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Select Topics in Macroeconomics – 2018
Questions and Answers
Section A
Question 1
The Modigliani life-cycle theory of consumption was developed by Franco Modigliani in the 1950s.
Unlike the Keynesian consumption function, this theory accounts for the fact that that the future,
asset returns and expectations affect consumption.
This model implies that at the beginning of their lifetime, households plan out their future
consumption in all periods so as to maximise their expected discounted lifetime utility. In such a
model, households live for a long but finite number of periods. In each period, they consume goods,
earn an income by supply labour, and can use “assets” (e.g. Bonds) to perfectly “move” consumption
back and forth through time. We assume that households do not face liquidity constraints and are
fully rational and forward-looking. As a result, spending decisions depend on future income.
To simplify our analysis, we can assume that the interest rate is zero for all periods, that initial
wealth is B/P + K, and the individuals do not discount consumption in future periods. Then, under
these assumptions, the optimal consumption path for individuals mandates full consumption
smoothing, so that in each period:
1 𝐵 𝑤
𝐶 = [ + 𝐾 + 𝑅 𝐿]
𝑇 𝑃 𝑃
The average propensity to consume implied by this model is:
𝐵
1 𝑃 + 𝐾
𝐶 /𝑌 = [ 𝑤 + 𝑅]
𝑇 𝐿
𝑃
Thus, the APC falls with income ( 𝐿) in cross-sectional data. This is because if income increases in
just one period, the individual does not consume all of this within that period. This is because they
would prefer to smooth their consumption, and therefore allocate the additional income across all
future periods. On the other hand, in long-run aggregate time series if income increases in the long
term, then the individual will choose to consume all of that additional income in the current period.
Thus, over longer time horizons, wealth and income grow together, so that the APC is constant.
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
Select Topics in Macroeconomics – 2018
Questions and Answers
Section A
Question 1
The Modigliani life-cycle theory of consumption was developed by Franco Modigliani in the 1950s.
Unlike the Keynesian consumption function, this theory accounts for the fact that that the future,
asset returns and expectations affect consumption.
This model implies that at the beginning of their lifetime, households plan out their future
consumption in all periods so as to maximise their expected discounted lifetime utility. In such a
model, households live for a long but finite number of periods. In each period, they consume goods,
earn an income by supply labour, and can use “assets” (e.g. Bonds) to perfectly “move” consumption
back and forth through time. We assume that households do not face liquidity constraints and are
fully rational and forward-looking. As a result, spending decisions depend on future income.
To simplify our analysis, we can assume that the interest rate is zero for all periods, that initial
wealth is B/P + K, and the individuals do not discount consumption in future periods. Then, under
these assumptions, the optimal consumption path for individuals mandates full consumption
smoothing, so that in each period:
1 𝐵 𝑤
𝐶 = [ + 𝐾 + 𝑅 𝐿]
𝑇 𝑃 𝑃
The average propensity to consume implied by this model is:
𝐵
1 𝑃 + 𝐾
𝐶 /𝑌 = [ 𝑤 + 𝑅]
𝑇 𝐿
𝑃
Thus, the APC falls with income ( 𝐿) in cross-sectional data. This is because if income increases in
just one period, the individual does not consume all of this within that period. This is because they
would prefer to smooth their consumption, and therefore allocate the additional income across all
future periods. On the other hand, in long-run aggregate time series if income increases in the long
term, then the individual will choose to consume all of that additional income in the current period.
Thus, over longer time horizons, wealth and income grow together, so that the APC is constant.
