Economics 104B - Lecture Notes Part III

Economics 104B - Lecture Notes - Professor Fazzari

Topic IV: Major Components of the Economy

(Final March 17, 2013)

A. Consumption: Source of Demand – Determinant of Saving

1. Consumption and income

a) Psychological “law:” consumption spending rises with income

In his classic book, The General Theory, Keynes described what he called a “fundamental psychological law:” the more income people have, the more they will consume.
This “law” may seem fairly obvious, but it is not necessary for people to consume more just because they make more money. People could live in a way where they just meet their needs and save all remaining income. However, this is not the usually the case; when people make more money, they tend to spend more.
Equivalently, when peoples’ incomes fall, they will consume less.
We can see evidence of this law at work in recessions and booms. Usually, consumption declines (or at least its growth slows substantially) in recessions, while consumption usually grows fast in economic booms with rising income.

b)Marginal propensity to consume (MPC)

Definition of the “MPC:” the change in consumption that occurs from a small change of income; the amount that will be spent from an additional $1 of income (or the amount spending is reduced when income declines by $1).
The MPC for an economy is usually assumed to be between 0 and 1. The MPC is positive because of the “psychological law.” A positive MPC means that consumption rises when income rises and falls when income falls. An MPC of 1 means that consumers spend all of any additional income they get and save none of it. An MPC of 0 means that households save all of any additional income they get and consume none of it. (All income either goes either into consumption or saving.)
The opposite of MPC is MPS, Marginal Propensity to Save:

MPS = 1 - MPC

The current savings rate in the U.S. economy is below five percent. If we think of the savings rate as a crude approximation for MPS, then aggregate MPC is about 0.95.

An individual could theoretically have an MPC greater than 1. Suppose that someone spent all of their additional income and also used their higher income to get a loan and spend even more. But this is unlikely for the economy as a whole.
It is important to understand the meaning of the work marginal in the definition of the MPC. The MPC is the effect of a small change of income on consumption, that is, the effect “on the margin.” The MPC is not simply the ratio of consumption to income (a concept often called the “average” propensity to consume).
Example: Suppose a household has income of $100,000 and consumes $90,000 in a year. This information is enough to determine that the average propensity to consume is 0.9. But we don’t know the MPC from these figures alone.
If the household were to receive an additional $1,000 in income, then we could observe the change in consumption to see what the MPC would be. For example, if consumption of the household rose by $800, we could estimate the MPC as 0.8.

c) Evidence of fluctuations in consumption and income over the business cycle

The graph below shows real consumption expenditures from 1970 through 2012. The main feature is strong growth in consumption over time as the economy has expanded.
If you look carefully at the graph, however, you will see that most of the time when the economy goes into recession (as indicated by the gray bars), consumption growth noticeably slows. This shows a linkage between consumption and income.

Careful inspection shows two events that stand out in the graph:
First, consumption did not really show any tendency to slow in the 2001 recession or the slow growth period after this downturn. The 2001 recession was driven primarily by a decline of business investment. The fact that consumption continued to grow strongly right through the recession helped make that event quite mild by historical standards.
Second, the most obvious deviation in consumption from the long-term trend happens with the Great Recession beginning late 2007. The drop is by far the largest on the graph and although consumption resumed growing in 2009 it has not recovered fast enough to attain the previous trend.
From a demand-side perspective, the drop in consumption in the Great Recession is an important cause of that significant event.

2. The Consumption Function

a) A mathematical model

C = a + (MPC) (Y)

where C = consumption

a = constant

Y = Income

MPC = Marginal Propensity to Consume, a number between zero and one assumed to be constant.

The constant “a” is literally the amount of consumption that would take place if income were zero. But we really don’t know what consumption would be if income were zero. In practice, “a” represents other factors affecting consumption besides income. An exogenous consumption “shock” will change “a.” For example an intense marketing campaign by automakers may cause consumption of cars to increase even though incomes have not changed.

(1)Movements along the consumption function with changes in disposable income

Holding all else constant, if Disposable Y changes, then you only move along the graph.

(2)Relation between slope of the consumption function and MPC

The algebraic consumption function describes a standard linear equation in “slope-intercept” form. The constant a is the intercept and the MPC is the slope.

slope = MPC

b) Shifts of the Consumption Function

Extra Material: Some General Principles in Working with Graphs. There are three types graphical movements you need to know:

- A movement along the graph: holding all else constant, if Disposable Y changes, then you only move along the graph.

Example:

Y0Y1

- A change in the slope of the graph: this is caused ONLY by a change in the MPC.

Example:

Y

- A change in the vertical-axis intercept: caused by a change in a. a will change due to a change in an exogenous variable (a consumption shock). Examples of typical shocks appear later in the notes.

