CH-16 Understanding Consumer Behavior – Macroeconomics : Book Guide

Answers to Textbook Questions and Problems CHAPTER 16 Understanding Consumer Behavior Questions for Review 1. First, Keynes conjectured that the marginal propensity to consume—the amount consumed out of an additional dollar of income—is between zero and one. This means that if an individual’s income increases by a dollar, both consumption and saving increase. Second, Keynes conjectured that the ratio of consumption to income—called the average propensity to consume—falls as income rises. This implies that the rich save a higher proportion of their income than do the poor. Third, Keynes conjectured that income is the primary determinant of consumption. In particular, he believed that the interest rate does not have an important effect on consumption. A consumption function that satisfies these three conjectures is C = C + cY. C is a constant level of “autonomous consumption,” and Y is disposable income; c is the marginal propensity to consume, and is between zero and one. 2. The evidence that was consistent with Keynes’s conjectures came from studies of household data and short time-series. There were two observations from household data. First, households with higher income consumed more and saved more, implying that the marginal propensity to consume is between zero and one. Second, higher-income households saved a larger fraction of their income than lowerincome households, implying that the average propensity to consume falls with income. There were three additional observations from short time-series. First, in years when aggregate income was low, both consumption and saving were low, implying that the marginal propensity to consume is between zero and one. Second, in years with low income, the ratio of consumption to income was high, implying that the average propensity to consume falls as income rises. Third, the correlation between income and consumption seemed so strong that no variables other than income seemed important in explaining consumption. The first piece of evidence against Keynes’s three conjectures came from the failure of “secular stagnation” to occur after World War II. Based on the Keynesian consumption function, some economists expected that as income increased over time, the saving rate would also increase; they feared that there might not be enough profitable investment projects to absorb this saving, and the economy might enter a long depression of indefinite duration. This did not happen. The second piece of evidence against Keynes’s conjectures came from studies of long time-series of consumption and income. Simon Kuznets found that the ratio of consumption to income was stable from decade to decade; that is, the average propensity to consume did not seem to be falling over time as income increased. 3. Both the life-cycle and permanent-income hypotheses emphasize that an individual’s time horizon is longer than a single year. Thus, consumption is not simply a function of current income. The life-cycle hypothesis stresses that income varies over a person’s life; saving allows consumers to move income from those times in life when income is high to those times when it is low. The lifecycle hypothesis predicts that consumption should depend on both wealth and income, since these determine a person’s lifetime resources. Hence, we expect the consumption function to look like C = αW + βY. In the short run, with wealth fixed, we get a “conventional” Keynesian consumption function. In the long run, wealth increases, so the short-run consumption function shifts upward, as shown in Figure 16-1. The permanent-income hypothesis also implies that people try to smooth consumption, though its emphasis is slightly different. Rather than focusing on the pattern of income over a lifetime, the permanent-income hypothesis emphasizes that people experience random and temporary changes in their income from year to year. The permanent-income hypothesis views current income as the sum of permanent income Yp and transitory income Yt. Milton Friedman hypothesized that consumption should depend primarily on permanent income: C = αYp. The permanent-income hypothesis explains the consumption puzzle by suggesting that the standard Keynesian consumption function uses the wrong variable for income. For example, if a household has high transitory income, it will not have higher consumption; hence, if much of the variability in income is transitory, a researcher would find that high-income households had a lower average propensity to consume. This is also true in short time-series if most of the year-to-year variation in income is transitory. In long time-series, however, variations in income are largely permanent; therefore, consumers do not save any increases in income, but consume them instead. 