Consumption Function Essay

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16 Understanding Consumer Behavior MACROECONOMICS N. Gregory Mankiw Modified for EC 204 by Bob Murphy PowerPoint ® Slides by Ron Cronovich © 2013 Worth Publishers, all rights reserved IN THIS CHAPTER, YOU WILL LEARN: an introduction to the most prominent work on consumption, including: § John Maynard Keynes: consumption and current income § Irving Fisher: intertemporal choice § Franco Modigliani: the life-cycle hypothesis § Milton Friedman: the permanent income hypothesis § Robert Hall: the random-walk hypothesis § David Laibson: the pull of instant gratification 2 Keynes’s conjectures 1. 0 < MPC < 1 2. Average propensity to consume (APC ) falls as income rises. (APC = C/Y ) 3. Income is the main determinant of consumption. CHAPTER 16 Understanding Consumer Behavior The Keynesian consumption function C c 1 c = MPC = slope of the consumption function Y CHAPTER 16 Understanding Consumer Behavior 4 The Keynesian consumption function C As income rises, consumers save a bigger fraction of their income, so APC falls. slope = APC Y CHAPTER 16 Understanding Consumer Behavior 5 Early empirical successes: Results from early studies § Households with higher incomes: § consume more, ⇒ MPC > 0 § save more, ⇒ MPC < 1 § save a larger fraction of their income, ⇒ APC ↓ as Y ↑ § Very strong correlation between income and consumption: ⇒ income seemed to be the main determinant of consumption Understanding Consumer Behavior CHAPTER 16 Problems for the Keynesian consumption function § Based on the Keynesian consumption function, economists predicted that C would grow more slowly than Y over time. § This prediction did not come true: § As incomes grew, APC did not fall, and C grew at the same rate as income. § Simon Kuznets showed that C/Y was very stable from

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