notes

EC201 Intermediate Macroeconomics
EC201 Intermediate Macroeconomics


Lecture 33-34: Consumption


Lecture Outline:
- Keynesian consumption function and the “consumption puzzle”;
- Fisher’s two period model of consumption;
- Life Cycle and Permanent Income theory of consumption;
- Consumption as a random walk;
Essential reading:
Mankiw: Ch. 17

Keynesian Consumption Function
When we discussed the Keynesian Cross model and the IS-LM model we did
introduce the Keynesian Consumption Function:
C t = C 0 + cYt 1)
The main features of that function are:
a) the only determinant of current aggregate consumption is current income;
b) the Marginal Propensity to Consume (MPC) is 0 < c < 1 ;
Ct C0
c) the Average Propensity to Consume (APC) = + c is decreasing with
Yt Yt
income;
The properties a), b) and c) are called the Keynes Conjectures.
Property b) means that only a part of current income is consumed and so a proportion
1 − c becomes saving.
Property c) says that as income increases (meaning consumers become richer)
consumers will save a larger fraction of income.
Graphically the Keynes Consumption function looks like:




1

, C


C=C0+cY




MPC
C0
slope=APC

Y

The slope of any ray connecting zero with a point on the consumption function is the
Average Propensity to Consume. As income increases a ray connecting zero with a
point on the production function becomes flatter meaning that the slope is decreasing.
Why the slope those rays is the APC? Consider the point C1 ,Y1 on the consumption
function. Take a ray starting from zero and passing through the point C1 ,Y1 . Then you
have a triangle (a right triangle). From basic trigonometry the slope of the ray is then
the opposite side ( C1 ) divided by the adjacent side ( Y1 ).



C


C=C0+cY



C1

slope=C1/Y1


Y1 Y

Now we can ask: Is the Keynesian Consumption function a good representation of
consumers’ behaviour?
This is an empirical question. By looking at early empirical evidence (in the 30s and
40s) we had:



2

, 1) Cross-sectional evidence: this was evidence coming from surveys about
households at a given point of time. For example a sample of 1000 consumers
in 1934. The results from this evidence were:
a) Richer households consumed more than poorer ones ⇒ MPC > 0
b) Richer households saved more than poorer ones ⇒ MPC < 1.
c) Richer households saved larger fractions of their income ⇒ APC ↓ asY ↑.
d). The correlation between current income and current consumption was
found to be very strong (this was found during the Great Depression).
Therefore according to this evidence it seemed that the Keynesian
Consumption Function was a good representation of consumers’ behaviour.
2) Time series evidence: in 40s new pieces of evidence about aggregate
consumptions were found by Simon Kuznets (a Nobel prize winner). He
created a set of data from the US national accounts from 1869 to the 1940s on
aggregate Y and C. According to the Keynes Consumption Function aggregate
consumption should grow more slowly than income. This is because as Y
increases, C also increases but proportionately less than income. Moreover as
income increases APC should decrease. Kuznets found that the ratio C/Y was
very stable in long time series data. This implies that C grew at the same rate
as income and as income increased APC did not fall.
Therefore we have two different pieces of evidence giving very different results.
The difference between the two was that the first one was cross-sectional in detail
(they looked at a snapshot of the economy at a point) whereas Kuznet’s study was of a
time series nature (it looked at the economy over many points in time). So the
evidence seemed to indicate that there were two consumption functions: a short-run
consumption function which seemed to conform to Keynes’s conjectures and a long-
run consumption function in which the APC was basically constant. This is known as
the Consumption Puzzle.
We can see how this looks with the following graph:




3