Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 15 The Economics of...

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Chapter 15

The Economics of ConsumptionBehavior

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 15-2

Theories of Consumer Behavior

• Recall: The Keynesian theory assumed that consumption depended on disposable income.

• Modern theories of consumption state that consumers have Forward-Looking Expectations, which are estimates of the future values of economic variables.– The Permanent Income Hypothesis (PIH) holds that consumption spending depends on the long-run average (or permanent) income that people expect to receive.

– The Live-Cycle Hypothesis (LCH) implies that households base their current consumption on their expected total lifetime incomes and their wealth.


Figure 15-1 Consumer Expenditure and Its Three Components as a Share of Natural GDP, 1960–2010


Composition of Consumption Spending

• The following table shows the percentage of consumption spending broken into 3 categories:


Cross-Section vs. Time Series Evidence

• A Cross Section consists of data for numerous units (e.g. households, firms, cities or states) observed over a single period of time.

• A Time Series consists of data covering a span of time for one or more variables of interest.

• Cross section data supports Keynes’ view that higher disposable income leads to higher saving rates, but time series data shows that saving rates have not increased as the U.S. has become wealthier.


Figure 15-2 The Relation Between Disposable Income (YD), Consumption Spending (C), and the Ratio of Saving to Income (S/YD) (1 of 3)


Figure 15-3 Ratio of Personal Saving to Disposable Personal Income (S/YD), Averages over Business Cycles, 1894–2010


The Permanent Income Hypothesis

• Permanent Income (YP) is the annual average income that people expect to receive over a period of years in the future.– People are assumed to estimate YP as follows:

• The PIH states that individuals consume a constant fraction (k) of their permanent income:

• Furthermore, consumption can be shown to depend on

both Transitory Income (Yt) and YP, but the marginal propensity to consume out of Yt is zero.

)( 11PP YYjkkYC −− −+=PkYC =

)( 11PPP YYjYY −− −+=


Implications of the PIH

• The motivation for the PIH was the conflict between cross-section data and time series data related to saving.

• The PIH contends that the high saving ratios of high-income people are due to their having atypically large, positive, Yt.– Similarly, low-income people dissave because they are more likely than the average person to have actual incomes that are temporarily below their YP.

• The long-run near-constancy of the saving ratio is due to the stability of YP.


Figure 15-4 The Permanent-Income Hypothesis of Consumption and Saving


The Life-Cycle Hypothesis

• Franco Modigliani of MIT suggested that people would try to stabilize their consumption over their entire lifetime.– C0L = Y0R or

where C0 = lifetime consumption per year

L = lifespan (in years) Y0 = income per year

R = # of years of employment

– With an endowment of assets equal to A1, lifetime consumption becomes:

00 YL

RC =

01

1 YL

R

L

AC +=


Implications of the LCH

• The life-cycle hypothesis can explain the positive association of saving and income, since the upward trend in per capita real GDP raises both the saving and income of those of working age relative to those who are retired.

• A temporary increase in income in boom years will be consumed over one’s entire life leading to higher saving in boom years.

• During the Global Economic Crisis, lower household net wealth caused consumption to fall.


Figure 15-5 The Behavior of Consumption, Saving, and Assets under the Life-Cycle Hypothesis


Figure 15-6 Consumption, Saving, and Assets under the Life-Cycle Hypothesis When There Is an Initial Stock of Assets


Rational Expectations and Consumption

• The Rational Expectations hypothesis suggests that people use forecasts of future economic magnitudes based on all information currently available about the structure and past performance of the economy and future government policies.– Since all past information is taken into account in forming expectations, only new information will change estimated permanent income Consumption only changes if unanticipated events occur.

– But empirically the behavior of consumption appears to be too volatile to be consistent with this theory.


Did Households Spend or Save the 2008 Economic Stimulus Payments?

• In Feb. 2008, Bush and Congress passed the Economic Stimulus Act (ESA): $100B in fiscal stimulus– 130M households received an average check of $770

• How large was the multiplier effect? The leading study…– 12-30% of ESA payments spent on nondurables and services– 50-90% of ESA payments spent on total consumption– Overall: C↑ by 1.8% in 2008:Q2 and 0.8% in 2008:Q3

• Annualized, C↑ by $65B in response to $100B in tax cuts mpc = 0.65

• Other studies found smaller effects– One survey found only 20% had spent ESA payments– Another: 30% spent stimulus, 18% saved it, 52% paid off

debt


Consumer Durables

• Both the PIH and the LCH are based on maintaining roughly constant level of enjoyment of C over time

• But consumer durables are bought at *one* time and then enjoyed over *many* years– Consumers must keep the stock of consumer goods fixed (as a fraction of YP)

to maintain service flow as a percentage of YP over time

• Both theories predict that (S/Y)↓ as Y↑ when consumer durables are counted as C, but not if consumer durables are counted as savings!


Bequest and Uncertainty

• Estimated that 80% of household asset accumulation is left to heirs– Lifetime may not be appropriate time horizon for the LCH!

• Barro-Ricardo Equivalence Theorem: People leave bequests because they care about children, therefore, any event that leaves children worse off will cause saving to rise to increase bequest size.– Not supported by the evidence: S did not ↑ as T↓ (in 1980s and

2001-3)• Why do people leave bequests?

– Uncertainty about time of death implies bequests are involuntary!

– Implication for LCH: Replace probable L with longest conceivable L• Why do retirees cut their consumption so much (when LCH predicts

fixed level of C over lifetime)?– Many retirees move to smaller, cheaper location– Many retirees have paid off their mortgage– Can eliminate previous work-related consumption – Additional leisure time allows more time for bargain-hunting!


International Perspective Why Do Some Countries Save So Much?


Household Assets and the Fall and Rise of S

• In the late 1990s, household saving as a percentage of disposable income was the lowest in the U.S. since the Great Depression. Why?

• The PIH would predict that higher incomes in the 1990s would have pushed up the saving rate.

• The LCH has consumption depending on lifetime income and on real assets.– The stock market boom in the late 1990s greatly increased people’s wealth C relative to income pushing down the saving rate.

– Saving did not revive in the 2000s when the stock market subsequently declined. Why?• Rising value of real estate• Low interest rates

After 2005: Net Worth Fell S↑


Figure 15-7 The Household Saving Rate and the Ratio of Household Net Worth to Personal Disposable Income, 1970–2010


Figure 15-8 Components of Household Assets as a Ratio to Personal Disposable Income, 1970–2010, in Percent


Official Household Saving Data

• The National Income and Product Accounts (NIPA) measure saving as:

S = YD – C – interest payments • Some flaws in the NIPA measure of S include:

– NIPA does not include capital gains on stocks, bonds, houses and other assets.

– NIPA does not include purchases of consumer durable goods, which would provide a stream of benefits in the future.

– Inflation raises the nominal interest paid leading to overestimates of S in periods of high inflation.

• The Flow of Funds (FFA) measure of S includes net investment in consumer durables.


Figure 15-9 Household Saving in the NIPA and Flow of Funds Accounts, 1960–2010


Figure 15-10 Flow of Funds Accounts and Gains-Inclusive Saving Rates, 1976–2010

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 15 The Economics of...

Documents

Transcript of Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 15 The Economics of...