumption smoothing is optimal
• To achieve smooth consumption, consumer divides his/her resources equally
overtime: C= (W+RY)/T, or C=αW+βY where T is lifetime in years.
• Where α = (1/T) is the MPC out of wealth and
• β = (R/T) is the MPC out of income.

• For example, if the consumer expects to live for 50 more years and
works for 30 of them, then T = 50 & R = 30, so, his C function is :
• C = 0.02W + 0.6Y.
 The life-cycle hypothesis
Implications.
Notice, however, that the intercept of the consumption function, which shows what
would happen to consumption if income ever fell to zero, is not a fixed value.
Instead, the intercept here is W and, thus, depends on the level of wealth.

 This life-cycle model of consumer behavior can solve the consumption puzzle.

 The life-cycle consumption function implies that the APC is C/Y = a (W/Y ) + 

 Because wealth does not vary proportionately with income from person to person or
from year to year, we should find that high income implies a low APC when looking at
data across individuals or over short periods of time.

But, over long periods of time, wealth and income grow together, which implies a
constant ratio W/Y and thus a constant APC.
 The life-cycle hypothesis
• In the short-run the life-cycle consumption function looks like
Keynes’s.

• In the long-run as wealth increases, the C function shifts

upward, and prevents the APC from falling as income increases.
• In this way, Modigliani reconciled the apparently conflicting
studies of the C function.

• It also implies that saving varies over a person’s life in a

predictable way.

• If a person begins adulthood with no wealth, he will accumulate

wealth during his working years and then run down his wealth
during his retirement years.
 The life-cycle hypothesis
Graphically,
 The Life-Cycle Hypothesis
 Now if the life-cycle hypothesis is correct:
 The high-income groups will contain a higher-than-
average proportion of persons who are at high-income
levels because they are in the middle years of life, and thus
have a relatively low C/Y ratio.

 The low-income groups will include relatively more

persons whose incomes are low because they are at the ends
of the age distribution, and thus have a high C/Y ratio.
 Thus, if the LCH theory is true, a cross-sectional study
will show C/Y falling as income rises, showing MPC < APC.

33
 The Life-Cycle Hypothesis …contd
 Criticisms of LCH
 The households, at all times, have a definite, conscious vision of:
 The family‘s future size and composition, including the life
expectancy of each member,
 The entire lifetime profile of the labor income of each
member—after the applicable taxes,
 The present and future extent and terms of any credit
available, and
 The future emergencies, opportunities, and social pressures
which might affect its consumption spending.
 It does not take into account liquidity constraints.
34
 The Life-Cycle Hypothesis …contd
 Policy Implication [Criticisms of LCH]
 Changes in current income have a strong effect on
current consumption ONLY if they affect expected
lifetime income.
 In Q2 1975 in the US, a one-time tax rebate of $8
billion was paid out to taxpayers to stimulate AD. The
rebate had little effect.
 Because consumers have viewed the rebate as a one-
time windfall rather than as an increment to
permanent income and consequently spent little of it
at the time it was received.
35
 5.4. The Permanent Income Hypothesis (The
Milton Friedman approach)
He employs the following Assumptions:
 Perfect certainty about future receipts; future interest
rates; future prices, etc.
 People save to reduce fluctuations in expenditures
 People are immortal (or leave bequests)
 Like Modigliani and Ando he noted consumption
shouldn‘t depend on current income alone.
 Unlike Life-Cycle Hypothesis (which hold income
follows regular pattern) the PIH hold that people face
random and temporary changes to their income from year
to year.
36
The Permanent Income Hypothesis (The Milton
Friedman approach)

 Friedman holds that, thus, current income (Y) could

be divided between permanent (Yp) and transitory
(YT) component.
Y= Yp+ YT
 Permanent Income: part of the income people
expected to persist (keep it up) into the future.
 Transitory Income: part of income that is not
expected to persist (is random: deviation from the
average).
37
The Permanent Income Hypothesis (The Milton
Friedman approach)
 Friedman maintained consumption primarily
depends on Yp & Consumer use Saving/borrowing to
smooth consumption for change in Y.
 Similarly consumers do save rather than spend their
transitory income (so as to distribute it over time).
Thus, the consumption function is given by:
𝐶 = 𝛼Yp where α is a constant
 Consumption is proportional to permanent income.

