Kuznets-consumption-puzzle PDF

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Introduction*to*Consumption:* The*Kuznets*Consumption*Puzzle* Consumption! is! the! economic! term! for! people! spending! money! on! goods! and! services.! Normal! people! are! referred! to! as! households! in! economics.! ! Why?% % Just%to%confuse%you.% ! Speaking! of! confusion,! here! is! a! problem! that! bugged! economists! for! far! longer! than! it! should! have,! given! how!simple!the!answer!is.!

The*Kuznets*Consumption*Puzzle* ! Kuznets!–!yep,!that’s!actually!a!real!name!–!observed!that!consumption!increases! proportionately! with! national! income! over! time,! meaning! that! when! the! economy! is! £100! richer,! consumption! also! increases! by! £100.! However,! if! you! tracked!a!particular!individual,!his!consumption!would!increase!by!less!and!less! as! the! economy! grew! richer.! Therefore,! each! individual! is! spending! less! as! the! economy! grows,! but! overall! the! economy! is! spending! the! same! amount.! This! posed!a!conundrum,!and!the!winner!would!receive!a!Noble!Prize.! ! ! Household! Economy1Wide1 ! Consumption,!C! Consumption1 ! over11time1 ! ! ! ! ! Individual1Households’1 ! Consumption1at1a1 ! particular1point1in1time1 ! ! ! ! ! National!Income,!Y!

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I!can’t!even!read.!

John%Maynard%Keynes:% pretending%to%read%a%book% ! ! Keyes!rose!to!the!challenge!and!created!the!Keynesian!Consumption!Function!to! model!how!people!spend!their!money,!and!what!happens!to!Consumption!when! Income!increases.! ! ! Keynesian!Consumption!Function:!C!=!a!+!bY! ! ! Glossary:1 C11Aggregate!Consumption,!the!amount!that!a!households!spend! Y11National!Income,!the!total!value!of!all!income!in!the!economy,!and!therefore!the!total! value!of!the!economy,!or!GDP! a1an!unimportant!mathematical!constant,!except!that!it!is!greater!than!one!! b1another!unimportant!constant,!except!it!is!between!0!and!1,!meaning!that!people! consume!some!fraction!of!their!income.!

! The! Keynesian! Consumption! Function! just! tells! us! that! the! total! level! of! consumption!in!the!economy!is!some!constant!plus!a!fraction!of!the!total!income! of!the!economy.! ! The!Average1Propensity1to1Consume!is!an!important!concept!that!tells!us!how! much!of!the!economy’s!total!income!will!be!spent!on!consumption.! ! 𝐶 𝐴𝑃𝐶 = ! ! 𝑌 Substituting!in!the!Keynesian!Consumption!Function:! 𝑎 𝐴𝑃𝐶 = ! + 𝑏! 𝑌

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Quick!Example:! Say!a!=!10,!b!=0.5!(meaning!we!spend!half!our!income)!and!Y!=!£100! 𝐶! = !10! + !0.5(100)! 𝐶! = !60! 60 𝐴𝑃𝐶! = ! ! 100 𝐴𝑃𝐶 = 0.6! In!this!example,!our!Average!Propensity!to!Consume!is!0.6!meaning!that,!on! average,!we!spend!60%!of!our!economy’s!income,!and!must!save!the!other!40%.! ! ! Looking! at! our! equations! so! far,! we! can! see! that! as! Y! increases,! so! should! C! because!the!economy!is!richer!and!has!more!to!spend.!However,!as!Y!increases,! our!APC!should!fall!because!a!and!b!are!both!positive!constants.! ! Quick!Example!2:! Say!a!=!10,!b!=0.5!(meaning!we!spend!half!our!income)!and!Y!=!£200! 𝐶! = !10! + !0.5(𝟐𝟎𝟎)! 𝐶! = !110! 110 𝐴𝑃𝐶! = ! ! 𝟐𝟎𝟎 𝐴𝑃𝐶 = 0.55! ! When!our!income!increased,!out!Consumption!increased!but!our!Average! Propensity!to!Consume!is!decreased!to!0.55!meaning!that,!on!average,!we!spend! 55%!of!our!economy’s!income,!and!must!save!the!other!45%.!

