The Economics Book

204

PEOPLE SMOOTH

CONSUMPTION OVER

THEIR LIFE SPANS

SAVING TO SPEND

I

n 1936, John Maynard

Keynes’s The General Theory

of Employment, Interest, and

Money put the issue of consumption

center stage: if total demand in the

economy is critical to making it run

smoothly, the groups who make up

that demand matter a great deal.

Public spending came under

government control. Investment

by firms was related to the interest

rate. But consumption by households

presented more of a challenge.

Keynes (p.161) claimed that

households consume a fraction

of their income and save the rest,

with richer households saving

more. The proportion all households

spend determines the size of

the “multiplier” (pp.164–65)—

the amount that government

spending increases when put

into practice. It creates jobs and

income, which is multiplied by the

spending of those who received

the extra jobs and income—and

in this way they impact on the

general economy. For Keynesian

economists this multiplier effect

lies behind the way the economy

moves between boom and

recession over time. For this reason

getting an accurate picture of

consumption is critical.

IN CONTEXT

FOCUS

Decision making

KEY THINKER

Franco Modigliani

(1918–2003)

BEFORE

1936 John Maynard Keynes

publishes The General Theory

of Employment, Interest and

Money, proposing a simple

mathematical function to

describe consumption.

1938 Keynesian economist

Alvin Hansen predicts

long-term stagnation in

the US economy.

AFTER

1978 US economist Robert

Hall estimates a function to

describe US consumption,

potentially confirming a

version of Friedman’s theory.

1982 US economists Robert

Hall and Frederick Mishkin

propose that households

follow a “rule of thumb” when

planning their consumption.

Households devote

a varying proportion

of their current income

to consumption.

This is because

individuals are rational,

look to the future, and

dislike shocks.

They consume based on

their expectations of

lifetime income, not

on current income.

People smooth

consumption over

their life spans.

They save when

young, and use up their

savings when old.