4. Fisher’s model of consumption looks at how a consumer who lives for two periods will make consumption choices in order to maximize total utility across the two time periods. Figure 16-2(A) shows the effect of an increase in second-period income if the consumer does not face a binding borrowing constraint. The budget constraint shifts outward, and the consumer increases consumption in both the first and the second period. In Figure 16-2(A), Y1 is the first period income and Y2 is second period income. In choosing to consume at point A or point B, the consumer is consuming more than their income in period 1 and less than their income in period 2. Figure 16-2(B) shows what happens if there is a binding borrowing constraint. The consumer would like to borrow to increase first-period consumption but cannot. If income increases in the second period, the consumer is unable to increase first-period consumption. Therefore, the consumer continues to consume his or her entire income in each period. That is, for those consumers who would like to borrow but cannot, consumption depends only on current income. 5. The permanent-income hypothesis implies that consumers try to smooth consumption over time, so that current consumption is based on current expectations about lifetime income. It follows that changes in consumption reflect “surprises” about lifetime income. If consumers have rational expectations, then these surprises are unpredictable. Hence, consumption changes are also unpredictable. 6. Section 16.6 included several examples of time-inconsistent behavior, in which consumers alter their decisions simply because time passes. For example, a person may legitimately want to lose weight, but decide to eat a large dinner today and eat a small dinner tomorrow and thereafter. But the next day, they may once again make the same choice—eating a large dinner that day while promising to eat less on following days. Problems and Applications 1. Figure 16-3 shows the effect of an increase in the interest rate on a consumer who borrows in the first period. The increase in the real interest rate causes the budget line to rotate around the point (Y1, Y2), becoming steeper. We can break the effect on consumption from this change into an income and substitution effect. The income effect is the change in consumption that results from the movement to a different indifference curve. Because the consumer is a borrower, the increase in the interest rate makes the consumer worse off—that is, he or she cannot achieve a high indifference curve. If consumption in each period is a normal good, this tends to reduce both C1 and C2. The substitution effect is the change in consumption that results from the change in the relative price of consumption in the two periods. The increase in the interest rate makes second-period consumption relatively less expensive; this tends to make the consumer choose more consumption in the second period and less consumption in the first period. On net, we find that for a borrower, first-period consumption falls unambiguously when the real interest rate rises, since both the income and substitution effects push in the same direction. Secondperiod consumption might rise or fall, depending on which effect is stronger. In Figure 16-3, we show the case in which the substitution effect is stronger than the income effect, so that C2 increases. 2. a. We can use Gita’s intertemporal budget constraint to solve the interest rate: C Y C + 2 =Y + 2 1 1+r 1 1+r $100 $210 $100+ =$0+ 1+r 1+r r =10% Gita borrowed $100 for consumption in the first period and in the second period used her $210 income to pay $110 on the loan (principal plus interest) and $100 for consumption. b. The rise in interest rates leads Gabe to consume less today and more tomorrow. This is because of the substitution effect: it costs him more to consume today than tomorrow, because of the higher opportunity cost in terms of forgone interest. This is shown in Figure 16-4. By revealed preference we know Gabe is better off: at the new interest rate he could still consume $100 in each period, so the only reason he would change his consumption pattern is if the change makes him better off. c. Gita consumes less today, while her consumption tomorrow can either rise or fall. She faces both a substitution effect and income effect. Because consumption today is more expensive, she substitutes out of it. Also, since all her income is in the second period, the higher interest rate raises her cost of borrowing and, thus, lowers her income. Assuming consumption in period one is a normal good, this provides an additional incentive for lowering it. Her new consumption choice is at point B in Figure 16-5. We know Gita is worse off with the higher interest rates because she could have consumed at point B before (by not spending all of her second-period money) but chose not to because point A had higher utility. 