Hobson's Choice

free script provided by

Marginal Propensity to Consume

February 25, 2005

Whenever students are introduced to the General Theory of Keynes, they are presented with a chart like this one:

The vertical axis, A, represents the sum of savings and investment. The horizontal axis Y represents income. The blue line is at a 45º angle to both axes, and reflects a condition under which all income available in the economy is either consumed forthwith or invested future output. The red line is what the Depression-era Cambridge research group established was closer to the truth: as income rose, consumption and investment rose too, but not fast enough. Income was neither spent nor invested; it was hoarded, mostly unintentionally in the banking system.

When I first read this, I recall throwing the book across the room and stamping my foot in scorn. The idea was simply fantastic. Everyone knew that if money lay around in savings accounts the interest rate would plummet to something really low, and somebody would up and borrow it. Leave it to an economist to fatalistically draw a chart like that one and attribute the Great Depression to it! But over time, researchers did, indeed, confirm the slope of the red line was something less than 1.00, and fiscal policy became a universally accepted concept.

This post is not about the history of that idea. It addresses an obvious objection: why is it that rich countries have trade deficits? As you can see, the USA should be far off to the right on the chart. In fact, we are, and have been for years. So our combined consumption and investment should be far less than gross national income (GNI). In fact, it's far more. In 1911, the USA had a gigantic trade surplus and a GNI per capita a fraction of what it is now. What's going on?

To understand this paradox, one has to imagine how researchers ever set about finding the marginal propensity to consume, or to invest. These numbers are not real. There is no clump of neurons in anyone's brain that says, "I just got a raise of $100 per week. I think I'll spend only $80 of it and put the rest in a sock." This figure is, like probabilities, a stand-in for vastly more complex, detailed information. Econometricists use regression analysis to find the MPC, typically by using time series data of personal consumption indicator against shifts in income such as that caused by shifts in taxes, etc. For an example of how it's done, see Mike Moffatt's article here. Very fine-grained studies incorporate the Ando-Modigliani Life-Cycles hypothesis,¹ but the underlying concept is very simple: the short-run correlation between components of A and national income are, indeed, significantly less than 1. The difference between under-saving, spendthrift USA (2005) and parsimonious, diligent USA (1911) is determined by a host of institutional changes, greater liquidity of personal wealth (as opposed to income), and sectional distinctions, such as within regions or between economic brackets.

The proliferation of studies pursuing "wealth effects" (marginal propensities to consume out of wealth, rather than income) has naturally refined the idea of the MPC. Real estate booms create sudden concentrations of wealth that may have surprising effects on household consumption expenditures; the domination of the US economy by regional monopsonies, like Wal-Mart, taxation policies and financial market regulation have all conspired to increase consumption as a share of income as a secular trend; however, over episodes of abrupt income increases, the chart above still applies.
NOTES 1 e.g., this one from the Federal Reserve Bank of Richmond - Economic Quarterly (PDF), Spring 2001 by Yash P. Mehra:

The present article investigates whether wealth has predictive content for future consumption. If it does, then changes in wealth may lead to changes in consumer spending. [2] I also examine whether consumer spending is sensitive to stock market wealth. The 1990s saw an enormous increase in household wealth generated by the rising value of household stock holdings. This increase has generated considerable interest among policymakers in identifying the magnitude of the stock market wealth effect on consumption.
[...]
The empirical results that are presented here show that aggregate consumer spending is cointegrated with labor income and wealth [...] indicating the existence of a long-term equilibrium relationship between consumption and its economic determinants, such as income and wealth. The coefficients that appear on income and wealth variables in the estimated cointegrating regression are statistically significant and measure the long-term responses of consumption to income and wealth. The results thus indicate wealth has a significant effect on consumption.

As opposed to merely income; this requires expectations of changes in personal endowments over ones' lifetime, not merely an ad hoc budget function.

Comments on this Post:

So if we were to add a 3rd dimension (time) to this chart, we would see that 45 degree slope around 1911 decline to something less (the red line)? I wonder what the picture looks like for Japan? Have there been even more radical changes in this slope since 2000? Is there any point looking at rich and poor in this scheme? Size of middle class?

