Macro 1 Consumption PDF

## CH 1 Macroeconomy: Consumption In the strict sense, consumption = destruction of goods or services through use for the direct satisfaction of a human need. In macroeconomics, consumption = goods and services purchased by households. Households consume both marketable and non-marketable goods a...

## CH 1 Macroeconomy: Consumption In the strict sense, consumption = destruction of goods or services through use for the direct satisfaction of a human need. In macroeconomics, consumption = goods and services purchased by households. Households consume both marketable and non-marketable goods and services. Non-marketable goods and services are mainly produced by public administrations (e.g., education, healthcare). Although these services are free, they still improve the standard of living and, thus, contribute to consumption, similar to the corresponding marketable services. (e.g., free primary school = not included, but a private school is included.) The expanded consumption of a population includes both free and paid services. Consumption of a country = goods and services purchased or privately consumed, plus individualizable non-marketable services. Individualizable services are partially paid because non-marketable services are not considered if free. ### 1) Structure of Consumption and Income It is necessary to further specify the income we are talking about: * **Gross national income**, **national income**, or **household disposable income**? The most relevant is **household disposable income.** At the household level, we find an equilibrium between **employment** and **resources**. **Household resources** are composed of: * **Income from work** + **Income from wealth** = **Primary income** * + **Social transfers** - **Tax payments** = **Net transfers**. **Gross disposable income** = Yd Yd is used for: * **Final consumption** + **Savings**. **Consumption classifications** are accompanied by **budgetary coefficients**: * **Consumption by function** = Consumption expenditures categorized by the type of household needs they satisfy. We distinguish: * **Complementary goods** = Goods that are simultaneously necessary to satisfy a single need (e.g., a car, fuel). * **Substitutable goods** = Goods that can satisfy a single need (e.g., a car, alternative transportation). * **Consumption by durability** = Goods classified by how long they are used, distinguished between **durable goods** (e.g., household appliances, leisure items), **semi-durable goods** (e.g., durable goods that are subject to wear and tear), and **non-durable goods** (e.g., food, energy). * **Consumption by product** = This classification considers the nature of the product consumed. This classification is useful for macroeconomic studies where it is necessary to relate consumption and production. The budgetary coefficient for good *i* is: $b_{i} = \frac{C_{i}}{C} \times 100$ This coefficient allows time and spatial comparisons. **Consumption structure** for a country changes over time. It also differs between countries at a given point in time. While this structure is not completely stable, there is a relationship between household income levels and spending patterns. **Ernest Engel** argued in 1957 that: * Spending on food increases at a slower pace than income. * Spending on housing and clothing increases at a similar rate as income. * Spending on other goods and services (culture, healthcare, transport) increases at a faster rate than income. The **elasticity of consumption with respect to income** measures the sensitivity of consumption changes to income changes. **Elasticity** = Change in relative consumption expenditure / Change in relative disposable income. Equation: $e_{c/yd} = \frac{\frac{\Delta C}{C}}{\frac{\Delta Yd}{Yd}}$ The **marginal propensity to consume** is the part of an income increase that is used for increased consumption. We call it the **marginal consumption derivative** in economics. $f'(x) = f(x)$ Therefore: $PmC = \frac{\Delta C}{\Delta Yd}$ The **marginal propensity to consume** represents the derivative of consumption expenditure with respect to disposable income. ### II) Consumption and Saving Behavior This area of study arises from **John Maynard Keynes's *General Theory of Employment, Interest, and Money* (1936).** In response to the 1929 crisis, Keynes sought to develop a macroeconomic framework to confront unemployment. His model shows a general relationship between income and consumption, where saving is the non-consumed part of income. Keynes considered savings to be detrimental because it leads to decreased demand, and thus, reduced production and employment. In contrast, the **classical school** argued that savings depend on **interest rate** and not on income. They viewed savings as **deferred consumption**. Thus, the decision to consume today versus tomorrow depends on the interest rate. ### 1) Keynesian Consumption Function The **Keynesian consumption function** is based on the **fundamental psychological law**: > People tend to consume more as their income increases, but not as much as the income increase. This means that if my income increases by 1000, I will not spend the entire 1000 on consumption, but only a part of it. This translates mathematically to: $0 < \frac{\Delta C}{\Delta Yd} < 1$ $0 < PmC < 1$ **PmC** = **marginal propensity to consume**. Since we deal with infinite decimals, mathematical derivatives are involved. $Y = f(x) = f'(x)$ $C = f(Yd) = f'(Yd)$ $PmC = \frac{dC}{d Yd}$ This law provides no information about the form of the function, but three forms are compatible: 1. **Linear function:**  Since the change in consumption expenditure is constant, the **marginal propensity to consume** (PmC) is constant and equal to the **average propensity to consume** (PMC). 2. **Affine function**:  $f(x) = ax + b$ The **incompressible consumption** (*C₀*> > 0) is a constant that reflects the non-consumption part of the income. $PmC = c$, where *c* is the derivative. 