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Consumption

ECON 30020: Intermediate Macroeconomics

Prof. Eric Sims

University of Notre Dame

Fall 2016

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Microeconomics of Macro
I We now move from the long run (decades and longer) to the
medium run (several years) and short run (months up to
several years)
I In long run, we did not explicitly model most economic
decision-making just assumed rules (e.g. consume a
constant fraction of income)
I Building blocks of the remainder of the course are decision
rules of optimizing agents and a concept of equilibrium
I Will be studying optimal decision rules first
I Framework is dynamic but only two periods (t, the present,
and t + 1, the future)
I Consider representative agents: one household and one firm
I Unrealistic but useful abstraction and can be motivated in
world with heterogeneity through insurance markets

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Consumption

I Consumption the largest expenditure category in GDP (60-70


percent)
I Study problem of representative household
I Household receives exogenous amount of income in periods t
and t + 1
I Must decide how to divide its income in t between
consumption and saving/borrowing
I Everything real think about one good as fruit

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Basics

I Representative household earns income of Yt and Yt +1 .


Future income known with certainty
I Consumes Ct and Ct +1
I Begins life with no wealth, and can save St = Yt Ct (can be
negative, which is borrowing)
I Earns/pays real interest rate rt on saving/borrowing
I Household a price-taker: takes rt as given
I Do not model a financial intermediary (i.e. bank), but assume
existence of option to borrow/save through this intermediary

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Budget Constraints
I Two flow budget constraints in each period:

Ct + St Yt
Ct +1 + St +1 St Yt +1 + rt St

I Saving vs. Savings: saving is a flow and savings is a stock.


Saving is the change in the stock
I As written, St and St +1 are stocks
I In period t, no distinction between stock and flow because no
initial stock
I St +1 St is flow saving in period t + 1; St is the stock of
savings household takes from t to t + 1, and St +1 is the stock
it takes from t + 1 to t + 2
I rt St : income earned on the stock of savings brought into t + 1
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Terminal Condition and the IBC
I Household would not want St +1 > 0. Why? There is no
t + 2. Dont want to die with positive assets
I Household would like St +1 < 0 die in debt. Lender would
not allow that
I Hence, St +1 = 0 is a terminal condition (sometimes no
Ponzi)
I Assume budget constraints hold with equality (otherwise
leaving income on the table), and eliminate St , leaving:

Ct + 1 Yt +1
Ct + = Yt +
1 + rt 1 + rt

I This is called the intertemporal budget constraint (IBC). Says


that present discounted value of stream of consumption
equals present discounted value of stream of income.
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Preferences
I Household gets utility from how much it consumes
I Utility function: u (Ct ). Maps consumption into utils
I Assume: u 0 (Ct ) > 0 (positive marginal utility) and
u 00 (Ct ) < 0 (diminishing marginal utility)
I More is better, but at a decreasing rate
I Example utility function:

u (Ct ) = ln Ct
1
u 0 ( Ct ) = >0
Ct
u 00 (Ct ) = Ct2 < 0

I Utility is completely ordinal no meaning to magnitude of


utility (it can be negative). Only useful to compare
alternatives
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Lifetime Utility

I Lifetime utility is a weighted sum of utility from period t and


t + 1 consumption:

U = u (Ct ) + u (Ct +1 )

I 0 < < 1 is the discount factor it is a measure of how


impatient the household is.

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Household Problem

I Technically, household chooses Ct and St in first period. This


effectively determines Ct +1
I Think instead about choosing Ct and Ct +1 in period t

max U = u (Ct ) + u (Ct +1 )


Ct ,Ct +1

s.t.
Ct + 1 Yt +1
Ct + = Yt +
1 + rt 1 + rt

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Euler Equation

I First order optimality condition is famous in economics the


Euler equation (pronounced oiler)

u 0 (Ct ) = (1 + rt )u 0 (Ct +1 )

I Intuition and example with log utility


I Necessary but not sufficient for optimality
I Doesnt determine level of consumption. To do that need to
combine with IBC

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Indifference Curve
I Think of Ct and Ct +1 as different goods (different in time
dimension)
I Indifference curve: combinations of Ct and Ct +1 yielding fixed
overall level of lifetime utility
I Different indifference curve for each different level of lifetime
utility. Direction of increasing preference is northeast
I Slope of indifference curve at a point is the negative ratio of
marginal utilities:

u 0 (Ct )
slope =
u 0 (Ct +1 )

I Given assumption of u 00 () < 0, steep near origin and flat


away from it

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Budget Line

I Graphical representation of IBC


I Shows combinations of Ct and Ct +1 consistent with IBC
holding, given Yt , Yt +1 , and rt
I Points inside budget line: do not exhaust resources
I Points outside budget line: infeasible
I By construction, must pass through point Ct = Yt and
Ct +1 = Yt +1 (endowment point)
I Slope of budget line is negative gross real interest rate:

slope = (1 + rt )

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Optimality Graphically
I Objective is to choose a consumption bundle on highest
possible indifference curve
I At this point, indifference curve and budget line are tangent
(which is same condition as Euler equation)
+1