Example:

(1) Wealth changes: distinction between wealth and income

Wealth is different from income. Wealth is a “stock” variable. Wealth is the value of all a person’s possessions at a point in time. Income is a “flow” variable. It is the amount earned over a period of time. Because a “flow” variable is measured over a period of time, we need to specify what that period is, whether an hour, month, quarter, or year.
Generally, a person who has a high income will have high wealth, but this is not always the case. A person right out of college can get a great job with an income of $100,000 a year, but he/she will have not accumulated a lot of wealth yet. Similarly, a person with a relatively low income could have invested some money in “the right” stocks, and made a lot of money. That person’s wealth would be high, but their income would remain low.
High consumer wealth will cause a larger value of “a,” that is, an upward shift in the consumption function. If consumers have high wealth, they will spend more for every income level.
Application: a fall in stock market prices will cause a decrease in consumer wealth. Therefore, the consumption function will shift down.

C High Wealth

Low Wealth

The decline in the stock market after the “tech bubble” burst in early 2000 could have been a factor contributing to the slowing of the economy and the recession of 2001.
There is a lot of interest in “wealth effects” due to the dramatic changes in the value of houses in recent years.
Many economists argue that the significant rise in the value of homes from the middle 1990s through 2007 pushed consumption upward, even holding income constant. This is a wealth effect, it would be modeled with the consumption function by pushing up the value of the intercept term “a.” Consumption would rise for any level of income.
Conversely, the remarkable fall in house prices after 2007 could cause a negative wealth effect on consumption.
From a demand-side perspective, these wealth effects could have an important impact on output and employment. The positive wealth effect from rising home prices stimulates consumption spending. Higher spending encourages firms to produce more and hire more workers. Economic growth is strong and unemployment falls. But the negative wealth effect after 2007 could be an important cause of the Great Recession. Reduced home prices lower wealth, reduce consumption and firms sales. Firms cut production and lay off workers (or at least do not replace workers that quit for other reasons). GDP and employment fall.

(2) Interest Rates

The interest rate is effectively the reward for saving. Therefore, when the Fed lowers interest rates, they are lowering the reward for saving. This encourages consumption. Furthermore, lower interest rates will reduce the amount of money households need to service their existing debt, which will make more money available for them to consume.

Low interest rates

High interest rates

Disp Y

The link between interest rates and consumption constitutes one way in which Fed policy affects overall macroeconomic activity.

(3) Expectations of future income: consumer confidence

Consumers make their spending decisions based not only on current income, wealth, etc., but also with an eye toward future conditions. Thus, expectations matter for consumption. Indeed, the importance of expectations is a major theme in modern research on consumption.
If households expect income to rise in the future, they will consume more today for a given level of current income. Therefore, the consumption function shifts upward.
In an important sense, higher expected future income is similar to an increase in wealth. Higher future income raises the resources available to households over time, just like the effect of higher wealth.
One aspect of this point relates to the importance of "consumer confidence" about future conditions. A private economic analysis group (the Conference Board) surveys American consumers monthly and publishes an index of consumer confidence. When this index falls, the implication is that people are more concerned about the future and therefore may cut back their spending plans. Thus, weaker consumer confidence shifts the consumption function downward. According to demand-side theory, this "shock" will reduce output and employment.
This consumer confidence effect explains how geopolitical events, outside of the narrow economic sphere, may affect the macro economy. For example, many analysts believed that the September 11, 2001 terrorist attacks would cause consumer confidence to fall and therefore hurt spending and weaken the economy through the demand side. (While this theory was logically coherent, in fact consumer spending held up pretty well after the attacks.)

(4) Application: temporary vs. permanent tax changes and consumption

Tax changes are another factor that shift the consumption function. It is sensible to assume that consumption depends on disposable income, which is income households have after their taxes are deducted (or paid directly to the government for self-employed people). Sometimes disposable income is called “take-home pay.”
When taxes are cut, people have more money in their pockets for a given level of pre-tax income. Consumption rises. Assuming that the horizontal axis of the consumption function measures pre-tax income, the consumption function would shift upward.
Note that later in the course we will consider more realistic models that include endogenous taxes such that the amount of taxes paid varies with the level of income. In this case, the effect on the consumption function is more complicated. But for now, it’s OK to think of taxes as “lump sum,” so that a tax change just shifts the consumption function up or down.
Because consumers base their spending decisions on expectations of the future, at least in part, we expect that permanent shocks will have a bigger effect on consumption than temporary shocks. The reason is that permanent changes affect not only current conditions, but future conditions as well.
An excellent example of this point is the impact of various tax cuts in recent years.
During the 1974-1975 recession, the government, led by President Gerald Ford, tried to stimulate consumption by sending a $100 check to every person who filed a 1974 tax return. Everybody knew that this was a temporary increase in their income. Nobody felt wealthier. Nobody expected a higher future income. Therefore, their consumption functions did not change very much.
In the early 1980s, President Ronald Reagan proposed tax cuts to permanently reduce the tax rates. Congress passed these tax cuts in 1981 and they went into effect over the next few years. Because this tax cut was permanent, it raised expected future disposable income, as well as current disposable income. Therefore, the effect on consumption was likely larger than the Ford plan discussed above. There was, in fact, a consumption boom in the 1980s, and while we cannot necessarily attribute this boom entirely to the tax cut, it is likely that it did play a role.
Because the Reagan tax cut raised peoples' expected future income, it shifted the consumption function.
An example of an obviously temporary tax cut with entirely short-term effects is from the George H.W. Bush administration (the “original” President Bush). The administration reduced employer tax withholding while keeping tax rates the same. Tax deductions on paychecks fell, but this change was offset by a smaller refund (or larger tax bill) when people filed their tax returns the following spring. The effect on consumption was negligible and temporary.
Similar arguments could be made in favor of allowing the tax cuts passed under President George W. Bush (the son) to be made permanent. Many people believe that even though the tax cuts now are scheduled to "sunset" (be repealed) in a few years, this threat is more of political game and the tax cuts will be made permanent.
Here is a graphical way to interpret temporary versus permanent tax cuts with the consumption function:

Consumption

Y0Y1Disposable Income

In this graph, the economy begins with disposable income of Y0 and consumption at point A. Now, a tax cut raises disposable income to Y1 and consumption rises to point B, assuming the tax cut is temporary. But if the tax cut is permanent and future disposable income is expected to be higher, the consumption function will shift upward (due to the change in expectations). The result will be higher consumption today, as shown by point C.

3. Consumption and Saving

When consumption rises, by definition, saving declines. Therefore, the factors that affect consumption also affect saving. Why should we care about saving?

a. Saving and individual wealth accumulation

Most obviously, saving determines the rate at which individuals build up personal wealth. Thus, society often conveys a message that saving is good and virtuous. People will benefit in the future by “sacrificing” consumption today.
One primary reason for saving is to provide resources for a household to maintain its consumption spending after retirement.
In particular, the large “baby boom” generation is encouraged to save because there are so many of them. When the baby boom retires, there will not be as many workers to support each retiree as was the case in earlier years, particularly the years when the baby boom generation was in the work force.
Because of these demographic realities, the baby boom generation will put more strain on programs that transfer income from workers to retirees, particularly the Social Security system. The normative conclusion from this observation is usually that the baby boom generation should save more than earlier generations.
In this context, many economists and policy makers worry about the strong trend in the U.S. toward higher consumption. Higher consumption implies less saving, and this trend has occurred just when the baby boom generation should have been putting away resources for their retirement.

b. Saving as source of funds for investment

Saving affects individual wealth. In particular, it determines how the ownership of an economy’s assets is distributed across individuals. But the larger question for performance of the aggregate macroeconomic system is how saving affects output and growth.
Some people save and others borrow. These transactions cancel out. But the household sector as a whole usually chooses to save more than it spends. You can think of the whole household sector as if it makes a deposit into the banking system. The more the households save, the more the banking system can lend to other parts of the economy.
In particular, the saving of the household sector is channeled by the financial system into financing for businesses. Firm use these funds to build new factories, purchase new and better equipment, and develop new technologies.
Higher saving (that is, lower consumption) by households releases resource that can be used for investment and capital accumulation by businesses.

c. Relevance of saving for the supply side and potential output

As we discussed in section III of the course, business capital and technology are key factors that determine potential output on the supply side. They also are perhaps the most important factor that determines growth in the long-run standard of living in society.
From this supply-side perspective, low consumption and high saving improve macroeconomic performance.

d. Conflict between demand-side and supply-side roles of consumption and saving

Note that the demand-side and supply-side perspectives on consumption and saving are contradictory.
According to the demand-side view, higher consumption stimulates business sales and encourages firms to produce more and hire more workers.
In supply-side theory, higher consumption reduces saving which lowers the resources available to business for investment and technological development. The result is lower potential output.
Which perspective is correct? The answer is complex and subject to debate. One simple resolution is that the demand-side perspective is correct in the short run (when demand-side theory is most relevant) while the supply-side theory applies to the long run. This resolution suggests that a rise in saving may hurt the economy for a while, but eventually it improves economic performance.
This is an attractive and intuitive conclusion. It is similar to the idea that a household sacrifices consumption today to have a higher of standard of living in the future.
But there are a number of reasons why this simple analogy between individual households and the economy as a whole may not be correct. We will return to this important and intellectually challenging question near the end of the course when we have studied macroeconomic theory more completely.
This distinction between the demand-side and supply-side effects of consumption and saving is also of relevance for determining whether the Great Recession was primarily a demand-side or a supply-side phenomenon.
Recall from the chart above that consumption dropped dramatically at the beginning of the Great Recession. This is consistent with a demand-side explanation for the Recession. Consumer spending declines, firms sell less, and they cut back on production and employment.
A basic interpretation of consumption in the Great Recession largely contradicts the supply-side explanation for this economic event. In a pure supply-side model, less consumption should raise saving and encourage higher output by making more resources available for business investment and capital accumulation. It is pretty clear that this did not happen. (We will look at investment data in the Great Recession in the next section of these notes.)
Largely for this reason, a majority of economists likely see the Great Recession as a demand-side phenomenon.
But supply-side effects, like labor-market mismatch, may still play some role in the Recession.
Some “new classical” economists, who explain macroeconomic fluctuations as almost exclusively supply side in origin, maintain that supply-side factors can still be responsible for the Great Recession even though the economy weakened when consumption declined. This approach would typically argue that there is some other factor (related to potential output) that caused both output and consumption to decline. In this case, the drop in consumption did not cause the Great Recession (as it would according to demand-side theory).

4. Consumption Statistics