People are myopic: Most skeptics argue that even though
the proposition predicts that consumers will not increase
consumption when taxes are cut, in reality lower taxes
are likely to increase consumption and decrease saving
as it is likely that most consumers do not understand
that the increase in government borrowing today is
likely to lead to higher taxes in the future. Hence,
consumers may respond to the current tax cut as they
would respond to any increase in current income by
increasing consumption.
Presence of a liquidity constraint: An underlying
assumption of the Ricardian theory is the existence of
perfect capital markets i.e. the ability for individuals to
borrow and save whenever they want.
Advocates of the traditional view argue that many
people cannot borrow. They would like to consume
more today, but because of liquidity constraints, they
are constrained to consuming less than they would want
according to their permanent income. Therefore a tax
cut for these people eases their liquidity constraint and
allows them to consume more.
Tuesday, June 3, 2008
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Saturday, May 31, 2008
Barro assumptions
Barro assumptions
For it to work, this needs several conditions, most commonly:
A perfect capital market where any household can
borrow or save as much as is required at a fixed rate
which is the same for all persons at a given date.
The path of government spending is fixed
Intergenerational concern. Ricardian equivalence only
happens when the current generation has some concern
for all future generations, even if not a perfect concern.
These assumptions are widely challenged.
For it to work, this needs several conditions, most commonly:
A perfect capital market where any household can
borrow or save as much as is required at a fixed rate
which is the same for all persons at a given date.
The path of government spending is fixed
Intergenerational concern. Ricardian equivalence only
happens when the current generation has some concern
for all future generations, even if not a perfect concern.
These assumptions are widely challenged.
Barro-Ricardian argument
Barro-Ricardian argument:
As the government has not changed its spending, the cut in
taxes today means that the government must have increased its
current borrowing (by selling bonds). As the government debt
has to be repaid with interest in the future, future taxes will be
higher which implies lower future disposable income.
Therefore although taxpayers would have more money now,
they realize that they would have to pay higher taxes in the
future. Therefore instead of spending more now they will save
the extra money in order to pay the future tax. The extra
saving by consumers would exactly offset the extra spending
by the government, so overall demand would remain
unchanged.
The idea that tax cuts do not affect desired consumption and
therefore also do not affect ational saving is called the
Ricardian Equivalence proposition
Barro-Ricardo Equivalence
Barro-Ricardo Equivalence - “Are Government Bonds
Net Wealth?”
Basic Idea behind the Barro-Ricardian Equivalence:
An economic theory that suggests that a debt-financed tax cut
(government budget deficits) aimed at stimulating demand do
not affect the total level of demand in the country even in the
short run.
Traditional view on Government Debt:
Traditionally it is believed that a debt-financed tax cut will
stimulate consumption as the reduction in tax raises disposable
income. (unless the economy is already operating at full
employment).
Net Wealth?”
Basic Idea behind the Barro-Ricardian Equivalence:
An economic theory that suggests that a debt-financed tax cut
(government budget deficits) aimed at stimulating demand do
not affect the total level of demand in the country even in the
short run.
Traditional view on Government Debt:
Traditionally it is believed that a debt-financed tax cut will
stimulate consumption as the reduction in tax raises disposable
income. (unless the economy is already operating at full
employment).
APC
APC therefore depends on the ratio of Yp to current income.
In the short run, if high current income temporarily rises above
permanent income, APC will fall as consumption increases only
with YP. Vice versa when current income temporarily falls
below permanent income, APC will be high.
APC is high when income is low and APC is low when income is high.
However, over a long period of time, changes in income
come from the permanent income component as transitory
income will tend to zero. Hence, in long run time series data,
APC will be stable.
In the short run, if high current income temporarily rises above
permanent income, APC will fall as consumption increases only
with YP. Vice versa when current income temporarily falls
below permanent income, APC will be high.
APC is high when income is low and APC is low when income is high.
However, over a long period of time, changes in income
come from the permanent income component as transitory
income will tend to zero. Hence, in long run time series data,
APC will be stable.
