What are the main determinants of consumption in the Keynesian, neoclassical, and new Keynesian frameworks?

In simple terms, Keynesian theory focuses on how changes in income affect spending. When people have more money, they tend to spend more, and when they have less, they spend less. Consumption changes based on individual disposable income, which illustrates the prediction made by the Keynesian consumption function. During the Great Depression, the New Deal introduced a variety of employment and assistance programs to let people spend on goods or services that later enabled them to maintain their consumption levels to some extent; despite the serious economic downturn. The result was that the federal state relief stabilized businesses and improved overall economic activity that greatly influenced future monetary recoveries.

The Keynesian consumption function suggests that consumption primarily depends on current disposable income, represented by C = a + bYd, where "a" is autonomous consumption, "b" is the marginal propensity to consume (MPC), and Yd is disposable income. According to this theory, consumption is stable and predictable based on income, with the MPC being constant and less than one. Unlike other consumption models, the Keynesian approach assumes that factors like interest rates, expectations, or wealth have little influence on immediate consumption behavior. This simplifies consumption patterns by focusing on income as the primary driver, making it useful for short-term economic analysis.

In the Keynesian framework, the consumption function is primarily driven by income. Keynes posited that as people’s disposable income increases, their consumption rises, but at a decreasing rate. This relationship is expressed in the formula C = a + bY, where C is consumption, a is autonomous consumption (independent of income), b is the marginal propensity to consume (MPC), and Y is disposable income. The MPC is crucial because it shows the portion of additional income that will be spent rather than saved. This model emphasizes the role of aggregate demand in the economy, suggesting that government policies can influence consumption through fiscal measures.

In simplistic terms, consumption, real income, and autonomous consumption or the interest to consume (MPC) measures the increase in consumption spending in response to a per unit increase in disposable income. The Keynesian concept stems from the fundamental law of consumption stating that when income increases it does not do so to the same extent as the rise in income (part of the income is saved). This law of consumption is based on three propositions with respect to consumption behavior. 1. When income increases expenditure increases but disproportionately. 2. An increment of income will be divided in some ratio between saving and consumption. 3. An increase in income will thus lead to an increase in both consumption and savings.

In the neoclassical intertemporal model, consumption decisions are based on optimizing behavior over a lifetime. Individuals plan their consumption and savings to maximize utility, considering both current and future income. Key determinants include the interest rate, which influences the trade-off between present and future consumption, and the individual's time preference for consumption. Higher interest rates encourage saving by making future consumption more attractive. Additionally, expectations about future income play a significant role; if people expect higher future income, they might consume more today.

Neoclassical theory studies spending decisions based on preferences or limitations like prices or income. People want to maximize long-term happiness by balancing consumption and saving, while delaying immediate spending. During the 2008 crisis, individuals faced economic uncertainty, job losses, and reduced access to credit. They made tough choices about consumption and saving when the unemployment reached 10% in October 2009. This model emphasizes rational decision-making, considering future expectations and financial obstacles, suggesting that delaying gratification contributes to long-term well-being. Without government intervention, consumer perception determines price, ensuring efficient resource allocation.

The neoclassical intertemporal model highlights the importance of stable economic policies for consumer confidence and planning. When policies are predictable, consumers can make informed decisions about consumption and savings, optimizing their lifetime utility. Volatile policies, like those seen during certain periods of political instability, disrupt this planning. For example, during the last Democratic presidency in the U.S., fluctuating policies created uncertainty, impacting consumers' ability to forecast and plan. Stable interest rates and fiscal policies provide a reliable environment, benefiting both individual financial planning and broader economic growth.

Neoclassical intertemporal theory focuses on supply and demand as the forces behind the production, pricing, and consumption of goods. The theory of consumption is a function of flexible income. Modern neoclassic theory is based on the assumption that consumption and employment are optimized with no quantity constraints. I feel the data behind this is dubious and the orthogonality conditions implied are substandard. Graphically, the utility function implies non-optimal functioning with a saddle point. When these points are concave the estimates imply that either consumption or leisure is an inferior good. In my humble conclusion the economic fluctuations do not support neoclassical dynamics. i.e. people don't always make good decisions.

