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SavingandWealthOvertheLifeCycle

Accordingtothelifecycleconsumptionfunction,theaverage
propensitytoconsume(APC)is:

3 .7 :

Becausewealthdoesnotvaryproportionatelywithincome from
persontopersonorfromyeartoyear,weshouldfindthathigh
incomecorrespondstoalow APCwhenlookingatdataacross
individualsorovershort periodsoftime.Butoverlong periodsof
time,wealthandincomegrowtogether,resultinginaconstant ratio
andthusaconstant APC.

SavingandWealthOvertheLifeCycle
Considerhowconsumptionfunctionchangesovertime.Keynes
positedthattheAPCfalls asincomerises.ButKeynessconjecture
holdsonlyintheshort runwhenwealthisconstant.Inthelong run,
aswealthrises,theconsumptionfunctionshiftsupward.Thisupward
shiftpreventstheAPCfromfalling asincomeincreases.
Inthisway,Modiglianiresolvedtheconsumptionpuzzleposedby
KeynessconjectureandbySimonKuznetssdata.

Figure 3B.7:HowChangesinWealthShifttheConsumption
Function

SavingandWealthOvertheLifeCycle
Thelifecyclehypothesishelpsseehowsavingandwealthevolveover
peopleslifetimes.
Forsimplicity,weassumethattherearenocapitalgainsorlosseson
theconsumerswealth,sothatthechangeinwealthforanyyearis
equaltotheamounthe/shehassaved:
.
Sincetheconsumerwantstosmoothconsumption,he/shewillwant
his/herconsumptiontobethesame everyperiodat :
3 .8
.

Example (3B.5):Continuation ofExample(3B.3)


IfCarmenhasasalaryof$50,000,howmuchwillsheconsumeevery
year?
(Ans.)

everyyear.

Nowletslookatwhathappenstosavingandwealthovertime.
Forthefirst45yearsofherworkinglife,

.
.
.
$
$ ,
.
Everyyearhersaving(wealth)isincreasingby$12,500until
sheretiresatageof65.

Figure3B.8:ConsumptionandSavingovertheLifeCycle

Figure 3B.9:WealthovertheLifeCycle

SavingandWealthOvertheLifeCycle
Wealthincreaseslinearly withaslopeof .
$ ,
.
Atretirement,Carmenstotalwealthhasaccumulatedto
$ ,
$
,
.Afterretirement,shehasnegative saving
equaltoherconsumption of .
or$37,500.Attheendofher
lifeshehasexhausted allofhersavings.
Thelifecyclehypothesisimpliesthataspeoplegrowolderbefore
retirement,theirwealthgrows;afterretirement,theirwealth
declines.Thisresultexplainsanimportantfactfoundinthedata:
older peopletendtohavehigher holdingsofassets(stocks,bonds,
andhousing)thandoyounger people.

ThePermanentIncomeHypothesis
Sinceborrowingconstraintsapplytoaminorityofhouseholds,Milton
Friedman(UniversityofChicago),inhismonumentalworkpublished
in1953,ATheoryofConsumptionFunction,arguedthatconsumption
smoothingwasakeyfeatureofconsumptionbehavior.
Friedmanspermanentincomeemphasizedthatconsumerslook
beyondcurrent income.
FriedmanspermanentincomehypothesiscomplementsModiglianis
lifecyclehypothesis:bothuseIrvingFisherstheoryoftheconsumer
toarguethatconsumptionshouldnotdependoncurrentincome
alone.

ThePermanentIncomeHypothesis
Butunlikethelifecyclehypothesis(whichincomefollowsaregular
patternoverapersonslifetime),thepermanentincomehypothesis
emphasizesthatpeopleexperiencerandom andtemporary changes
inincomefromyeartoyear.
Friedmandividedincomeintotwocomponents,permanentincome
andtransitoryincome
:
3 .9
.

Transitoryincome isthecomponentofincomethatdoesnot persist


foralongperiodoftimeandsoissubjecttotemporaryfluctuations
whilepermanentincomeisthepartofincomethatpeopleexpectto
persistintothefuture.

ThePermanentIncomeHypothesis
Putdifferently,permanentincomeisaverage income,andtransitory
incomeistherandom deviationfromtheaverage.
MiltonFriedmanreasonedthatconsumerswouldnot consumemuch
more becauseofhigher transitory income(likewinningajackpot)but
wouldinsteadsave mostofit,andspendalittlemoreovermany
years.Ontheotherhand,ifpermanent incomerose,saybecauseof
anadvanceddegree,consumptionwouldbemuchhigher.

