Consumption Economics PDF

## Consumption and Saving Prepared by: Mahmuda Akhter Khanam, Assistant Professor, Department of Humanities, CUET ### Keynesian Consumption Function * The assumption of the Keynesian consumption function is that consumption depends on income, other things being equal. The higher the income, highe...

## Consumption and Saving Prepared by: Mahmuda Akhter Khanam, Assistant Professor, Department of Humanities, CUET ### Keynesian Consumption Function * The assumption of the Keynesian consumption function is that consumption depends on income, other things being equal. The higher the income, higher is the consumption, _ceteris paribus_. * Keynes' psychological law of consumption (The concept of the marginal propensity to consume). Keynes argues that when the income increases, consumption also increases but not to the same extent as the increase in income. ### Consumption (C) and Investment (I) * Since we are more concerned with the two-sector model in our course, we will discuss about consumption and investment. * In a two-sector model, a simple but an imaginary assumption of no government and no foreign trade is made. * Here Y₁ =C+S or Y₁ =AD (aggregate demand) * This also implies that C+S=C+I ### Consumption * **Introducing you with:** - What is consumption? - What is the consumption function? - What are the determinants of consumption? - What is MPC? - What is APC? ### Consumption "Consumption is the sole end and purpose of all production." - Adam Smith * **Consumption** is the act of spending income for buying goods and services to satisfy wants. * **Determinants of consumption:** - Disposable income (after tax income) of the consumers - Accumulated wealth or assets - Their expected future income - The actual price level - The expected general price level - Rate of interest - Thriftiness - Their age, sex, and family size etc. ### Consumption Function * A relation between consumption and its various determinants is called the **consumption function**. The consumption function taking all these determinants into account can be written as: $C=f (Ya, W, Ye, P, Pe, r, s, DF.....)$ ### Keynesian Consumption Function * Keynes, however, asserts that income alone is the most important determinant of consumption. Here, income refers to the disposable income. The Keynesian consumption function, can be written as: - $C=f (Ya), 1>f>0$ - Where, - C=Consumption demand - $Ya$ = Disposable income= (Y-T) - Y=Personal income - T=Taxes (related to income) ### Keynesian Psychological Law * The fundamental psychological law, upon which we are entitled to depend with great confidence both _a priori_ from our knowledge of human nature and from the detailed facts of experience is that men are disposed of, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income. * The idea is that when the income increases, consumption also increases but less than proportionally. Alternatively, **marginal propensity to consume (MPC)** is positive but less than unity (0<MPC<1). ### Marginal Propensity to Consume * Keynesian Psychological Law is also called the MPC. * Given the consumption function: C= f (Ya), the **MPC** is the ratio between change in consumption expenditure and the change in income level. * $MPC= \frac{\Delta C}{\Delta Y} = \frac{Change in consumption}{Change in disposable income}$ * i.e. 0< =$\frac{\Delta C}{\Delta Y}$ <1 ### Marginal Propensity to Consume * Suppose, initial income level is Rs. 1000 and consumption demand is Rs. 800. When income level increases to Rs. 1500, and consumption demand to Rs. 1200, MPC will be: $MPC= \frac{\Delta C}{\Delta Y}=\frac{400}{500}=0.80$ * This implies that when income increases by Rs. 100, consumption demand increases by Rs 80. And the difference Rs. 20 is the saving. * This means $Ya = C+S$ * i.e. Disposable income=Consumption+Saving ### Average Propensity to Consume * The fraction of total disposable income spent on consumption demand is called the **average propensity to consume (APC)**. * $APC= \frac{Consumption demand}{Disposable income} = \frac{C}{Ya} $ * APC implies the average