Question

Write a short note in each of the following; d) Keynesian theory of consumption and criticism e) Life-cycle theory of consumption and criticism f) Time inconsistency problem of the Monetary policy

Answer 1

Keynesian theory of consumption and criticism:

The consumption function states that aggregate real consumption expenditure of an economy is a function of real national income. This is called the Keynesian Consumption Function. The classical economists used to argue that consumption was a function of the rate of interest such that as the rate of interest increased the consumption expenditure decreased and vice versa. Keynes stated that the rate of interest may have some influence on consumption but the real income was the important determinant of consumption.

It should be remembered that in the consumption function consumption expenditure refers to intended or ex-ante consumption and not actual consumption. Similarly, income refers to anticipated income and not actual income. Therefore, the consumption function shows what consumption expenditure would be at different levels of income. The aggregate consumption in the economy can be found out from the consumption expenditure of different individuals purchasing commodities

Life-cycle theory of consumption

The life-cycle theory of the consumption function was developed by Franco Modigliani, Alberto Ando and Brumberg.

According to Modigliani, The point of departure of the life cycle model is the hypothesis that consumption and saving decisions of households at each point of time reflect more or less a conscious attempt at achieving the preferred distribution of consumption over the life cycle, subject to the constraint imposed by the resources accruing to the household over its life time.

An individual’s or household’s level of consumption depends not just on current income but also, and more importantly, on long-term expected earnings.Individuals are assumed to plan a pattern of consumer expenditure based on expected earnings over their lifetime.

Criticisms of Life Cycle Theory

• It assumes people run down wealth in old age, but often this doesn’t happen as people would like to pass on inherited wealth to children. Also, there can be an attachment to wealth and an unwillingness to run it down. See: Prospect theory and the endowment effect.
• It assumes people are rational and forward planning. Behavioural economics suggests many people have motivations to avoid planning.
• People may lack the self-control to reduce spending now and save more for future.
• Life-cycle is easier for people on high incomes. They are more likely to have financial knowledge, also they have the ‘luxury’ of being able to save. People on low-incomes, with high credit card debts, may feel there is no disposable income to save
• Government means-tested benefits for old-age people may provide an incentive not to save because lower savings will lead to more social security payments.

Time inconsistency problem of the Monetary policy

Time inconsistency occurs whenever a policy maker can publicly commit to a certain policy action in a non-binding way. This is an issue in several settings (commitment vs. discretion settings and, as you see, policy coordination settings). You've run across the issue of time inconsistency in the context of policy coordination across interdependent economies. One can summarize the issue as follows: I promise in t−1t−1 to deliver policy action A in period tt but instead deliver policy action B once we arrive in period tt.

Consider, as does the paper you cite here, a simple two-country model where the policy actions in a domestic country impact the loss function of the foreign economy and vice versa. Under certain first order conditions (laid out in the very paper you quote) there are obvious gains available to the policy makers of these nations if they are able to arrive at a coordinated equilibrium rather than the Nash equilibrium. However, in a dynamic game with no commitment device aside from reputational concerns it might be the case that one country will promise to play the coordinated equilibrium and then deviate unilaterally to the cheater equilibrium. As you can see, time inconsistency in this context means (literally) for one to be inconsistent over time with promised and realized policy actions.