ThePermanentIncomeConsumptionFunction
Friedmanconcludedthatwecanapproximately treatconsumptionas
afunctionofpermanent income:



3 . 10
In
3 . 10 , isaconstant fractionthatrepresentsthemarginal
propensitytoconsume(MPC)relativetopermanentincome.
Inotherwords,thepermanentincomehypothesisindicatesthat
consumptionis proportional topermanentincome.

RelationshipofthePermanentIncomeHypothesisand
IntertemporalChoice
Usingtheconceptofpermanentincome,wecanseehowinter
temporalchoicetheorycomestothesameconclusion:
thatconsumptionrespondsmoretoariseinpermanent incomethan
itdoestoariseintransitory income.
Inthetheoryofintertemporalchoice,consumptionrespondstothe
presentvalueoffutureincomestreams,

.Apermanent rise

inincomeliftsboth and ,liftinglifetimeresourcesand


increasingconsumptionbothtoday andtomorrow.

RelationshipofthePermanentIncomeHypothesis
andIntertemporalChoice
Ontheotherhand,atransitory hikeinincomewilllift butnot ,
andboostlifetimeresources(andtodaysconsumption)byamuch
smaller amount.Becausethepermanentincomehypothesisis
derivedinamultiperiodframework,itcomestoanevenstronger
conclusionthatconsumptionrespondsmostlytopermanent income
andhardlyatalltotransitory income.

ImplicationsofThePermanentIncomeHypothesis
Thepermanentincomehypothesissolvestheconsumptionpuzzleby
suggestingthatthestandardKeynesianconsumptionfunctionuses
thewrong variable.Accordingtothepermanentincomehypothesis,
consumptiondependsonpermanentincome ;yetmanystudiesof
consumptionfunctiontrytorelateconsumptiontocurrent
consumption .Friedmanarguedthatthiserrorinvariable problem
explainstheseeminglycontradictoryfindings.

ImplicationsofThePermanentIncomeHypothesis
LetsseewhatFriedmanshypothesisimpliesforthe

Accordingtothepermanentincomehypothesis,the
dependson
theratioofpermanent incometocurrent income.
Nowconsiderthestudiesofhouseholddata.Friedmanarguedthat
thesedatareflectacombinationofpermanentandtransitoryincome.
Householdswithhigh permanentincomehaveproportionately
higher consumption.Ifallvariationincurrentincomecamefromthe
permanent component,the
wouldbethesame inall
households.

ImplicationsofThePermanentIncomeHypothesis
Butsomeofthevariationinincomecomesfromthetransitory
component,andhouseholdswithhigh transitoryincomedonot have
higher consumption.Therefore,researchersfindthathighincome
householdshave,onaverage,lower
.
Similarly,considerthestudiesoftimeseriesdata.Friedmanreasoned
thatyeartoyearfluctuationsinincomearedominatedbytransitory
income.Therefore,yearsofhigh incomeshouldbeyearsoflow
.
Butoverlong periodsoftime say,fromdecadetodecade the
variationinincomefromthepermanent income.Hence,inlong time
series,oneshouldobserveaconstant
,asinfactKuznetsfound.

RobertHallandtheRandomWalkHypothesis
In1978,RobertHall(thenfromMITandnowatStanford)published
apathbreakingpaperbasedonthelifecycleandpermanentincome
hypothesisthatifconsumersareveryforesighted,thenchangesin
consumptionshouldbeunpredictable:Thebestforecastof
consumptionnextyearwouldbeconsumptionthisyear!Putanother
way,changesinconsumptionshouldbeveryhardtopredict.

RobertHallandtheRandomWalkHypothesis
Thisresultcameasasurprisetomostmacroeconomistsatthetime,
butitisinfactbasedonasimpleintuition:Ifconsumersarevery
foresighted,theywillchangetheirconsumptiononlywhentheylearn
somethingnew aboutthefuture.But,bydefinition,suchnews
cannot bepredicted.Whenchangesinavariableareunpredictable,
thevariableissaidtofollowarandom walk,andthatiswhyHalls
theory consumptionfollowsarandomwalk hasbecomeknownas
therandomwalkhypothesis. Thispaperbecamethebenchmarkin
consumptionresearchthereafter.

RandomWalkHypothesis
Thereasoningbehindtherandomwalkhypothesisstartswiththree
steps.
Step 1:Thelifecycleandpermanentincomehypothesis(aswellas
thetheoryofintertemporalchoice)implythatconsumersare
forwardlooking.Thatis,theybasetheirconsumptiondecisionson
theircurrentexpectation onfuture incomethatwilldeterminetheir
lifetimeresources.
Step 2:Onlywhenexpectationsoffutureincomechangewill
expectationsoflifetimeresourceschange.

