Consumption Function

Consumption

Income is used for consumption and savings

Yd = C + S

If C = a + bYd

Then S = Yd – C

= Yd – a – bYd

= - a + (1-b)Yd

Where Yd = personal disposable income

C = consumption

S = savings

a,b = parameters

Components of Consumption

Non-durable goods – foods, drinks, lighting & heating

Durable goods – furniture, kitchen appliances, washing machines, cars, ACs and other white goods.

Services – non durable – transport, banking, insurance, health, education, legal etc.

Keynes Psychological Law of consumption

When aggregate income increases, aggregate consumption also increases, but by a somewhat smaller amount.

Increase in income is divided in some proportion between saving and spending.

Increase in income is unlikely to lead to lesssavings or less spending than before.

Absolute Income Hypothesis

In his 1936 book on ‘The General Theory of Employment, Interest & Money’, he advanced the hypothesis that consumption has two components:

1. Autonomous (C0)

2. Induced => varies directly with current income through a linear function.

C = C0 + bY

Where C0, b > 0

And b < 1

or 0 < b < 1

Propensity to Consume

Expresses the relationship between income and consumption.

Shows how consumption expenditure changes as income varies.

Marginal Propensity to Consume

change in consumption

mpc = -----------------------------------

change in income

DY C S mpc

600 600 0 -

800 760 40 0.8

1000 920 80 0.8

1200 1080 120 0.8

1400 1240 160 0.8

1600 1400 200 0.8

0

500

1000

1500

2000

1 2 3 4 5 6

Co

ns

um

pti

on

& D

I

DY

C

Savings Function

Aggregate Savings is the difference between disposable income and consumption expenditure.

Savings function is the schedule relating total consumer savings to total disposable income in the economy.

Marginal Propensity to Save

change in savings

mps = ------------------------

change in income

mpc + mps = 1

Under the AIH, the mpc is a constant ‘b’.

δC

mpc = ---------- = b

δY

Average propensity to consume falls as the income increases.

C C0

APC = --------- = --------- + b

Y Y

APC -> MPC as Y -> infinity

Corollary

mps is a constant (=1-b)

aps increases as income increases

S = Y – C

= Y – C0 – bY

= - C0 + (1-b)Y

δS

mps = ---------- = 1-b

δY

Co

APS = ---------- + (1-b)

Y

APS -> MPS as Y -> infinity.

MPC + MPS = 1

APC + APS = 1

As economy prospers, Y and savings rate (S/Y=APS) goes up.

Rich people and rich countries have high savings rates as compared to poor people and poor countries.

Prosperity leads to stagnation.

Permanent Income HypothesisGiven by Milton Friedman (1957)

Consumption is determined by long term expected income rather than the current level of income

long term expected income is called permanent income

People experience random and temporary changes in their income from year to year

Current income is the sum of two components: permanent income YP and transitory Income YT.

Y = YP + YT

Permanent income is that part of the income that people expect to persist into the future.

Transitory income is the random deviation from it

Consumption should depend primarily on permanent income.

C = αααα YP

Where α = fraction of permanent income consumed

Keynes Friedman

C YP

APC = --------- = α -------

Y Y

Rational Expectations & Random-Walk ConsumptionForward-looking consumers base their consumption decisions not only on their current income but also on the income they expect to receive in the future.

Rational expectation

People will make optimal forecasts about the future.

Robert Hall was the first to derive the implications of rational expectations for consumption.

=> changes in consumption over time should be unpredictable

– follow a “Random Walk”

=> changes in consumption reflect “surprises” about lifetime income.

Determinants of Consumption Function

Wealth & Distribution of Wealth

Relative Income =>

1. Current income relative to past peak income (Y/Ymp).

2. Own income relative to average income of the neighbourhood. (Demonstration / Bandwagon Effect)

Determinants (cont…)

Interest Rate

Credit availability

Consumer’s expectations

Consumption Function

C = f { Y, W, Y/Ymp, i, CA, CE, IWD, µ}

Y = income

W = wealth

Ymp = maximum past income

i = interest rate

CA = ease of credit availability

CE = consumer’s expectations

IWD = inequality of income/ wealth distribution

µ = unknown/other factors

The Multiplier

Concept

Multiplier expresses the relationship between an initial increment in investment and the final increment in aggregate income.

It is the ratio of the change in income to the change in investment.

Y

K = -----------

I

Multiplier & MPC

The size of the multiplier depends upon the size of the mpc.

The higher the mpc, the higher is the size of the multiplier; the lower the mpc, lower is the size of the multiplier.

An example

Building a woodshed

Initial/primary investment = Rs. 1,000 => income of carpenter & lumber producer (say tier one consumer ‘A’) = Rs. 1,000

Let mpc = 2/3

Expenditure by A on consumption goods

= 2/3*1000 = 666.67

Producer’s income = Rs. 666.67

Expenditure (B) = 2/3 * 666.67 = 444.44

Example (cont…)

Total income generated =

(1 x 1000) + 2/3(1000) + (2/3)2(1000) + (2/3)3(1000) + ----------

1

= ------------- x 1000 = 3000

1 – 2/3

1 1K = ---------- = -----------

1-m s

The size of the multiplier depends on the size of the mpc or the mps

Limiting case

if mpc = 0

K = 1

If mpc = 1

K = infinity

Aggregate Demand

Total amount of goods demanded in the economy.

AD = C + I + G + (X-M)

Equilibrium is achieved when

Quantity supplied = quantity demanded

Y = AD = C + I + G + (X-M)

Income

Aggre

gate

Dem

an

d

ADo

AD=Y

C

AD

E0

Yo Y1

E1

Diagrammatic representation

Assumptions / Limitations

Availability of consumer goods

Maintenance of investment

No change in mpc

Existence of less than full employment

Criticisms

Prof Henry Hazlitt

There is no precise, pre-determinable relationship between investment and income

Assumes unemployment

The propensity to consume assumes that what is not spent on consumption is not spent at all