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375
CHAPTER 16
Understanding Consumer Behavior
Notes to the Instructor
Chapter Summary
This chapter discusses the theory of the consumer. It is structured so as to follow, more or less,
the history of thought on the topic. It first presents the Keynesian consumption function, then
discusses Irving Fisher’s model of intertemporal choice, and then addresses the life-cycle and
permanent-income theories of consumption. The chapter also includes a discussion of rational-
expectations theories of consumption.
Comments
This material probably requires two to three lectures. This is a good time to discuss the
importance of microfoundations in macroeconomic models. I suggest to students that the
material in Part V of the book allows us to both justify and to refine the important behavioral
assumptions that underlie the earlier models. In the case of consumption theory, looking at the
underlying microeconomics improves the performance of the short-run macroeconomic model.
This chapter can be treated as an extended case study on the development of a theory in
Use of the Web Site
One important advantage of the Web-based software is that it allows students to see explicit life-
cycle behavior with a nonzero interest rate and also to see how much difference interest rate
changes can make. Students may also be surprised at how difficult it is to smooth their
consumption over their lifetime. Students could also try to obtain something other than a
completely smooth consumption path—one possibility would be consumption increasing
gradually through the lifetime; another would be smooth consumption except for a blip
somewhere in middle age (say, for financing children through college).
376 | CHAPTER 16 Understanding Consumer Behavior
Use of the Dismal Scientist Web Site
Go to the Dismal Scientist Web site and download quarterly data on the major components of
personal consumption expenditures (durable, nondurable, and services) in the U.S. over the past
ten years. Assess the effect of the recession of 2001 and the recession of 2008–2009 on
consumer spending. Did it decline during these recessions? Did certain components decline but
Chapter Supplements
16-2 The Stock Market and Consumer Spending
16-4 The 1975 Tax Cut (Case Study)
16-5 Do Consumers Anticipate Changes in Social Security Benefits? (Case Study)
16-6 Is Unemployment Insurance Really an Automatic Stabilizer?
16-7 Additional Readings
Lecture Notes | 377
Lecture Notes
Introduction
Modern macroeconomics emphasizes the need for solid microeconomic foundations. Although
we make many simplifications in macroeconomics and ignore most differences among
individuals, we still hope that our macroeconomic theory is grounded in sensible
microeconomics. Macroeconomics and microeconomics, after all, should not be completely
separate disciplines; they are attempts to understand economic phenomena on different scales.
16-1 John Maynard Keynes and the Consumption Function
The consumption function was introduced into macroeconomics by John Maynard Keynes in
The General Theory of Employment, Interest and Money. We start our analysis by considering
Keynes’s ideas about the consumption function.
Keynes’s Conjectures
Recall that our models are based on a simple consumption function:
C = C(Y – T).
This simple Keynesian consumption function is not a bad starting point. It captures a number of
plausible notions about people’s behavior—that they will always want to consume something;
that they will consume more as their income goes up; and that they will tend to spend some and
save some of each additional dollar of disposable income that they earn. We can summarize
these features as follows:
2. The average propensity to consume (C/Y) is a decreasing function of income.
Keynes conjectured that these features were characteristics of actual consumption behavior.
This consumption function is also a bit naive. First, the consumption decision is,
equivalently, a saving decision. Therefore, consumption theory should be about the choice
between consuming now and consuming at some point in the future. That intertemporal aspect is
The Early Empirical Successes
Early work seemed to support the Keynesian consumption function. Surveys of households
found that households with higher incomes both consumed more and saved a higher proportion
!
Figure 16-1
that both consumption and saving were low when income was low.
Secular Stagnation, Simon Kuznets, and the Consumption
Puzzle
As more data became available and more studies were conducted, the evidence became less
clear. First, the Keynesian consumption function implies that saving increases as income
growing, the Keynesian function did not do so well. Instead, consumption was approximately
proportional to income. One way to summarize these findings is that the long-run marginal
propensity to consume differed from the short-run marginal propensity to consume. Another way
of putting this is that the long-run consumption function was steeper than the short-run
views today’s consumption as part of a plan that extends into the future. This plan is not
immutable: As time goes by, people revise their consumption plans, perhaps because they get
new information, or perhaps simply because they change their minds about what they want to
do. Nonetheless, most people’s consumption decisions probably incorporate a forward-looking
element.
16-2 Irving Fisher and Intertemporal Choice
The consumption function Keynes used does not consider how people make decisions over time.
