MACRO CH 13

Tasha Singh
April 2024

1 **Consumption Under Uncertainty:**

Consumption behavior is a central aspect of economic analysis, as it constitutes
a significant portion of aggregate demand and GDP. Traditional Keynesian mod-
els often assumed a high marginal propensity to consume (MPC), implying that
changes in income lead to proportional changes in consumption. Mathemati-
cally, this can be represented as ∆C = M P C × ∆Y , where ∆C is the change in
consumption and ∆Y is the change in income. However, modern theories rec-
ognize that the relationship between consumption and income is more nuanced.
For instance, the permanent income hypothesis (PIH) suggests that individuals
base consumption decisions on their expected lifetime income rather than cur-
rent income levels alone. This implies that individuals may save during periods
of high income to maintain consumption levels during periods of low income,
leading to a more stable pattern of consumption over time.
Incorporating these concepts into models of consumption dynamics requires
accounting for both permanent and transitory components of income. The life-
cycle hypothesis (LCH) posits that individuals aim to maintain stable consump-
tion levels over their lifetime, adjusting spending based ontheir expected lifetime 
income. Mathematically, this can be expressed as Ct = β Yt + Y1+r t+1 Yt+2
+ (1+r) 2 + ... ,

where Ct is consumption at time t, Yt is income at time t, r is the discount rate,

and β represents the marginal propensity to consume out of permanent in-
come. This framework suggests that individuals prioritize maintaining a steady
standard of living over time, smoothing consumption in response to changes in
income.
However, empirical evidence suggests that individuals may not perfectly
smooth consumption in response to income fluctuations. Instead, consumption
may be influenced by factors such as liquidity constraints, myopia, and uncer-
tainty. Liquidity constraints arise when individuals are unable to borrow against
future income to smooth consumption during periods of low income. Myopia
refers to the tendency of individuals to focus on short-term consumption needs
rather than long-term financial planning. Addressing these challenges requires
incorporating behavioral insights into economic models of consumption, allow-
ing for a more nuanced understanding of how individuals make consumption
decisions in the face of uncertainty and income volatility.

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1.1 **2. Life-Cycle Theory and Permanent-Income The-
ory:**
The life-cycle theory of consumption posits that individuals aim to smooth
consumption over their lifetime, adjusting spending based on their expected
lifetime income. This implies that individuals save during periods of high in-
come to maintain consumption levels during periods of low income, such as
retirement.
 Mathematically, the life-cycle model can be represented as Ct =
Yt+1 Yt+2
β Yt + 1+r + (1+r)2 + . . . , where Ct is consumption at time t, Yt is income
at time t, r is the discount rate, and β represents the marginal propensity to
consume out of permanent income.
Permanent-income theory, on the other hand, suggests that consumption
decisions are based on longer-term expectations of income rather than current
income levels alone. Individuals smooth consumption over time, anticipating
changes in income and adjusting spending accordingly. This implies that indi-
viduals may save during periods of high income to maintain consumption levels
during periods of low income, leading to a more stable pattern of consumption
over time. Mathematically, the permanent-income model can be represented as
Ct = βYp , where Ct is consumption at time t, Yp is permanent income, and β
represents the marginal propensity to consume out of permanent income.
Both theories provide valuable insights into how individuals make consump-
tion decisions over their lifetime. By considering the interplay between perma-
nent and transitory income, as well as the role of expectations and forward-
looking behavior, economists can develop more accurate models of consumption
dynamics that capture the complexity of individual decision-making.

