The Life-Cycle Theory of Consumption
• People tend to consume less than they earn during their main working years, and dissave, or use up savings, during their early and later years.
Prices also play a major role in the consumption/labor supply decision.
The nominal wage rate is the wage rate in current dollars.
The real wage rate is the amount that the nominal wage rate can buy in terms of goods and services.
The Labor Supply Decision
Households make consumption and labor supply decisions simultaneously.
Consumption cannot be considered separately from labor supply, because it is precisely by selling your labor that you earn income to pay for your ce Theory of Consumption
Policy changes, like tax-rate changes, are likely to have more of an effect on household behavior if they are expected to be permanent rather than temporary.
An increase in the wage rate causes the opportunity cost of leisure to rise, leading to a larger labor supply—a larger labor force. This is called the substitution effect of a wage rate increase.
The Life-Cycle Theory of Consumption
Consumption decisions are likely to be based on permanent income rather than on current income.
Permanent income is the average level of one’s expected future income stream.
C APC
Y
The Life-Cycle Theory of Consumption
The life-cycle theory of consumption is an extension of Keynes's theory. It states that households make lifetime consumption decisions based on their expectations of lifetime income.
The Labor Supply Decision
Factors that determine the quantity of labor supplied include:
◦ The wage rate ◦ Prices ◦ Wealth and nonlabor income
The Labor Supply Decision
Data suggests that the substitution effect prevails over the income effect, so higher wages lead to an increase in labor supply.
The Labor Supply Decision
The Labor Supply Decision
Workers do not care about their nominal wage—they care about the purchasing power of this wage—the real wage rate.
The Labor Supply Decision
A higher wage means that people will spend some of it on leisure by working less. This is the income effect of a wage rate increase.
Household and Firm Behavior in the Macroeconomy: A Further Look
Households: Consumption and Labor Supply Decisions
Keynes suggested that consumption is a positive function of income, and that high-income households consume a smaller portion of their income than lowincome households.
The Keynesian Theory of Consumption: A Review
The average propensity to consume (APC) is the proportion of income households spend on consumption. Determined by dividing consumption (C) by income (Y).