In other words, when people decide how much to consume and how much to save, they take into
account both the present and the future. People face a tradeoff in that more consumption today
The Intertemporal Budget Constraint
We consider an individual who gets income today and tomorrow and who consumes today and
tomorrow. He has to decide how much he wants to save and how much he wants to consume
today. First, what is his budget constraint? In the first period, he gets income of Y1, which he
!Figure 16-2
Lecture Notes | 379
Y1 = C1 + S.
In the second period, he earns interest on his saving, so he has S(1 + r), where r is the real
interest rate. His consumption in the second period is thus
C2 = Y2 + S(1 + r).
FYI: Present Value, or Why a $1,000,000 Prize Is Worth Only
$623,000
If you put $100 in a bank account earning 5 percent interest a year, in ten years you would have
$162.89. Thus, the present value of $162.89 received ten years from now is $100. Formally
Consumer Preferences
We can now analyze the consumer’s problem using standard tools from microeconomics. His
preferences over consumption today and tomorrow can be summarized by indifference curves,
which give combinations of C1 and C2 that yield equal satisfaction. The slope of an indifference
curve gives the rate at which the consumer is willing to trade current for future consumption; it
is called the marginal rate of substitution (MRS).
Optimization
As standard microeconomics teaches, the consumer chooses to consume where he is just
indifferent between giving up a unit of consumption today for extra consumption tomorrow,
which is the point of tangency of his indifference curve and the budget line. At this point, MRS =
1 + r.
How Changes in Income Affect Consumption
The intertemporal budget constraint reveals that changes in income in either period will alter the
present value of income. In terms of the diagram, a change in income in either period shifts the
budget constraint out. Thus, the consumer will consume more in both periods. (In
microeconomics, we pay attention to the possibility that the consumer might consume less of a
good as his income rises. In a macroeconomic analysis, where we are considering an individual’s
!
Figure 16-4
!
Figure 16-5
!
Figure 16-6
380 | CHAPTER 16 Understanding Consumer Behavior
How Changes in the Real Interest Rate Affect Consumption
Suppose that the real interest rate increases. This means that the budget line becomes steeper—
the consumer gets more additional consumption in the future for giving up a unit of consumption
In the previous discussion, the person was presumed to be a saver in the first period. If he
were a borrower, then the increase in the interest rate would reduce his income. We can see this
on the diagram by noting that the budget line rotates around the endowment point (Y1, Y2). If the
individual is a saver, then the new budget line lies outside the old one, and the individual is
better off. If he is a borrower, then increases in the interest rate make him worse off, as
Constraints on Borrowing
Not everyone can borrow freely against future income as the Fisher model supposes. In reality, it
is often difficult to obtain loans to finance current consumption. Thus, some consumers may face
borrowing constraints (also known as liquidity constraints). When a liquidity constraint binds on
the consumer, so he would like to borrow but cannot, his first-period consumption equals his
16-3 Franco Modigliani and the Life-Cycle Hypothesis
We now return to the attempts to explain the conflicting results on consumption, that is, the idea
that the long-run consumption function is steeper than the short-run consumption function.
Franco Modigliani, Albert Ando, and Richard Brumberg proposed an explanation based on the
ideas in the Fisher model. In particular, they focused on the role of saving in smoothing
individuals’ consumption over their lifetimes.
The Hypothesis
A stylized fact of economic data is that consumption is much smoother than income. This
suggests that people may use saving to shift resources from times of high income to times of low
income to maintain a relatively constant level of consumption. The life-cycle hypothesis is based
on the idea that people wish to smooth their consumption over their lifetime. In particular,
therefore, they save during their working years to finance consumption during their retirement.
Lecture Notes | 381
Now suppose that earnings equal Y in every working year and that the individual wishes to
smooth his consumption perfectly, so that he consumes C in every year. Then the budget
constraint implies that
CT = W + RY.
Consumption is given by
Implications
The life-cycle model reconciles the short-run and long-run consumption functions. In the
short run, wealth is approximately constant, so we obtain a Keynesian consumption function.
But in the long run, wealth increases with income, so the average propensity to consume is
constant:
uncertainty about future income and about time of death, and so on. All these amendments make
the model more complicated, but the basic message is the same; we still end up with a picture
that resembles Figure 16-12 in the textbook.