1.2 **3. Liquidity Constraints, Myopia, and Buffer-Stock

Saving:**
Challenges to modern consumption theories include liquidity constraints, my-
opia, and the need for buffer-stock saving. Liquidity constraints arise when
individuals are unable to borrow against future income to smooth consumption
during periods of low income. This can lead to deviations from the predictions
of the life-cycle hypothesis and permanent-income theory, as individuals may be
forced to reduce consumption during times of financial distress. Mathematically,
liquidity constraints can be incorporated into consumption models by introduc-
ing a borrowing constraint, such as Ct ≤ Yt + Bt , where Ct is consumption at
time t, Yt is income at time t, and Bt represents borrowing.
Myopia refers to the tendency of individuals to focus on short-term con-
sumption needs rather than long-term financial planning. This can lead to sub-
optimal consumption decisions, as individuals may fail to adequately save for
retirement or other long-term goals. Addressing myopia requires interventions
that encourage individuals to consider their future financial needs and prioritize
saving accordingly. Behavioral economics offers insights into the factors that in-
fluence myopic behavior, allowing policymakers to design effective interventions

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to promote long-term financial security.
Buffer-stock saving serves as a mechanism to mitigate income uncertainty,
with individuals accumulating assets to safeguard against future downturns in
income or unexpected expenses. Empirical evidence suggests that saving behav-
ior may vary across different stages of life, with younger individuals prioritizing
buffer-stock saving to build financial resilience and older individuals focusing on
retirement planning. By understanding the factors that influence saving behav-
ior, policymakers can develop targeted policies to promote saving and financial
stability across different demographic groups.

1.3 Empirical Evidence and Challenges:

Empirical studies examining consumption behavior provide mixed evidence re-
garding the validity of different consumption theories. While some findings
support the idea of consumption smoothing and forward-looking behavior, oth-
ers suggest that households may exhibit varying degrees of sensitivity to income
changes. Challenges in empirical research include accurately identifying and
measuring the relevant factors influencing consumption decisions, as well as
addressing potential biases and limitations in data sources. Additionally, indi-
vidual preferences, attitudes toward risk, and cultural norms can further com-
plicate the relationship between income and consumption, making it challenging
to generalize findings across different populations and contexts.

1.4 International Differences in Saving Behavior:

Cross-country variations in saving rates highlight the influence of economic,
social, and cultural factors on consumption behavior. Some countries exhibit
high saving rates driven by cultural norms that prioritize saving for the future
or government policies that encourage personal saving through tax incentives
or mandatory retirement savings programs. In contrast, other countries may
have lower saving rates due to factors such as easier access to credit, demo-
graphic trends favoring consumption over saving, or robust social safety nets
that reduce the need for precautionary saving. Understanding these interna-
tional differences in saving behavior requires considering a range of factors, in-
cluding demographics, income distribution, financial market development, and
institutional frameworks governing saving and investment. By examining these
factors, policymakers and economists can better understand the drivers of sav-
ing behavior and develop strategies to promote sustainable economic growth
and financial stability.

1.5 **4. Barro-Ricardo Problem:**

The Barro-Ricardo equivalence proposition, named after economists Robert
Barro and David Ricardo, posits that deficits financed by government bonds
are equivalent to future tax liabilities and do not affect current consumption

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behavior. Mathematically, this proposition suggests that an increase in govern-
ment borrowing today will lead individuals to anticipate higher future taxes,
prompting them to save more to offset the expected tax burden. Consequently,
any increase in government spending today will be offset by an equivalent re-
duction in private consumption, resulting in no net effect on aggregate demand
or economic activity.
However, empirical evidence and theoretical objections challenge the Barro-
Ricardo equivalence proposition. Critics argue that individuals may not fully
anticipate future tax liabilities or adjust their saving behavior in response to
changes in government borrowing. Additionally, the proposition assumes that
households are forward-looking and rational in their consumption decisions,
which may not always hold true in practice. Behavioral factors, such as my-
opia and uncertainty, can lead to deviations from the predictions of the Barro-
Ricardo equivalence proposition, highlighting the complexities of understanding
the relationship between deficits, saving, and consumption.