3. a. A consumer who consumes less than his income in period one is a saver and faces an interest rate rs. His budget constraint is C1 + C2/(1 + rs) = Y1 + Y2/(1 + rs). b. A consumer who consumes more than income in period one is a borrower and faces an interest rate rb. The budget constraint is C1 + C2/(1 + rb) = Y1 + Y2/(1 + rb). c. Figure 16-6 shows the two budget constraints; they intersect at the point (Y1, Y2), where the consumer is neither a borrower nor a lender. The shaded area represents the combinations of firstperiod and second-period consumption that the consumer can choose. To the left of the point (Y1, Y2), the interest rate is rb. d. Figure 16-7 shows the three cases. Figure 16-7(A) shows the case of a saver for whom the indifference curve is tangent to the budget constraint along the line segment to the left of (Y1, Y2). Figure 16-7(B) shows the case of a borrower for whom the indifference curve is tangent to the budget constraint along the line segment to the right of (Y1, Y2). Finally, Figure 16-7(C) shows the case in which the consumer is neither a borrower nor a lender: the highest indifference curve the consumer can reach is the one that passes through the point (Y1, Y2). e. If the consumer is a saver, then consumption in the first period depends on [Y1 + Y2/(1 + rs)]—that is, income in both periods, Y1 and Y2, and the interest rate rs. If the consumer is a borrower, then consumption in the first period depends on [Y1 + Y2/(1 + rb)]—that is, interest rate rb. Note that borrowers discount future income more than savers. If income in both periods, Y1 and Y2, and the the consumer is neither a borrower nor a lender, then consumption in the first period depends just on Y1. 4. The potency of fiscal policy to influence aggregate demand depends on the effect on consumption: if consumption changes a lot, then fiscal policy will have a large multiplier. If consumption changes only a little, then fiscal policy will have a small multiplier. That is, the fiscal-policy multipliers are higher if the marginal propensity to consume is higher. a. Consider a two-period Fisher diagram. A temporary tax cut means an increase in first-period disposable income Y1. Figure 16-8(A) shows the effect of this tax cut on a consumer who does not face a binding borrowing constraint, whereas Figure 16-8(B) shows the effect of this tax cut on a consumer who is constrained. The consumer with the constraint would have liked to get a loan to increase C1, but could not. The temporary tax cut increases disposable income: as shown in the figure, the consumer’s consumption rises by the full amount that taxes fall. The consumer who is constrained thus increases first-period consumption C1 by more than the consumer who is not constrained—that is, the marginal propensity to consume is higher for a consumer who faces a borrowing constraint. Therefore, fiscal policy is more potent with binding borrowing constraints than it is without them. b. Again, consider a two-period Fisher diagram. The announcement of a future tax cut increases Y2. Figure 16-9(A) shows the effect of this tax cut on a consumer who does not face a binding borrowing constraint, whereas Figure 16-9(B) shows the effect of this tax cut on a consumer who is constrained. The consumer who is not constrained immediately increases consumption C1. The consumer who is constrained cannot increase C1 because disposable income has not changed. Therefore, the announcement of a future tax cut has no effect on consumption or aggregate demand if consumers face binding borrowing constraints: fiscal policy is less potent. 5. a. The life-cycle hypothesis states that individuals want to smooth their consumption as much as possible during their lifetime. People will add up their expected earnings and divide by the number of years they expect to live. Early in life they will save, and later in life they will dissave. Wealth will rise until they retire, and then will decline. Table 16-1, which follows, shows the consumption for Albert and Franco across five years, and Table 16-2, which follows, shows their saving across the five years. Note that Franco saves nothing during the first year because his income is less than his consumption. In the second year, when his income rises, he consumes $60,000, pays off his debt of $20,000, and saves the remaining $20,000. Table 16-1 C1 C2 C3 C4 C5 Albert 60,000 60,000 60,000 60,000 60,000 Franco 60,000 60,000 60,000 60,000 60,000 Table 16-2 S1 S2 S3 S4 S5 Albert 40,000 40,000 40,000 0 0 Franco 0 20,000 100,000 0 0 b. Table 16-3, which follows, identifies the level of wealth for Albert and Franco at the beginning of each across the five years. Both individuals start with no wealth. At the beginning of the second year, Albert has $40,000 of wealth due to his saving. Franco has –$20,000 because he had to borrow. Table 16-3 W1 W2 W3 W4 W5 W6 Albert 0 40,000 80,000 120,000 60,000 0 Franco 0 –20,000 20,000 120,000 60,000 0 c. Figure 16-10 shows Albert’s consumption, income, and wealth across the five years. Note that Albert’s wealth increases steadily to a level of $120,000 and then declines to zero over the last two years. Figure 16-11 shows Franco’s consumption, income, and wealth across the five years. Note that Franco’s wealth is negative in the first year, and then rises to its peak of $120,000 by the beginning of the fourth year. d. If