Case Study: The Consumption and Saving of the Elderly
The life-cycle model predicts that the elderly dissave; however, empirical research suggests that
16-4 Milton Friedman and the Permanent-Income Hypothesis
Milton Friedman’s approach to consumption theory complements the life-cycle model. Unlike
that model, however, Friedman’s permanent-income hypothesis focuses on the effects on
consumption of random and unpredictable changes in income.
The Hypothesis
Spending”
C = αYP.
This is similar to the life-cycle hypothesis if we view transitory income as changes in
wealth and permanent income as changes in income. The marginal propensity to consume out of
transitory income (wealth) is low; the marginal propensity to consume out of (permanent)
income is high.
Implications
We can write YP = Y – YT. We thus obtain that the average propensity to consume is
APC = αYP/Y = α(1 – YT/Y).
When transitory income is positive, APC will be lower, and vice versa. High-income
households, on average, are those with positive transitory income and so exhibit, on average, a
low average propensity to consume. Over time, however, income changes because of changes in
permanent income.
Case Study: The 1964 Tax Cut and the 1968 Tax Surcharge
The temporary/permanent distinction is very important for correct policy analysis. In 1964 there
to separate the effects of tax policy from other events occurring simultaneously.
Case Study: The Tax Rebates of 2008
In response to an imminent recession, Congress early in 2008 passed the Economic Stimulus
those who received the check later. Overall, the study found that average household spending
increased by about 50 percent to 90 percent of the payment. These results suggest that even if the
“The 1975 Tax
Cut”
Lecture Notes | 383
permanent-income theory is correct in predicting larger effects on consumer spending from
permanent tax changes than from transitory changes, the latter still have significant effects on
16-5 Robert Hall and the Random-Walk Hypothesis
Recent work on consumption has combined rational expectations with the permanent-income
hypothesis, which really means assuming that people are very sophisticated in their guesses
about what their income is going to do.
The Hypothesis
Robert Hall was the first economist to show how rational expectations influence the pattern of
consumption over time. If consumers have rational expectations and follow the permanent-
income hypothesis, then consumption follows a random walk. This means that the best
prediction of consumption during this period is that it will be the same as it was in the recent
past. In other words, changes in consumption are unpredictable. Why is this? If people have
Implications
An implication of this idea is that if we are trying to explain consumption behavior, we need to
know not only if changes in income are temporary or permanent but also if they are anticipated
or unanticipated. If a consumer is told this year that he will receive a raise next year, then the
rational-expectations view of consumption predicts that his consumption will increase this year,
Case Study: Do Predictable Changes in Income Lead to
Predictable Changes in Consumption?
If changes in income are predictable, then according to the random-walk theory we should
observe no change in consumption when income changes. Individuals should adjust their
consumption as soon as they know that their income will change rather than wait for the change
to occur.
The observation that income and consumption fluctuate together over the business cycle
does not negate the random-walk theory because many changes in income are unpredictable.
Studies of predictable income changes show that when income is expected to change,
16-6 David Laibson and the Pull of Instant Gratification
Economists in recent years have turned to psychology for explanations of consumer behavior.
One of the more prominent economists bringing insights from psychology into the study of
consumption is David Laibson. He finds that many consumers believe themselves to be poor
decision-makers. For example, many respondents to surveys understand perfectly well that they
!
Supplement 16-5,
“Do Consumers
Anticipate Changes
in Social Security
Benefits?”
!Supplement 16-6,
“Is Unemployment
Insurance Really an
Automatic
384 | CHAPTER 16 Understanding Consumer Behavior
consumers alter their decisions simply because time has passed. Work is proceeding on this
promising area of research from which we may gain new insights regarding the effects of
economic policies on consumer behavior.
Case Study: How to Get People to Save More
The field of behavioral economics offers some suggestions for getting people to save more. One
approach is to take advantage of inertia in people’s decision making, for example, by
automatically enrolling employees in a company’s 401K retirement plan rather than requiring
employees to “sign-up” for the plan in advance. Studies have shown that people are far less
16-7 Conclusion
The permanent-income and life-cycle hypotheses break the strong, simple link between
disposable income and consumption that the Keynesian consumption function posits. This link
underlies the multiplier in the IS–LM model. These more sophisticated theories of consumption
ADDITIONAL CASE STUDY
16-1 The Components of Consumption
Personal consumption expenditures are divided into durables, nondurables, and services. In 2014, for
example, total consumption expenditures were about $12 trillion, of which services were $8 trillion,
nondurables were $2.7 trillion, and durables were $1.32 trillion1. Thus, spending on services accounts for
two-thirds of total consumption expenditures. This dominance of services is a relatively recent
If we subdivide these components of expenditure further, we find that 34 percent of durable goods
spending is accounted for by motor vehicles and parts, while 22 percent is accounted for by furnishings
and household equipment. Food accounts for 33 percent of nondurable spending, with spending on
clothing and shoes contributing 14 percent.