38
 Implications of PIH
 The PIH can solve the consumption puzzle: Friedman
hypothesis implies APC=C/Y= 𝛼YP/Y, i.e. APC depends on
the ratio of permanent income to current income.
 When current income temporarily rises above permanent
income, the APC temporarily falls; when current income,
temporarily falls below permanent income, the APC
temporarily rises.
 To the extent that high income households have higher
transitory income than low income households, the APC
will be lower in high income households.
 Over the long run, income variation is due mainly (if not solely) to
variation in permanent income, which implies a stable APC.
 The Permanent Income Hypothesis…
 Regarding the HH data it combines permanent and transitory
income; so
 If all variation comes from the permanent component, we
observe no different in APC across HHs
 But if the variation comes form the transitory component,
HH with higher transitory income will NOT have higher
consumption and hence we find such [high income] HH
having lower/declining APC.
 Regarding the Time Series data:
 Friedman argues year to year fluctuation are dominated by
transitory income, therefore:
 Years of high income will see a declining APC.
 But over the long-run (say decade to decade) variation in income
comes from the permanent component hence the APC is
almost constant. (i.e the PI varies with C)
40
 PIH vs. LCH
 In both, people try to achieve smooth consumption in the
face of changing current income.

 In the LCH, current income changes systematically as

people move through their life cycle.

 In the PIH, current income is subject to random,

transitory fluctuations.

 Both hypotheses can explain the consumption puzzle.

 Distinguishing features of LCH & PIH
 Similarities
 I)The two models are similar in the starting point of the
analysis in the consumption-PV relationship.
 In other words, both hypotheses have micro foundation.
 Thus, they argued that an individual have different
income stream of income in life and smooth out
consumption overtime.
 II) Both concentrate on the structural relationship
between expected lifetime income and current
consumption.

 III) Both the LCH and PIH treated the wealth effect on
consumption.
 Differences: The two theories differ in the empirical
implementation of the theory.
42
 …Cont.
 I)The LCH model exhibit smaller MPC than PIH because
the former also includes a wealth variable whereas in
the latter the wealth effect is included in permanent
income.
 II)Friedman’s consumption model/function is somewhat
less satisfactory than Modigliani in that assets are only
implicitly taken into account as determinants of
permanent income. In short, he did not clearly
distinguishes between permanent income y and P

a (which is considered as a shift factor) as did by Ando-

0

Modigliani.

 III) Friedman relies on the unobservable concepts of

income (i.e., permanent income and transitory incomes)
while Ando-Modigliani relies on the observable income
(i.e., income from labour and income from
assets/property) .
43
 The random-walk hypothesis [The HALL Approach)
 Due to Robert Hall (1978)
 Based on Fisher’s model & PIH, in which forward-looking
consumers base consumption on expected future income.
 Hall adds the assumption of rational expectations, that people use
all available information to forecast future variables like income.
 Hall showed that If PIH is correct and consumers have rational
expectations, then consumption should follow a random walk:
changes in consumption should be unpredictable.
 Only unanticipated changes in income or wealth that alter
expected permanent income will change consumption.
 The random-walk hypothesis [The HALL Approach)

Hall's Reasoning:

 According to the PIH consumers smooth consumption

based on their current expectation of their future income.

 Over time they change consumption if they revise their

expectation based on news or new information.
• The Implications:
• If consumers obey the PIH and have rational expectations, then
policy changes will affect consumption only if they are
unanticipated (unexpected).
45
 Summing up of consumption theory
 Keynes: consumption depends primarily on current
income.
 Recent work: consumption also depends on
 expected future income
 wealth
 interest rates

 Economists disagree over the relative importance of

these factors, borrowing constraints, and psychological
factors.
 Summing up of consumption theory

1. Keynesian consumption theory

Keynes’ conjectures
• MPC is between 0 and 1

• APC falls as income rises

• current income is the main determinant of current consumption

Empirical studies
 In household data & short time series: confirmation of Keynes’ conjectures

 In long-time series data:

• APC does not fall as income rises

slide 47
 Summing up of consumption theory

2. Fisher’s theory of intertemporal choice

 Consumer chooses current & future consumption to maximize lifetime
satisfaction of subject to an intertemporal budget constraint.

 Current consumption depends on lifetime income, not current income,

provided consumer can borrow & save.

3. Modigliani’s life-cycle hypothesis

 Income varies systematically over a lifetime.

