Determining the Level of Consumption
The consumption function shows the relationship between: a. planned consumption expenditures and disposable income. b. permanent income and savings. c. The consumption function is an equation describing how a household's level of consumption varies with its disposable income. In order to fully understand the. The consumption function is a relationship between current disposable income and current Figure "The Consumption Function" shows this relationship.
Since at zero level of income, consumption is positive, so MPC must always be positive. Further, since increase in consumption is less than that of increase in income, the value of MPC must be less than one. The relationship between planned consumption expenditure and disposable income is presented in Table But as income increases, consumption rises. Further, as the rise in consumption is less than the rise in income, APC declines.
However, since the rate of increase in consumption is less than the rate of increase in income, the value of MPC is always less than one here 0.
At the same time, MPC is always positive because consumption is positive even if income is zero. The relationship between consumption spending and income is usually explained in an equation form: This equation indicates that consumption is a linear function of income since it is the equation of a straight line.
This part of consumption spending is independent of the level of income. According to Keynes, MPC is always positive but less than one. Thus, MPC is the slope of the consumption line. The consumption function equation can be represented in terms of Fig. This means that, as income rises, consumption rises. Such consumption is called induced consumption. That is to say, at point E, income equals consumption.
Such equality of income and consumption is called breakeven point. To the left of point E, say at OY1 income level, as consumption exceeds income there occurs negative saving or dissaving.
This means that people consume more than their income, i. On the other hand, to the right of E, i. As people do not spend their entire income on consumption, the rest is saved. As income rises, APC declines but it never becomes zero. Its value is less than unity since the rate of increase in consumption dt is less than the rate of increase in income ft.
This may be explained by examining Fig. Thus, APC at point H is: Lines such as these are called rays. Similarly, the slope of the ray to point H1 is the APC. Using survey data, researchers Matthew D. They note that this low increased spending is particularly surprising, since the rebate was part of a general tax cut that was expected to last a long time.
At the other end, David S. Parker, and Nicholas S. Souleles, using yet another data set, found that looking over a six-month period, the MPC was about two-thirds.
So, while there is disagreement on the size of the MPC, all conclude that the impact was non-negligible.
Answers to Try It! Problems A sharp increase in stock prices makes people wealthier and shifts the consumption function upward, as in Panel a of Figure This would be reported as a reduction in consumer confidence. Consumers are likely to respond by reducing their purchases, particularly of durable items such as cars and washing machines.
The consumption function will shift downward, as in Panel b of Figure A reduction in the price level increases real wealth and thus boosts consumption. The consumption function will shift upward, as in Panel a of Figure Distinguish between autonomous and induced aggregate expenditures and explain why a change in autonomous expenditures leads to a multiplied change in equilibrium real GDP. Discuss how adding taxes, government purchases, and net exports to a simplified aggregate expenditures model affects the multiplier and hence the impact on real GDP that arises from an initial change in autonomous expenditures.
The consumption function relates the level of consumption in a period to the level of disposable personal income in that period. In this section, we incorporate other components of aggregate demand: In doing so, we shall develop a new model of the determination of equilibrium real GDP, the aggregate expenditures model Model that relates aggregate expenditures to the level of real GDP.
This model relates aggregate expenditures The sum of planned levels of consumption, investment, government purchases, and net exports at a given price level. We shall see that people, firms, and government agencies may not always spend what they had planned to spend.
If so, then actual real GDP will not be the same as aggregate expenditures, and the economy will not be at the equilibrium level of real GDP. As we saw in the chapter that introduced the aggregate demand and aggregate supply model, a change in investment, government purchases, or net exports leads to greater production; this creates additional income for households, which induces additional consumption, leading to more production, more income, more consumption, and so on.
The aggregate expenditures model provides a context within which this series of ripple effects can be better understood. A second reason for introducing the model is that we can use it to derive the aggregate demand curve for the model of aggregate demand and aggregate supply. To see how the aggregate expenditures model works, we begin with a very simplified model in which there is neither a government sector nor a foreign sector. Then we use the findings based on this simplified model to build a more realistic model.
The equations for the simplified economy are easier to work with, and we can readily apply the conclusions reached from analyzing a simplified economy to draw conclusions about a more realistic one. The Aggregate Expenditures Model: A Simplified View To develop a simple model, we assume that there are only two components of aggregate expenditures: In the chapter on measuring total output and income, we learned that real gross domestic product and real gross domestic income are the same thing.
Consumption and the Aggregate Expenditures Model
With no government or foreign sector, gross domestic income in this economy and disposable personal income would be nearly the same. To simplify further, we will assume that depreciation and undistributed corporate profits retained earnings are zero.
Thus, for this example, we assume that disposable personal income and real GDP are identical. Finally, we shall also assume that the only component of aggregate expenditures that may not be at the planned level is investment. Firms determine a level of investment they intend to make in each period. The level of investment firms intend to make in a period is called planned investment The level of investment firms intend to make in a period. Some investment is unplanned.
Someone with a relatively low current income but a high permanent income a college student planning to go to medical school, for example might save little or nothing now, expecting to save for retirement and for bequests later. A person with the same low income but no expectation of higher income later might try to save some money now to provide for retirement or bequests later.
Propensity to Consume or Consumption Function
Because a decision to save a certain amount determines how much will be available for consumption, consumption decisions can also be affected by expected lifetime income. Thus, an alternative approach to explaining consumption behavior is the permanent income hypothesis Consumption in any period depends on permanent income.
An important implication of the permanent income hypothesis is that a change in income regarded as temporary will not affect consumption much, since it will have little effect on average lifetime income; a change regarded as permanent will have an effect. The current income hypothesis, though, predicts that it does not matter whether consumers view a change in disposable personal income as permanent or temporary; they will move along the consumption function and change consumption accordingly.
The question of whether permanent or current income is a determinant of consumption arose in when President George H. Bush ordered a change in the withholding rate for personal income taxes. Workers have a fraction of their paychecks withheld for taxes each pay period; Mr.
Bush directed that this fraction be reduced in The change in the withholding rate did not change income tax rates; by withholding less intaxpayers would either receive smaller refund checks in or owe more taxes. Economists who subscribed to the permanent income hypothesis predicted that the change would not have any effect on consumption.
Those who subscribed to the current income hypothesis predicted that the measure would boost consumption substantially in That is considerably less than would be predicted by the current income hypothesis, but more than the zero change predicted by the permanent income hypothesis. This result, together with related evidence, suggests that temporary changes in income can affect consumption, but that changes regarded as permanent will have a much stronger impact.
Many of the tax cuts passed during the administration of President George W. Bush are set to expire in The proposal to make these tax cuts permanent is aimed toward having a stronger impact on consumption, since tax cuts regarded as permanent have larger effects than do changes regarded as temporary.
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Other Determinants of Consumption The consumption function graphed in Figure Changes in disposable personal income cause movements along this curve; they do not shift the curve. The curve shifts when other determinants of consumption change. Examples of changes that could shift the consumption function are changes in real wealth and changes in expectations.
Among the events that would shift the curve upward are an increase in real wealth and an increase in consumer confidence. A reduction in the level of consumption at each level of disposable personal income shifts the curve downward in Panel b. The events that could shift the curve downward include a reduction in real wealth and a decline in consumer confidence. Changes in Real Wealth An increase in stock and bond prices, for example, would make holders of these assets wealthier, and they would be likely to increase their consumption.
An increase in real wealth shifts the consumption function upward, as illustrated in Panel a of Figure