14
CONSUMPTION AND SAVING
FOCUS OF THE CHAPTER
• Consumption is the largest component of aggregate demand.
• The amount that we consume today depends not only on our current income, but also on our
wealth and our expectations of future income.
• Because people try to spread their resources out over their lifetimes, transitory changes in
income do not affect their consumption very much at all. Permanent changes in income do.
SECTION SUMMARIES
1.
The Life-Cycle/Permanent Income Theory of Consumption and Saving
The life-cycle and permanent income theories tell a very similar story, and for that reason have
been grouped together in this textbook. Both are based on the notion that people try to smooth
consumption over their lifetimesthat they borrow when their income is low and save when
their income is high in order to maintain a constant level of consumption over the years. They
really only differ in the way that they model the decision-making involved in this process.
The life-cycle theory of consumption assumes that consumption is a function of both wealth and
our average lifetime income, and that we have different marginal propensities to consume out of
each: a high marginal propensity to consume out of income, and a low marginal propensity to
consume out of wealth, which we try to spread out evenly over our lifetimes. It emphasizes the
demographic aspect of saving behaviorpeople’s tendency to borrow against their future
income when they are young, save for retirement when they are older, and to live off of their
savings after they retire.
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154 CHAPTER 14
The permanent income theory suggests that people form expectations of the income they will
receive over their lifetime, divide it by the number of years during which they expect to live, and
consume an amount equal to that each period. When their actual income is below their
permanent income, they borrow or draw down their savings. When their actual income exceeds
their permanent income, they save. For this reason, temporary changes in people’s incomes do
not affect their consumption very much; the benefits of a windfall gain today get spread out over
an entire lifetime.
It is interesting to note that, in both of these models, changes in people’s expectationseither
their expectations regarding their future income or their expectations regarding their time of
deathcan strongly influence their consumption patterns.
2.
Consumption Under Uncertaintythe Modern Approach
Modern consumption theory both emphasizes the link between income uncertainty and changes
in consumption and takes a slightly more formal approach to modeling the way that people
decide how much to consume. Here, consumption does not change unless something causes
people’s expectations to change. Changes in people’s consumption, as a result, should not be
predictable.
The empirical predictions of modern consumption theory have not been validated. Consumption
seems to respond both too strongly to predictable (read expected) changes in income, and not
strongly enough to unexpected changes in incomecharacteristics which are referred to,
respectively, as excess sensitivity and excess smoothness.
Excess sensitivity could well be the result of liquidity constraintsconstraints on people’s ability
to borrow money that force them to finance their consumption entirely out of current income. It
could also result from myopiaa short-sightedness that prevents people from learning or caring
about the future, and hence from forming good expectations of their lifetime incomes.
Excess smoothness could well result from precautionary, or buffer-stock saving: saving intended
to provide inheritances for children or grandchildren, or to leave something in the bank for a
future rainy day.
3.
Further Aspects of Consumption Behavior
Just how does the stock market fit into the picture of explaining consumption behavior? The
effects of rise or fall in stock prices on consumption works through wealth of the consumer
(called wealth effect). A rise (fall) in stock prices implies an increase (decrease) in wealth thereby
increasing (reducing) consumption. Empirical research, however, shows it is hard to pin down
the size of this effect.
Barro-Ricardo equivalence, also called Ricardian equivalence, follows directly from the LifeCycle/Permanent Income Hypothesis. Under Ricardian Equivalence, it doesn’t matter whether
CONSUMPTION AND SAVING
155
deficits are financed through increased taxes or the accumulation of debt. Debt financing merely
postpones taxes to a future date, and, under some stringent conditions, is identical to current
taxation.
There are two main theoretical objections to this proposition, however. First, people have finite
lifetimes, and because of this do not need to worry about taxes that are postponed into the very
distant future. The second objection echoes one we have already heard: people may very well be
liquidity constrained. If this is the case, a tax cut todayeven one that people know they’ll have
to pay back in 5 yearscan be of real benefit to people, since they wish to consume more than
their current income allows. Note that this is consistent with one of our explanations for excess
sensitivity.
The household savings rate in the United States is one of the lowest found in industrialized
countries. Our net saving ratethe rate at which we are adding to our wealthand our national
(government plus private) savings rate are remarkably low as well. Most private saving is done
by the business sector, in the form of retained earnings (earnings not paid out to
stockholders/owners). Why is this? One reason may be demographics: we have an aging
population. The U.S. also has a very well developed financial sector; it may be that residents of
the U.S. have an easier time borrowing to finance large purchases, and don’t need to save in
order to pay for them with cash. These explanations do not fully explain low U.S. saving, but
they do help close the gap.