(1 + ) + +1

2,+1 (2)

+1

3,+1
(3) = 2
0,+1

1,+1 = 1
(0)
(1) = 0

0, 3, 2, 1, +1
+
1 + 13 / 36
Consumption Function

I What we want is a decision rule that determines Ct as a


function of things which the household takes as given Yt ,
Yt +1 , and rt
I Consumption function:

Ct = C d (Yt , Yt +1 , rt )

I Can use indifference curve - budget line diagram to


qualitatively figure out how changes in Yt , Yt +1 , and rt affect
Ct

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Increases in Yt and Yt +1

I An increase in Yt or Yt +1 causes the budget line to shift out


horizontally to the right
I In new optimum, household will locate on a higher
indifference curve with higher Ct and Ct +1
I Important result: wants to increase consumption in both
periods when income increases in either period
I Wants its consumption to be smooth relative to its income
I Achieves smoothing its consumption relative to income by
adjusting saving behavior: increases St when Yt goes up,
reduces St when Yt +1 goes up
C d C d
I Can conclude that Yt > 0 and Yt +1 >0
d
I Further, C
Yt < 1. Call this the marginal propensity to
consume, MPC

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Increase in rt

I A little trickier
I Causes budget line to become steeper, pivoting through
endowment point
I Competing income and substitution effects:
I Substitution effect: how would consumption bundle change
when rt increases and income is adjusted so that household
would locate on unchanged indifference curve?
I Income effect: how does change in rt allow household to locate
on a higher/lower indifference curve?
I Substitution effect always to reduce Ct , increase St
I Income effect depends on whether initially a borrower
(Ct > Yt , income effect to reduce Ct ) or saver (Ct < Yt ,
income effect to increase Ct )

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Borrower
+1

Hypothetical bundle
with new on same
indifference curve
+1

0,+1
1,+1

0,+1 Original bundle

New bundle


1, 0,
0,

I Sub effect: Ct . Income effect: Ct


I Total effect: Ct
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Saver
+1

New bundle

1,+1 Hypothetical bundle with new


on same indifference curve

0,+1
Original bundle
0,+1

+1



0, 0,
1,

I Sub effect: Ct . Income effect: Ct


I Total effect: ambiguous
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The Consumption Function

I We will assume that the substitution effect always dominates


for the interest rate
I Qualitative consumption function (with signs of partial
derivatives)
Ct = C (Yt , Yt +1 , rt ).
+ +

I Technically, partial derivative itself is a function


I However, we will mostly treat the partial with respect to first
argument as a parameter we call the MPC

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Algebraic Example with Log Utility

I Suppose u (Ct ) = ln Ct
I Euler equation is:

Ct +1 = (1 + rt )Ct

I Consumption function is:


 
1 Yt +1
Ct = Yt +
1+ 1 + rt

1
I MPC: 1+ . Go through other partials

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Permanent Income Hypothesis (PIH)

I Our analysis consistent with Friedman (1957) and the PIH


I Consumption ought to be a function of permanent income
I Permanent income: present value of lifetime income
I Special case: rt = 0 and = 1: consumption equal to
average lifetime income
I Implications:
1. Consumption forward-looking. Consumption should not react
to changes in income that were predictable in the past
2. MPC less than 1
3. Longer you live, the lower is the MPC
I Important empirical implications for econometric practice of
the day. Regression of Ct on Yt will not identify MPC (which
is relevant for things like fiscal multiplier) if in historical data
changes in Yt are persistent

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Applications and Extensions

I We will consider several applications / extensions:


1. Wealth
2. Permanent vs. transitory changes in income
3. Uncertainty
4. Random walk

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Wealth
I Allow household to begin life with stock of wealth Ht 1 . Real
price of this asset in t is Qt
I Household can accumulate more of this asset or sell it
I Period t constraint:

Ct + St + Qt (Ht Ht 1 ) Yt

I Period t + 1 constraint:

Ct +1 + St +1 + Qt +1 (Ht +1 Ht ) Yt + (1 + rt )St

I Imposing terminal conditions, IBC is:


Ct + 1 Yt +1 Q t + 1 Ht
Ct + + Qt Ht = Yt + + Qt Ht 1 +
1 + rt 1 + rt 1 + rt
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Simplifying Assumptions and the Consumption Function

I First, assume household must choose Ht = 0. It simply sells


off the asset in period t at price Qt :
Ct + 1 Yt +1
Ct + = Yt + + Qt Ht 1
1 + rt 1 + rt

I Increase in Qt then functions just like increase in Yt

Ct = C d (Yt , Yt +1 , rt , Qt )
+ + +

I Empirical application: stock market boom of 1990s (increase


in Qt )

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Alternative Simplifying Assumption
I Assume Ht 1 = 0, and assume that household must purchase
an exogenous amount of the asset, Ht (e.g. has to buy a
house)
I IBC:
 
Ct +1 Yt +1 Qt +1
Ct + = Yt + + Ht Qt
1 + rt 1 + rt 1 + rt

I Increase in Qt +1 : functions like increase in Yt +1 :

