Macro Unit-3 Consumption PDF

CONSUMPTION FUNCTION ❖Theory of consumption function explain relationship between consumption & income ❖As per J.M Keynes, consumption expenditure of household depends mainly on their current income. Other factors influence like interest rate, taxation, amount of wealth et...

CONSUMPTION FUNCTION ❖Theory of consumption function explain relationship between consumption & income ❖As per J.M Keynes, consumption expenditure of household depends mainly on their current income. Other factors influence like interest rate, taxation, amount of wealth etc. ❖As per Keynes, when income increases, consumption increases but in a lesser proportion due to savings factor ❖Consumption Function is also known as Propensity to consume ❖Factors influencing consumption spending of the people is influenced, among others, by the following factors: ❖ the real income of the individual, ❖ past savings, ❖ rate of interest.  PROPENSITY TO CONSUME ❖Propensity to consume is also called consumption function.‘ 𝑎𝑝𝑐 = 𝐶/𝑌 In Keynesian theory, consumption function is not concerned with the consumption of an individual consumer but with the sum total of consumption spending by all the individuals. ❖Average and Marginal Propensities to Consume ❖The relationship between income and consumption is measured by the average and marginal propensities to consume. ❖The average propensity to consume is a relationship between total consumption and total income in a given time period. It is the ratio of consumption to income. ❖The marginal propensity to consume measures the incremental change in consumption as a result of a given increment in income. It is the ratio of change in consumption to changes in income. FACTORS DETERMINING CONSUMPTION FUNCTION 2 types of Factors : Objective Factors and Subjective Factors (help in more saving rather than spending hence consumption is reduced) Objective Factors: Subjective Factors Size of Income Precaution against illness Price Level Accident, unemployment etc Distribution of Income Future Expectations & Needs Propensity to Save Accumulation of Wealth Future Expectations Independence Taste & Fashion Investment Rate of Interest Sudden Gains or Losses Speculation Fiscal Policy KEYNES PSYCHOLOGICAL LAW OF CONSUMPTION ❖ Keynes’s Psychological Law of Consumption ❖ Keynes put forward a psychological law of consumption, according to which, as income increases consumption increases but not by as much as the increase in income. Demand for consumption goods ❖ In other words, marginal propensity to consume (MPC) is less than one. 1 > ∆C/∆Y > 0 ❖ While Keynes Demand recognized goods for investment that many subjective and objective factors including interest rate and wealth influenced the level of consumption expenditure, he emphasized that it is the current level of income on which the consumption spending of an individual and the society depends.  KEYNES PSYCHOLOGICAL LAW OF CONSUMPTION ❖“The amount of aggregate consumption depends mainly on the amount of aggregate income. The fundamental psychological law, upon which we are entitled to depend with great confidence both a prior from our knowledge of human nature and from the detailed facts of experience is that men (and women, too) are disposed, as a rule and on an average to increase their consumption as their income increases, but not by as much as the increase in their income”  KEYNES PSYCHOLOGICAL LAW OF CONSUMPTION ❖Keynes makes three points based on above statement on consumption behaviour, ❖First, he suggests that consumption expenditure depends mainly on absolute income of the current period, that is, consumption is a positive function of the absolute level of current income. ❖The more income in a period one has, the more is likely to be his consumption expenditure in that period. ❖In other words in any period the rich people tend to consume more than the poor people do.  KEYNES PSYCHOLOGICAL LAW OF CONSUMPTION ❖Secondly, Keynes points out that consumption expenditure does not have a proportional relationship with income. ❖According to him, as the income increases, a smaller proportion of income is consumed. ❖The proportion of consumption to income is called average propensity to consume (APC). ❖Keynes argues that average propensity to consume (APC) falls as income increases.  