Posted by: calmo at February 28, 2005 04:32 AM

The point is, there are millions of things which the "Keynesian cross" only dimly approximates. For example, I suppose you could call me some kind of Keynesian. However, I've always been skeptical of this component of the analysis because it is simply an approximation of a process vastly more complex. In a way, the ascendance of Dynamic General Equilibrium (DGE) analysis has indeed superseded multiplier theory, but for the formative period 1975-1995 or so was obsessed with debunking the whole of Keynesian theory to achieve a rightwing political goal.

Recently, the assumption of monopoly enterprise is one way in which DGE & Keynesian theory have been reconciled.

Posted by: James R MacLean at February 28, 2005 08:14 AM

This "but for the formative period 1975-1995 or so was obsessed with debunking the whole of Keynesian theory" strikes me as ideological analysis. [My bias is to take things apart and yours would be to look for unions and reconciliations.] And it may have been obsessive but isn't that the paradigm of scientific revolutions especially so in economics where the established framework is at best wobbly?

Posted by: calmo at February 28, 2005 04:46 PM

Despite the italics, I am not feeling the force of your complaint that this is a simplistic approximation of a complex process. I do want the analysis to disentangle the complex reality, no? I don't want to hide it, but I do want to draw out its salient and relevant features.

No, of course not, but in modeling a phenomenon mathematically you need to make provisions for the salient features that are inevitably going to get left behind, such as the institutional changes that have caused post-1981 saving in the USA to fall. Usually models can be tweaked to accommodate greater richness.

This "but for the formative period 1975-1995 or so was obsessed with debunking the whole of Keynesian theory" strikes me as ideological analysis

This shows selection bias, naturally, but one of my texts in 2nd year Macro was The Rational Expectations Revolution, an anthology of monographs on the new economics by such worthies as Edward Prescott, Fin Kydland, Robert Barro, et al. These were heavily larded with polemical critiques of Keynesian theory; there's ample evidence to suggest that privately-funded thinktanks developed rational expectations for promotion of conservative policies.

Look at Barro's papers and editorials and you'll see what I mean. Barro is certainly entitled to hold forth on controversial issues of the day, but I humbly submit he's a partisan hack for organizations of power and wealth, and his academic work is of a piece. In contrast, Paul Krugman--cited by rightwingers as shrill--takes unrewarding positions (I mean, come on, who's going to pay him to criticize social security reform?!) and economic positions that are well within the mainstream. I guess I believe this it's because I've observed the way this polemical battle has played out. Someone like Paul Krugman tends to rely on arguments I regard as intellectually honest, whether I agree with them or not; Barro's monographs are remarkably similar to his editorials for the Weekly Standard, i.e., manifestly dishonest. He has the persona of a teenaged rightwing dork, but he is a member of an extremely powerful coterie that controls the country's economics departments. You've heard of rightwing lysenkoism? Economics fell victim to it in the 1980's and he's Trofim Lysenko's nasty little sidekick.

Posted by: James R MacLean at February 28, 2005 09:14 PM

Thanks for the links to Barro's work and although I generally resist lumping authors in camps, let alone calling them 'teenaged rightwing dorks', I can see that when the evidence is that high, there is nothing for it but to let loose.
Taking it to the next level, rightwing lysenkoism in American? Economic academia sounds a tad extreme until I ponder how accommodating or quiet these folks have been on the issue of privatizing social security.

Posted by: calmo at March 2, 2005 04:15 PM

Economic academia sounds a tad extreme until I ponder how accommodating or quiet these folks have been on the issue of privatizing SS.

You should read Billmon (1, 2).

Unfortunately, the use of "Lysenkoism" as an epithet has been degraded by overuse, especially in absurd situations. I propose to restrict "Lysenkoism" to circumstances where a clear case can be made for coercive enforcement of the belief system from outside the system (e.g., by state patronage). For example, if a concept spreads concurrently among the scientific communities of several countries, it is almost certainly not Lysenkoism. One might feel like calling it that, but the analogy with Lysenko would fail to apply.

Posted by: James R MacLean at March 2, 2005 06:31 PM