Consumption Theories

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Economics 314 Coursebook, 2010

Jeffrey Parker

16 THEORIES OF CONSUMPTION AND
SAVING
Chapter 16 Contents
A.  Topics and Tools............................................................................. 1  B.  The Kuznets Paradox ....................................................................... 3  C.  Relative-Income Hypothesis .............................................................. 5  D.  Life-Cycle Model and Permanent-Income Hypothesis .............................. 7  Life-cycle model ............................................................................................................8  Permanent-income hypothesis ........................................................................................9  Permanent vs. temporary changes in income ................................................................. 11  The dangers of ignoring macroeconomists: A policy faux pas .......................................... 12  E.  Understanding Romer=s Chapter 7 ....................................................... 13  Empirical consumption functions ................................................................................. 13  Uncertainty, rational expectations, and consumption ..................................................... 14  Quadratic utility ........................................................................................................ 16  F. Empirical Tests of the Random-Walk Hypothesis.................................... 16  Testing the random-walk hypothesis............................................................................. 18  Later tests and excess sensitivity of consumption to income.............................................. 20  G.  Suggestions for Further Reading ........................................................ 23  Classic studies of consumption ..................................................................................... 23  Some recent advances .................................................................................................. 23  H.  Works Cited in Text ....................................................................... 23 

A. Topics and Tools
There is no topic in macroeconomics that has a longer, deeper, or more prominent literature than households’ choice of how much of their income to consume and save. As we saw earlier in the course, the theory of consumption is central to the model of

Keynes’s General Theory, which is often considered to be the origin of macroeconomics. Since then it has been the subject of countless theoretical and empirical studies. Keynes treated consumption on a very “common sense” level. Like most other economists of his day, his methodology included neither abstract, mathematical theory nor detailed econometrics. Rather he relied almost entirely on intuition, as he demonstrates when he introduces the central principle of his consumption theory in Chapter 8: The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge of human nature and from the detailed facts of experience, is that men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income. Keynes (1936) Keynes gives no basis for his theory in terms of utility maximization nor indeed gives any consideration of why a consumer would behave in the way he assumes. In place of rational-choice theory, Keynes relies on his “knowledge of human nature.” Nor does he give any support using numerical data, but instead claims to glean support from “detailed facts of experience.” How much economics has changed in seventy years! While Keynes placed consumption theory at the center of the macroeconomic stage, he left it for future generations of economists to work out the microeconomic basis for his theory and competing theories. Keynes also inspired pioneers in the emerging field of...
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