Ct = C d (Yt , Yt +1 , rt , Qt , Qt +1 )
+ + +

I Empirical applications: house price boom of 2000s


(anticipated increase in Qt +1 )

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Permanent vs. Transitory Changes in Income
I Go back to standard consumption function:

Ct = C d (Yt , Yt +1 , rt )

I Take total derivative (differs from partial derivative in allowing


everything to change):

C d () C d () C d ()
dCt = dYt + dYt +1 + drt
Yt Yt +1 rt

dCt C d ()
I If just dYt 6= 0, then dY t
is equal to partial Yt
I But if changes in income are persistent (i.e. dYt > 0
d
dYt +1 > 0), then dYdCt
t
> CY()
t
I Implication: consumption reacts more to a change in income
the more persistent is that change in income
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Application: Tax Cuts
I Suppose household pays taxes, Tt and Tt +1 , to government
each period, so net income is Yt Tt and Yt +1 Tt +1 .
Consumption function is:

Ct = C d (Yt Tt , Yt +1 Tt +1 , rt )

I A cut in taxes is equivalent to an increase in income


I Implication: tax cuts will have bigger stimulative effects on
consumption the more persistent the tax cuts are
I Empirical studies: Shaprio and Slemrod (2003) and Shapiro
and Slemrod (2009)
I Initial installment of Bush tax cuts in 2001 was close to
permanent (ten years). Theory predicts consumption ought to
react a lot. It didnt.
I Tax rebates 2008: known to be only one time. Theory predicts
consumption should react comparatively little. It did.
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Uncertainty
I Suppose that future income is not known with certainty
I Say it can take on two values: Yth+1 with probability p, and
Ytl+1 with probability 1 p. Expected future income is:

E (Yt +1 ) = pYth+1 + (1 p )Ytl+1

I Household will want to maximize expected lifetime utility.


Utility from future consumption is not known, because future
consumption isnt known given uncertainty about income
I Euler equation looks the same, but has an expectation
operator:
u 0 ( Ct ) = ( 1 + r t ) E u 0 ( Ct + 1 )
 

I Key insight: expected value of a non-linear function is not


equal to the function of the expected value.
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Expected Marginal Utility vs. Marginal Utility of Expected
Consumption
I Assume u 000 () > 0. Then E [u 0 (Ct +1 )] > u 0 (E [Ct +1 ])
(+1 )


(+1 )

[ (+1 )]

([+1 ])


(+1 )

+1
[+1 ]
+1 +1

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Increase in Uncertainty: Mean-Preserving Spread

I Raises E [u 0 (Ct +1 )]
(+1 )

uncertainty [ (+1 )]

(1,+1 )


(0,+1 )

[ (1,+1 )]
[ (0,+1 )]
([+1 ])


(0,+1 )

(1,+1 )

+1

1,+1
0,+1 [+1 ] 0,+1 1,+1

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Precautionary Saving

I Increase in uncertainty raises expected marginal utility of


consumption E [u 0 (Ct +1 )]
I For the Euler equation to hold, need to adjust current
consumption to raise current marginal utility, u 0 (Ct )
I This requires increasing saving consume less holding current
income fixed
I Intuition: bad state of the world hurts you more than the
good state helps you, so you adjust behavior in present to
effectively self-insure against bad future state
I Empirical application: high uncertainty and weak consumption
during and in wake of Great Recession

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Random Walk Hypothesis

I Suppose that (1 + r ) = 1
I Euler equation is then implies u 0 (Ct ) = E [u 0 (Ct +1 )]
I Suppose that u 000 () = 0 (so no precautionary saving). Then
this implies that E [Ct +1 ] = Ct
I In expectation, future consumption ought to equal current
consumption. This is the random walk hypothesis
I Doesnt mean that future consumption always equals current
consumption
I But it does imply future changes in consumption ought to not
be predictable, because in expectation future consumption
should equal current consumption
I Random walk model due to Hall (1978)

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Empirical Tests

I Random walk hypothesis one of the most tested


macroeconomic theories
I Generally fails:
I Parker (1999): exploits facts about social security withholding
and predictable changes over course of year. Consumption
reacts to predictable changes in take home pay
I Evans and Moore (2012): look at relationship between receipt
of paycheck (which is predictable) and within-month mortality
cycle

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Borrowing Constraints
I Empirical failures can potentially be accounted for by
borrowing constraints
I Simplest form of a borrowing constraint: you cant. St 0.
Introduces kink into budget line
+1

(1 + ) + +1

+1

Infeasible if 0


+1
+
1 +
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Binding Borrowing Constraint
I If borrowing constraint binds you locate at the kink in the
budget line (i.e. Euler equation does not hold)
+1

0,+1 = 0,+1

0,,+1


0, = 0, 0,,

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Implications of a Binding Borrowing Constraint

I Current consumption equals current income


I Means that if household gets more income, will spend all of it
I Further means that if household expects more income in
future, cant adjust consumption until the future
consumption will react to anticipated change in income
I Potential resolution of some empirical failures of random walk
/ PIH model
I Also has policy implications. Makes sense to target
taxes/transfers to households likely to be borrowing
constrained if objective is to stimulate consumption

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