The Consumption Function

Based on “Macroeconomics” by Dornbusch and Fischer and

“Elements of Economics” by Tullao

Introduction Consumption

activity pursued by individuals in disposing the final goods and services produced by the economy

expands the wealth of a nation

Factors Affecting Consumption Expenditure

taste or preference for present goods against future goods

socioeconomic characteristics such as number of HH members, age group, educational attainment, employment status of HH head

interest rate, which can be viewed as the price of present goods relative to future goods

Factors Affecting Consumption Expenditure wealth determined by human

and non-human factors taxes, which affects disposable

income population income distribution

Factors Affecting Consumption Expenditure inflation rate decreases the

amount real goods and services that HH income can buy

expectations income

Theories on the Consumption Function positive relationship between the level

of consumption and the level of income represented by the marginal propensity to

consume (mpc) mpc: additional consumption due to an extra

unit of income varies across income levels, periods, age, etc.

provide approximate explanation for changes in AD and aggregate supply

Theories on the Consumption Function Absolute Income Hypothesis (Keynes)

Properties consumption is stable relative to current

income short-run mpc < long-run mpc long-run mpc < average propensity to

consume change in wealth of HHs has a positive effect

on the consumption function

Theories on the Consumption Function Absolute Income Hypothesis (Keynes)

Implication increase in national income would lead to an

increase in aggregate consumption expenditure

Limitation there are cases when consumption

expenditures of individuals and HHs are below or above their current income

Theories on the Consumption Function Relative Income Hypothesis

(Deusenberry) Assertion

consumption is a function of current income relative to income in previous periods and relative to the income of income groups considered as model of the HH

Theories on the Consumption Function Relative Income Hypothesis

(Deusenberry) Assertion

ratchet effect the difficulty in reversing previous

consumption due to a current shortfall in income

HH’s relate their consumption with that of their neighbors’

Theories on the Consumption Function Permanent Income Hypothesis

(Friedman) Assumptions

current income is composed of a permanent and a transitory component

consumption is not based on current income but on permanent income

permanent income is based on expected income in the future and is influenced by the expected return on the human and nonhuman wealth

Theories on the Consumption Function Permanent Income Hypothesis

(Friedman) Assertions

sudden decline in transitory income will not affect permanent consumption

permanent consumption will go down if the reduction is in permanent income

consumption in the short-run will not go down despite the reduction in income if the decline in the latter is transitory in nature

Theories on the Consumption Function Life Cycle Hypothesis (Modigliani)

Assertions consumption is based on permanent

income permanent income is dependent on the

returns to human and nonhuman assets or wealth

HHs smoothen their consumption over time by allocating consumption expenditures equally over time

Thus, consumption may differ from a HH’s current income

Volatility of Consumption Expenditures consumption is affected mainly by

income and wealth wealth is determined by expectations,

interest rates, inflation rates, etc. aggregate demand - ultimately

aggregate supply - varies according to changes in consumption