Consumption and Savings in Economics

• Consumption in economics refers to the utilization of goods and services by households.
• Consumption expenditure is when households purchase goods and services.
• Savings are defined as all unconsumed disposable income (income after taxes).
• Consumer expenditure makes up the largest component of aggregate demand, giving consumption a central role in macroeconomics.
• C = a + cY, consumption is therefore an increasing function of income.
• Savings functions are directly related to consumption functions.
• Increasing the disposable income leads to greater personal and aggregate savings.
• The Marginal Propensity to Save (MPS) indicates the proportion of each disposable income increment that goes to savings, measuring the change in saving per unit change in disposable income.
• The Marginal Propensity to Consume (MPC) measures shifts to the value of consumer expenditure per unit increment to income.
• MPC + MPS = 1

Consumption Theories

• The study of consumption is often begun with John Maynard Keynes's General Theory, initially published in 1936
• Keynes brought the consumption function to center stage of his economic fluctuation theory, paving the way for the macroeconomic analysis that followed
• Keynes's conjectures about the consumption function were based on casual observation.
• The marginal propensity to consume, and the amount consumed out of each additional dollar of income is between 0 and 1.
• Consumption increases with disposable income (MPC ≥ 0), but it increases by less than the increase in disposable income (MPC ≤ 1), i.e., 0 ≤ MPC ≤ 1.
• Individuals tend to increase consumption as their income increases, but not by the full amount of the income increase, meaning consumers save some of each additional dollar earned.
• The average propensity to consume, the ratio of consumption to income (C/Y) decreases as income rises because saving is seen as a luxury.
• Income serves as the primarily determinant of levels of consumption, with interest rates playing only a minor role.
• The Keynesian consumption function is often written as C = Ĉ + cY, Ĉ > 0, 0 < c < 1.
• C = consumption
• Y = disposable income
• Ĉ = constant (autonomous consumption)
• c = the marginal propensity to consume.

Properties

• The marginal propensity to consume (c) is between zero and one, so higher income promotes more consumption and saving.
• The average propensity to consume (APC) decreases as income (Y) increases as represented by APC = C/Y = Ĉ/Y + c.
• The interest rate is not included in the equation as a determinant of consumption.
• Households with higher incomes consume more (MPC > 0) and save more (MPC < 1).
• With higher incomes households save a larger fraction of their income (APC decreases as Y increases).
• A very strong correlation exists between income and consumption, making income the main determinant of consumption.
• Predicted growth of consumption (C) would be slower than the growth of income (Y) over time based on the Keynesian consumption function.
• Over time, the average propensity to consume did not fall as incomes grew, and consumption (C) grew at the same rate.
• Economist Simon Kuznets, found that the ratio C/Y remained very stable over long periods.

Irving Fisher's Inter-temporal Model

• Irving Fisher's model analyzes how logical, forward-thinking consumers make decisions about consumption over time.
• He believed that consumers consider both the present as well as future financial situations.
• An inter-temporal budget constraint encompasses a consumer's decisions on how much to consume today compared to how much to save for tomorrow.
• Rational consumers can make inter temporal choices involving different periods of time.
• Constraints consumers experience can influence their choices of consumption and savings.
• Most people would prefer to increase the quantity or quality of consumer goods such as nicer clothes, better restaurants, or access to more movies.
• Consumption is constrained by income.
• A budget constraint limits the amount spent.
• When individuals decide how much to consume today versus how much to save for the future, they face an inter temporal budget constraint.

Basic Two-Period Model

• Period 1: the present.
• Period 2: the future.
• Y1 = income in period 1.
• Y2 = income in period 2.
• C1 = consumption in period 1.
• C2 = consumption in period 2.
• S = Y1 - C1 = saving in period 1.
• The notation (S < 0) indicates the consumer borrows during period 1.
• Period 2 budget constraint: C2 = Y2 + (1 + r) S = Y2 + (1 + r) (Y1 - C1).
• This is rearranged to: (1 + r) C1 + C2 = Y2 + (1 + r) Y1.
• Finalized to make C₁ + C₂/(1 + r) = Y₁ + Y₂/(1 + r).
• Y₁ + Y₂/(1 + r) = Present value of lifetime income.
• C₁ + C₂/(1 + r) = Present value of lifetime consumption.

Consumer Budget Constraints

• If he chooses points between A and B, the consumer consumes less than his income in the first period and saves the rest for the second period.
• If he chooses points between A and C, he consumes more than his income in the first period and borrows to make up the difference.
• Consumer's can borrow or save, with point A representing the consumer consuming exactly his income, with no saving or borrowing.
• At point B, the consumer saves all income and consumes nothing.
• Second-period consumption C2 is (1 +r)Y1+Y2.
• The consumer plans to consume nothing in the 2nd time period, with borrows as much as possible against 2nd period income for point C.
• First-period consumption C1 is Y1+Y2 /(1+r).
• Fishers theory suggests that the consumer chooses current as well as future consumption to maximize lifetime satisfaction, within an inter-temporal budget constraint.
• Current consumption depends on lifetime income not current income, given that a consumer can save or borrow.

Modigliani's Cycle Hypothesis

• Modigliani emphasized that saving enables consumers to shift income from high-income periods to low-income periods.
• Interpretation of consumer behavior that created the basis of the life cycle hypothesis.
• A reason that income alters over the course of a lifetime is retirement.
• Many people intend to stop working by a target date and anticipate for incomes to drop off upon retiring.
• People don't want a big reduction in their living conditions so they turn to earlier savings.
• Current disposable income is not the only factor in consumption.
• Future expected income is factored into overall saving/borrowing patterns during each individuals personal life cycle.
• Alterations to savings rates as time progresses affect individual decisions due to increased average lifespan.
• The Life-Cycle Hypothesis (LCH) suggests income varies throughout each phase of the consumer's 'life cycle,' allowing savings to achieve consistent consumption.
• Basic models include
• W = the value of initial wealth.
• Y = annual income until retirement.
• R = number of retirement.
• T = lifetime in years.
• The model assumes there is a zero real for simplification as well as consumption smoothing.
• To achieve consistent amounts of consumption individuals divide resources evenly over time represented by C = (W + RY)/T or C = αW + βY.
• α = (1/T) is the marginal propensity to consume with wealth.
• β = (R/T) is the marginal propensity to consume with income.
• Following that theory, the APC will become C/Y = a(W/Y) + β.
• Households with high incomes should have a lower APC than that of a low income household.

The Permanent-Income Hypothesis

• Milton Friedman created this hypothesis as a measure of actual consumption compared to permanent earning instead of modern profits.
• It says that households are the result.
• It is not expected that consumption will depend upon a modern day's earnings alone.
• Lifestyle, routine and the effects of age can affect consumption in different ways.
• Current income Y is the sum of permanent income YP (average income) and transitory income YT (temporary deviations).
• The hypothesis dictates that an individual can dictate when consumption shifts based off smoothing efforts when responding to earning changes.
• The PIH consumer function is seen as: C = aYP, a = a is the part of permanent pay spent by consumers each year.
• When modern pay exceeds permanent pay, the average propensity to consume quickly drops.
• Should modern pay fall more than the typical earner, the average would rise.
• Friedman theorized these data reflected permanent and transitory income combinations.
• If all variation in current income came from the permanent component, propensity to spend would be similar across households..
• Transitory income for those with the income do not tend to result in greater numbers for consumer activity.
• In the modern age, earnings often lead to a reduction in rates to consume.
• Changes in time reflect shifting short term earning conditions.
• High rates of income are expected to lower tendencies to spend profits.
• Shifts over the long run come from the steady long term source that can be seen in the consistent model.

PIH versus LCH: Points

• Both say to smooth out consumer patterns when handling variations in income.
• Lifecycle occurs by those moving slowly within shifts to the market or economic change.
• Individuals can be expected to face shifts to long and short term shifts
• Both assumptions here can be used when solving typical consumer based activity.
• The Random Walk states those who forecast shifts will do so under information that allows consumers to anticipate events before they have taken hold.
• The random model works when rationalized by data that provides consistent reactions. Those results may be unpredictable .
• Changing profit margins can result in the need for greater income or savings to address changes in those results to better forecast patterns by trends.
• Only unexpected shifts in pay results can change individual responses due to long term earnings forecasts.

Random Walk Theory Criticisms

• Overly simplistic: Critics argue that the theory may not fully capture real-world complexities such as liquidity constraints or psychological factors that influence consumption behavior.
• Data limitations: The validity of the random walk theory can be sensitive to data quality and measurement issues.
• Empirical challenges: Studies have found evidence that consumption may be slightly predictable based on past consumption patterns, contradicting the pure random walk hypothesis.