1.6 **5. International Saving Rates:**

Cross-country differences in saving rates reflect a combination of economic, so-
cial, and cultural factors that influence consumption behavior. Some countries
exhibit higher saving rates due to structural factors such as demographic trends,
borrowing opportunities, and cultural attitudes toward saving. For example,
countries with aging populations may have higher saving rates as individuals
save for retirement, while countries with young populations may have lower sav-
ing rates as individuals prioritize consumption over saving. Additionally, access
to credit and the availability of social safety nets can impact saving behavior,
with countries offering more extensive welfare programs potentially experiencing
lower saving rates.
Cultural attitudes toward saving also play a significant role in determining
international saving rates. In some societies, saving is deeply ingrained in cul-
tural norms, leading individuals to prioritize saving for future financial security.
Government policies, such as tax incentives for saving or mandatory savings
programs, can further influence saving behavior and contribute to cross-country
variations in saving rates. Understanding the factors driving international dif-
ferences in saving rates is essential for policymakers seeking to promote saving
and financial stability at both the national and global levels. By identifying
the structural, demographic, and cultural determinants of saving behavior, pol-
icymakers can develop targeted interventions to encourage saving and ensure
long-term economic prosperity.

1.7 **1. Understanding Consumption and Income Dy-

namics:**
Consumption function in Keynesian economics:

C = c0 + c1 (Y − T )

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where: - C is consumption, - c0 is autonomous consumption, - c1 is the marginal
propensity to consume (MPC), - Y is income, and - T is taxes.
The life-cycle consumption function:
Yt − Tt Wt
Ct = +
1+r (1 + r)T

where: - Ct is consumption at time t, - Yt is income at time t, - Tt is taxes at

time t, - Wt is wealth at time t, - r is the discount rate, and - T is the remaining
lifespan.
**2. Life-Cycle Theory and Permanent-Income Theory:**
Life-cycle consumption function:
Yt − Tt Wt
Ct = +
1+r (1 + r)T

where the first term represents consumption out of current income and the
second term represents consumption out of wealth.
Permanent-income hypothesis equation:
Yp − T
C=
1+r
where: - Yp is permanent income, and - T is taxes.
**3. Liquidity Constraints, Myopia, and Buffer-Stock Saving:**
Buffer-stock saving equation:

at+1 = (1 + r)at + Yt − Ct

where: - at+1 is assets at time t + 1, - at is assets at time t, - Yt is income at

time t, - Ct is consumption at time t, and - r is the interest rate.
**4. Barro-Ricardo Problem:**
The Barro-Ricardo equivalence proposition:

∆Ct = ∆Gt

where: - ∆Ct is the change in consumption, - ∆Gt is the change in government

spending.
**5. International Saving Rates:**
Saving rate calculation:
Saving
Saving rate = × 100%
Income
where: - Saving is the amount saved, and - Income is the total income.

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1.8 CONCEPTUAL
1. **Why does the ratio of consumption to accumulated saving decline over
time until retirement, and what assumption about consumption behavior leads
to this result? What happens to this ratio after retirement?** The decline in
the ratio of consumption to accumulated saving over time until retirement is
driven by the life-cycle hypothesis, which posits that individuals aim to main-
tain a stable standard of living over their lifetime. This assumption suggests
that people prioritize saving during their working years to support consumption
during retirement when their earning capacity diminishes. As a result, the ra-
tio of consumption to accumulated saving decreases as individuals accumulate
wealth to prepare for retirement. After retirement, the ratio may increase as
individuals draw down their savings to sustain consumption levels with reduced
income.
2. **Suppose you earn just as much as your neighbor but are in much
better health and expect to live longer than she does. Would you consume
more or less than she does? Why? Derive your answer using the equation
from the text, C = f (W, L, Y ). According to the life-cycle hypothesis, what
would be the effect of the social security system on your average propensity
to consume out of (disposable) income? Is the credibility of the social security
system an issue here?** If you are in better health and expect to live longer than
your neighbor, you would likely consume less than she does. This is because
your higher longevity implies a longer time horizon for consumption planning,
leading you to prioritize saving more of your income to support consumption
over a longer lifespan. According to the life-cycle hypothesis, individuals base
their consumption decisions on their long-term estimates of income rather than
temporary fluctuations. Thus, your expectation of living longer influences your
consumption behavior.
The effect of the social security system on your average propensity to con-
sume out of disposable income depends on its credibility. If the system is credible
and provides reliable income support during retirement, it may reduce your need
to save for old age, potentially increasing your average propensity to consume
out of disposable income during your working years. However, the credibility of
the social security system can influence individuals’ saving and consumption de-
cisions, as doubts about future benefits may lead to higher precautionary saving
and lower current consumption.
3. **In terms of the permanent-income hypothesis, would you consume
more of your Christmas bonus if (a) you knew there would be a bonus every
year, or (b) this was the only year the bonus would be given?** According
to the permanent-income hypothesis, you would likely consume more of your
Christmas bonus if you knew there would be a bonus every year. The theory
suggests that individuals base their consumption decisions on their long-term
estimates of income rather than temporary fluctuations. If the bonus is expected
to recur annually, it would be considered part of your permanent income, leading
to increased consumption. Conversely, if the Christmas bonus was a one-time
occurrence, the permanent-income hypothesis suggests that you would consume

