®

CHAPTER 17
Consumption

A PowerPointTutorial
To Accompany

MACROECONOMICS, 7th. Edition

N. Gregory Mankiw
Tutorial written by:
Mannig J. Simidian
Chapter Seventeen B.A. in Economics with Distinction, Duke University 1
M.P.A., Harvard University Kennedy School of Government
M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management
The consumption function was central to Keynes’ theory of economic
fluctuations presented in The General Theory in 1936.
• Keynes conjectured that the marginal propensity to consume— the
amount consumed out of an additional dollar of income is between
zero and one. He claimed that the fundamental law is that out of
every dollar of earned income, people will consume part of it and save
the rest.
• Keynes also proposed the average propensity to consume, the ratio of
consumption to income falls as income rises.
• Keynes also held that income is the primary determinant of
consumption and that the interest rate does not have an important role.
Chapter Seventeen 2
 C=
C =C
C++ ccY,
Y, C>
C > 0,
0, 00 <
< cc <1
<1
C
Consumption cYY
c
spending by disposable C++
households marginal ==C
income CC
depends propensity to
on consume (MPC)
C
autonomous Y
consumption
C determines the intercept on the
vertical axis. The slope of the
Chapter Seventeen consumption function is lower 3case c,
the MPC.
 This
Thisconsumption
consumptionfunction
function
APC = C/Y = C/Y
APC = C/Y = C/Y + c exhibits + c exhibitsthree
threeproperties
propertiesthat
that
Keynes
Keynesconjectured.
conjectured.First,
First,
C the
themarginal
marginalpropensity
propensitytoto
consume
consumeccisisbetween
betweenzero
zero
and
andone.
one.Second,
Second,the
theaverage
average
APC1 propensity
propensitytotoconsume
consumefalls
falls
C APC2 as
asincome
incomerises.
rises.Third,
Third,
11 consumption
consumptionisisdetermined
determinedby by
current
currentincome
incomeY. Y.
Y
As Y rises, C/Y falls, and so the average propensity to consume C/Y
falls. Notice that the interest rate is not included in this equation as a
determinant of consumption.
Chapter Seventeen 4
 To
Tounderstand
understandthe
themarginal
marginalpropensity
propensitytotoconsume
consume(MPC),
(MPC),
consider
consideraashopping
shoppingscenario.
scenario.AAperson
personwhowholoves
lovesto
toshop
shop
probably
probablyhas
hasaalarge
largeMPC,
MPC,let’s
let’ssay
say(.99).
(.99).This
Thismeans
meansthat
thatfor
for
every
everyextra
extradollar
dollarheheororshe
sheearns
earnsafter
aftertax
taxdeductions,
deductions,he heor
or
she
shespends
spends$.99
$.99ofofit.
it. The
TheMPC
MPCmeasures
measuresthethesensitivity
sensitivityof
of
the
thechange
changeininone
onevariable,
variable,consumption,
consumption,withwithrespect
respectto
toaa
change
changein inthe
theother
othervariable,
variable,income.
income.

Chapter Seventeen 5
During World War II, on the basis of Keynes’s consumption function,
economists predicted that the economy would experience what they
called secular stagnation—a long depression of infinite duration—
unless the government used fiscal policy to stimulate aggregate demand.
It turned out that the end of the war did not throw the United States into an
depression, but it did suggest that Keynes’s conjecture that the average
propensity to consume would fall as income rose appeared not to hold.

