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14.02_Lectures_5-7

14.02_Lectures_5-7 - TOPIC TOPIC 3 The Demand Side of the...

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TOPIC 3 Th D d Sid f h E The Demand Side of the Economy
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Road Map What drives business investment decisions? What drives household consumption? What is the link between consumption and savings? Does consumption theory accurately match the data? What theories of consumption seem to match the data? What role can the government play in shaping spending? 2
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Part I: Consumption
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An Introduction to Consumption Consumption = demand for consumer goods and services by households Why Consumption is an important macroeconomic variable? 1 C i th j t f d d ( th 2/3 f GDP i US!) 1. C is the major component of demand (more than 2/3 of GDP in US!) 1. Household consumption decision is closely linked to saving decision . (For given level of disposable income deciding how much to consume = (For given level of disposable income, deciding how much to consume = deciding how much to save!) We are interested in Aggregate levels of Consumption and Saving We are interested in Aggregate levels of Consumption and Saving. 4
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Old School Consumption Keynesian Consumers (from John Maynard Keynes) C + b*Y (i i T d T f Y Y) C = a + b*Y d (ignoring Taxes and Transfers: d = Y) a = ‘subsistence’ level of Consumption b = marginal propensity to consume = MPC b marginal propensity to consume MPC Key: Consumption is based solely on current income. Based on cross-country and long run time series data: a ~ 0 , MPC = Δ C/ Δ Y ~ 0.90 Problem: In Micro Data ( household data ) over short term, MPC << 0.90 People run a regression: Δ C = β 0 + β 1 Δ Y + error. With household data β 1 around 0.40! 5 Keynesian consumption function does not seem to match short run (household) data, although it does match long run (country level) data.
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What is missing? Drawbacks to Keynesian Consumption Functions (aside from not matching data): Does not Include Expectations <<this is important!>> Does not Distinguish Between Different Types of Income Changes (one-time Does not Distinguish Between (one-time increase vs. permanent increase) Does not allow for the role of interest rates Does not result from optimizing household behavior Is there another theory which allows us to look at household Consumption Behavior? Yes - Lifecycle/Permanent Income Hypothesis! 6
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Permanent Income Hypothesis (PIH) Milton Friedman/Franco Modigliani: Consumers like Smooth Consumption Optimize ‘lifetime’ utility (over consumption and leisure) Today, you plan your consumption based upon what you observe today and what you expect to happen tomorrow! People like to smooth ‘marginal utility’ across seasons, business cycles and life cycles. Think about it: Retirement, Job Loss, Summer Vacations, etc. 7 Does much better at matching data – (although not perfect)
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Model Set-Up Assumptions: 1. Time horizon = 2 periods (think at working age and retirement) 2. Current income, future income, and wealth are given 3. Agents can borrow and lend at the same given real interest rate r Notation: y = current real income y f = future real income a
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