Summary EC 108 Consumption Review

Consumption

Keynesian consumption function

● 𝐶 = 𝐶0 + 𝐶1 𝑌
● Average propensity to consume falls as income rises as consumers save a
bigger fraction of their income
𝐶 𝐶0
○ 𝐴𝑃𝐶 = 𝑌 = + 𝐶1
𝑌
○ Income is the main determinant of consumption
● Households with higher incomes consume more (Marginal propensity to
consume > 0), save more (Marginal propensity to consume < 1) and save a
larger fraction of their income (falling average propensity to consume)
● There is a strong correlation between income and consumption
● There was a prediction that average propensity to consume would fall over
time as C would grow more slowly over time
○ This did not happen as C/Y was stable in the long run
● The consumption puzzle - on a macro scale, average propensity to consume
is constant but on a micro-scale, average propensity to consume falls over
time
● Current consumption depends on current income - a static model

The 2-period model / intertemporal choice

● Consumers are subject to an intertemporal budget constraint
○ Considers the present and the future
𝐶 𝑌
● 𝐶1 + 1+𝑟
2 2
= 𝑌1 + 1+𝑟
○ Saving in period 1 (S) = 𝑌1 − 𝐶1
■ S < 0 if the consumer borrows in period 1
𝐶2
○ Present value of lifetime consumption = 𝐶1 +
1+𝑟
𝑌
○ Present value of lifetime income = 𝑌1 + 1+𝑟
2


● Maximum consumption in period 2 = 𝑌2 + (1 + 𝑟)𝑌1 - if C1=0
𝑌
● Maximum consumption in period 1 = 𝑌1 + 1+𝑟
2


● Period 2 budget constraint - 𝑌2 + (1 + 𝑟)𝑆

Optimisation

● The marginal rate of substitution - the amount of c2 that the consumer would
be willing to substitute for one unit of c1
○ Higher at lower levels of consumption
○ Depends on the indifference curve
● At the optimal point, the MRS = 1+r