NOTES Keynesian_Consumption and Investment.pdf

# NOTES Keynesian_Consumption and Investment.pdf - Module 3a...

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Module 3a: Keynesian Consumption & Investment Theories of Consumption o Current income hypothesis (Keynes) o Intertemporal consumption hypothesis(Fisher) o Life-cycle hypothesis (Modigliani) o Permanent income hypothesis (Friedman) Theories of Investment o Neoclassical model o Accelerator model 1 Current Income Hypothesis MPC=Marginal Propensity to Consume, APC=Average Propensity to Consume ? < ?𝑷𝑪 < ? means for every additional income, we consume more but also save more. (We consume some of the additional, but not all of it) 𝑨𝑷𝑪 = 𝑪 𝒀 falls as income rises. Income is the main determinant of consumption . Consumption Puzzle Based on the Keynesian consumption function, economists predicted that C would grow more slowly than Y over time (sectoral stagnation thesis), since 𝑏 = ?𝑃𝐶 < 1 . But as incomes grew, the APC did not fall, and C grew just as fast. Simon Kuznets showed that APC= C/Y was very stable in the long term . -?

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2 Intertemporal Choice (Irving Fisher) The basis for much subsequent work on consumption. Assumes consumer chooses consumption for the present and future to maximize lifetime satisfaction . Consumer’s choices are subject to an intertemporal budget constraint , a measure of the total resources available for present and future consumption Basic model assumes only 2 periods, present (Period 1) and the future (Period 2) 𝑌 𝑖 = income in period i 𝐶 𝑖 = consumption in period i 𝑆 = 𝑌 1 − 𝐶 1 is saving in period 1. (S < 0 if the consumer borrows in period 1) r = real interest rate 𝐶 2 = 𝑌 2 + (1 + 𝑟)𝑆 = 𝑌 2 + (1 + 𝑟)(𝑌 1 − 𝐶 1 ) (1 + 𝑟)𝐶 1 + 𝐶 2 = 𝑌 2 + (1 + 𝑟)𝑌 1 Question : In the intertemporal consumption hypothesis, what determines the proportion of income consumed and saved in each time period? a. Interest rate on savings b. Time preference of individuals (determines how they maximize their utility) c. Current labor income Current income hypothesis: current C depends only on current Y Intertemporal consumption hypothesis: current C depends only on present value of lifetime Y . (The timing of income is irrelevant because the consumer can borrow or lend between periods.) People try to achieve smooth consumption (same C all throughout)
3 Life Cycle Hypothesis (Modigliani) Income (and savings) varies systematically over the phases of the consumer’s “life cycle,” and saving allows the consumer to achieve smooth consumption.

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• Fall '17
• Macroeconomics, Consumption function, APC, Permanent income hypothesis

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