Macroeconomics

Summary

1.

Keynes conjectured that the marginal propensity to consume is between

zero and one, that the average propensity to consume falls as income rises,

and that current income is the primary determinant of consumption. Stud-

ies of household data and short time-series confirmed Keynes’s conjectures.

Yet studies of long time-series found no tendency for the average propensi-

ty to consume to fall as income rises over time.

2.

Recent work on consumption builds on Irving Fisher’s model of the

consumer. In this model, the consumer faces an intertemporal budget con-

straint and chooses consumption for the present and the future to achieve

the highest level of lifetime satisfaction. As long as the consumer can save

and borrow, consumption depends on the consumer’s lifetime resources.

3.

Modigliani’s life-cycle hypothesis emphasizes that income varies somewhat

predictably over a person’s life and that consumers use saving and

borrowing to smooth their consumption over their lifetimes. According to

this hypothesis, consumption depends on both income and wealth.

4.

Friedman’s permanent-income hypothesis emphasizes that individuals expe-

rience both permanent and transitory fluctuations in their income. Because

consumers can save and borrow, and because they want to smooth their

consumption, consumption does not respond much to transitory income.

Instead, consumption depends primarily on permanent income.

5.

Hall’s random-walk hypothesis combines the permanent-income hypothesis

with the assumption that consumers have rational expectations about future

income. It implies that changes in consumption are unpredictable, because

consumers change their consumption only when they receive news about

their lifetime resources.

6.

Laibson has suggested that psychological effects are important for

understanding consumer behavior. In particular, because people have a

strong desire for instant gratification, they may exhibit time-inconsistent

behavior and end up saving less than they would like.

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Consumption

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P R O B L E M S   A N D   A P P L I C A T I O N S

c. What will happen to Jill’s consumption in the

first period when the interest rate increases? Is

Jill better off or worse off than before the

interest rate increase?

3.

The chapter analyzes Fisher’s model for the

case in which the consumer can save or

borrow at an interest rate of r and for the 

case in which the consumer can save at this

rate but cannot borrow at all. Consider now

the intermediate case in which the consumer

can save at rate r

s

and borrow at rate r

b

, where

r

s

< r

b

.

a. What is the consumer’s budget constraint in

the case in which he consumes less than his

income in period one?

b. What is the consumer’s budget constraint in

the case in which he consumes more than his

income in period one?

K E Y   C O N C E P T S

Marginal propensity to consume

Average propensity to consume

Intertemporal budget constraint

Discounting

Indifference curves

Marginal rate of substitution

Normal good

Income effect

Substitution effect

Borrowing constraint

Life-cycle hypothesis

Precautionary saving

Permanent-income hypothesis

Permanent income

Transitory income

Random walk