Simon Kuznets constructed new aggregate data on consumption and

investment dating back to 1869. His work would later earn him a
Nobel Prize. Kuznets discovered that the ratio of consumption to income w
stable over time, despite large increases in income; again, Keynes’s
conjecture was called into question.
Chapter Seventeen 6
This brings us to the puzzle…
The
Thefailure
failureof
ofthe
thesecular-stagnation
secular-stagnationhypothesis
hypothesisand
andthe
thefindings
findingsofof
Kuznets
Kuznetsboth
bothindicated
indicatedthat
thatthe
theaverage
averagepropensity
propensityto
toconsume
consumeisisfairly
fairly
constant
constantover
overtime.
time. This
Thispresented
presentedaapuzzle:
puzzle:Why
Whydid
didKeynes’s
Keynes’s
conjectures
conjectureshold
holdupupwell
wellin
inthe
thestudies
studiesof
ofhousehold
householddata
dataand
andininthe
the
studies
studiesof
ofshort
shorttime-series,
time-series,but
butfail
failwhen
whenlong-time
long-timeseries
serieswere
were
examined?
examined?
Long-run Studies
Studiesof ofhousehold
householddatadataand
andshort
short
C consumption time-series
time-seriesfound
foundaarelationship
relationship
function between
betweenconsumption
consumptionand andincome
income
(constant APC) similar
similartotothe
theone
oneKeynes
Keynesconjectured
conjectured
Short-run ——this
thisisiscalled
calledthe
theshort-run
short-run
consumption consumption
consumptionfunction.
function.But,
But,studies
studies
function using
usinglong
longtime-series
time-seriesfound
foundthat
thatthe
the
(falling APC) APC
APCdid
didnotnotvary
varysystematically
systematicallywith
with
Y income—this
income—thisrelationship
relationshipisiscalled
called7the
the
Chapter Seventeen
long-run
long-runconsumption
consumptionfunction.
function.
The
Theeconomist
economistIrving
IrvingFisher
Fisherdeveloped
developedthe themodel
model
with
withwhich
whicheconomists
economistsanalyze
analyzehow
howrational,
rational,
forward-looking
forward-lookingconsumers
consumersmakemakeintertemporal
intertemporal
choices—that
choices—thatis,is,choices
choicesinvolving
involvingdifferent
differentperiods
periods
of
oftime.
time. The
Themodel
modelilluminates
illuminatesthe
theconstraints
constraints
consumers
consumersface,
face,the
thepreferences
preferencesthey
theyhave,
have,and
andhow
how
these
theseconstraints
constraintsand
andpreferences
preferencestogether
togetherdetermine
determine
their
theirchoices
choicesabout
aboutconsumption
consumptionand andsaving.
saving.

When
Whenconsumers
consumersare aredeciding
decidinghow
howmuch
muchto to
consume
consumetoday todayversus
versushow
howmuch
muchto
toconsume
consume
in
inthe
thefuture,
future,they
theyface
faceananintertemporal
intertemporal
budget
budgetconstraint,
constraint,which
whichmeasures
measuresthe
thetotal
total
resources
resourcesavailable
availablefor
forconsumption
consumptiontoday
todayand
andin
inthe
the
future.
future.
Chapter Seventeen 8
Here
Hereisisananinterpretation
interpretationof ofthe
theconsumer’s
consumer’sbudget budgetconstraint:
constraint:
The
Theconsumer’s
consumer’sbudgetbudgetconstraint
constraintimplies
impliesthatthatififthe
theinterest
interest
rate
rateisiszero,
zero,the
thebudget
budgetconstraint
constraintshows
showsthat thattotal
total
consumption
consumptionin inthe
thetwo
twoperiods
periodsequals
equalstotaltotalincome
income
in
inthe
thetwo
twoperiods.
periods. InInthe
theusual
usualcase
casein inwhich
whichthethe
interest
interestrate
rateisisgreater
greaterthan
thanzero,
zero,future
futureconsumption
consumptionand andfuture
futureincome
income
are
arediscounted
discountedby byaafactor
factorof of11++r.r.This
Thisdiscounting
discountingarisesarisesfrom
fromthethe
interest
interestearned
earnedon onsavings.
savings. Because
Becausethe theconsumer
consumerearns earnsinterest
interestonon
current
currentincome
incomethatthatisissaved,
saved,future
futureincome
incomeisisworth
worthless
lessthan
thancurrent
current
income.
income.Also,
Also,because
becausefuture
futureconsumption
consumptionisispaid paidforforout
outofofsavings
savings
that
thathave
haveearned
earnedinterest,
interest,future
futureconsumption
consumptioncosts costsless
lessthan
thancurrent
current
consumption.
consumption.The Thefactor
factor1/(1+r)
1/(1+r)isisthe
theprice
priceofofsecond-period
second-period
consumption
consumptionmeasured
measuredin interms
termsofoffirst-period
first-periodconsumption;
consumption;ititisisthethe
amount
amountof offirst-period
first-periodconsumption
consumptionthat thatthe
theconsumer
consumermust mustforgo
forgototo
obtain
obtain11unitunitof
ofsecond-period
second-periodconsumption.
consumption.
Chapter Seventeen 9
Here are the combinations of first-period and second-period consumption
the consumer can choose. If he chooses a point between A and B, he
consumes less than his income in the first period and saves the rest for
the second period. If he chooses between A and C, he consumes more that
his income in the first period and borrows to make up the difference.