Arguments have been made that policy measures that increase the rate of interest on savings
accounts will increase household saving. Empirical evidence, however, suggests that changes in
interest rates have had little impact on household saving in the U.S. It may be that we’re all just
more myopic, and don’t like to save as much as others.
KEY TERMS
life-cycle hypothesis
permanent income hypothesis
lifetime utility
lifetime budget constraint
marginal utility of consumption
random-walk model of consumption
excess sensitivity
excess smoothness
liquidity constraint
myopia
buffer-stock saving
government saving
private saving
business saving
personal saving
Ricardian (or Barro-Ricardo) equivalence
liquidity constraints
operations bequest motive
156 CHAPTER 14
GRAPH IT 14
This graph allows you to see for yourself why the marginal propensity to consume might appear
to be too small in estimates based on cross-sectional data (data that takes a “slice” of the current
population instead of following a few select individuals through time).
Table 14–1 provides data for a hypothetical cross-section of the population. There are six
individuals in our sample; three have one level of permanent income, and three have another.
Each person is experiencing a different level of good or bad fortune, so that their actual income
does not equal their permanent income.
Graph each point in the sample, and find the line that best fits the group as a whole. Does the
mpc appear too small? Does the consumption function appear to have a positive intercept? This
is an example of what statisticians call an “errors in variables” problem. Our estimate of the
marginal propensity to consume is biased (wrong) because we have plotted consumption against
the wrong variable.
What variable does life-cycle/permanent-income theory suggest we should have placed on the
horizontal (or “X“) axis?
TABLE 14–1
Permanent Income
(YP)
Total Income
(Y)
$500
$400
$400
$500
$500
$400
$500
$600
$400
$1,000
$900
$800
$1,000
$1,000
$800
$1,000
$1,100
$800
* We assume that c, the marginal propensity to consume, is 0.8
Consumption*
(C = cYP)
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157
C 800 C = .8Y 400 100 200 300 400 500 600 0 700 800 900 1,000 1,1000 Y Chart 141
THE LANGUAGE
OF ECONOMICS 14
Theories and Hypotheses
All theories begin as hypothesesideas, proposed relationships, statements about what might be.
If you told a friend, for example, that you believed there were life on other planets, you would be
making a hypothesis. If you thought that perhaps humans had evolved from seaweed, you would
be making another hypothesis.
Not all hypotheses are true, and not all hypotheses become theories. A theory is nothing more
than a hypothesis, or set of hypotheses, that seem to provide a good description of the world.
The theory of general relativity was once a hypothesis; so was the belief that the sun orbited the
Earth. The latter, obviously, is not considered a “good” theory today.
REVIEW OF TECHNIQUE 14
Errors in Variables
“Errors in variables” is a phrase borrowed from statistics to describe a problem that arises when
we try to test theories and hypotheses. Often we cannot find precise measures of the variables
that we wish to look at; there are no universally accepted measures of the depreciation rate, for
example, and there are so many different measures of the interest rate and the money supply that
it’s hard to know which one to use. Often there are no good measures: think of trying to measure
intelligence or courage, for example.
158 CHAPTER 14
An errors-in-variables problem occurs when we use a variable that we can measure in place of a
more appropriate variable that we can’tactual instead of permanent income, for example, or IQ
test scores in place of intelligence. Substituting variables in this way can biasintroduce
systematic errors intoour estimates.
Consider the consumption function: The permanent-income hypothesis suggests that
consumption is most appropriately expressed as a function of permanent income (YP)
C  cYP .
If we substitute actual income for permanent income when actual income (Y) is given by the
function
Y  YP  YT ,
where YT is the transitory deviation of actual income from permanent income, and try to
estimate c (the marginal propensity to consume), our estimate c˜ will be biased downwards:
C~
cY  ~
c YP  YT  .
Note that c˜ here will be a weighted average of the marginal propensities to consume out of
permanent and transitory income and therefore, because the marginal propensity to consume out
of transitory income is
small, too low.
1
2
3
CROSSWORD
4
5
ACROSS
1 Idea, possibility
6
5 Type of "walk"; modern
theory says consumption
7
should take one
7 Consumption exhibits
excess smoothness; it does
8
9
10
not change enough in
response to ___ changes in
11
income
8 Type of income, mpc is
small
12
13
CONSUMPTION AND SAVING
159
10 Appears to be higher in the short run than in the long run
12 Life-cycle hypothesis
13 Permanent income hypothesis
DOWN
2 Type of saving; meant to guard against "rainy
days"
3 Type of income, mpc is large
4 Type of constraint; people cannot borrow
enough to support consumption at permanent
income levels
6 When we say consumption exhibits excess
sensitivity, we mean that it changes too much
in response to this kind of change in income
9 Type of earnings; not paid out to
owners/stockholders
11 Do most of the saving in the U.S.
FILL-IN QUESTIONS
1.