Milton Friedman’s Permanent Income Hypothesis
Milton Friedman’s Permanent Income Hypothesis
Like Modigliani, Friedman argued that consumption is related
not to current income but to a longer term estimate of income,
which Friedman terms as “permanent income”. But the PIH is
different from the LCH in that while income follows a regular
pattern over a person’s lifetime in the LCH, the PIH
emphasizes that people experience temporary and random
changes in their income year after year.
Friedman argued that a person’s current income (Y) can be
decomposed into two parts (i) permanent income (Yp) and (ii)
transitory income (Yt). Yp is the income that people expect to
persist into their future (long term income). Yt is unexpected
income/windfall.
Although income fluctuates, people generally rather have a
constant standard of living though time. For people to avoid
fluctuations in their consumption, Friedman argued that
consumption should mainly depend on Yp rather than Yt
because in the latter people will have to borrow and save to
smooth their consumption over time.
Like Modigliani, Friedman argued that consumption is related
not to current income but to a longer term estimate of income,
which Friedman terms as “permanent income”. But the PIH is
different from the LCH in that while income follows a regular
pattern over a person’s lifetime in the LCH, the PIH
emphasizes that people experience temporary and random
changes in their income year after year.
Friedman argued that a person’s current income (Y) can be
decomposed into two parts (i) permanent income (Yp) and (ii)
transitory income (Yt). Yp is the income that people expect to
persist into their future (long term income). Yt is unexpected
income/windfall.
Although income fluctuates, people generally rather have a
constant standard of living though time. For people to avoid
fluctuations in their consumption, Friedman argued that
consumption should mainly depend on Yp rather than Yt
because in the latter people will have to borrow and save to
smooth their consumption over time.
individual’s lifetime resources
What’s the individual’s lifetime resources?
- His initial wealth
- His life time earnings
Since the individual tries to consume the same amount each
year, he will divide this lifetime resources equally among his
remaining T years of life.
In the short run, when wealth is a constant, the consumption
function of the LCH looks like the Keynesian function. In the
long run, as wealth increases it caused the consumption
function to shift upwards and when this happens, APC does not
decline when income increases.
Modigliani’s LCH also predicted that savings varies over a
person’s lifetime. Consumption plans are made so as to achieve
a smooth or even level of consumption by saving during periods
of high income and dissaving during period of low income.
Assuming a person begins adulthood with no wealth, he will
accumulate wealth (through savings) during his working years.
He runs down his wealth during his retirement years. This
means that he will then be dissaving in such a way that his
assets will be zero at the end of his life.
Franco Modigliani ‘s Life Cycle Hypothesis (LCH)
Franco Modigliani ‘s Life Cycle Hypothesis (LCH)
Basic Idea:
The LCH of consumer behavior emphasizes that (i) income
varies systematically over people’s lives and (ii) saving allow
consumers to move income from those time in life when income
is high to those times when income is low.
Example to illustrate the LCH - Assumptions:
Assuming that a person has an initial wealth (W); he expects to
live another T years; and expects to earn income Y until he
retires R years from now.
Basic Idea:
The LCH of consumer behavior emphasizes that (i) income
varies systematically over people’s lives and (ii) saving allow
consumers to move income from those time in life when income
is high to those times when income is low.
Example to illustrate the LCH - Assumptions:
Assuming that a person has an initial wealth (W); he expects to
live another T years; and expects to earn income Y until he
retires R years from now.
Effect of an increase in r
Effect of an increase in r can be decomposed into:
Substitution Effect –
Increase in r makes Cc more expensive comparef to Cf
- decrease in Cc and an increase in Cf.
Income Effect –
Consumer is better off in this instance since he is a saver
and hence a lender rather than a borrower and can
therefore go to a higher indifference curve. If Cc and
Cf are normal goods then there will be an increase in
both Cc and Cf.
Overall the increase in r - increase in Cf but we are not
quite sure about Cc as it depends on whether the
substitution or income effect is stronger.
Conclusion
Where the consumer will be depends on his preferences as
well as the budget constraint. The diagram above illustrates a
case where the individual saves in the current period and
consumes more in the future.