RandomWalkHypothesis
Step 3:Sincecurrentconsumptionisdeterminedbychangesin
expectationsoflifetimeresources,changesinconsumptionshould
onlychangewhentheseexpectationschange.
Becauseexpectationsarederivedfromallavailableinformation,only
new information,thatis,unanticipated surprises,willcause
expectationstochange.Hence,expectationsoflifetimeresources
andcurrentconsumptionwillchangeonlywhenthereis
unanticipated newinformation,andsochangesinconsumptionare
unpredictable. Thatis,theyfollowarandom walk.

ImplicationsofRandomWalkHypothesis
Ifconsumersobeythepermanentincomehypothesisandhave
rational expectations,thenonlyunexpected policychangesinfluence
consumption.Thesepolicychangestakeeffectwhentheychange
expectations.Forexample,supposeCongresspassesataxcut when
theeconomyisinrecession,butthistaxcutwasalreadyexpected
becauseCongresshasalwayspassedsuchtaxcutsinprevious
recessions.Thetaxcutwillnot changeexpectationsoflifetime
resourcesandhencewillnot causeconsumptiontochange.Onlyif
thetaxcutisasurprise willitworktoraise consumption.

ImplicationsofRandomWalkHypothesis
Indeed,ataxcutthatissmaller thanthepublicexpectscouldeven
causeconsumptiontofall,not rise.Becausethepublicexpectedits
disposableincometobehigher asaresultofalarger taxcut,the
smallertaxcutwouldcausethepublictorevisedownward its
expectationsoflifetimeresources.Therandomwalkhypothesisthus
statesthattheeffectsoftaxpolicyonconsumptionarehighly
uncertain becausetheeffectonconsumptiondependsonwhatthe
policyisrelativetowhatitwasexpectedtobe.

ImplicationsofRandomWalkHypothesis
Conclusion:Accordingtotherandomwalkhypothesis,taxpolicy
cannot beusedtomanagefluctuationsinconsumptioninorderto
softenswingsineconomicactivity.Toputanother,sinceexpectations
cannot beobserveddirectly,itisthusoftenhardtoknowhowand
whenchangesinfiscalpolicyalteraggregatedemand.

BehavioralEconomicsandConsumption
Keynescalledtheconsumptionfunctionafundamentally
psychologicallaw.Yet,psychologyhasplayedlittleroleinthe
subsequentstudyofconsumptionsincetherationalmaximization
modelofhumanbehaviorwasthebasisforalltheworkon
consumptiontheoryfromIrvingFishertoRobertHall.Recently,
economistssuggestthattheoptimizingbehaviorofconsumersmay
not beacompletelyaccuratecharacterizationofhowconsumers
actuallybehave.

BehavioralEconomicsandConsumption
Morerecently,economistshavestartedtoreturntopsychology.
Theyhavesuggestedthatconsumptiondecisionsarenot madeby
theultrarationalHomo economicus butbyrealhumanbeingswhose
behaviorcanbefarfromrational.Thisnewsubfieldinfusing
psychologyintoeconomicsiscalledbehavioral economics.Themost
prominentbehavioraleconomiststudyingconsumptionisHarvard
professorDavidLaibson.

BehavioralEconomicsandConsumption
Behavioreconomics
Anewfieldineconomicsthatappliesofconceptsfromothersocial
sciences,suchasanthropology,sociology,and(inparticular)
psychology,tothestudyofeconomicbehavior
Considerthefollowingtwoquestions:
Question 1:Wouldyouprefer(A)acandytodayor(B)twocandies

tomorrow?
Question 2:Wouldyouprefer(A)acandyin100daysor(B)two

candiesin101days?

BehavioralEconomicsandConsumption
Inasense,manypeoplearemorepatient inthelong runthanthey
areintheshort run.Thisraisesthepossibilitythatconsumers
preferencesmaybetimeinconsistent;theymanyaltertheirdecisions
simplybecausetimepasses.
Oneimplicationofbehavioreconomicsisthatconsumersmaybe
swayedbyinstant gratification,andsotheirdecisionsmaynot put
enoughweightonthefuture.DavidLaibson haslabeledthis
phenomenonhyperbolicdiscounting,tocapturetheideathat
consumerswillnot consistentlydiscount thefutureovertime,asis
assumedinthetheoryofintertemporalchoice.

BehavioralEconomicsandConsumption
Weseethiskindofbehaviorinmanysituationsinlife.When
tomorrowarrives,thepromisesareinthepast,andanewselftakes
controlofthedecisionmaking,withitsowndesireforinstant
gratification.Oneresultofsuccumbingtoinstantgratificationand
therebymakingdecisionswithtoohighadiscountrateisthat
consumersmayoverreact tocurrent incomeandnot smooth
consumptionsufficiently.
Theseobservationsraiseasmanyquestionsastheyanswer.

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