The consumption of nondurables and services comes close to measuring a flow of consumption services. Excess variability of aggregate consumption relative to aggregate income. Even though consumption is smoother than income, consumption is not quite smooth enough tomatch the theory. Two possible explanations for the excess variability in consumptionoImperfections in the credit market Theory assumes consumer can smooth consumption by borrowing or lending at the market real interest rate. Reality - consumers cant borrow all they want the the market interest rate. Interest rates are typically higher. Less ability to smooth consumption oWhen all consumers are trying to smooth consumption in the same way simultaneously, this will change market prices. Increase in Future Income Expected increase in future income, the consumer acts to smooth consumption over time. Increase in future income leads to smoothing backward, with the consumer saving less in the current period so that current consumption can increase. Increases lifetime wealth. Temporary and Permanent Changes in Income Milton Friedman --> permanent income hypothesis. oPrimary determinant of a consumers current consumption is their permanent income oTemporary changes in income --> small changes in permanent income/current consumption. oPermanent changes in income --> large effects on permanent income/current consumption. We can show this by examining a change in income in current period, and the current and futureperiod. Example --> temporary tax cut (small increase in consumption. Permanent tax cut (large increasein consumption)
Increase in the Real Interest Rate How consumer responds to a change in the real interest rate. oWill change the slope of the budget constraint. (1/1+r) is the relative price of future consumption goods in terms of current consumption goods. A change in the real interest rate will also have income and substitution effects in its influence onconsumption. If the real interest rate increases, with taxes and income held constant --> budget constraint will be steeper. Lifetime wealth will decrease (we) We(1+r) = (y-t)(1+r) + y' -t' A change in r results in a change in the relative price of consumption in the current and future periods. oFuture consumption becomes cheaper relative to current. oReturn on savings is higher An increase in the real interest rate causes the lifetime budget constraint of the consumer to become steeper and to pivot around the endowment point. Intertemporal substitution effect Increase in the real interest rate Borrowers and lendershigher real interest rate lowers the relative price of future consumption in terms of current consumption. Substitution of future consumption for current consumption = increase savings. Consumption will decrease for each borrower when the real interest rate goes up, the consumption on lenders will thus depend on the strength of opposing income and substitution effects.