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Chapter 12
Consumption and Saving
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
12-1
Objectives
• Evaluate modern theories of consumption which
link lifetime consumption to lifetime income
• Consider consumption under uncertainty
• Investigate further aspects of consumption
behaviour
• Explain the Barro-Ricardo problem
12-2
Chapter Organisation
12.1
The Life-Cycle–Permanent-Income Theory
of Consumption and Saving
12.2
Consumption under Uncertainty: the
Modern Approach
12.3
Further Aspects of Consumption Behaviour
12-3
12.1 Consumption and Saving
• Consumption accounts for more than 61% of
aggregate demand.
• A simple model of consumption was outlined in
Chapter 7.
• It assumed that consumption was determined by
disposable income in a simple linear relation.
(12.1)
12-4
12.1 The Life-Cycle Theory
• Life-cycle (LC) hypothesis
– Individuals plan their consumption and savings
behaviour over long periods with the intention of
allocating consumption over their entire lifetime.
• A key assumption is individuals choose to
consume at about the same level every period.
• This implies that the MPC will vary over the
life-cycle of the individual.
12-5
The Life-Cycle Theory
• Modern consumption theories consider the way
in which individuals plan and make choices over
an extended period of time.
• Two theories explain consumption patterns:
– The life-cycle hypothesis
– The permanent income theory.
• These two models focus on different aspects
of consumption planning.
• Today, these two theories have largely merged.
12-6
• Example
– Assume a person starts work at 20, plans to work
until they are 65, expects to die at 80, and earns
– $30 000 a year (YL).
– The person’s lifetime resources would be YL times
working life (WL) or $30 000  (65 – 20) = $1.35m.
– Spreading the lifetime resources over the lifespan (NL)
gives an annual C of $22 500.
– C = (WL/NL)  YL = $1.35m/(80 – 20) = $22 500
12-7
• Example
– C = (WL/NL)  YL
– So the MPC is WL/NL = (65 – 20)/(80 – 20) = 0.75
• Consider now a permanent increase in Y of $3000:
– The extra Y times 45 working years spread over 60 years
of life would increase annual consumption by
+$3000  (45/60) = +$2250
– The MPC out of permanent Y would still be:
WL/NL = 45/60 = 0.75
12-8
• Consider now a transitory increase in Y of $3000
for 1 year only:
– The extra Y spread over 60 years would increase
annual consumption by +$3000  (1/60) = +$50
– The MPC out of transitory Y would be
1/NL = 1/60 = 0.017
– The MPC out of permanent Y is large while the
MPC out of transitory Y is small.
12-9
Permanent-Income Theory
• The Permanent-Income hypothesis (PIH) claims
C is not related to current Y but rather longer-term
estimates of Y.
• Permanent-Income is:
– The steady rate of C a person could maintain for the
rest of his or her life
– Given the present level of wealth and the Y earned
now and in the future.
12-10
Permanent-Income Theory
• This implies that consumption is proportional to
permanent Y.
• C = cYP
(12.2)
• Where YP is permanent (disposable) Y.
• Transitory Y is assumed not to have any
substantial affects on consumption.
12-11
12.1
The Life-Cycle–Permanent-Income Theory
12.2
Consumption under Uncertainty: the Modern
Approach
12.3
12-12
12.2 Consumption under Uncertainty: the
Modern Approach
• The modern version of the LC-PIH links income
uncertainty and changes in consumption.
• Changes is consumption arises from surprise
changes in Y.
• Without surprises, maximising consumers equate
consumption over all periods.
12-13
Modern Approach
• Any reallocation of consumption from the optimum
will reduce total utility.
• A person enjoys utility u from consumption C in
period t: u(Ct).
• Lifetime utility (LU) is the sum of period-by-period
utilities.
12-14
Modern Approach
– Starting at period t until the final period T
LU = u(Ct) + u(Ct + 1) + ….. + u(CT - 1) + u(CT)
• The lifetime budget constraint (LBC) is the sum
of the period-by-period consumption
LBC = Ct + Ct + 1 + ….. + CT - 1 + CT
= wealth +YLt +YLt+1 + …..+YLT - 1+YLT
(12.3)
12-15
Modern Approach
• Equation 12.3 states that consumers choose
consumption each period:
– To maximise lifetime utility
– Subject to total lifetime resources.
• The optimal choice is the C path that equates
the marginal utility of C across periods:
– MU(Ct + 1) = MU(Ct)
– No reallocation over time can increase total utility.
12-16
Modern Approach
• Now consider uncertainty.
– Future marginal utility is unknown at time t.