The _______________________ theory of consumption assumes that people try to smooth
consumption over their lifetimes, and make consumption decisions based on the income
they expect to earn over their lifetimes.
2.
When people’s actual income exceeds their permanent income, they ___________________.
3.
The marginal propensity to consume out of permanent income is _________________ than the
marginal propensity to consume out of transitory income.
4.
The life-cycle hypothesis suggests that the marginal propensity to consume out of income is
___________________ than the marginal propensity to consume out of wealth.
5.
The life-cycle/permanent income theory of consumption implies that consumption should
follow a ___________________.
6.
The marginal propensity to consume depends on the number of years they spend
___________________ relative to the number of years they spend ___________________.
7.
The ___________________ hypothesis highlights the way that demographic changes affect
national saving.
8.
Purchases of ___________________ are very sensitive to changes in the interest rate.
9.
The permanent-income hypothesis suggests that saving should change slightly over the
business cycle, rising in ___________________ and falling in ___________________.
10.
Young people anticipating high incomes in the future will want to ___________________ to
increase their current level of consumption.
160 CHAPTER 14
TRUE-FALSE QUESTIONS
T
F
1.
Consumption is the largest component of aggregate demand.
T
F
2.
The life-cycle and permanent-income hypotheses make very different claims
about the way that people make consumption decisions.
T
F
3.
The long-run mpc appears to be higher than the short-run mpc.
T
F
4.
Consumption appears to change too much in response to predictable changes in
income.
T
F
5.
Consumption appears to change too much in response to unpredictable changes in
income.
T
F
6.
The life-cycle hypothesis suggests that countries with higher proportions of
retired individuals should see savings rise.
T
F
7.
People may save more than the life-cycle/permanent income theory suggests
because they wish to leave inheritances for their children.
T
F
8.
People may not be able to smooth consumption as much as the lifecycle/permanent income theory suggests because they are liquidity constrained.
T
F
9.
Changes in the rate of interest paid by savings accounts have a strong impact on
household savings.
T
F
10.
Most of the saving in the U.S. is done by households.
MULTIPLE-CHOICE QUESTIONS
1. Estimates of long-term consumption opportunities based on expectations of lifetime income
are called _________ income.
a. disposable
b. adjusted
c. permanent
d. transitory
2. Characteristic of consumption; consumption changes too much in response to predictable
changes in income.
a. liquidity constraint
b. excess sensitivity
c. excess smoothness
d. myopia
CONSUMPTION AND SAVING
161
3. Characteristic of consumption; consumption does not change enough in response to
unpredictable changes in income.
a. liquidity constraint
b. excess sensitivity
c. excess smoothness
d. myopia
4. Constraints on people’s ability to borrow money at the market interest rate are referred to as
a. liquidity constraints
b. budget constraints
c. myopia
d. bequests
5. Saving for a rainy day (precautionary saving) is referred to as
a. bequest saving
b. myopic saving
c. buffer-stock saving
d. excess saving
6. Most of the saving in the U.S. is done by
a. businesses
b. households
c. the government
d. children
7. Consumption responds to changes in stock prices because of
a. myopia
b. liquidity constraint
c. wealth effect
d. budget constraint
8. The life-cycle/permanent-income theory of consumption is associated with the
a. Keynesian school
b. Monetarist school
c. neither
d. both
9. The life-cycle hypothesis suggests that wealth during a person’s working years should.
a. increase
b. decrease
c. not change, on average
d. all be spent
10. Which of the following groups of people should have the highest rate of saving?
a. college students
b. children
c. people who have retired
d. people approaching the end of their
working lives
CONCEPTUAL PROBLEMS
1. Why do modern theorists argue that, if the life-cycle/permanent income theory of
consumption is correct, consumption should follow a random walk?
162 CHAPTER 14
2. How do you think longer life-spans will affect people’s saving patterns? Explain.
3. How should an increase in the interest rate affect people’s permanent income?
4. Are you liquidity constrained?
TECHNICAL PROBLEMS
1. If the typical urban consumer expects to work for 30 years and live 10 years beyond
retirement, how should a $100 tax cut on labor income affect consumption? Does your answer
depend on whether the tax cut is temporary or permanent? Disregard any multiplier effects.
2. Will expansionary fiscal policy be more or less effective when people are liquidity
constrained? Justify your answer.