Chapter 2

1.CONSUMPTION AND CONSUMPTION

EXPENDITURE
Consumption Spending and the Consumption
Function
 Consumer expenditure constitutes more
than half a percentage of GNP in most
economies;
 so any analysis of the factors determining
the level of GNP must be considered with
consumer expenditure at some point.
 we know that the consumption function is
the principal building block.
1

 Continued
 The consumption - expenditure of a
household depends on the disposable
income (income left after tax).
 That means C = c (Yd). Where C =
Consumption and Yd = Disposable
income.
The effect of consumption
expenditure can be seen in two
ways:
 A. Consumption decision is crucial for
long - run analysis because of its
effect in economic growth.
 B. The consumption decision is
crucial for short - run analysis because2

 Theories of Consumer Behavior and
Consumption Function
 For the question what determines the
aggregate consumption function,
there was a hot debate among
intellectuals for years.
 Yet no consensus is reached on the
exact determinant of consumption.
 Some economists believed that it is
the current income of households,
which is the key factor that affects the
current consumption while for other
economists, it is life time income that
matters still for some others,
permanent income mainly determines3 
 Keynesian theory of consumption
 When Keynes develop the model, there
was no national income accounting
statistics that show the overall effect of
consumption on the economy.
 Thus, instead of relying on statistical
analysis Keynes made his study based
on cross- section that means based on
introspection and causal observations.
 The short - run consumption function
that Keynes introduced is shown in
figure 1.1, which plots real consumer
expenditure C against real income Y.
 This function reflects the observations
that as income increases people tend to
spend a decreasing percentage of
income, or conversely tend to save an 4 
 Continued
 1. The slope of the consumption
function called the marginal
propensity to consume lies between
zero and unity, i.e., 0< MPC < 1
 2. Keynes posted that the slope of a
line from the origin to a point on the
consumption function called Average
prospensity to consume (APC) or the
ratio of consumption to income, falls
as income rises.
i.e, APC=C/Y
 3. current disposable income is the
main determinant of consumption5 
Continued
1 Figure 1.1 Keynes' consumption function
C

C(Y)

 6
 Empirical Evidences
 After Keynes has formulated the above
consumption function and the
conjectures discussed, economists began
collecting data on consumption to test
and evaluate the validity of the
Keynesian consumption function.
 On the basis of these earliest studies
indicated that the Keynesian
consumption to be a good approximation
of how consumers behave.
 Thus some of the findings were the
following.
7

Continued
Cross - sectional findings
 Higher income households consume
more i.e., MPC > 0
 Households with higher income save
more i.e. MPC < 1.
 Higher income households save a higher
fraction of their income, i.e., APC falls as
income rises.
Time series data analysis
 Researchers examined aggregate data on
consumption and income for the period
between the two world wars.
 These data also support Keynesian
consumption function.ater on, challenge
came on the Keynes's consumption function
8
Secular stagnation: Simon Kuznets and the
Consumption Puzzle.

 Two anomalies/inconsistencies of
Keynesian consumption function.

 Secular stagnation hypothesis is a long

depression of economy of indefinite
duration.
 In other words, on the basis of the
Keynesian consumption function,
economists predicted that the economy
would experience what they called
secular stagnation, unless fiscal policy
was used to expand aggregate demand. 9 
Cont…
But it turned out erroneous/invalid -
during WW-II on the basis of the
Keynesian consumption function,
economists reasoned that as income in
the economy grew over time,
households would consume smaller
and smaller fraction of their incomes.
And they predicted that the economy
would experience low consumption
and high saving which is called
secular stagnation.
 12/12/24  10
Continued
 Although incomes were much higher after the
WWII than before, these higher incomes did
not lead to large increases in the rate of
saving.
 Keynes’s conjecture that the average
propensity to consume would fall as
income rose appeared not to hold.
 The second anomaly arose when
economist Simon Kuznets constructed new
aggregate data on consumption and
income dating back to 1869.
 Simon Kuznets discovered that the ratio of
consumption to income was remarkably
stable from decade to decade, despite
11

Continued
 Kuznets' data pointed out two important things about
consumption behavior.
 First, it appeared that on average over the long-
run the ratio of consumer expenditure to
income, C/Y or APC, showed no downward
trend, so the MPC = APC as income grew along
the trend.
 The failure the secular - stagnation hypothesis
and the findings of Kuznets both indicated that
APC is fairly constant over a long period of
time.
 Economists wanted to know why some studies
confirmed Keynes’s conjectures and others
refuted them.
 That is, why did Keynes’s conjectures hold up
well in the studies of household data and in the
studies of short time-series, but fail when long
time-series were examined?
 This is what economists call it consumption
12
puzzle!

