Magazine article Business Review (Federal Reserve Bank of Philadelphia)

The Peopling of Macroeconomics: Microeconomics of Aggregate Consumer Expenditures

Magazine article Business Review (Federal Reserve Bank of Philadelphia)

The Peopling of Macroeconomics: Microeconomics of Aggregate Consumer Expenditures

Article excerpt

Consumer spending is the largest single expenditure category in the final demand for goods and services, accounting for more than two-thirds of gross domestic product (GDP). A clear understanding of the underpinnings of consumer spending is a valuable asset for central bankers and policymakers. Since the 1950s, macroeconomists have been engaged in building a theory of aggregate consumer spending from the bottom up. (1) In this approach, macroeconomists first seek to understand how individual households choose to spend and how their choices change when interest rates, the unemployment rate, and other indicators of overall economic activity change. The relationship between aggregate consumer spending and indicators of economic activity is then obtained by aggregating the predicted changes in the spending choices of individual households with respect to changes in indicators of overall economic activity.

It was not always so. In the early years of macroeconomics, scholars looked for enduring empirical relationships ("economic laws") that connected one set of macroeconomic aggregates to another without explicit reference to the individual decisions that would make sense of such connections. This was because economists hadn't fully worked out how a household acting rationally in the face of uncertainty would behave over time--the sort of knowledge needed to meaningfully connect macroeconomic aggregates to the millions of individual choices that make up those aggregates. But as economists began to acquire this knowledge, the process of connecting macroeconomics to individuals' behavior started in the 1950s and gathered steam in the 1970s and 1980s. Although the process of integration is far from complete, predictions of aggregate consumer spending are now rooted in predictions of individual behavior.

The attempt to predict aggregate consumer spending by first predicting what individual households would do is what I mean by "the peopling of macroeconomics." The aim of this article is to give an account of this now half-century-long intellectual endeavor. It is meant to be a (quick!) historical survey that takes the reader from the early work on the consumption function to the theory of aggregate consumer spending in modern macroeconomic models.

GENESIS OF THE CONSUMPTION FUNCTION

The origin of macroeconomics as a distinct sub-field of economics is often traced to John Maynard Keynes's General Theory of Employment, Interest, and Money. Published in 1936, the book sought to explain the reasons for the economic depression that gripped the industrialized world after 1929. In the course of doing so, Keynes introduced a theoretical construct he called the consumption function. According to Keynes, the consumption function was the causal relationship between annual aggregate disposable (or after-tax) income and annual aggregate consumer spending.

Keynes asserted that this relationship looked like the brown line shown in Figure 1. Aggregate consumer spending was directly and linearly related to aggregate disposable income. The point at which the brown line crosses the black line gives the income level at which consumer

spending is equal to income. To the left of this point, spending exceeds income, and to the right of this point, spending is less than income. Importantly, the relationship between income and spending was a nonproportional one, with higher incomes associated with a smaller ratio of spending to income. To see this, consider the points marked X and Y on the brown line. At point X income is $40,000 and spending is $34,000; at point Y, income is $80,000 and spending is $58,000. Thus, a doubling of income leads to less than a doubling of spending, which means that the ratio of spending to income declines as incomes rise.

[FIGURE 1 OMITTED]

Because the consumption function was central to Keynes's analysis, the construct attracted a great deal of attention and soon became the focus of controversy. …

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