– The consumer must estimate the expected value of
tomorrow’s t + 1 utility: E [MU(Ct + 1)].
– The optimum time path of consumption is where
E[MU(Ct + 1)] = MU(Ct).
– If the (marginal) utility function is one-to-one with C, then:
E (Ct + 1) = Ct.
12-17
Modern Approach
• Now consider uncertainty.
– E (Ct + 1) = Ct
– If observed C is expected C with a random surprise 
Ct + 1 = E (Ct + 1) + 
– Then substituting for the expected value derives a simple
random-walk model of consumption
Ct + 1 = E (Ct + 1) + 
= Ct + 
12-18
Modern Approach
• The random walk model suggests that changes
in consumption should not be predictable.
• Consumption is assumed to be based on future
expected income as well as current income.
• The predictions of the random walk model
appear to be fairly accurate.
12-19
LC–PIH: The Traditional Model
Strikes Back
• Empirical evidence suggests:
– Both the simple consumption function and the LC–PIH
help explain consumption behaviour.
– Campbell and Mankiw (1989) found that 1/3 of household
consumption can be explained by current Y rather than
permanent Y.
– Consumption behaviour exhibits excess sensitivity
(C responds strongly to predictable changes in Y) and
excess smoothness (C responds sluggishly to surprise
changes in Y).
12-20
Liquidity Constraints and Myopia
• Why doesn’t LC–PIH fully explain consumption
behaviour?
• Three reasons may account for this shortfall:
– Liquidity constraints
– Myopia
– Uncertainty and buffer stock saving.
12-21
• Liquidity constraints
– Represent constraints on borrowing
– A consumer may not be able to borrow to sustain current
consumption in the expectation of higher future Y
– Example: Students cannot obtain a large loan now merely
on the basis of expected higher future Y.
12-22
• Myopia
– Consumers may not be as forward looking as
suggested by the LC–PIH
– They take a short-sighted approach
– Example: An announcement that social security
benefits will be increased in 6 weeks' time
– Doesn’t increase consumption (until benefits are
paid) because the recipients do not have the available
assets to increase consumption (liquidity constraint), or
– They do not pay attention to the announcement
(myopia), or they don’t believe it.
12-23
Uncertainty and Buffer-Stock Saving
• Some saving is precautionary (buffer-stocks) to
guard against times when income is low.
– Y fluctuations create considerable risk for the consumer.
– The pain caused by a large drop in spending is greater
than the pleasure caused by an equal-size increase
in spending.
– Consumers may avoid having to cut C sharply in bad
times if they have a buffer-stock.
12-24
12.1
The Life-Cycle-Permanent-Income Theory
12.2
Consumption under Uncertainty: the Modern
Approach
12.3
12-25
12.3 Further Aspects of Consumption
Behaviour
• The Barro-Ricardo Problem (Ricardian
equivalence)
– Claims that a reduction in taxes does not increase
consumption.
– Households save the additional disposable income,
with unchanged consumption spending.
– Debt financing of the budget deficit by bond issue will
require future increases in taxes.
– So households increase their savings now to pay for
the future tax increase.
12-26
Further Aspects of Consumption
Behaviour
• Objections to the Ricardian equivalence
– People have finite lives, so later generations pay for the
debt that the present generation enjoys.
– For a given tax cut now, people increase their
consumption now, as the tax cut eases their liquidity
constraints.
– They do not save now for the future increase in taxes
as their liquidity constraints imply they are consuming
less now then their optimal consumption level.
12-27
International Differences in Savings Rates
• Gross national savings
– The sum of private sector and public sector savings.
• Public sector savings
– Includes total government saving and savings of public
sector enterprises and financial institutions.
• Private sector savings
– Includes personal (household) and business savings.
12-28
12-29
• From Figure 12.5:
– Significant declines in both private and public sector
savings in the early 1990s contributed to national
savings reaching a post-war low of around 15.5%
of GDP in late 1992.
– Since then, national savings has increased to 18.9%
of GDP.
– This has been entirely due to increased public savings.
– Private savings have continued to decline.
12-30
12-31
• Table 12.1 shows that Australia had an average
gross national savings rate in the 1990s of 18.5%.
• This rate is similar to Canada’s (17.5%).
• This rate is higher than the rates for the US
(16.5%) and the UK (15.7%).
• However, national saving is considerably lower
than Japan’s (31%).
12-32
• What underlies the trend of savings in Australia
and internationally?
– Large budget deficits imply reduced saving in the
public sector.
– Changing demographics (such as a larger senior
citizen population) account for some of the changes
in saving rates over time.
– Australia and other OECD economies find it easier
to borrow than most other nations.
12-33

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