Dependence of Consumption on Wealth, not Income

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Neutrality

• Other than its contribution to a consumer’s wealth, current income has no independent effect on the consumption of a utility-maximizing consumer.

Wealth- The value of current assets plus the discounted value of future earnings

Friedman’s View

• Friedman’s view is in support of the neutrality

• Friedman looks at the two-period Irving Fisher model U(c1,c2), which looks at a consumer’s spending over two periods

C1 = current consumption in the first period

C2 = consumption in the second period

• When maximizing U(c1,c2) a dollar earned in period 1 has the same effect on current consumption as an equivalent discounted dollar earned in period 2. Therefore, consumption will depend solely on the discounted value of current and future income and the interest rate.

Permanent Income- the amount of wealth that can be spent without its depletion

Permanent Income Hypothesis- consumption is affected by permanent, not current income

Keynes’ View

• Keynes’ work came before Friedman’s, and is contradictory of the neutrality

• Keynes believes that current income does have a direct effect on current consumption

Fundamental Psychological Law- “men are disposed, as a rule and on the average, to increase their consumption as income increases, but not by as much as the increase in income.” (Keynes, The General Theory)

Keynes also believed that other components of wealth (expected future income and interest rate) affected current consumption; however, consumption is more sensitive to changes in current income

Testing the Theories

Campbell and Mankiw (1989)

• Tests Friedman’s view that consumption depends solely on wealth, and a simplified Keynes view that consumption depends solely on current income

λ= people who act like Keynes

(1-λ)= people who act like Friedman

• The experiment estimates λ by finding the percent of consumers that “overreact to changes that would be predictable from past changes in income and consumption.” The experiment finds λ to be 40 to 50 percent depending on the number of periods used in the experiment. This suggests a deviation from Friedman and the neutrality.

Explaining the Deviation

• Textbooks are a good indication of how many economists explain the deviation from Permanent Income Hypothesis. According to Akerlof, the standard textbook explains the violation of the neutrality by frictions, not by a missing consumer motivation

Dornbusch and Fischer (1987)- “Given that the permanent income hypothesis is correct, there are two possible explanations.”

1. Liquidity constraints for consumers

2. Myopia in consumers projections of future income

Using Norms: An Alternative Possibility

The problem is not with consumers, but with the utility function itself. Economists have left out necessary components of utility functions. These components relate to “how people think they should or should not behave.” In other words, consumer's views on how much they should consume will affect the consumption function. These views easily explain the excess dependence of current consumption on current income. “It is natural for people to think that they can consume more if they deserve it, and an increase in their current income gives the most natural reason why they might deserve more.” This view has also been supported by real world evidence. For example, the fact that people paid monthly will spend more in the aftermath of a pay-day than over the rest of the month (Huffman and Barenstein, 2003). Also, when people reach a milestone, they tend to think they deserve a celebration.

The Missing Motivations in Macroeconomics | Ricardian Equivalence | The Modigliani-Miller Theorem | Natural Rate Theory | Rational Expectations