10. Consumption Function

3

Definitions

1. Disposable/Net Income: YD = Y G – T = C+ S

2. Consumption Function  Expresses consumption spending as a function of disposable income.

10. CONSUMPTION FUNCTION

Torsten Jochem

10. Consumption Function 10. Consumption Function

2 4

Consumption
The individual Consumption Function
Gross income (Y) can be either consumed (C), saved/ invested (S), or given to the government in taxes (T) Consumption spending (C)

Y = C + S + T

 C = Y – S – T The more income you have No difference to what we the more you can save. did before in GDP chapter! GDP computation by expenditure approach: Y = GDP = C + I + G Disposable income (DI) 10. Consumption Function 10. Consumption Function

5 7

The individual Consumption Function
The individual Consumption Function

C=DI - Increase in Wealth Consumption Consumption (= assets – liabilities) spending (C) spending (C) - Lower interest rates /returns to investment -Expectations, e.g. * higher future income The more income you have * higher future inflation the more you can save.

Disposable Disposable

“dissaving” Break-even saving income (DI) income (DI)

10. Consumption Function 10. Consumption Function

6 8

The individual Consumption Function
The individual Consumption Function

Consumption Consumption spending (C) spending (C) - Decrease in Wealth C2 - Higher interest rates /returns to investment C1 A shift in disposable income - Expectations, e.g. (not wealth! ), changes the * lower future income position along the curve. * deflation

DI1 DI2 Disposable Disposable income (DI) income (DI) 10. Consumption Function 10. Consumption Function

9 11

The aggregate Consumption Function
The aggregate Consumption Function

More aggregate consumption Consumption Consumption C=DI Note: can occur through spending (C) - the relationship between spending - a (true or believed) increase DI and C is almost 1! of aggregate wealth (e.g. - Typical savings rate housing prices up, stock between 4-10% of market up) Autonomous income in the U.S. - Lower interest rates / Consumption investment returns Level (negative -Expectations for savings) * Higher future inflation * Higher future income

Disposable disposable “dissaving” Break-even saving income (DI) income

10. Consumption Function 10. Consumption Function

10 12

The aggregate Consumption Function
Consumer Confidence & Consumption

Less aggregate consumption Consumption can occur through spending - a decrease of aggregate wealth - Higher interest rate / investment returns -Expectations for * deflation * lower future income

New Zealand U.S. disposable income 10. Consumption Function 10. Consumption Function

13 15

Marginal Propensity to Consume (MPC): Individual
Marginal Propensity to Consume: Aggregate Case
How much more do we spend in consumption with one extra dollar of income? Consumption Again, the slope of the spending (here, aggregate) Consumption spending (C) consumption function is the MPC. C2 The slope of the consumption Since the aggregate function f’(x) for some C1 consumption function is disposable income x, is virtually linear, we can called the marginal get the slope from any propensity to consume two points on the line. (MPC) at x.

disposable DI1 DI2 Disposable income income (DI)

10. Consumption Function 10. Consumption Function

14 16

Marginal Propensity to Consume (MPC): Individual
Marginal Propensity to Consume: Aggregate Case
= how much more do we spend in consumption with one Consumption extra dollar of income? spending
Example:  Someone earning $x gets a salary increase of $1. Of the ∆ C ∆C increase she spends $0.90 on consumption and saves $0.10. = slope = MPC  her MPC (at x) = 90% = 0.9 ∆DI Also, her Marginal Propensity to Save  MPS (at x) = 10% = 0.1 Note: MPS + MPC = 1 disposable ∆ DI income 10. Consumption Function 10. Consumption Function

17 19

Example: Given the following graph,
MPC vs. APC what’s the MPC?
Average Propensity to Consume (APC) Consumption spending = Total consumption spending/Total disposable income  one point on the consumption function is enough.

$9.975 trill.
APC = C / DI $9.5 trill  Fraction of consumption in total disposable income
MPC = ΔC / ΔDI  What we spend on consumption with an increase of $10 trill. $10.5 trill disposable disposable income income

10. Consumption Function 10. Consumption Function

18 20

Example: Given the following graph,
The aggregate Consumption Function what’s the MPC? Consumption spending MPC = ∆C / ∆DI DI C S C(DI) = 5 + 0.95 DI 0 5 -5 Consumption $9.975 trill. MPC = (9.975-9.5) / (10.5 – 10) 100 100 0 spending (C) = 0.475/.5 195 $9.5 trill = 0.95 200 195 5 100  MPS = 0.05

5 “Break even” at $10 trill. $10.5 trill disposable D.I = C = 100 0 100 200 Disposable income income (DI) 10. Consumption Function

21

Any Questions?