Looking at services, the most striking feature of the data is that spending on health care now accounts
LECTURE SUPPLEMENT
16-2 The Stock Market and Consumer Spending
As the stock market soared in the late 1990s, an important issue for policymakers was determining how
large an effect the gain in wealth might have on consumer spending. Federal Reserve Chairman Alan
Greenspan, testifying before Congress in February 2000, expressed his belief that the wealth effect was an
important factor in the surging U.S. economy:
very small set of households. Even though more than half of all U.S. households now hold some equities
(mainly through 401K retirement accounts), the distribution is still highly skewed, with the richest 5
percent of households owning 75 percent of equity wealth and the richest 20 percent owning 95 percent of
equity wealth.
Some evidence suggests that the largest effects on spending were indeed seen among the very
2000.
2 See K.E. Dynan and D.M. Maki, “Does Stock Market Wealth Matter for Consumption?” Federal Reserve Board Finance and Economics
ADDITIONAL CASE STUDY
16-3 Saving and the Fear of Nuclear War
One of the more intriguing and controversial hypotheses about saving is that it fluctuates because of
changes in the public’s perception of the probability of nuclear war. Because people save to provide for
consumption in the future, an increase in the probability of nuclear war—and, hence, a decrease in the
probability of surviving into the future—should reduce the amount people save.
Source: Department of Commerce, Bureau of Economic Analysis and Bulletin of Atomic Scientist
Opinion polls indicate that the public has at times considered nuclear war to be a serious threat. In
June 1981, for example, a Gallup poll asked, “How likely do you think we are to get into a nuclear war
within the next ten years?” Nineteen percent of the respondents said that nuclear war was “very likely,”
CASE STUDY EXTENSION
16-4 The 1975 Tax Cut1
In March 1975 Congress passed a tax rebate bill refunding up to $200 of a taxpayer’s 1974 income taxes.
$24.2 billion while savings rose by $49 billion and accounted for most of the increase in disposable
income.3
1975. Saving as a percentage of disposable personal income rose sharply in May 1975, as shown in Figure
3. Notice that both the change in APC and the saving rate were reversed in June 1975, providing further
evidence of the transitory nature of the tax cut.
1 This supplement draws from Peter Yoo, “The Tax Man Cometh: Consumer Spending and Tax Payments,” Federal Reserve Bank of St. Louis
CASE STUDY EXTENSION
16-5 Do Consumers Anticipate Changes in Social Security Benefits?
1989): 228–304.
2 S. Zeldes, “Consumption and Liquidity Constraints: An Empirical Investigation,” Journal of Political Economy 97, no. 2 (April 1989): 305–46. See
also Supplement 16-6, “Is Unemployment Insurance Really an Automatic Stabilizer?”
392
ADDITIONAL CASE STUDY
16-6 Is Unemployment Insurance Really an Automatic Stabilizer?
Chapter 18 of the textbook discusses automatic stabilizers, such as income taxes and unemployment
insurance. The idea of automatic stabilizers is that they tend to stimulate the economy when it is in
recession and decrease aggregate demand in booms. In a recession, for example, tax revenues fall and
transfer payments rise, so disposable income (and hence consumption) falls by less than it would in the
absence of these provisions. The multiplier effects of income changes are lessened.
Permanent-income and life-cycle theories of consumption teach us that the argument is more subtle.
To the extent that people can successfully smooth their consumption over the course of the income
fluctuations of the business cycle, automatic stabilizers are largely irrelevant. Automatic stabilizers work
by making disposable income less variable to make consumption less variable; they do not matter if
consumption is not affected by income fluctuations. Automatic stabilizers are more important when people
393
LECTURE SUPPLEMENT
16-7 Additional Readings
Richard Thaler’s “Anamolies” feature in the Journal of Economic Perspectives 4, no. 1 (Winter 1990):
193–205, discusses some of the failures of the life-cycle model of consumption.
The “Symposium on Consumption Behavior” in the Journal of Economic Perspectives 15, no. 3