spending tendency of the community or the people of a country. * Given the consumption function, C=C₂+bYa * $APC= \frac{C}{Yd}= \frac{Ca+bYd}{Yd}$ * Or, $APC = \frac{C +b}{Ya}$ ### Calculating APC and MPC | Yd | C | APC | MPC | S=Yd-C | |---|----|-----|-----|-----| | 0 | 100 | - | - | -100 | | 100 | 175 | 1.75 | 0.75 | -75 | | 200 | 250 | 1.25 | 0.75 | -50 | | 300 | 325 | 1.08 | 0.75 | -25 | | 400 | 400 | 1 | 0.75 | 0 | | 500 | 475 | 0.95 | 0.75 | 25 | | 600 | 550 | 0.92 | 0.75 | 50 | ### Main Observations * When disposable income increases, consumption also increases but not proportionately. * When disposable income increases, APC declines. * When disposable income increases, MPC remains constant and APC>MPC. * At low level of income, there is dissaving and at higher level of income there is saving. * At a particular level of income (i.e. at Rs. 400, C=Y), saving is just zero. This point is called the **break-even point**. ### Graphical Presentation This is a graph with disposable income on the x-axis and consumption (C) and saving (S) on the y-axis. * The y-axis intercepts are the autonomous part of consumption (Ca) and saving (-Ca). * The 45 degree line represents equilibrium where Y=C+S. * The graph shows a consumption function for both the short run (CSR) and the long run (CLR), with the short run consumption function shown as a steeper line. **Short run and long run consumption** * The **short run consumption** is non-proportional in the sense that consumption is partly autonomous and partly induced, that is related to the current disposable income. * The **long run consumption** fully depends on income. The long run autonomous consumption is zero and according to Keynes, in the long run, we all die if fail to generate our own income. ### Saving Function * Savings is the disposable income not spent on consumption. * Savings is the difference between disposable income and consumption. * It can be represented by the equation: - $S = Y - C$ - $S = Yd - (Ca+bYd)$ - $S = -Ca+(1-b)Yd$ - Where, $-Ca$=Autonomous saving that is negative or that is dissaving. A person must borrow in order to survive. - 1-b is **marginal propensity to save** as we know b is **marginal propensity to consume**. ### Types of Saving * **Private saving:** (Y− T) – C * **Public saving:** T-G * **National saving, S:** private saving + public saving = (Y-T)-C + T-G = Y-C-G ### Marginal Propensity to Save * **MPS** is the change in saving as a result of an additional unit of disposable income. * $MPS = \frac{\Delta S}{\Delta Y}= \frac{Change in saving}{Change in disposable income}$ * Since MPC+MPS=1, when MPC increases, MPS decreases. This relationship between MPC and MPS can also be shown graphically by plotting MPS on the vertical axis and MPC on the horizontal axis. ### Average Propensity to Save * **APS** is the ratio between total saving and total disposable income. * $APS = \frac{S}{Yd}= \frac{Saving}{Disposable income}$ * APS increases when disposable income increases and vice versa. ### Relation Between APC and APS * C+S=Y * Dividing both sides by disposable income Y we have: $\frac{C}{Y} + \frac{S}{Y} + \frac{Y}{Y} = 1$ * Since $ \frac{C}{Y} $ is average propensity to consume and $ \frac{S}{Y} $ is average propensity to save, we have: - APC + APS = 1 - or APS = 1-APC * This means for example, that if a society consumes 75 per cent of its disposable income, that is, APC = 0.75, then it will save 25 per cent of its disposable income or its average propensity to save (APS) will be 0.25 (1 – 0.75 = 0.25). * From C + S = Y, it follows that any change in income (ΔY) must induce either change in consumption (ΔC) or change in saving (ΔS). Thus, - ΔC + ΔS = ΔΥ * Dividing both sides by ΔY we have: - $\frac{\Delta C}{\Delta Y} + \frac{\Delta S}{\Delta Y} = \frac{\Delta Y}{\Delta Y}= 1$ - MPC + MPS = 1 ### Determinants of Consumption * Changes in the General Price Level: Real Balance Effect * Fiscal Policy: * Rate of Interest: * Stock of Wealth: * Credit Condtions and Consumer Indebtedness: * Income Distribution: * Windfall Gains and Losses: * Change in Expectations: