Recently I had a conversation with a certain person (call her X) about the marginal propensity to consume (and about the multiplier effect).

With marginal propensity to consume I mean $c_1$ as a part of aggregate income (Y). For clarity let's say: $$Y_t =c_0 +c_1Y_{t-1} +I-G$$ with $c_0$ as autonomous spending; I as Investments and G as government spending. For simplicity lets say $I$ and $G$ are exogenous. The model can be found in every macroeconomics text book, e. g. Blanchard.

The conversation went something like this:

X: "Why do you use a value of $c_1$=0.1?"

Me: "This value is equivalent to empirical results done by many different studies for example: this"

X: "You don't really think that marginal propensity to consume is that small. It should be something like $c_1$=0.9. Are you sure that you don't mean $1-c_1$=0.1?"

At this moment I was pretty shocked by the response of person X and didn't really know what to say because the answer was so straight forward and forceful.

After thinking about this conversation I came across some (at least in my mind) strange contradictions:

  • at first I thought to myself: "ok let's look at the original source of this function i. e. the book from Blanchard (Macroeconomics 5th edition). As it turns out in the appendix he is "estimating" the marginal propensity to consume and get's a value of 0.77
  • then I thought to myself: "but wait a minute. If $c_1$ is that high the multiplier would be huge with 4.34" which can not be realistic
  • another thing that was going through my mind is the aspect of the permanent income hypothesis which basically states that consumers smooth their consumption over their lifespan. Based on this approach a high value for $c_1$ is also unrealistic because this would lead to a high volatility of consumption
  • I know that there is a difference between a permanent change in income (Y) and a temporary change but I don't really think in either of both cases a value of $c_1=0.8$ can be justified

My question is the following: What is the the current view on the marginal propensity to consume?



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