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Chapter 15
The Economics
of Consumption
Behavior
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Theories of Consumer Behavior
• Recall: The Keynesian theory assumed that
consumption depended on disposable income.
• Modern theories of consumption state that
consumers have Forward-Looking Expectations,
which are estimates of the future values of
economic variables.
– The Permanent Income Hypothesis (PIH) holds that
consumption spending depends on the long-run average
(or permanent) income that people expect to receive.
– The Live-Cycle Hypothesis (LCH) implies that
households base their current consumption on their
expected total lifetime incomes and their wealth.
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Figure 15-1 Consumer Expenditure and Its
Three Components as a Share of Natural GDP,
1960–2010
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Composition of Consumption
Spending
• The following table shows the percentage of
consumption spending broken into 3 categories:
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Cross-Section vs. Time Series
Evidence
• A Cross Section consists of data for numerous
units (e.g. households, firms, cities or states)
observed over a single period of time.
• A Time Series consists of data covering a span of
time for one or more variables of interest.
• Cross section data supports Keynes’ view that
higher disposable income leads to higher saving
rates, but time series data shows that saving rates
have not increased as the U.S. has become
wealthier.
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Figure 15-2 The Relation Between Disposable
Income (YD), Consumption Spending (C), and
the Ratio of Saving to Income (S/YD) (1 of 3)
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Figure 15-2 The Relation Between Disposable
Income (YD), Consumption Spending (C), and
the Ratio of Saving to Income (S/YD) (2 of 3)
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Figure 15-2 The Relation Between Disposable
Income (YD), Consumption Spending (C), and
the Ratio of Saving to Income (S/YD) (3 of 3)
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Figure 15-3 Ratio of Personal Saving to
Disposable Personal Income (S/YD), Averages
over Business Cycles, 1894–2010
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The Permanent Income Hypothesis
• Permanent Income (YP) is the annual average income
that people expect to receive over a period of years in
the future.
– People are assumed to estimate YP as follows:
P
P
P
1
1
Y  Y  j (Y  Y )
• The PIH states that individuals consume a constant fraction
(k) of their permanent income:
 C  kY  k j (Y  Y )
• Furthermore, consumption can be shown to depend on both
Transitory Income (Yt) and YP, but the marginal propensity
to consume out of Yt is zero.
C  kY
P
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P
1
P
1
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Implications of the PIH
• The motivation for the PIH was the conflict between
cross-section data and time series data related to
saving.
• The PIH contends that the high saving ratios of
high-income people are due to their having
atypically large, positive, Yt.
– Similarly, low-income people dissave because they are
more likely than the average person to have actual
incomes that are temporarily below their YP.
• The long-run near-constancy of the saving ratio is
due to the stability of YP.
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Figure 15-4 The Permanent-Income
Hypothesis of Consumption and Saving
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The Life-Cycle Hypothesis
• Franco Modigliani of MIT suggested that people
would try to stabilize their consumption over their
entire lifetime.
R
– C0L = Y0R or C0  Y0
L
where C0 = lifetime consumption per year
L = lifespan (in years)
Y0 = income per year
R = # of years of employment
– With an endowment of assets equal to A1, lifetime
consumption becomes:
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A1 R
C1 
 Y0
L L
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Implications of the LCH
• The life-cycle hypothesis can explain the positive
association of saving and income, since the upward
trend in per capita real GDP raises both the saving
and income of those of working age relative to those
who are retired.
• A temporary increase in income in boom years will be
consumed over one’s entire life leading to higher
saving in boom years.
• During the Global Economic Crisis, lower household
net wealth caused consumption to fall.
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Figure 15-5 The Behavior of Consumption,
Saving, and Assets under the Life-Cycle
Hypothesis
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Figure 15-6 Consumption, Saving, and Assets
under the Life-Cycle Hypothesis When There Is
an Initial Stock of Assets
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Rational Expectations and
Consumption
• The Rational Expectations hypothesis suggests
that people use forecasts of future economic
magnitudes based on all information currently
available about the structure and past performance
of the economy and future government policies.