KEYNES PSYCHOLOGICAL LAW OF CONSUMPTION ❖ Keynes’ consumption function ❖ The Keynes’ consumption function can be expressed in the following form: C = a + bYd ❖ where C is consumption expenditure and Yd is the real disposable income which equals gross national income minus taxes, a and b Demand forwhere are constants, consumption a is thegoods intercept term, that is, the amount of consumption expenditure at zero level of income. Thus, a is autonomous consumption. ❖ The parameter b is the marginal propensity to consume (MPC) which measures the increase in consumption spending in response to per unit increase in disposable income. Thus, MPC = ∆C/∆Y ❖ It is evident from Fig. 1 and 9.3 the behaviour of consumption expenditure as perceived by Keynes implies that marginal propensity to consume (MPC) which is measured by the slope of consumption function curve CC at a point is less than average propensity to consume (APC) which is measured by the slope of the line joining a point on the consumption function curve CC to the origin (that is, MPC < APC). This is because as income rises consumption does not increase proportionately and as income falls consumption does not fall proportionately as people seek to protect their earlier consumption standards. This can be seen from Fig. 2 the slope of consumption function curve CC’ measuring MPC and the slopes of lines OA and OB which give the APC(i. e C/Y ) at points A and B respectively are falling whereas slope of the linear consumption function CC’ remains constant. ❖In Fig.2 we have shown a linear consumption function with an intercept term. ❖In this form of linear consumption function, though marginal propensity to consume (AC/AF) is constant, average propensity to consume (C/F) is declining with the increase in income as indicated by the slopes of the lines OA and OB at levels of income Y1, and Y2 respectively. ❖The straight line OB drawn from the origin indicating average propensity to consume at higher income level Y2 has a relatively less slope than the straight line OA drawn from the origin to point Z at lower income level. ❖The decline in average propensity to consume as the income increases implies that the proportion of income that is saved increases with the increase in national income of the country. ❖This result also follows from the studies of family budgets of various families at different income levels. ❖The fraction of income spent on consumption by the rich families is lower than that of the poor families. ❖In other words, the rich families save a higher proportion of their income as compared to the poor families. ❖The assumption of diminishing average propensity to consume is a significant part of Keynesian theory of income and employment. This implies that as income increases, a progressively larger proportion of national income would be saved. ❖Therefore, to achieve and maintain equilibrium at full-employment level of income, increasing proportion of national income is needed to be invested. ❖ If sufficient investment opportunities are not available, the economy would then run into trouble and in that case it would not be possible to maintain full-employment because aggregate demand will fall short of full-employment output. ❖ On the basis of this increasing proportion of saving with the increase in income and, consequently, the emergence of the problem of demand deficiency, some Keynesian economists based the theory of secular stagnation on the declining propensity to consume. ✔ The concept of equilibrium is self contradictory ✔ Keynesian economics is mainly static ✔ It has ignored the long period equilibrium ✔ Unrealistic assumption of perfect competition ✔ Keynesian theory is not a general theory ✔ Based on the assumption of closed economy ✔ Keynesian analysis is not so empirical ✔ It ignores the cost-push inflation  THE MODEL - ASSUMPTIONS Variables that depend on other variables within the model are called endogenous. Variables that are not explain within the model are called exogenous. * The Demand for Goods Identity * The total demand for goods is written as: Under the assumption that the economy is closed, X = IM = 0, then: CONSUMPTION The function C(YD) is called the consumption function. It is a behavioral function, that is, it captures the behavior of consumers. Disposable income, (YD) * A more specific form of the consumption function is this linear relation: C= a+bY or * This function has two parameters: * c1 - propensity to consume * c0 - intercept of the consumption function CONSUMPTION (C) Consumption increases with disposable income, but less than one.  