 Consumers use saving & borrowing to smooth consumption.

 Consumption depends on income & wealth.

slide 48
 Summing up of consumption theory

4. Friedman’s permanent-income hypothesis

• Consumption depends mainly on permanent income.

• Consumers use saving & borrowing to smooth consumption in the face of

transitory fluctuations in income.

5. Hall’s random-walk hypothesis

• Combines PIH with rational expectations.

• Main result: changes in consumption are unpredictable, occur only in

response to unanticipated changes in expected permanent income.

49
 Applicability of the consumption theories to LDCs
 How consumption theories discussed so far are relevant
to LDCs such as a typical African economy?
 1)Both the LCH and PIH emphasize on households
consumption smoothing or have uniform consumption
pattern (intertemporal consumption) due to their
assumption of absence of borrowing and lending
constraints to households. However, these assumptions
are unrealistic in explaining the actual situation of African
economies where households have excessive borrowing
and lending constraints.
 This is because the financial sectors are
underdeveloped in almost all African economies=>
majority of households do not have easy access to
financial sectors=> are forced to relay mostly on
informal financial sector for borrowing.
 Financial intermediaries they have acute shortage of
loanable fund due to high propensity to consume /or low
propensity to save/ by the population due to high
dependency ratio and in part due to commercial banks
weak capacity to mobilize savings. 70
 Applicability of the consumption theories to LDCs
 How consumption theories discussed so far are relevant
to LDCs such as a typical African economy?
 1)Both the LCH and PIH emphasize on households
consumption smoothing or have uniform consumption
pattern (intertemporal consumption) due to their
assumption of absence of borrowing and lending
constraints to households. However, these assumptions
are unrealistic in explaining the actual situation of African
economies where households have excessive borrowing
and lending constraints.
 This is because the financial sectors are
underdeveloped in almost all African economies=>
majority of households do not have easy access to
financial sectors=> are forced to relay mostly on
informal financial sector for borrowing.
 Financial intermediaries they have acute shortage of
loanable fund due to high propensity to consume /or low
propensity to save/ by the population due to high
dependency ratio and in part due to commercial banks
weak capacity to mobilize savings. 70
 …Cont.
 Moreover, protracted loan application screening and
disbursement processes; high collateral requirements of banks
than most households can afford; and high lending interest rates
(e.g. >8.5% in Ethiopia compared to only 1.5% in England) are
also the major constraints.
 There are preferential treatments of financial intermediaries to
public sectors borrowing than private firms and/or individuals in
LDCs. This biased policy can be either due to political reasons;
credit ceilings; or poor loan repayment enforcement mechanism
to defaulters. The later has to do mostly with the
underdevelopment of legal and judiciary system in LDCs.
 2)The notion of the PV of future income streams in both the LCH
and PIH models implies that consumers or economic agents have
long planning horizon. Nevertheless, this assumption is irrelevant
for a typical LDC even though there is no borrowing and lending
constraints=> due to uncertainty in terms of what will happen next,
which in turn influence peoples’ preferences for investment (which
is more of long term than short term planning horizon); perception
of life, and control over assset.
 …Cont.
 3)The assumption of perfect capital markets in both the LCH
and PIH and hence income from assets at any time is equal to
the value of asset itself are also irrelevant to LDCs or African
economies=> because markets in LDCs are more of imperfect
and hence getting information about the value of assets is
costly.

 4)The argument of the LCH that individuals will save when

income is high during adult for retirement does not also explain
much LDCs economies due to different demographic structure
compared to DCs=> because LDCs have more young
population, large family size, and high population growth
compared to DCs due to high birth rate.
 High population growth and the type and composition of family
in LDCs (extended family compared to nuclear family in
developed countries) have in turn lead to high dependency
ratio. Thus, if resources are shared between workers and the
dependents, the argument of the LCH adults will save for
retirement is not necessary
72
 …Cont.
 5)Income derived from agriculture is not considered
explicitly in the models.

 In a typical African household economy, there is high

uncertainty of income due to the erratic behavior of agricultural
output or its vulnerability to weather change and
macroeconomic instabilities such as fluctuation of price and
exchange rate fueled by internal and external shocks.

 Hence, the subsistence income level derived from agriculture

possesses a real threat to consumption level of households, a
threat that is likely to exert powerful influence on the way in
which income is spend and saved. 73