there is no borrowing, then nothing changes for Albert because he never borrowed. Since Franco is unable to borrow in year 1 when his income is low, he will consume his entire income of $40,000. His consumption in the remaining years is now higher than it was when he could borrow because his income is much higher in years 2 and 3. He spreads this higher income across the remaining 4 years and saves accordingly. Tables 16-4, 16-5, and 16-6, which follow, identify Albert’s and Franco’s consumption, saving, and wealth when there is no borrowing across the five years. Figure 16-12, which follows, illustrates Franco’s new consumption, income, and wealth levels across the five years. Table 16-4 C1 C2 C3 C4 C5 Albert 60,000 60,000 60,000 60,000 60,000 Franco 40,000 Table 16-5 65,000 65,000 65,000 65,000 S1 S2 S3 S4 S5 Albert 40,000 40,000 40,000 0 0 Franco 0 Table 16-6 35,000 95,000 0 0 W1 W2 W3 W4 W5 W6 Albert 0 40,000 80,000 120,000 60,000 0 Franco 0 0 35,000 130,000 65,000 0 6. The life-cycle model predicts that an important source of saving is that people save while they work to finance consumption after they retire. That is, the young save, and the old dissave. If the fraction of the population that is elderly will increase over the next 20 years, the life-cycle model predicts that as these elderly retire, they will begin to dissave their accumulated wealth in order to finance their retirement consumption: thus, the national saving rate should fall over the next 20 years. 7. a. In this chapter, we discussed two explanations for why the elderly do not dissave as rapidly as the life-cycle model predicts. First, because of the possibility of unpredictable and costly events, they may keep some precautionary saving as a buffer in case they live longer than expected or have large medical bills. Second, they may want to leave bequests to their children, relatives, or charities, so again, they do not dissave all of their wealth during retirement. b. If the elderly who do not have children dissave at the same rate as the elderly who do have children, this seems to imply that the reason for low dissaving is the precautionary motive; the bequest motive is presumably stronger for people who have children than for those who don’t. An alternative interpretation is that perhaps having children does not increase desired saving. For example, having children raises the bequest motive, but it may also lower the precautionary motive: you can rely on your children in case of financial emergency. Perhaps the two effects on saving cancel each other. 8. a. If you are a fully rational and time-consistent consumer, you would certainly prefer the saving account that lets you take the money out on demand. After all, you get the same return on that account, but in unexpected circumstances (e.g., if you suffer an unexpected, temporary decline in income), you can use the funds in the account to finance your consumption. b. By contrast, if you face the “pull of instant gratification,” you may prefer the account that requires a 30-day notification before withdrawals. In this way, you precommit yourself to not using the funds to satisfy a desire for instant gratification. This precommitment offers a way to overcome the time-inconsistency problem. That is, some people would like to save more, but at any particular moment, they face such a strong desire for instant gratification that they always choose to consume rather than save. c. If you prefer the account that lets you take money out on demand, then you are the type of consumer described by the models of Irving Fisher, Franco Modigliani, and Milton Friedman. If you prefer the account that requires 30-day notice to withdraw funds, then you are the type of consumer described by the model of David Laibson. 9. a. According to Fisher’s model, consumers allocate their income across time periods so that the marginal rate of substitution between consumption in any two periods is equal to 1 + r, where r is the real interest rate. In this problem, the real interest rate is zero. The marginal rate of substitution is the ratio of the marginal utilities in any two periods. To find the marginal utility, differentiate the utility function with respect to Ci to find MUi = 1/Ci. For time periods 1 and 2, we find 1/C1 =1 1/ C2 C1 =C2 For time periods 2 and 3, we find 1 / C2 =1 1/ C3 C2 =C3 Therefore, C1 = C2 = C3 = $40,000. b. David also sets his marginal rate of substitution between any two periods equal to 1. For time periods 1 and 2, we find 2/C1 =1 1/ C2 C1 = 2C2 For time periods 2 and 3, we find 1 / C2 =1 1/ C3 C2 =C3 We also know C1 + C2 + C3 = $120,000. Substitute in for C1 and C3 from the preceding equations to find 2C2 + C2 + C2 = $120,000, such that C1 = $60,000 and C2 = C3 = $30,000. After period 1, David has $60,000 in wealth. c. In period 2, David now gets twice as much utility as in period 3. Following the same process as in the preceding, we find C2 = 2C3, such that David will consume $40,000 in period 2 and $20,000 in period 3. David has revised his decision from period 1 because he values present consumption twice as high as future consumption. d. If David could constrain his choices in period 2, he would prefer to consume $30,000 in period 2 and $30,000 in period 3. Given his utility function, he prefers to consume $60,000 in year 1 and $30,000 in each of the two next years. David’s preferences are an example of Laibson’s pull of instant gratification model. David may know he is an imperfect decision maker, so he may prefer to constrain his future decisions. 