Consumer’s
Consumer’sbudget
budgetconstraint
constraint
Second-period

B
consumption

Saving
Vertical
Verticalintercept
interceptisis
(1+r)Y
(1+r)Y11++YY22
A Borrowing
Y2
Horizontal
Horizontalintercept
interceptisis
C YY1 ++YY2/(1+r)
Y1 1 2/(1+r)
Chapter Seventeen 10
First-period consumption
 The
Theconsumer’s
consumer’spreferences
preferencesregarding
regardingconsumption
consumptionin inthe
the
two
twoperiods
periodscan
canbe berepresented
representedby byindifference
indifferencecurves.
curves. AnAn
indifference
indifferencecurve
curveshows
showsthe thecombination
combinationof offirst-period
first-periodand
and
second-period
second-periodconsumption
consumptionthat thatmakes
makesthe theconsumer
consumerequally
equally
happy.
happy. The
Theslope
slopeatatany
anypoint
pointononthe
theindifference
indifferencecurve
curve
shows
showshowhowmuch
muchsecond-period
second-periodconsumption
consumptionthe theconsumer
consumer
requires
requiresininorder
orderto tobe
becompensated
compensatedfor foraa1-unit
1-unitreduction
reductionin in
first-period
first-periodconsumption.
consumption.This Thisslope
slopeisisthe
themarginal
marginalrate rateof
of
substitution
substitutionbetween
betweenfirst-period
first-periodconsumption
consumptionand andsecond-
second-
period
periodconsumption.
consumption. ItIttellstellsus
usthe
therate
rateatatwhich
whichthe the
consumer
consumerisiswilling
willingto tosubstitute
substitutesecond-period
second-periodconsumption
consumption
for
forfirst-period
first-periodconsumption.
consumption.
Chapter Seventeen 11
 consumption
Second-
period Y Z
X IC2
W IC1
First-period consumption
Indifference
Indifferencecurves
curvesrepresent
representthetheconsumer’s
consumer’spreferences
preferencesoveroverfirst-
first-
period
periodand
andsecond-period
second-periodconsumption.
consumption.An Anindifference
indifferencecurve
curvegives
givesthe
the
combinations
combinationsof ofconsumption
consumptionin inthe
thetwo
twoperiods
periodsthat
thatmake
makethetheconsumer
consumer
equally
equallyhappy.
happy.HigherHigherindifferences
indifferencescurves
curvessuch
suchasasIC
IC22are
arepreferred
preferredtoto
lower
lowerones
onessuchsuchas asIC
IC11..The
Theconsumer
consumerisisequally
equallyhappy
happyatatpoints
pointsW,W,X,X,
and
andY,
Y,but
but
Chapter
prefers
prefers point
Seventeen pointZZto toall
allthe
theothers.
others.Point
PointZZisison
onaahigher
higher 12
indifference
indifferencecurvecurveandandisistherefore
thereforenotnotequally
equallypreferred
preferredto toW,
W,X,X,and
andY.Y.
 consumption
Second-
O

period IC3
IC2
IC1
First-period consumption
The
Theconsumer
consumerachieves
achieveshishishighest
highest(or
(oroptimal)
optimal)level
levelof
ofsatisfaction
satisfaction
by
bychoosing
choosingthe thepoint
pointon onthe
thebudget
budgetconstraint
constraintthat
thatisison
onthe
thehighest
highest
indifference
indifferencecurve.
curve. Here
Herethetheslope
slopeof
ofthe
theindifference
indifferencecurve
curve
equals
equalsthe
theslope
slopeof ofthe
thebudget
budgetline.
line.At
Atthetheoptimum,
optimum,the theindifference
indifference
curve
curveisistangent
tangentto tothe
thebudget
budgetconstraint.
constraint.The
Theslope
slopeofofthe
theindifference
indifference
curve
curveisisthe
themarginal
marginalraterateofofsubstitution
substitutionMRS,
MRS,andandthe
theslope
slopeof
ofthe
the
budget
budgetline
lineisis11++the
thereal
realinterest
interestrate.
rate.AtAtpoint
pointO,O,MRS
MRS==11++r.r.
Chapter Seventeen 13
 consumption
Second-
period O
IC2
IC1
First-period consumption
An increase in either first-period income or second-period income
shifts the budget constraint outward. If consumption in period one and
consumption in period two are both normal goods—those that are
demanded more as income rises, this increase in income raises
consumption in both periods.
Chapter Seventeen 14
 Economists
Economistsdecompose
decomposethe theimpact
impactofofan
anincrease
increaseininthe
thereal
realinterest
interest
rate
rateon
onconsumption
consumptioninto intotwo
twoeffects:
effects:an
anincome
incomeeffect
effectand
andaa
substitution
substitutioneffect.
effect.The
Theincome
incomeeffect
effectisisthe
thechange
changein inconsumption
consumption
that
thatresults
resultsfrom
fromthe
themovement
movementto toaahigher
higherindifference
indifferencecurve.
curve.TheThe
substitution
substitutioneffect
effectisisthe
thechange
changeininconsumption
consumptionthat thatresults
resultsfrom
fromthe
the
change
changeininthe
therelative
relativeprice
priceof
ofconsumption
consumptionin inthe
thetwo
twoperiods.
periods.

