Consumption

Outline briefly the permanent income and life cycle theories of consumption

These two theories offer explanations for the long-term behaviour of consumption. They are not competing, but complement each other; the permanent income hypothesis tries to explain the way in which individuals form expectations about their future incomes, and the life-cycle hypothesis explains the motives for saving and consumption over the course of an individual's life.
The permanent income hypothesis was developed by Milton Friedman in the 1950s. It argues that people base their consumption behaviour on their permanent or long-term income, and not the current level of income. In the short-run, incomes tend to fluctuate; however, this is not reflected in fluctuations in people's consumption patterns. Instead, they will save when income is temporarily high, and use this saving to support consumption when income is temporarily low. Thus overall consumption will be generally constant. This is because of diminishing marginal utility of consuming plenty in one time period, whereas by distributing so as to equate consumption over two time periods, the overall utility will be greater. To illustrate this, Friedman offers the example of someone who gets paid weekly on Friday. We would not expect that person to spend all of their money on the Friday and consume nothing on the other days. We expect the person to equate consumption on every day, rather than preferring plenty today and scarcity later. Friedman extrapolates by saying that income per quarter or year is not what the consumption decision is based upon; instead, it is based on longer periods of time.
The life-cycle hypothesis is similar to this, but instead says that consumption follows a pattern over the course of an individual's life, with people saving as they continue through their working life, and dissaving when their income falls as they retire. The individuals wish to allocate their consumption in the best possible way over the course of their entire lifetime. They will accumulate assets during the working life, and will begin to live off these assets when they retire. By the end of the person's life, they will have used up all of their assets; this includes any they wish to leave to their children. Consumption thus remains constant over the period of the person's lifetime. This can be illustrated in Diagram 1. The individual may also begin with inherited wealth; this will be used to support consumption in the early years.

Explain how the average aggregate propensity to consume would be affected by:

1) A faster than average rise for a year in personal disposable income.

Consumption will rise as the level of disposable income rises; however, people will not anticipate that the rise in income is a permanent one, and will return to the expected level during the next year. Thus in terms of the Keynesian cross diagram, the individual will shift along their consumption function to the new equilibrium level of income, but the consumption function will not shift up. Therefore, the average propensity to consume will initially fall as the equilibrium level of income is not on the 45 degree line. In the longer-run, because the increase is only a temporary one, people will move back to their initial position, and the average propensity to consume will increase to its initial level.

2) A rise in share prices.

Shares are counted as stocks of wealth, and thus an increase in their value will increase a person's stock of wealth. According to the life-cycle hypothesis, every year a fraction of a person's wealth is consumed, and consumption is partially dependent on a person's wealth. If people take profits, or expect the share price to remain high, then their consumption function will shift upwards, and the average propensity to consume will remain constant, as the new equilibrium level of national income will be on the 45 degree line. At every point on this line, the APC is constant; hence no change. This assumes that none of the extra income of cashed-in shares are saved. If some is saved, then APC will decline, as the increase in income is greater than the increase in consumption. If however, if people think the rise in share prices is only a temporary, then their consumption will be unchanged, and the APC will be unchanged. In terms of the aggregate APC, it is likely that at least some people will sell their shares and spend some of the proceeds, thus raising aggregate consumption. However, APC will remain unchanged if all of the increase is spent; with some saved, it will decline.

3) A rise in interest rates.

There are two possibilities here. A rise in interest rates will increase the return for savers, so it might be thought that it would increase savings and reduce consumption. This would lower the APC. However, when saving is more attractive, it is also less necessary. If a person decides on an amount that they wish to have available for their retirement, and are less interested in saving a proportion of their income, then with the higher interest rate, they do not need to save as much and will still have the target they set themselves available when they retire. Therefore, savings would fall, and consumption would rise. This would increase the APC. In reality, it is difficult to identify which of these happens; data collected does not suggest conclusively that either theory is correct.

4) A slowing down in the growth rate of the population.

When the rate of growth of the population slows, less investment is necessary to maintain the capital-labour ratio at a constant level per head, and thus there is greater output per head of the population. This will allow greater saving in the economy, and will thus reduce consumption. Thus APC will rise.

5) A fall in the level (relative to incomes) of the state pension.

The state pension provides income that will be consumes after retirement along with the accumulated assets that a person has saved over the course of their working life. A fall in the level of the state pension will mean that the expected level of income after retirement will also fall. People will either have to reduce their consumption when they retire (as they will have less to spend), or they will have to compensate during their working lives in order to build up the same stock of assets as they would have done with the pension at its higher level. Thus, this will mean saving more now, and thus consumption will fall. This will reduce the aggregate APC, as income will fall more than consumption due to the effects of the multiplier, which acts in reverse in this case.

6) The beginning of the National Lottery.

A National Lottery will increase overall consumption in a country for two reasons. Firstly, there is the effect of those actually playing the game. A successful lottery that encourages people to play every week in the hope of winning a prize will be an increase in consumption (assuming that the money now spent on the Lottery was previously saved; it could be that the amount spent on the Lottery is simply a reallocation of the consumer's expenditure, in which case their total consumption will remain unchanged). However, this is the minor effect. The major impact on consumption will be expansionary due to the large handouts it will give, both in terms of prize money and grants to good causes. Prize winners will spend some, if not most of their winnings, and the grants have to be spend and cannot be saved. Thus there will be large increases in aggregate consumption and national income. The effect on APC will be to decrease it.

This involves a redistribution of wealth from the poor to the rich. This could be caused by the rich getting richer and the poor either getting poorer or getting richer at a slower rate. As richer people have a lower marginal propensity to consume than poorer people, this will mean that among the rich, consumption will fall. If the poor are really getting poorer, i.e. their incomes are falling, they may increase consumption. It is difficult to see which effect will be dominant; if overall aggregate consumption falls, the APC will rise, and vice-versa. If, however, consumption among the poor remains unaltered, then overall consumption will certainly fall, leading to a rise in the APC.

Providing that people fully adjust to the changes, there should be no appreciable effect on permanent income; during periods where income is exceptionally high, people would (hopefully) recognise that this was only a temporary phenomenon, and that it may be followed by a period where income is lower than expected. In order to counter this, they must save more when income is very high, which will allow them to maintain their previous level of consumption during the periods when income is low. If, however, they fail to adjust, then when income falls to low levels, they will be left with fewer assets, and will be unable to maintain their previous level of consumption. Thus they will have to cut back; aggregate consumption will fall, and the APC will rise.

9) Banks and building societies being prepared to give second mortgages on houses.

A second mortgage will increase consumption for two reasons. Firstly, the mortgage allows money to be spent on consumption or perhaps investment, and secondly, it must also be paid back, which itself counts for a large amount of consumption demand. Hence, both the effects of the spending of the second mortgage and its repayment will raise consumption and the APC would fall as the equilibrium level of national income rose.

10) A belief that PDI was going to rise more rapidly in the future.

If people believed that this were going to happen, they could respond in one of two ways. They could either maintain the target of assets that they wish to accumulate for their retirement, and thus be free to spend the extra income that they anticipate. Pursuing this course of action would increase consumption, causing the APC to fall. However, they could also decide to increase their stock of assets for after their retirement; this would lead to an increase in savings. If all of the increase in income was treated this way, then there would be no change in consumption, but because income has risen, the APC would fall. The effect would be difficult to assess if some combination of increase in consumption and increase in saving out of the increase in income were chosen.