Note that (i) changes in Yc or Yf affects the position of
the budget line as it changes the present value of income; while
changes in interest rate affects the slope of the budget
constraint.
Conclusion:
Regardless of whether it is Yc or Yf that increases, the
consumer spreads it over consumption in both periods (this is
called consumption smoothing) i.e. Cc and Cf increases so long
as both are normal goods. [Implication Cc depends not just on
Yc but on a person’s income over his lifetime].
Optimization
Optimization
The aim of the consumer is to maximize his satisfaction.
Consumer satisfaction is maximized when the highest IC is
tangent to the budget constraint.
At this point of tangency:
MRS = slope of the budget constraint
What this means is that what the consumer is willing to do is
equal to what it costs him. If it is not equal, the consumer can
always increase his utility by substituting.
The Intertemporal Budget Constraint
The Intertemporal Budget Constraint
In the current period
S = Yc – Cc
In the future period
Cf = (1+r)S + Yf
Cf = (1 + r) (Yc-Cc) + Yf
The equation tells us that the present value of his lifetime
consumption is equal to the present value of lifetime income.
Consumer Preferences
People’s preferences are represented by indifference curves. The
IC in this instance shows the combinations of Cc and Cf that
gives the consumer the same level of satisfaction
The slope of the IC is the marginal rate of substitution (MRS). In
this instance it indicates the individual’s willingness to substitute
Cf for Cc. Secondly, higher IC curves are preferred to lower
ones.
Saturday, May 24, 2008
Irving Fisher and Intertemporal Choice
Irving Fisher and Intertemporal Choice
Contrary to Keynes, who related consumption to
current income, Fisher’s model showed how rational forward
looking consumers chooses consumption for the present and
future to maximize their lifetime satisfaction.
To illustrate Fisher’s intertemporal choice, let’s assume
that an individual’s lifetime is made up of two time
periods, current (c) future(f); (ii) the individual has a current
income (Yc) and a current consumption (Cc) as well as a future
income (Yf) and a future consumption (Cf); (iii) the individual
can borrow or save in the first period at the same real interest rate
( r), which is positive.
Contrary to Keynes, who related consumption to
current income, Fisher’s model showed how rational forward
looking consumers chooses consumption for the present and
future to maximize their lifetime satisfaction.
To illustrate Fisher’s intertemporal choice, let’s assume
that an individual’s lifetime is made up of two time
periods, current (c) future(f); (ii) the individual has a current
income (Yc) and a current consumption (Cc) as well as a future
income (Yf) and a future consumption (Cf); (iii) the individual
can borrow or save in the first period at the same real interest rate
( r), which is positive.
Friday, May 23, 2008
Keynesian Consumption Function 3
These early findings supported Keynes conjectures about
consumption. But in the 1940s, two anomalies arose – both of
which were inconsistent with Keynes conjecture that APC falls
as income increases.
(1) Contrary to Keyes theory, a secular stagnation did not
result at the end of WWII as APC did not decline as income
rose.
(2) Simon Kuznets found (based on data on consumption
and income for a long period between 1869 – 1940s) that
consumption was in fact stable in spite of rising income i.e.
APC was relatively stable in long periods.
Evidences therefore showed that there are two consumption
functions – a short term consumption function (which
seemed to confirm Keynes conjectures) and a long-run
consumption function in which the APC was constant at
different levels of income. This difference between APC in the
short run and the long run became known as the consumption
puzzle.
This consumption puzzle – that the short-run and cross-
sectional consumption functions looked very different from the
long-term consumption function resulted in the development
of alternative theories of consumption.
consumption. But in the 1940s, two anomalies arose – both of
which were inconsistent with Keynes conjecture that APC falls
as income increases.
(1) Contrary to Keyes theory, a secular stagnation did not
result at the end of WWII as APC did not decline as income
rose.
(2) Simon Kuznets found (based on data on consumption
and income for a long period between 1869 – 1940s) that
consumption was in fact stable in spite of rising income i.e.
APC was relatively stable in long periods.
