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Unformatted text preview: 13 C ONSUMPTION AND S AVING FOCUS OF THE CHAPTER Consumption is the largest component of aggregate demand. The amount that we consume today depends not only on our current income, but also on our wealth and our expectations of future income. Because people try to spread their resources out over their lifetimes, transitory changes in income do not affect their consumption very much at all. Permanent changes in income do. SECTION SUMMARIES 1. The Life-Cycle/Permanent Income Theory of Consumption and Saving The life-cycle and permanent income theories tell a very similar story, and for that reason have been grouped together in this textbook. Both are based on the notion that people try to smooth consumption over their lifetimes that they borrow when their income is low and save when their income is high in order to maintain a constant level of consumption over the years. They really only differ in the way that they model the decision-making involved in this process. The life-cycle theory of consumption assumes that consumption is a function of both wealth and our average lifetime income, and that we have different marginal propensities to consume out of each: a high marginal propensity to consume out of income, and a low marginal propensity to consume out of wealth, which we try to spread out evenly over our lifetimes. It emphasizes the demographic aspect of saving behavior peoples tendency to borrow against their future income when they are young, save for retirement when they are older, and to live off of their savings after they retire. The permanent income theory suggests that people form expectations of the income they will receive over their lifetime, divide it by the number of years during which they expect to live, and consume an amount equal to that each period. When their actual income is below their 143 144 C HAPTER 13 permanent income , they borrow or draw down their savings. When their actual income exceeds their permanent income, they save. For this reason, temporary changes in peoples incomes do not affect their consumption very much; the benefits of a windfall gain today get spread out over an entire lifetime. It is interesting to note that, in both of these models, changes in peoples expectations either their expectations regarding their future income or their expectations regarding their time of death can strongly influence their consumption patterns....
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- Spring '09