3. **Concave function**:  $F(Yd) \ \frac{d}{d Yd} > 0$ This function depicts a decreasing slope. This means that the **marginal propensity to consume** decreases as income increases. The **average propensity to consume** is decreasing as income increases. According to **Keynes**, as income increases, the **marginal propensity to consume** tends to decrease (the slope is less steep). When we use this approach, the concave function is more suitable. However, for practical purposes, the **linear function** is more often preferred. Therefore, we have a constant **marginal propensity to consume** and a decreasing **average propensity to consume**. High-income earners tend to have a smaller proportion of income dedicated to consumption than low-income earners. ### Function of Savings Starting from the consumption function, we can arrive at the **function of savings**. Household disposable income is used for saving and consumption:  Savings are the residual: $S = (1-c) Yd - C_{0}$ From the formula, the **average propensity to save** (PHS) is increasing with disposable income: $PHS = \frac{S}{Yd} = (1-c) - \frac{C_{0}}{Yd}$ The **marginal propensity to save** is constant and equal to 1 - PmC: $PmS = \frac{dS}{dYd} = 1-c = 1-PmC$ ### Empirical Verification This involves comparing theory with reality by researching whether the theoretical assumptions are validated. This can be done by studying **time series**. This involves analyzing a variable through different time periods (e.g., consumption in 1987, 2007, 2021). A priori, estimations align with the theoretical findings, yielding a constant marginal propensity to consume (PmC) that is less than 1. However, when applying the Keynesian consumption function to post-war consumption, the projections underestimate consumption. In conclusion, the **Keynesian consumption function** is not fully satisfactory. When using longer time series (more than 10 years), Kuznets (1946) estimated the consumption function for the United States from 1919 onwards and concluded that the marginal propensity to consume (PmC) equals the average propensity to consume (PMC), which contradicts the affine function. However, this suggests a linear relationship, with c = 0.86. This highlights the inconsistencies between short-term and long-term series. Another type of verification involves **instantaneous cross-section studies**. This compares the level of consumption among individuals across income brackets at a specific point in time. These studies support the Keynesian consumption function, confirming that consumption increases proportionally with income growth. However, this type of study has limitations. It focuses on microeconomic behavior, which is not sufficient to validate the macroeconomic consumption function. ### Post-Keynesian Developments The critique prompted the emergence of new theories, including: 1. **The Habit Formation Effect:** * **Duesenberry (1948)** introduced the concept of habit formation. This theory assumes a dynamic consumption function where consumers have "ratchet effects," meaning past consumption levels impact current consumption. Therefore, current consumption depends on both current income and the highest income level achieved in the past. This effect can explain why consumption falls less sharply than income during recessions, as consumers resist reducing their spending back down to previous levels. * This theory suggests that the **marginal propensity to consume** is lower in the short term than in the long term. There is a "catch-up" effect as high income earners have a higher marginal propensity to consume in the long term. The habit formation effect is criticized for being too rigid, leading to a sudden change in consumption behavior. Other models, such as the **inertia effect** (Brown, 1952) incorporate habit formation more subtly, allowing for a gradual adjustment of consumption behavior. 2. **The Demonstration Effect:** * **Duesenberry (1949)** argued that consumption is determined by **relative income**, comparing individual income to average income. This implies that households with lower incomes tend to consume more to emulate the consumption patterns of wealthier households, leading to a higher marginal propensity to consume. The **relative income hypothesis** is supported by empirical evidence. When comparing income levels of high and low-income earners, the marginal propensity to consume is higher for lower-income earners, particularly when their income is significantly lower than the average. ### Intertemporal Models 1. **Life Cycle Theory:** * **Brumberg and Modigliani (1954)** argue that individuals plan consumption expenditure over their lifetimes in order to smooth consumption and maintain a constant level of consumption. This theory considers both the individual's total lifetime wealth (including assets and income) and their expected lifespan. It suggests that people borrow during their youth, save during their working years, and then draw down their savings in retirement. * This approach assumes an infinite horizon and certainty about the future. 2. **Permanent Income Theory:** * **Friedman (1957)** proposed that consumption is determined by an individual's "permanent income," which is the average income they expect to receive over their lifetimes. This theory suggests that individuals view fluctuations in income as temporary, adjusting their current consumption patterns based on this long-term perspective. * This approach assumes that income variability is temporary. It uses **actuarial discount factors** for income and consumption to determine their present discounted value. The **life cycle theory** assumes an infinite horizon and perfect foresight, while the **permanent income theory** uses a finite horizon and considers uncertainty about future income. **Keynesian theory** focuses on the relationship between current income and consumption, while **intertemporal models** consider individual lifetime plans and long-term income expectations. **Intertemporal models** have been criticized for their simplifying assumptions, such as certainty about the future and perfect rationality. **Empirical evidence** supports both theories, although they have different strengths and weaknesses. The **permanent income theory** aligns with observed consumption patterns, but some evidence suggests that individuals are more sensitive to changes in current income than the model predicts. ### Determinants of Saving #### Short-Term Determinants * **Purchasing power:** A decrease in purchasing power, often caused by inflation, discourages saving. As prices rise, consumers spend more to avoid buying goods later at a higher cost. * **Unemployment**: A rise in unemployment fuels precautionary saving. Individuals facing job insecurity tend to save more to mitigate potential financial hardship during periods of joblessness. * **Interest rates:** * For borrowers, rising interest rates discourage saving as they need more funds to cover loan payments. * For lenders, rising interest rates encourage saving as they receive higher returns on their investments. #### Long-Term Determinants * **Population aging**: An aging population implies a higher number of retired individuals relying on savings. As a result, there is a greater demand for savings, potentially leading to increased saving. * **Pension system:** Government pension systems can have mixed effects on saving. * **Negative:** Pension systems can reduce the incentive to save for retirement, as individuals rely on pensions for post-employment income.. * **Positive:** The perceived inadequacy of pension systems, especially if they face financial strain, might lead to greater precautionary saving. The determinants of saving are complex and can have both positive and negative effects on saving behavior. Understanding these factors is crucial for analyzing macroeconomic trends and policies related to saving, consumption, and economic growth.