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less of it, as it would be perceived as transitory income, prompting individuals
to save a larger portion of it to smooth consumption over time.
4. **Explain why successful gamblers (and thieves) might be expected to live
very well even in years when they don’t do well at all.** Successful gamblers and
thieves might be expected to live well even in lean years due to their perceptions
of income volatility and risk tolerance. Both groups may exhibit confidence in
their abilities to generate income, leading them to maintain relatively high levels
of consumption regardless of short-term fluctuations in earnings. Additionally,
they may engage in precautionary saving during periods of success to mitigate
the impact of potential downturns, supporting their consumption during lean
times. Therefore, their consumption behavior may not align with traditional
income patterns but rather with their beliefs about future income prospects.
5. **What are the similarities between the life-cycle and the permanent-
income hypotheses? Do they differ in their approaches to explaining why
the long-run MPC is greater than the short-run MPC?** The life-cycle and
permanent-income hypotheses share similarities in their emphasis on individu-
als’ long-term income expectations in shaping consumption behavior. Both the-
ories suggest that individuals smooth consumption over time, adjusting spend-
ing based on anticipated changes in income. However, they differ in their ap-
proaches to explaining why the long-run marginal propensity to consume (MPC)
is greater than the short-run MPC. The life-cycle hypothesis emphasizes the role
of wealth accumulation and lifecycle stages, suggesting that individuals save
during working years to support consumption during retirement. In contrast,
the permanent-income hypothesis focuses on individuals’ perceptions of income
stability, arguing that consumption is based on long-term income expectations
rather than short-term fluctuations.
6. **The United States, during the 1980s, found its rate of personal saving
to be particularly low. It also, during that time, had a demographic blip—the
baby-boomer generation, then in its late 20s to early 30s. Does the life-cycle hy-
pothesis suggest a reason that these two facts might be connected? What does
this hypothesis suggest we should see as this generation ages?** The life-cycle
hypothesis suggests a connection between the low personal saving rate in the
United States during the 1980s and the demographic blip of the baby-boomer
generation entering its late 20s to early 30s. According to the hypothesis, indi-
viduals tend to save more during their working years to prepare for retirement,
resulting in a decline in the personal saving rate as a large cohort of baby
boomers entered their peak earning years. As this generation ages, the life-
cycle hypothesis predicts an increase in the personal saving rate as individuals
approach retirement and seek to build wealth for old age. This trend reflects the
lifecycle pattern of saving and consumption, with older individuals prioritizing
saving to support consumption during retirement.
7. **Rank the following marginal propensities to consume: (a) Marginal
propensity to consume out of permanent income. (b) Marginal propensity to
consume out of transitory income. (c) Marginal propensity to consume out
of permanent income when consumers are liquidity-constrained. (d) Marginal
propensity to consume out of transitory income when consumers are liquidity-

