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 less savings 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 600 800 1000 1200 1400 1600

C 600 760 920 1080 1240 1400

S 0 40 80 120 160 200

mpc 0.8 0.8 0.8 0.8 0.8

2000

C o n s u m p tio n & D I

1500 1000 500 0 1 DY C 2 3 4 5 6

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. C mpc = ---------- = b Y

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=YC = Y C0 bY = - C0 + (1-b)Y

S mps = ---------- = 1-b Y 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 Hypothesis

Given 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 = YP

Where = fraction of permanent income consumed

Keynes

Friedman

C YP APC = --------- = ------Y Y

Rational Expectations & Random-Walk Consumption

Forward-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 Consumers expectations

Consumption Function
C = f { Y, W, Y/Ymp, i, CA, CE, IWD, }
Y = income W = wealth Ymp = maximum past income i = interest rate CA = ease of credit availability CE = consumers expectations IWD = inequality of income/ wealth distribution = 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 = -----------

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 Producers 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

K = ---------- = ----------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)

Diagrammatic representation
AD=Y Aggregate Demand ADo E0 E1 AD C

Yo

Y1

Income

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