The neoclassical intertemporal model offers a more dynamic and forward-looking approach to understanding consumption compared to the static nature of the Keynesian model. By incorporating factors like interest rates, wealth, and lifetime income, it provides a more comprehensive framework that better captures how consumers adjust their behavior in response to economic shifts. This makes the model especially relevant for analyzing long-term consumption patterns and the effects of policy changes on savings and spending. However, its assumption of perfectly rational, forward-looking consumers can sometimes oversimplify real-world decision-making, where uncertainties and behavioral biases also play a significant role.

In the New Keynesian framework, consumption habits introduce more complexity into understanding consumption patterns. This model recognizes that consumers may develop habits based on past consumption, which influences their current consumption choices. Key determinants include past consumption levels, which create a “habit persistence” effect—individuals prefer to maintain a certain standard of living. Additionally, expectations about future income and economic conditions play a role, but are adjusted by this habit persistence. Factors like consumer confidence, credit availability, and monetary policy also affect consumption. The New Keynesian approach integrates elements of both Keynesian and neoclassical theories.

The new Keynesian model of consumption habits offers a more realistic view of consumer behavior by accounting for the persistence of habits and the reluctance to adjust consumption quickly. It highlights the importance of both past and present factors, such as previous consumption patterns, current income, and expectations about the future. This makes the model well-suited for analyzing the effects of economic shocks or policy changes, as it captures the gradual nature of consumption adjustments. However, its complexity, by including habits and expectations, also makes it more challenging to predict short-term consumer reactions, as various factors can influence the pace of change in consumption behavior.

People tend to stay with their spending habits and are hesitant to change them too quickly. They can also face uncertainty and limits on how easily they can adjust their spending over time. New Keynesians say that consumption is influenced by a mixed factors, including income, interest rates, expectations, and habits; but it responds to changes in the economy and government policies. Despite the efforts to stimulate spending by cutting interest rates and fiscal stimulus packages, consumer spending remains calm during economic contractions.

Using the New Keynesian model, internal and external habit formation are multiplicative and additive functional forms and, for a popular class of utility functions log-linear approximation whether habits are additive or multiplicative, internal or external, appears largely unimportant for business cycle behavior. In the absence of an optimally designed consumption tax, the competitive equilibrium is inefficient when the habit formation is external. Due to the effect it has on a firms pricing decisions, the choice of additive or multiplicative habits can have important implications when habits are modeled at the goods level. Asset prices, the magnitude of the equity premium, depend on how habit formation is introduced and are quite dynamic.

When analyzing consumption, consider additional factors. Psychlogical influences, like consumer confidence and sentiment, significantly impact spending behaviors.Wealth effects, such as changes in asset prices like real estate or stocks, can alter consumption patterns. Credit access and interest rates also play crucial roles; easier crdit boosts spending while tighter conditions restrain it. Government policies, including taxation and subsidies, directly affect disposable income and spending choices. Demographics, like age and family size, and techological changes that create new consumption opportunities, further influence consumption. These factors provide a nuanced understanding of consumption dynamics beyond traditional economic models.

In addition to traditional models, behavioral economics plays a crucial role in understanding consumption. Cognitive biases like "present bias" and social influences often lead consumers to make decisions that deviate from rational predictions. Incorporating these insights helps explain why consumption patterns may not align with purely economic expectations, offering a more complete view of real-world behavior.

Diverse policy interventions play a role in how these consumption theories contribute to economic growth. Behavioral economics explore how psychological factors, cognitive biases, and social influences affect your economic decisions, which may include consumption choices. They argue that people are distant from the rational, profit-maximizing behavior assumed in traditional economic models; due to factors such as realistic thinking, risk aversion, and social norms. Another consideration is evaluating the effects and limitations of policy approaches that can provide valuable insights about consumption.