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 Keynes’s conjectures 1. 0 < MPC 0 ▪ save more, so MPC < 1 ▪ save a larger fraction of their income, so APC  as Y  ▪ Very strong correlation between income and consumption: income seemed to be the main determinant of consumption 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 decade to decade. The Consumption Puzzle Y Irving Fisher and Intertemporal Choice ▪ The basis for much subsequent work on consumption. ▪ Assumes consumer is forward-looking and chooses consumption for the present and future to maximize lifetime satisfaction. ▪ Consumer’s choices are subject to an intertemporal budget constraint, a measure of the total resources available for present and future consumption. The basic two-period model ▪ Period 1: the present Period 2: the future ▪ Notation Y1, Y2 = income in period 1, 2 C1, C2 = consumption in period 1, 2 S = Y1 − C1 = saving in period 1 (S < 0 if the consumer borrows in period 1) Deriving the intertemporal budget constraint ▪ Period 2 budget constraint: C Y2 = + +2 (1 rS) = + +Y2 (1 r Y C)( 1 − 1) ▪ Rearrange terms: (1+rC C Y) 1 + = + +2 2 (1 rY) 1 ▪ Divide through by (1+r ) to get… C C1 + 2 1+r Y = Y1 + 2 1+r present value of present value of lifetime consumption lifetime income C2 C1 The slope of the budget line equals −(1+r ) Y2 Consumer preferences An indifference curve shows all combinations of C1 and C2 that make the consumer equally happy. Consumer preferences Marginal rate of 2 substitution (MRS ): the amount of C2 the consumer would be willing to substitute for one unit of C1. Optimization The optimal (C1,C2) is where the budget line just touches the highest indifference curve. How C responds to changes in Y Results: C Provided they are both normal goods, C1 and C2 both increase, …whether the income increase occurs in period 1 or period 2. Keynes vs. Fisher ▪ Keynes: Current consumption depends only on current income. ▪ Fisher: Current consumption depends only on the present value of lifetime income. The timing of income is irrelevant because the consumer can borrow or lend between periods. How C responds to changes in r As depicted here, C1 falls and C2 rises. However, it could turn out differently… Y2 How C responds to changes in r ▪ income effect: If consumer is a saver, the rise in r makes him better off, which tends to increase consumption in both periods. ▪ substitution effect: The rise in r increases the opportunity cost of current consumption, which tends to reduce C1 and increase C2. ▪ Both effects imply C2. Whether C1 rises or falls depends on the relative size of the income & substitution effects. ▪ In Fisher’s theory, the timing of income is irrelevant: Consumer can borrow and lend across periods. ▪ Example: If consumer learns that her future income will increase, she can spread the extra consumption over both periods by borrowing in the current period. ▪ However, if consumer faces borrowing constraints (a.k.a. liquidity constraints), then she may not be able to increase current consumption …and her consumption may behave as in the Keynesian theory even though she is rational & forward-looking. C2 Y1 1 C2 The borrowing constraint takes the form: C1 ≤ Y1 Y2 Y1 1 Consumer optimization when the borrowing constraint is not binding C2 The borrowing constraint is not binding if the consumer’s optimal C1 is less than Y1. Y1 1 Consumer optimization when the borrowing constraint is binding The optimal choice is at point D. But since the consumer cannot borrow, the best he can do is point E. Y1 1 ▪ due to Franco Modigliani (1950s) ▪ Fisher’s model says that consumption depends on lifetime income, and people try to achieve smooth consumption. ▪ The LCH says that income varies systematically over the phases of the consumer’s life cycle, and saving allows the consumer to achieve smooth consumption. ▪ The basic model: W = initial wealth Y = annual income until retirement (assumed constant) R = number of years until retirement T = lifetime in years ▪ Assumptions: ▪zero real interest rate (for simplicity) ▪ consumption smoothing is optimal ▪ Lifetime resources = W + RY ▪ To achieve smooth consumption, consumer divides her resources equally over time: C = (W + RY )/T , or C = W + Y where  = (1/T ) is the marginal propensity to consume out of wealth  = (R/T ) is the marginal propensity to consume out of income Implications of the Life-Cycle Hypothesis The LCH can solve the consumption puzzle: ▪ The life-cycle consumption function implies APC = C/Y = (W/Y ) +  ▪ Across households, income