New budget An
Anincrease
increasein inthe
theinterest
interestrate
rate
rotates
rotatesthe thebudget
budgetconstraint
Second-period

constraint constraint
consumption

around
aroundthe thepoint
pointC,
C,where
whereCCisis
B Old budget (Y
(Y11,,YY22).). The
Thehigher
higherinterest
interestrate
rate
constraint reduces
A reducesfirst firstperiod
periodconsumption
consumption
Y2 C IC2 (move
(moveto topoint
pointA)A)and
andraises
raises
IC1 second-period
second-periodconsumption
consumption
Chapter Seventeen Y1 (move
(moveto topoint
pointB).
B). 15
First-period consumption
The
Theinability
inabilityto
toborrow
borrowprevents
preventscurrent
currentconsumption
consumptionfrom
fromexceeding
exceeding
current
currentincome.
income.AAconstraint
constrainton
onborrowing
borrowingcan
cantherefore
thereforebe
beexpressed
expressed
as
asCC11<<YY11..

This
Thisinequality
inequalitystates
statesthat
thatconsumption
consumptionin
inperiod
periodone
onemust
mustbebeless
lessthan
than
or
orequal
equalto
toincome
incomein inperiod
periodone.
one. This
Thisadditional
additionalconstraint
constrainton
onthe
the
consumer
consumerisiscalled
calledaaborrowing
borrowingconstraint,
constraint,or
orsometimes,
sometimes,aaliquidity
liquidity
constraint.
constraint.

The
Theanalysis
analysisof ofborrowing
borrowingleads
leadsus
usto
toconclude
concludethatthatthere
thereare
aretwo
two
consumption
consumptionfunctions.functions. For
Forsome
someconsumers,
consumers,the theborrowing
borrowing
constraint
constraintisisnot notbinding,
binding,and
andconsumption
consumptionin inboth
bothperiods
periodsdepends
depends
on
onthe
thepresent
presentvaluevalueofoflifetime
lifetimeincome.
income.ForForother
otherconsumers,
consumers,thethe
borrowing
borrowing constraint
constraint binds.
binds. Hence,
Hence,for
for those
those consumers
consumers who
who would
would
Chapter Seventeen 16
like to borrow but cannot, consumption depends only on current
like to borrow but cannot, consumption depends only on current income. income.
In the 1950s, 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.
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.

Chapter Seventeen 17
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.
Chapter Seventeen 18
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.

Chapter Seventeen 19
Recently, economists have turned to psychology for further explanations
of consumer behavior. They have suggested that consumption decisions
are not made completely rationally. This new subfield infusing
psychology into economics is called behavior economics. Harvard’s
David Laibson notes that many consumers judge themselves to be
Imperfect decisionmakers. Consumers’ preferences may be time-
inconsistent: they may alter their decisions simply because time passes.
Pull of Instant
Gratification

Chapter Seventeen 20
Marginal propensity to consume Substitution effect
Average propensity to consume Borrowing constraint
Intertemporal budget constraint Life-cycle hypothesis
Discounting Precautionary saving
Indifference curves Permanent-income hypothesis
Marginal rate of substitution Permanent income
Normal good Transitory income
Income effect Random walk

Chapter Seventeen 21