INVESTMENT (I) Investment here is taken as given (an exogenous variable): I = f (Y,r) * Government Spending (G) *Government spending, G, together with taxes, T, describes fiscal policy. *We shall assume that G and T are also exogenous. THE DETERMINATION OF EQUILIBRIUM OUTPUT Equilibrium in the goods market requires that production, Y, be equal to the demand for goods, Z Then: USING ALGEBRA  GOODS-MARKET EQUILIBRIUM Saving is the sum of private plus public saving. Private saving (S), is saving by consumers. Public saving equals taxes minus government spending. INVESTMENT EQUALS SAVING Investment equals saving—the sum of private plus public saving. This equilibrium condition for the goods market is called the IS relation: what firms want to invest must be equal to what people and the government want to save.  SAVINGS = INVESTMENT Consumption and saving decisions are one and the same. In equilibrium: Rearranging terms, we get the same result as before: DIFFERENT KINDS OF SAVING Private saving = The portion of households’ income that is not used for consumption or paying taxes =Y–T–C Public saving = Tax revenue less government spending =T–G 9/1/2024 36 NATIONAL SAVING National saving = private saving + public saving = (Y – T – C) + (T – G) = Y – C – G = the portion of national income that is not used for consumption or government purchases 9/1/2024 37 SAVING AND INVESTMENT Recall the national income accounting identity: Y = C + I + G + NX For the rest of this chapter, focus on the closed economy case: Y=C+I+G national saving Solve for I: I = Y–C–G = (Y – T – C) + (T – G) Saving = investment in a closed economy 9/1/2024 38 BUDGET DEFICITS AND SURPLUSES Budget surplus = an excess of tax revenue over govt spending = T–G = public saving Budget deficit = a shortfall of tax revenue from govt spending = G–T = – (public saving) 9/1/2024 39 A.Calculations ▪ Suppose ▪ GDP equals $10 trillion, ▪ consumption equals $6.5 trillion, ▪ the government spends $2 trillion ▪ a budget deficit of $300 billion. ▪ Find public saving, taxes, private saving, national saving, and investment. 9/1/2024 40 Answers, part A Given: Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3 Public saving = T – G= – 0.3 Taxes: T = G – 0.3 = 1.7 Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8 National saving = Y – C – G = 10 – 6.5 - 2 = 1.5 Investment = national saving = 1.5 9/1/2024 41 B. How a tax cut affects saving ▪ Use the numbers from the preceding exercise, but suppose now that the government cuts taxes by $200 billion. ▪ In each of the following two scenarios, determine what happens to public saving, private saving, national saving, and investment. 1. Consumers save the full proceeds of the tax cut. 2. Consumers save 1/4 of the tax cut and spend the other 3/4. 9/1/2024 42 Answers, part B In both scenarios, public saving falls by $200 billion, and the budget deficit rises from $300 billion to $500 billion. 1. If consumers save the full $200 billion, national saving is unchanged, so investment is unchanged. 2. If consumers save $50 billion and spend $150 billion, then national saving and investment each fall by $150 billion. 9/1/2024 43 C. Discussion The two scenarios from this exercise were: 1. Consumers save the full proceeds of the tax cut. 2. Consumers save 1/4 of the tax cut and spend the other 3/4. ▪ Which of these two scenarios do you think is more realistic? ▪ Why is this question important? 9/1/2024 44  MEANING OF SAVING AND INVESTMENT ▪ Private saving is the income remaining after households pay their taxes and pay for consumption. ▪ Examples of what households do with saving: ▪ Buy corporate bonds or equities ▪ Purchase a certificate of deposit at the bank ▪ Buy shares of a mutual fund ▪ Let accumulate in saving or checking accounts 9/1/2024 45  THE MEANING OF SAVING AND INVESTMENT ▪ Investment is the purchase of new capital. ▪ Examples of investment: ▪ General Motors spends $250 million to build a new factory in Flint, Michigan. ▪ You buy $5000 worth of computer equipment for your business. ▪ Your parents spend $300,000 to have a new house built. Remember: In economics, investment is NOT the purchase of stocks and bonds! 