Lecture 39

Review of the Previous
Lecture
• Consumption
– Consumer Preferences
– Optimization
– Income Effect and Substitution Effect
• Role of Real Interest Rate
– Constraints on Borrowings
Topics under Discussion
• Franco Modigliani and the life-cycle
Hypothesis
– Life-cycle consumption Function
– Solving the Consumption Puzzle
• Milton Friedman and the Permanent-Income

Hypothesis
• Robert Hall and the Random-Walk Hypothesis
John Maynard Keynes and the
Consumption Function
The consumption function exhibits three
properties that Keynes conjectured.
1.The marginal propensity to consume c is

between zero and one.
2.The average propensity to consume falls as
income rises.
3.Consumption is determined by current
income.
Simon Kuznets and the
Consumption Puzzle
• The failure of the secular-stagnation hypothesis
and the findings of Kuznets both indicated that
the average propensity to consume is fairly
constant over time.
• This presented a puzzle: why did Keynes’
conjectures hold up well in the studies of
household data and in the studies of short time-
series, but fail when long time series were
examined?
Irving Fisher and
Intertemporal Choice
• The economist Irving Fisher developed the
model with which economists analyze how
rational, forward-looking consumers make
intertemporal choices-- that is, choices
involving different periods of time.
• The model illuminates
• the constraints consumers face,
• the preferences they have, and
• how these constraints and preferences
together determine their choices about
consumption and saving.
Irving Fisher and
Intertemporal Choice
When consumers are deciding how much to
consume today versus how much to consume
in the future, they face an intertemporal
budget constraint, which measures the total
resources available for consumption today and in
the future. The generalization is:
C2 Y2
C1 + = Y1 +
1+r 1+r
Franco Modigliani and the life-
cycle Hypothesis
In the 1950’s, Franco Modigliani, Ando and
Brumberg used Fisher’s model of consumer
behavior to study the consumption function. One
of their goals was to study the consumption
puzzle. According to Fisher’s model,
consumption depends on a person’s lifetime
income.
Franco Modigliani and the life-
cycle Hypothesis
Modigliani emphasized that income varies
systematically over people’s lives and that saving
allows consumers to move income from those
times in life when income is high to those times
when income is low.
This interpretation of consumer behavior formed
the basis of his life-cycle hypothesis.
The Hypothesis
• Most people plan to stop working at about age
65, and they expect their incomes to fall when
they retire, but don’t want a drop in standard of
living characterized by consumption.
• Suppose a consumer expects to live another T
years, has wealth of W and expects to earn
income Y until she retires R years from now.
– What level of consumption will the consumer
choose to have a smooth consumption over
her life?
The Life-cycle Consumption
Function
• The Lifetime resources of consumer for T years
are wealth W and lifetime earnings of R x Y
(assuming interest rate to be zero).
• To have smoothest consumption over lifetime,
she divides such that
C = (W + RY) / T or
C = (1 / T)W + (R / T)Y
Function
• If she expects T = 50 and R = 30, then the
consumption function will be
C = 1 / 50W + 30/50Y or
C = 0.02W + 0.6Y
• Generalizing for Aggregate Consumption
function of the economy:
C = αW + βY
Where, α = MPC out of Wealth
β = MPC out of Income
Function
Consumption, C
β
1
αW
Income, Y
Solving the Consumption
Puzzle
• According to Life-cycle consumption function,
APC = C/Y = α(W/Y) + β
• Because, in short periods, wealth does not vary
proportionately with incomes, High incomes
corresponds to Low APC.
• But over longer periods, wealth and incomes
grow together, resulting in constant W/Y ratio
and hence a constant APC
Solving the Consumption
Puzzle
Consumption, C
The Upward
Shift prevents
the APC from
falling as income
increases. Thus αW2
solving Keynes’s αW1
puzzle
Income, Y
Consumption, Income and
Wealth over Life-cycle
$
Wealth
Income
Consumption
Retirement End of
Begins Life
Consumption, Income and
Wealth over Life-cycle
$
Wealth
Income
Savings
Consumption Dissavings
Retirement End of
Begins Life
Consumption and Saving of
Elderly
• Research findings show that elderly people do
not dissave as much as the life cycle model
predicts.
• In other words, the elderly do not run down their
wealth as quickly as one would expect if they
were trying to smooth their consumption over
their remaining years of life.
Consumption and Saving of
• Reasons
Elderly
– They are concerned about unpredictable
expenses. Additional saving that rises from
uncertainty is called precautionary saving.
This may be due to expecting a long life and
to plan for a longer period of retirement.
• It is not completely persuasive considering
the availability of annuity schemes of
insurance companies and public health
insurance plans.
– They may want to leave bequests to their
children
Milton Friedman and the
Permanent-Income Hypothesis
• In 1957, Milton Friedman proposed the
permanent-income hypothesis to explain
consumer behavior.
• Its essence is that current consumption is
proportional to permanent income. Friedman’s
permanent-income hypothesis complements
Modigliani’s life-cycle hypothesis: both use
Fisher’s theory of the consumer to argue that
consumption should not depend on current
income alone.
• But unlike the life-cycle hypothesis, which
emphasizes that income follows a regular
pattern over a person’s lifetime, the permanent-
income hypothesis emphasizes that people
experience random and temporary changes in
their incomes from year to year.
• Friedman suggested that we view current
income Y as the sum of two components,
permanent income YP and transitory income YT.
Y = Y P + YT
• Permanent Income is the part of income that
people expect to persist in the future.
• Transitory income is the part of income that
people do not expect to persist.
• Friedman reasoned that consumption should
depend primarily on permanent income
because consumers use savings and
borrowings to smooth consumption in response
to transitory changes in income.
• Friedman approximation of consumption
function is:
C = αYP
• While Average propensity to consume is:
APC = C/Y = αYP /Y
– When Y > YP , APC Falls
– When Y < YP , APC rises
Robert Hall and the Random-
Walk Hypothesis
Robert Hall was first to derive the implications of
rational expectations for consumption. He showed
that if the permanent-income hypothesis is correct,
and if consumers have rational expectations, then
changes in consumption over time should be
unpredictable. When changes in a variable are
unpredictable, the variable is said to follow a
random walk.
According to Hall, the combination of the permanent-
income hypothesis and rational expectations implies
that consumption follows a random walk.
Summary
• J M Keynes and the Consumption Function
• Simon Kuznets and Consumption Puzzle
• Irving Fisher and Intertemporal Choice
• Franco Modigliani the life-cycle Hypothesis
• Milton Friedman and the Permanent-Income
Hypothesis
Upcoming Topics
• Investment
– Business Fixed Investment
• Rental Price of Capital
• Cost of Capital
• The Determinants of Investment
• Taxes and Investment

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Review of the Previous

• Milton Friedman and the Permanent-Income

1.The marginal propensity to consume c is

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