varies more than wealth, so high-income households should have a lower APC than low-income households. ▪ Over time, aggregate wealth and income grow together, causing APC to remain stable. Implications of the Life-Cycle Hypothesis The Permanent Income Hypothesis ▪ due to Milton Friedman (1957) ▪ Y = Y P + Y T where Y = current income Y P = permanent income average income, which people expect to persist into the future Y T = transitory income temporary deviations from average income The Permanent Income Hypothesis ▪ Consumers use saving & borrowing to smooth consumption in response to transitory changes in income. ▪ The PIH consumption function: C =  Y P where  is the fraction of permanent income that people consume per year. The Permanent Income Hypothesis The PIH can solve the consumption puzzle: ▪ The PIH implies APC = C / Y =  Y P/ Y ▪ If high-income households have higher transitory income than low-income households, APC is lower in high-income households. ▪ Over the long run, income variation is due mainly (if not solely) to variation in permanent income, which implies a stable APC. PIH vs. LCH ▪ Both: people try to smooth their consumption in the face of changing current income. ▪ LCH: current income changes systematically as people move through their life cycle. ▪ PIH: current income is subject to random, transitory fluctuations. ▪ Both can explain the consumption puzzle. The Random-Walk Hypothesis ▪ due to Robert Hall (1978) ▪ based on Fisher’s model & PIH, in which forward-looking consumers base consumption on expected future income ▪ Hall adds the assumption of rational expectations, that people use all available information to forecast future variables like income. The Random-Walk Hypothesis ▪ If PIH is correct and consumers have rational expectations, then consumption should follow a random walk: changes in consumption should be unpredictable. ▪ A change in income or wealth that was anticipated has already been factored into expected permanent income, so it will not change consumption. ▪ Only unanticipated changes in income or wealth that alter expected permanent income will change consumption. Implication of the R-W Hypothesis If consumers obey the PIH and have rational expectations, then policy changes will affect consumption only if they are unanticipated. The Psychology of Instant Gratification ▪ Theories from Fisher to Hall assume that consumers are rational and act to maximize lifetime utility. ▪ Recent studies by David Laibson and others consider the psychology of consumers. The Psychology of Instant Gratification ▪ Consumers consider themselves to be imperfect decision makers. ▪ In one survey, 76% said they were not saving enough for retirement. ▪ Laibson: The “pull of instant gratification” explains why people don’t save as much as a perfectly rational lifetime utility maximizer would save. Two questions and time inconsistency 1. Would you prefer (A) a candy today, or (B) two candies tomorrow? 2. Would you prefer (A) a candy in 100 days, or (B) two candies in 101 days? In studies, most people answered (A) to 1 and (B) to 2. A person confronted with question 2 may choose (B). But in 100 days, when confronted with question 1, the pull of instant gratification may induce her to change her answer to (A). Summing up ▪ Keynes: consumption depends primarily on current income. ▪ Recent work: consumption also depends on ▪ expected future income ▪ wealth ▪ interest rates ▪ Economists disagree over the relative importance of these factors, borrowing constraints, and psychological factors. 1. Keynesian consumption theory ▪ Keynes’s conjectures ▪MPC is between 0 and 1 ▪APC falls as income rises ▪ current income is the main determinant of current consumption ▪ Empirical studies ▪ in household data & short time series: confirmation of Keynes’s conjectures ▪in long-time series data: APC does not fall as income rises 2. Fisher’s theory of intertemporal choice ▪ Consumer chooses current & future consumption to maximize lifetime satisfaction of subject to an intertemporal budget constraint. ▪ Current consumption depends on lifetime income, not current income, provided consumer can borrow & save. 3. Modigliani’s life-cycle hypothesis ▪ Income varies systematically over a lifetime. ▪ Consumers use saving & borrowing to smooth consumption. ▪ Consumption depends on income & wealth. 4. Friedman’s permanent-income hypothesis ▪ Consumption depends mainly on permanent income. ▪ Consumers use saving & borrowing to smooth consumption in the face of transitory fluctuations in income. 5. Hall’s random-walk hypothesis ▪ Combines PIH with rational expectations. ▪ Main result: changes in consumption are unpredictable, occur only in response to unanticipated changes in expected permanent income. 6. Laibson and the pull of instant gratification ▪ Uses psychology to understand consumer behavior. ▪ The desire for instant gratification causes people to save less than they rationally know they should. Solution Manual for Macroeconomics Gregory N. Mankiw 9781464182891, 9781319106058