9/1/2024 46 THE MARKET FOR LOANABLE FUNDS ▪ A supply–demand model of the financial system ▪ Helps us understand: ▪ how the financial system coordinates saving & investment. ▪ how govt policies and other factors affect saving, investment, the interest rate. 9/1/2024 47 THE MARKET FOR LOANABLE FUNDS Assume: Only one financial market ▪ All savers deposit their saving in this market. ▪ All borrowers take out loans from this market. ▪ There is one interest rate, which is both the return to saving and the cost of borrowing. 9/1/2024 48 THE MARKET FOR LOANABLE FUNDS The supply of loanable funds comes from saving: ▪ Households with extra income can loan it out and earn interest. ▪ Public saving, if positive, adds to national saving and the supply of loanable funds. If negative, it reduces national saving and the supply of loanable funds. 9/1/2024 49  SLOPE OF THE SUPPLY CURVE An increase in Interest the interest rate Rate Supply makes saving more attractive, which increases 6% the quantity of loanable funds supplied. 3% 60 80 Loanable Funds ($billions) 9/1/2024 50 MARKET FOR LOANABLE FUNDS The demand for loanable funds comes from investment: ▪ Firms borrow the funds they need to pay for new equipment, factories, etc. ▪ Households borrow the funds they need to purchase new houses. 9/1/2024 51  SLOPE OF THE DEMAND CURVE A fall in the interest Interest rate reduces the cost Rate of borrowing, which 7% increases the quantity of loanable funds demanded. 4% Demand 50 80 Loanable Funds ($billions) 9/1/2024 52  EQUILIBRIUM The interest rate Interest adjusts to equate Rate Supply supply and demand. The eq’m quantity 5% of L.F. equals eq’m investment and eq’m saving. Demand 60 Loanable Funds ($billions) 9/1/2024 53  POLICY 1: SAVING INCENTIVES Tax incentives for saving Interest increase the supply of L.F. Rate S1 S2 …which reduces the eq’m 5% interest rate and increases the eq’m quantity of L.F. 4% D1 60 Loanable Funds 70 ($billions) 9/1/2024 54  POLICY 2: INVESTMENT INCENTIVES An investment tax Interest credit increases the Rate S1 demand for L.F. 6% …which raises the 5% eq’m interest rate and increases the D2 eq’m quantity of L.F. D1 60 70 Loanable Funds ($billions) 9/1/2024 55  Budget deficits ▪ Use the loanable funds model to analyze the effects of a government budget deficit: ▪ Draw the diagram showing the initial equilibrium. ▪ Determine which curve shifts when the government runs a budget deficit. ▪ Draw the new curve on your diagram. ▪ What happens to the equilibrium values of the interest rate and investment? Answers A budget deficit reduces national saving and the Interest S2 supply of L.F. Rate S1 6% …which increases the eq’m 5% interest rate and decreases the eq’m quantity of L.F. and investment. D1 60 Loanable Funds 50 ($billions) 9/1/2024 57 BUDGET DEFICITS, CROWDING OUT, AND LONG-RUN GROWTH ▪ Increase in budget deficit causes fall in investment. The govt borrows to finance its deficit, leaving less funds available for investment. ▪ This is called crowding out. ▪ Recall from the preceding chapter: Investment is important for long-run economic growth. Hence, budget deficits reduce the economy’s growth rate and future standard of living. 9/1/2024 58  GOVERNMENT DEBT ▪ The government finances deficits by borrowing (selling government bonds). ▪ Persistent deficits lead to a rising govt debt. ▪ The ratio of govt debt to GDP is a useful measure of the government’s indebtedness relative to its ability to raise tax revenue. ▪ Historically, the debt-GDP ratio usually rises during wartime and falls during peacetime—until the early 1980s. 9/1/2024 59  U.S. GOVERNMENT DEBT AS A PERCENTAGE OF GNP, 1790–2012 120% WW2 100% Financial 80% Crisis Revolutionary 60% War Civil War WW1 40% 20% 0% 9/1/2024 60 1790 1810 1830 1850 1870 1890 1910 1930 1950 CONCLUSION ▪ Like many other markets, financial markets are governed by the forces of supply and demand. ▪ One of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity. Financial markets help allocate the economy’s scarce resources to their most efficient uses. ▪ Financial markets also link the present to the future: They enable savers to convert current income into future purchasing power, and borrowers to acquire capital to produce goods and services in the future. 9/1/2024 61 32