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constrained.** The ranking of marginal propensities to consume is as follows: -
Marginal propensity to consume out of permanent income. - Marginal propen-
sity to consume out of transitory income. - Marginal propensity to consume
out of permanent income when consumers are liquidity-constrained. - Marginal
propensity to consume out of transitory income when consumers are liquidity-
constrained. These rankings reflect the impact of different income compo-
nents and liquidity constraints on individuals’ consumption decisions. Marginal
propensities to consume out of permanent income are typically higher than those
out of transitory income, as permanent income represents a more reliable in-
dicator of future earning capacity. Liquidity constraints may further influence
consumption behavior, with constrained consumers exhibiting different propen-
sities to consume compared to unconstrained consumers.
8. **What is a random walk? How is Hall’s random-walk model of consump-
tion related to the life-cycle and permanent-income hypotheses?** A random
walk refers to a stochastic process where future values cannot be predicted based
on past observations, exhibiting random fluctuations over time. Hall’s random-
walk model of consumption suggests that individuals’ consumption decisions
follow a random walk pattern, reflecting their attempts to smooth consumption
over time in response to income uncertainty. This model is related to both
the life-cycle and permanent-income hypotheses, as it emphasizes the impor-
tance of income expectations and uncertainty in shaping consumption behavior.
However, it differs from these theories by focusing on the unpredictability of
consumption fluctuations rather than long-term income patterns.
9. **What are the problems
of excess sensitivity and excess smoothness? Does their existence disprove
or invalidate the LC-PIH? Explain.** Excess sensitivity and excess smoothness
refer to deviations from the predictions of the life-cycle-permanent-income hy-
pothesis (LC-PIH). Excess sensitivity occurs when consumption changes more
than income, indicating that individuals exhibit higher marginal propensities
to consume than predicted by the LC-PIH. Excess smoothness, on the other
hand, occurs when consumption changes less than income, suggesting that in-
dividuals smooth consumption too much relative to income fluctuations. The
existence of these phenomena does not necessarily disprove or invalidate the
LC-PIH but highlights its limitations in explaining all aspects of consumption
behavior. These deviations may arise due to factors such as liquidity constraints,
imperfect information, or behavioral biases, indicating areas where the theory
may need refinement or supplementation.
10. **What assumption(s) regarding consumers’ knowledge and behavior in
the life-cycle–permanent-income hypothesis do we need to change in order for it
to explain the presence of precautionary, or buffer-stock, saving? Do these as-
sumptions, in your opinion, bring the model closer to or further from the world
as you know it?** To explain the presence of precautionary, or buffer-stock,
saving within the life-cycle-permanent-income hypothesis (LC-PIH), we need to
relax the assumption of perfect foresight and certainty regarding future income.
In the traditional LC-PIH, individuals are assumed to have perfect knowledge
of their future income paths and behave rationally based on this information.

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However, by introducing uncertainty or imperfect information about future in-
come, individuals may engage in precautionary saving to mitigate the impact
of potential income shocks or adverse events. Relaxing the assumption of per-
fect foresight brings the model closer to real-world behavior by acknowledging
the role of uncertainty and risk aversion in shaping saving and consumption
decisions.
11. **Why does the interest rate affect saving, and has this relationship
been confirmed empirically?** a. The interest rate affects saving through its
impact on the opportunity cost of current consumption. Higher interest rates
incentivize saving by offering higher returns on saved funds, making it more at-
tractive to defer consumption and invest in interest-bearing assets. Conversely,
lower interest rates reduce the opportunity cost of current consumption, po-
tentially encouraging individuals to save less and consume more. b. Empirical
evidence generally supports the relationship between interest rates and saving,
although the magnitude of the effect may vary depending on other economic
factors and individual preferences. Higher interest rates tend to be associated
with higher saving rates, reflecting the interplay between interest rate incentives,
consumption preferences, and economic conditions.
12. **In the Barro-Ricardo view, does it make any difference whether the
government pays for its expenditures by raising taxes or issuing debt? Why?
What are the two main theoretical objections to the Barro-Ricardo view?**
a. In the Barro-Ricardo view, the method of financing government expendi-
tures, whether through raising taxes or issuing debt, does not affect individuals’
consumption behavior in the present period. According to this view, deficits
financed by issuing debt are equivalent to future tax liabilities, implying that
individuals anticipate future tax increases to repay government debt. Therefore,
individuals adjust their consumption and saving decisions based on their expec-
tations of future tax burdens rather than the current method of government
financing. b. The two main theoretical objections to the Barro-Ricardo view
are the Ricardian Equivalence Proposition and the Modigliani-Miller Theorem.
The Ricardian Equivalence Proposition posits that individuals fully internal-
ize the future tax implications of government deficits and adjust their saving
behavior accordingly, rendering government financing methods irrelevant for
consumption decisions. The Modigliani-Miller Theorem suggests that the value
of government debt and taxation is independent of the method of government
financing, challenging the notion that deficits financed by debt issuance impose
future tax burdens on households. These objections highlight the complexities
of government financing and its implications for individual behavior.

