If policymakers inject some money into the economy—whether it be through a tax cut, an extension of a social insurance program such as unemployment insurance, or through an expansion of credit by lowering interest rates—how readily will that money be spent? It depends, in part, on who is getting the money. But how should policymakers determine which households will spend the largest portion of their extra bucks? Some recent economics research looks into the variation in consumption responses across households, the results of which can help guide the thinking of policymakers when they want to boost demand in the economy amid economic downturns.
Before examining this new research, however, it’s important to step back and look at economists’ earlier understanding of how consumption works in the economy to help put the newer research and results in context. The dominant way of thinking about households’ consumption for many years was the “permanent income” hypothesis. Put simply, this hypothesis holds that a person’s consumption is a function of his or her permanent or lifetime income. A person would only change his or her consumption patterns if his or her lifetime income changed, but wouldn’t change his or her spending much if he or she experienced a temporary increase or decrease in spending. Households, according to this line of thinking, smoothed their consumption over the course of their lives according to their lifetime income.
If this hypothesis were true, then households wouldn’t spend much of any additional, or marginal, dollars flowing to them from policymakers to boost consumption. They would have a “marginal propensity to consume” of close to zero, using the terminology of economists. And that means households shouldn’t vary much in their propensity to spend an additional dollar.
Yet more recent research finds that most households have a high marginal propensity to consume—the outliers being some wealthy households that do seem to spend according the permanent income hypothesis. A paper released today as part of the Equitable Growth Working Paper series is part of the research base that shows the difference in consumption responses across households. The paper is by Jonathan Fisher of Stanford University, David Johnson of the University of Michigan, Jonathan P. Latner of the University of Bamberg, Timothy Smeeding of the University of Wisconsin, and Jeffrey Thompson of the Federal Reserve Board of Governors.
The five authors use data from the Panel Survey of Income Dynamics, which includes information on income, wealth, and consumption for households over time from 1999 to 2013. This dataset enabled them to track changes in consumption in response to changes in income or wealth for the same individuals over time. Their topline finding is that the aggregate marginal propensity to consume over this time period was 10 percent, which is on the lower end of previous estimates.
Supporting findings from other research papers, this new paper finds that the marginal propensity to consume for wealthy households (the top 20 percent) is lower than for households with less wealth. The authors argue this implies that households with less or no wealth can’t smooth their consumption and so they react more to changes in income. A household with more wealth could draw on their assets to keep their consumption going. In contrast, households in the bottom 40 percent of the wealth distribution appear to be “credit constrained” because they do not have access to credit, which would allow them to smooth their consumption in the absence of assets to draw down.
Previous estimates of the marginal propensity to consume have not considered the joint distribution of income, consumption, and wealth. Prior studies, for example, looked at how changes in income affect consumption, but the research could not directly factor in how wealth plays a role in responding to policymakers’ efforts to boost consumption in the economy. This new paper looks at all three measures and their interaction, which gives a better view of a household’s economic resources. Income matters for consumption, but wealth also factors in, as it allows households to smooth their consumption when they are hit by negative shocks.
Given these differences, the paper finds that a redistribution that boosted the financial resources of low-wealth households would have a stimulative effect on consumption. Moving resources from the top 20 percent to the bottom 80 percent of households would boost total consumption by between 3 percent to 4 percent, according to the authors’ calculations. This means policymakers interested in most effectively increasing consumption should look at policies that send money toward credit-constrained households and those with low amounts of wealth.
Workers who lose their jobs and don’t have much liquid wealth to fall back on, for example, will end up pulling back on their consumption dramatically. Programs that automatically send money to households such as unemployment insurance or the Supplemental Nutrition Assistance Program would be an effective means for counteracting an economic downturn. Channeling resources toward these workers would be an efficient policy not only to help them but also to strengthen the overall economy for everyone.