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The!Average1Propensity1to1Save!is!whatever!we!don’t!!consume!and!so! 𝐴𝑃𝑆 = 1 − 𝐴𝑃𝐶! ! So!as! our!national! income!increases,! our!APC! falls!causing! our!APS! to!increase.! Problem! Solved,! said! Keynes,! and! left! some! number! crunchers! to! prov Shit! him!right.! ! But!wait!! ! What’s!this?!?!?!! ! The! numbers! did! not! come! back! as! he! expected.! ! When! studying! any! individual! household! over!time,!the!results!were!as!he!proposed;! falling! APC.! However,! when! studying! the! entire! economy,! APC! was! constant,! and! unaffected!by!rising!income.!

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Two*Theories:*Same*Answers* ! 1) Franco!Modigliani’s!LifedCycle!Theory!of!Consumption! ! Key!Premise:!Income!varies!systematically!over!the!phases!of!a!consumers! “life!cycle”!so!consumers!make!plans!to!smooth!lifetime!consumption.!As!a! consumer!grows!older!they!save!more!of!their!income!for!retirement.! ! Consumption! depends! on! lifedtime! wealth! and! savings! are! used! to! smooth! consumption.!Temporary!changes!in!current!income!have!little!effect!on!lifetime! income!and!so!little!affect!on!consumption.!

Life*Cycle*Pattern:* ! ! ! Income1 ! ! ! ! Student:! ! borrows! ! ! Modigliani’s!Solution:! !

Time1 Adult:! saves!

Retired:! spends%savings%

𝛼𝑊 𝐶 ! 𝐴𝑃𝐶 = ! ! = ! 𝑌 𝑌

! Glossary:1 W1lifetime!wealth! α!the!fraction!of!our!wealth!that!we!spend!rather!than!save! ! Why! Household! APC! is! falling:! Over! short! periods! of! time! (like! a! single! consumer’s!lifetime)!when!Y!increases,!wealth!does!not!because!the!consumer!is! likely!to!be!saving!as!they!grow!older.!Therefore!APC!is!falling.! Why!Aggregate! APC! is! constant:! Over!long! periods! of! time!(like! a! few! hundred! years),!Y!and!W!rise!together.!Therefore!APC!is!constant.! ! 2) Milton!Friedman’s!Permanent!Income!Theory! Key!Premise:!Current!Income!is!the!sum!of!Permanent!Income!+!Transitory! Income!and!Consumption!is!only!affected!by!changes!in!Permanent!Income.! ! Glossary:! Permanent1Income"Long!Run!Income!such!as!a!stable!salary.! Transitory1Income1Short!Run!Income!such!as!a!bonus,!shares!or!unemployment! benefits!

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! If!changes!in!current!income!are!mainly!transitory!d!such!as!losing!a!job!and!so! income!decreases!for!a!few!weeks!until!finding!a!new!one!d!then!they!have!little! affect! on! permanent! income,! and! so! little! affect! on! consumption! because! they! transitory! effects! mainly! affect! savings! (increased! savings! if! we! get! a! raise,! decreased!savings!if!we!crash!our!car)! ! Friedman’s!Solution:! ! 𝐶 𝛼𝑌 ! 𝐴𝑃𝐶 = ! ! = ! ! ! 𝑌 𝑌 + 𝑌! ! Glossary:1 YT1Transitory!Income! YP1Permanent!Income1 YT1+1YP1Lifetime!Income! α!the!fraction!of!our!temporary!income!that!we!spend!rather!than!save! 1 By!making!the!distinction!between!permanent!(lifedtime)!income!and!transitory! income!we!can!better!understand!what!affects!aggregate!consumption!and!what! affects! household! consumption.! Saving! are! borrowing! are! used! to! smooth! consumption! when! we! have! changes! in! transitory! income,! and! each! household! tends! to! be! saving! more! as! they! become! richer.! Across! the! whole! economy! however,! these! transitory! effects! cancel! each! other! out! and! we! see! that! as! permanent! income! increases,! aggregate! consumption! increases! with! it.! Thus,! household!APC!falls,!but!economydwide!APC!is!constant.! ! % Bottom1Line1 1 Consumption1depends1mainly1upon1lifetime1wealth1and1permanent1 changes1to1our1income.1Short1run1and1transitory1affects1have1only1a1small1 effect1on1our1current1consumption,1because1we1save/borrow1most1of1these1 changes.1 ! ! ! ! !

Problem!Solved!! ! ! Seriously?!This!won!two!Noble!Prizes?!I’ve!done!harder!puzzles!on!Christmas! Day!with!my!grandma,!and!she’s!blind.!Bless!her.!

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