1.9 TECHNICAL
1. a. Your permanent income Y P is calculated as the average of your income
over the past five years. Given that you earned 20, 000peryearf orthepast10years, yourpermanentincomeiscalcu
Y P = 15 × (20, 000 + 20, 000 + 20, 000 + 20, 000 + 20, 000) = 15 × 100, 000 =
20, 000.b.If nextyear(periodt−1) you earn 30, 000, yournewpermanentincomeY P

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becomes:
1 1
YP = ×(20, 000+20, 000+20, 000+20, 000+30, 000) = ×110, 000 = 22, 000.
5 5
c. Your consumption this year and next year can be calculated using the given
consumption function C = 0.9 × Y P : - For this year: C = 0.9 × 20, 000 =
18, 000. - For next year: C = 0.9 × 22, 000 = 19, 800. d. The short-run marginal
propensity to consume (MPC) is the change in consumption divided by the
change in income for the next period:
∆C 19, 800 − 18, 000 1, 800
Short − runM P C = = = = 0.9.
∆Y 22, 000 − 20, 000 2, 000
The long-run MPC is the change in consumption divided by the change in
permanent income:
∆C 19, 800 − 18, 000 1, 800
Long − runM P C = = = = 0.9.
∆Y P 22, 000 − 20, 000 2, 000
e. To graph the value of permanent income in each period, we use the equation
Y P = 15 × (Y + Y1 + Y2 + Y3 + Y4 ), where Y = 30, 000 for all periods from t − 1
onwards.
2. a. To determine the level of consumption compatible with an even con-
sumption profile throughout the life cycle, we need to consider the budget con-
straint, which equates lifetime consumption to lifetime income minus savings.
Assuming no earnings during retirement, the individual saves during periods of
higher income and dis-saves during periods of lower income to maintain a smooth
consumption profile. b. If borrowing is not possible, the individual’s consump-
tion will be constrained by current income levels. Without the ability to borrow,
consumption may fluctuate more sharply in response to income changes, leading
to a less even consumption profile over the life cycle. c. With an increase in
wealth of 13, theallocationoverthelif ecyclewilldependonwhetherborrowingisallowed.If borrowingispossible, th
with a larger increase allowing for more significant consumption smoothing if
borrowing is permitted.
3. a. If 70 percent of the population behaves according to the traditional
model with an MPC of 0.8, and disposable income changes by 10million, consumptionwillchangeby0.8×
10million = 8million. b. If 70 percent of the population behaves according to
the LC-PIH, while 30 percent follows the traditional model, the overall change
in consumption would depend on the MPCs of each group and the magnitude
of income changes. c. If 100 percent of the population behaves according to
the LC-PIH, consumption changes would depend solely on the MPC associated
with permanent income changes.
4. a. An increase in the real interest rate from 2 to 4 percent increases the
opportunity cost of consuming today compared to tomorrow. This higher oppor-
tunity cost may incentivize individuals to save more of their income, leading to a
higher fraction of income saved. b. If the goal is to have 1millionsavedbyretirement, theindividualmayadjustth
5. To raise the rate of saving in the United States by 3 percentage points,
various policy measures could be implemented, including: - Implementing tax

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incentives for saving, such as tax deductions or credits for contributions to re-
tirement accounts. - Enhancing financial literacy and education to promote
saving habits among the population. - Implementing policies to increase access
to retirement savings plans, such as automatic enrollment in employer-sponsored
retirement plans. - Encouraging employer contributions to retirement savings
plans to incentivize employee saving. - Implementing government savings pro-
grams or incentives to encourage saving for specific goals, such as homeown-
ership or education. The preferred solution would depend on factors such as
effectiveness, feasibility, and alignment with broader economic goals and policy
objectives.

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