– Since all past information is taken into account in forming
expectations, only new information will change estimated
permanent income  Consumption only changes if
unanticipated events occur.
– But empirically the behavior of consumption appears to be
too volatile to be consistent with this theory.
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Did Households Spend or Save the
2008 Economic Stimulus Payments?
• In Feb. 2008, Bush and Congress passed the Economic
Stimulus Act (ESA): $100B in fiscal stimulus
– 130M households received an average check of $770
• How large was the multiplier effect? The leading study…
– 12-30% of ESA payments spent on nondurables and services
– 50-90% of ESA payments spent on total consumption
– Overall: C↑ by 1.8% in 2008:Q2 and 0.8% in 2008:Q3
• Annualized, C↑ by $65B in response to $100B in tax cuts  mpc =
0.65
• Other studies found smaller effects
– One survey found only 20% had spent ESA payments
– Another: 30% spent stimulus, 18% saved it, 52% paid off debt
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Consumer Durables
• Both the PIH and the LCH are based on maintaining roughly constant
level of enjoyment of C over time
• But consumer durables are bought at *one* time and then enjoyed
over *many* years
– Consumers must keep the stock of consumer goods fixed (as a fraction of YP) to
maintain service flow as a percentage of YP over time
• Both theories predict that (S/Y)↓ as Y↑ when consumer durables are
counted as C, but not if consumer durables are counted as savings!
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Bequest and Uncertainty
• Estimated that 80% of household asset accumulation is left to heirs
– Lifetime may not be appropriate time horizon for the LCH!
• Barro-Ricardo Equivalence Theorem: People leave bequests
because they care about children, therefore, any event that leaves
children worse off will cause saving to rise to increase bequest size.
– Not supported by the evidence: S did not ↑ as T↓ (in 1980s and 2001-3)
• Why do people leave bequests?
•
– Uncertainty about time of death  implies bequests are involuntary!
– Implication for LCH: Replace probable L with longest conceivable L
Why do retirees cut their consumption so much (when LCH predicts
fixed level of C over lifetime)?
– Many retirees move to smaller, cheaper location
– Many retirees have paid off their mortgage
– Can eliminate previous work-related consumption
– Additional leisure time allows more time for bargain-hunting!
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International Perspective Why Do
Some Countries Save So Much?
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Household Assets and the Fall
and Rise of S
• In the late 1990s, household saving as a
percentage of disposable income was the lowest in
the U.S. since the Great Depression. Why?
• The PIH would predict that higher incomes in the
1990s would have pushed up the saving rate.
• The LCH has consumption depending on lifetime
income and on real assets.
– The stock market boom in the late 1990s greatly
increased people’s wealth  C relative to income
pushing down the saving rate.
– Saving did not revive in the 2000s when the stock market
subsequently declined. Why?
• Rising value of real estate
• Low interest rates
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After 2005: Net
Worth Fell  S↑
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Figure 15-7 The Household Saving Rate and
the Ratio of Household Net Worth to Personal
Disposable Income, 1970–2010
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Figure 15-8 Components of Household Assets
as a Ratio to Personal Disposable Income,
1970–2010, in Percent
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Official Household Saving Data
• The National Income and Product Accounts (NIPA)
measure saving as:
S = YD – C – interest payments
• Some flaws in the NIPA measure of S include:
– NIPA does not include capital gains on stocks, bonds,
houses and other assets.
– NIPA does not include purchases of consumer durable
goods, which would provide a stream of benefits in the
future.
– Inflation raises the nominal interest paid leading to
overestimates of S in periods of high inflation.
• The Flow of Funds (FFA) measure of S includes net
investment in consumer durables.
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Figure 15-9 Household Saving in the NIPA
and Flow of Funds Accounts, 1960–2010
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Figure 15-10 Flow of Funds Accounts and
Gains-Inclusive Saving Rates, 1976–2010
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