Macroeconomics | Chapter Highlights

Rudi Dornbusch, Massachusetts Institute of Technology
Stanley Fischer, International Monetary Fund, on leave from MIT
Richard Startz, University of Washington
Frank Atkins, University of Calgary
Gordon Sparks, Queen's University

Chapter Highlights

The life-cycle-permanent-income hypothesis (LC-PIH) predicts that the marginal propensity to consume out of permanent income is large and that the marginal propensity to consume out of transitory income is very small. Modern theories of consumption assume that individuals want to maintain relatively smooth consumption profiles over their lifetimes. Their consumption behaviour is geared to their long-term consumption opportunities-permanent income or lifetime income plus wealth. With such a view, current income is only one of the determinants of consumption spending. Wealth and expected income play a role, too.
Observed consumption is much smoother than the simple Keynesian consumption function predicts. Current consumption can be very accurately predicted from last period's consumption. Both these observations accord well with the LC-PIH.
The LC-PIH is a very attractive theory, but it does not give a complete explanation of consumption behaviour. Empirical evidence shows that the traditional consumption function appears to also play a role.
The life-cycle hypothesis suggests that the propensities of an individual to consume out of disposable income and out of wealth depend on the person's age. It implies that saving is high (low) when income is high (low) relative to lifetime average income. It also suggests that aggregate saving depends on the growth rate of the economy and on such variables as the age distribution of the population.
The rate of consumption, and thus of saving, could in principle be affected by the interest rate. But the evidence, for the most part, shows little effect of interest rates on saving.
The Barro-Ricardo equivalence proposition notes that debt represents future taxes. It asserts that debt-financed tax cuts will not have any effect on consumption or aggregate demand.