Evidences therefore showed that there are two consumption
functions – a short term consumption function (which
seemed to confirm Keynes conjectures) and a long-run
consumption function in which the APC was constant at
different levels of income. This difference between APC in the
short run and the long run became known as the consumption
puzzle.
This consumption puzzle – that the short-run and cross-
sectional consumption functions looked very different from the
long-term consumption function resulted in the development
of alternative theories of consumption.
Friday, May 16, 2008
Keynesian Consumption Function 2
APC falls as income increases as /Y falls. The fact that
APC falls as income increases implies that consumers are
saving a bigger proportion of their income.
Following the publication of Keynes general theory, a great
deal of work was carried out to either prove or disprove the
ideas contained within the theory. Year to year surveys on
households found that:
(i) richer households consumed more than poorer ones;
(ii) richer households saved more than poorer ones; and that
(iii) richer household saved a greater fraction of their income
Thursday, May 15, 2008
Keynesian Consumption Function
Keynesian Consumption Function (Absolute Income
Hypothesis)
Keynes had 3 conjectures about consumption:
(i) Income (Y) is the predominant determinant of
consumption (C);
(ii) MPC is positive but less than 1, indicating that C
increases whenever income increases but the increase
in C is less than the increase in Y;
The ratio of consumption to income i.e. the APC falls
as Y increases.
The Keynesian consumption function is usually expressed as:
C = + cY
Where : = autonomous consumption
c = MPC
Y = current aggregate disposable income
Hypothesis)
Keynes had 3 conjectures about consumption:
(i) Income (Y) is the predominant determinant of
consumption (C);
(ii) MPC is positive but less than 1, indicating that C
increases whenever income increases but the increase
in C is less than the increase in Y;
The ratio of consumption to income i.e. the APC falls
as Y increases.
The Keynesian consumption function is usually expressed as:
C = + cY
Where : = autonomous consumption
c = MPC
Y = current aggregate disposable income
Wednesday, May 14, 2008
Consumption 2
Consumption is a major component AD. Therefore to
understand the forces that affect AD, we need to understand
what drives consumption. Secondly, consumption is the flip-
side of savings and the latter matters for capital accumulation
and growth.
1.3 Up to this point in time, we have assumed that
consumption and saving are dependent only on the current
level of income. We will now look at the newer models on
consumption, models which take expectations into account.
1.4. But first let’s review Keynes consumption theory before
proceeding to look at the consumption theories of Irving Fisher,
Franco Modigliani and Milton Friedman.
understand the forces that affect AD, we need to understand
what drives consumption. Secondly, consumption is the flip-
side of savings and the latter matters for capital accumulation
and growth.
1.3 Up to this point in time, we have assumed that
consumption and saving are dependent only on the current
level of income. We will now look at the newer models on
consumption, models which take expectations into account.
1.4. But first let’s review Keynes consumption theory before
proceeding to look at the consumption theories of Irving Fisher,
Franco Modigliani and Milton Friedman.
Tuesday, May 13, 2008
Consumption 1
Background
One of the major concerns of Macroeconomics is about
why output fluctuates or economic growth is uneven. An
understanding of what causes output to fluctuate will in turn
give us a better understanding of the appropriate measures
that could be used to help stabilize the economy.
You will recall that:
(i)
AD = C + I +G (for a closed economy); and
AD = C + I + G + NX (for an open economy)
(ii)
Equilibrium is achieved when aggregate demand is equal to
aggregate output
Y = AD = C + I + G (for a closed economy);
Y = AD = C + I + G + NX (for an open economy)
One of the major concerns of Macroeconomics is about
why output fluctuates or economic growth is uneven. An
understanding of what causes output to fluctuate will in turn
give us a better understanding of the appropriate measures
that could be used to help stabilize the economy.
You will recall that:
(i)
AD = C + I +G (for a closed economy); and
AD = C + I + G + NX (for an open economy)
(ii)
Equilibrium is achieved when aggregate demand is equal to
aggregate output
Y = AD = C + I + G (for a closed economy);
Y = AD = C + I + G + NX (for an open economy)
Tuesday, April 29, 2008
Welcome to My Macroeconomics
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