Forward Looking Theories of Consumption: Permanent Income Hypothesis and Life Cycle Theory | Study notes Economics

Fall Semester ’05-’06

Akila Weerapana

Lecture 22: Consumption

I. OVERVIEW

•In the last 20% of the class, we explore the microeconomics underlying each of the component

parts of the IS Curve in a thorough manner, first consumption, then investment, government

spending and net exports and the open economy in order. This will enable us to look at more

sophisticated economic concepts beyond the scope of the IS-LM model

•We initially focus on the consumption decision, which is the largest component of GDP (about

65% of GDP). It is also the most important from an individual’s perspective. In the IS-LM

analysis we worked with a very simple Keynesian consumption function where consumption

today depended only on current disposable income. While this is analytically convenient,

it does not in anyway capture the complications of the consumption decision that people

undertake everyday.

II. FORWARD LOOKING THEORIES OF CONSUMPTION

•In the IS-LM model we used the Keynesian consumption function C=¯

C+b(1 −t)Y. Any

changes to Consumption that are unrelated to current income are captured by the exoge-

nous consumption term ¯

C. However, we would like to incorporate some of these additional

determinants more directly into our consumption function.

•The Keynesian consumption function seemed to hold up empirically when researchers used

data over a long period of time. The MPC (b) seemed to be about 0.93. However, when they

surveyed the consumption patterns of households over shorter periods of time, they found

that the MPC was much lower about 0.72. Since the Keynesian Consumption function did

not allow for the pattern of consumption to differ between the short run and the long run, a

better theory was required.

•There were two such theories proposed in the 1960’s. Milton Friedman’s Permanent In-

come Hypothesis and Franco Modigliani’s Life Cycle Hypothesis. These 2 theories

collectively are often referred to as the Forward Looking Theories of Consumption and

share a common economic intuition. This intuition is built on the assumption that consumers

are forward looking individuals who calculate a plan for their future consumption and then

attempt to smooth consumption as much as possible.

The Life Cycle Theory of Consumption

•Modigliani’s life-cycle model describes individuals as going through several phases in life -

youth when typically little or no income is earned, middle-aged working years when most of

their income is earned and the retired years when they have to live off savings and social

security.

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Fall Semester ’05-’ Akila Weerapana

Lecture 22: Consumption

I. OVERVIEW

In the last 20% of the class, we explore the microeconomics underlying each of the component parts of the IS Curve in a thorough manner, first consumption, then investment, government spending and net exports and the open economy in order. This will enable us to look at more sophisticated economic concepts beyond the scope of the IS-LM model
We initially focus on the consumption decision, which is the largest component of GDP (about 65% of GDP). It is also the most important from an individual’s perspective. In the IS-LM analysis we worked with a very simple Keynesian consumption function where consumption today depended only on current disposable income. While this is analytically convenient, it does not in anyway capture the complications of the consumption decision that people undertake everyday.

II. FORWARD LOOKING THEORIES OF CONSUMPTION

In the IS-LM model we used the Keynesian consumption function C = C¯ + b(1 − t)Y. Any changes to Consumption that are unrelated to current income are captured by the exoge- nous consumption term C¯. However, we would like to incorporate some of these additional determinants more directly into our consumption function.
The Keynesian consumption function seemed to hold up empirically when researchers used data over a long period of time. The MPC (b) seemed to be about 0.93. However, when they surveyed the consumption patterns of households over shorter periods of time, they found that the MPC was much lower about 0.72. Since the Keynesian Consumption function did not allow for the pattern of consumption to differ between the short run and the long run, a better theory was required.
There were two such theories proposed in the 1960’s. Milton Friedman’s Permanent In- come Hypothesis and Franco Modigliani’s Life Cycle Hypothesis. These 2 theories collectively are often referred to as the Forward Looking Theories of Consumption and share a common economic intuition. This intuition is built on the assumption that consumers are forward looking individuals who calculate a plan for their future consumption and then attempt to smooth consumption as much as possible.

The Life Cycle Theory of Consumption

Modigliani’s life-cycle model describes individuals as going through several phases in life - youth when typically little or no income is earned, middle-aged working years when most of their income is earned and the retired years when they have to live off savings and social security.

Consumers then are likely to dissave when young and old and save when they are middle aged so as to consume most of their resources over their lifetime.
This can help explain the discrepancies in the short and long run link between C and Y. In the long run, C and Y will be closely related as individuals will consume most of their income so the MPC will be high. But in the short run, many groups such as the young, the old and the working will not consume in proportion to their incomes because they will be either saving or dissaving depending on the stage of the life-cycle that they are in. -

Y, C

Age

C

Y

The Permanent Income Hypothesis

Friedman’s Permanent Income Hypothesis is similar to the Life Cycle Theory. Instead of fo- cusing on the age of the consumer, Friedman focused on the type of income that the consumer received.
He categorized income into 2 types: permanent income and transitory income. Permanent income is income that people expected to last into the future while transitory income consists of temporary deviations from permanent income.
He then observed that the MPC out of permanent income should be close to 1 while the MPC from temporary income should be considerably less than 1 because individuals would tend to smooth consumption over time.
The intuitive reasonableness of this argument can be illustrated by thinking about a Powerball lottery winner who has a choice of receiving a single lump-sum payment of $150 million or something like 30 annual payments of $10 million a year). The single lump-sum would be counted as transitory income while the $10 million payment would count as permanent income.
Intuition would tell us that they would increase annual consumption by about $10 million a year in the 2nd case (a MPC close to 1) while they would save most of the $150 million in the first case (a MPC close to 0).
This too can explain the short and long run differences in consumption. When we use long- term data, permanent income dominates income so we would expect MPC to be close to 1. However, when looking at short-term data, income consists of both permanent and transitory income so the MPC would be much lower.

III. IMPLICATIONS FOR IS-LM ANALYSIS

Both the Friedman and the Modigliani approaches to modeling consumption have powerful implications for IS-LM analysis.
The length of tax cuts matter because we have to distinguish between permanent and tem- porary income. If individuals are forward looking then a temporary tax cut will affect them less than an equivalent tax cut that is permanent will. So we would have to incorporate the permanency of tax cuts into our IS-LM analysis. Example: A permanent tax cut announced in 1964 stimulated the economy because consumption increased. In contrast was the 1968 Vietnam War tax surcharge which lasted 1 year, this did not reduce aggregate demand at all because people smoothed out the tax increase over their lifetimes.
Expectations matter. So announcements of future tax cuts will affect consumption today because forward looking consumers are likely to take the future into account.
While the permanent income hypothesis can explain some puzzles it still is not empirically foolproof. In particular, consumption seems to depend much more on current income than on future income.
Potential explanations for this are
1. Irrationality: Consumers are likely to believe that good times will always stay and bad times will go away
2. Short-sightedness: Consumers are not forward looking to the degree predicted by Fried- man and Modigliani.
3. Uncertainty about future income: so they save money for a rainy day
4. Liquidity constrained consumers: even though people like to smooth consumption they are unable to spend more than they earn so they will use temporary income increases to finance consumption.

Forward Looking Theories of Consumption: Permanent Income Hypothesis and Life Cycle Theory, Study notes of Economics

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Partial preview of the text

Download Forward Looking Theories of Consumption: Permanent Income Hypothesis and Life Cycle Theory and more Study notes Economics in PDF only on Docsity!

Lecture 22: Consumption

I. OVERVIEW

II. FORWARD LOOKING THEORIES OF CONSUMPTION

Y, C

C

Y

III. IMPLICATIONS FOR IS-LM ANALYSIS