Continued
 Studies of household data and short - time
series found that a relationship similar to
the one Keynes conjectured.
 In the short - run consumption function with
falling APC as income rises.
 But studies of long time series data found that
the APC did not vary systematically with
income.
 Why did the Keynesian theory of consumption
hold up well in cross - section household
surveys, but apparently refuted in other
studies using long term time series data?
 Empirical studies were suggesting that there
were two consumption functions.
 The Keynesian consumption function failed to
take into account the long run consumption 13

Continued
Long - run consumption function.
 Studies of long - term data found that APC did
not vary systematically with income.
 This is called the Long run consumption
function given by: C = c(Y-T), as change
in Y mainly explain change in C and APC
will be APC = C/Y,
 Thus APC is constant as income
changes.
 Notice that the short-run consumption
function has a falling average propensity
to consume, whereas the long-run
consumption function has a constant
average propensity to consume. 14 
 Continued

Figure 1.2 long- run and short run consumption function

C long run consumption function MPC = APC

Short run Function:
MPC< APC

 15
Continued

Figure 1.3 long-run consumption function

C C = kY

C = C  Y

 16
Continued
2. Irving Fisher and the Inter-temporal Choice
 The consumption function introduced by Keynes
relates current consumption to current income.
 This relationship, however, is incomplete
at best.
 When people decide how much to
consume and how much to save, they
consider both the present and the future.
 The more consumption they enjoy today,
the less they will be able to enjoy
tomorrow.
 In making this trade off, households must
look ahead to the income they expect to
17
Continued
 In this regard, Irving Fisher developed the
model with which economists analyze how
rational, forward - looking consumers make inter-
temporal choices - that is, choices involving
different periods of time.

I. The Inter-temporal Budget Constraint

 Consumers face a limit on how much they can
spend called budget constraint.
 When they are deciding how much to
consume today versus how much to save
for the future, they face an inter-
temporal budget constraint which
measures the total resources available for
consumption today and in the future. 18 
Continued
 Following the original work of Irving Fisher,
lifetime utility is a function of his real
consumption C in all time period up to T, the
instant before he dies. i.e.
U = F(Co... Ct ..........CT)
 The consumer will try to maximize his
utility subject to the constraint that the
present value of his total consumption in
T YT
life cannot
0 1  r t   1 present
T
exceed
C t the , value of
r  is,
t
his total income in life;
0 that

 We thus have an individual with an expected

19
stream of lifetime income who will want to

Continued
 To capture the essence of this problem
let us consider as an example of a two
period case in which the individual is
living for two periods:
 Period one the consumer's youth age
 Period two the consumer's old age.
 Income in period one to be represented by
Y1
 Income in period two designated by Y2
 Consumption in period one represented by
C1
 Consumption in period two represented by
C2 20

 Continued
 In the second period, consumption equals the
accumulated saving, including the interest
earned on that saving plus second period
income.
C2= (S+ S .r) +Y2
[2] C2 = S (1+r) + Y2
Where r = real interest rate.
 From these two equations we can infer
the following:
 If first period consumption (C1) is less than
first period income (Y1), then the consumer is
saving and saving (S) is greater than zero. 21

 Continued
 If first period consumption (C is greater than
1)
first period income, then the consumer is
borrowing and saving (S) is less than zero.
 For simplicity, the interest rate for borrowing
is the same as the interest rate for saving.
 Thus, from (1) and (2) above, we can derive
the budget constraint as follows: substituting
S = Y1 - C1 and
C2 = (1+r)S + Y2 then
C2 = ( 1+r) ( Y1- C1) + Y2 Cas SY= YY1 - C1
2
1
2

r 1 r
Rearranging, we have: 1(3)
C1 +

 Equation (3) relates consumption in to the two

periods to income in the two periods. 22

 Continued
If the interest rate is equal to zero, then total
consumption in the two periods equals total
incomes in the two periods.
However, in the usual case interest rate is
greater than zero, thus future consumption and
future income are discounted by a factor (1+r).
Figure 1.4 Two - period Consumption
case

23
Cont…
 At point A, the consumer consumes exactly his income
in each period. i.e.
C1 = Y1 and C2 = Y2
 so there is neither saving nor borrowing between the two
periods.
 At point B, the consumer consumes nothing in the first
period(C1 = 0) and saves all income, so second-period
consumption C2 is (1 + r)Y1 + Y2.
 At point C, the consumer plans to consume nothing in
the second period (C2 = 0) and borrows as much as
possible against second-period income, so first-period
consumption C1 is Y1 + Y2/(1 + r).
 12/12/24  24
Continued
 According to the inter-temporal model a
rational consumer preference to consume
different combination of the two period
commodities that maximize their life time
satisfaction.
 Technically this point is given at a point of
tangency b/n the highest level of indifference
curve and budget line.
 How ever this point could be changed as a
result of change in income or interest rate.
25

Continued

26

Continued

Figure1.6 Two - period consumption case

C2

C E2
1
2
*
C 2* E1
* IC2

IC1
C1
*
C1 C1 **

 12/12/24  27
Continued

28

Continued
 How changes in Real Interest Rate
affect Consumption
 Fisher's model considers two cases for this to
answer:
 The case the consumer is initially saving.
 The case the consumer is initially
borrowing

29

Continued
Figure 1.7: two period consumption case
C2 New BL

IC2

C2 A

IC1 Old BL
Y2
C

C1
Y1
C1

 12/12/24  30
Continued

31

Continued

32

 3. The Ando - Modigliani Approach: The life -
cycle Hypotheses
According to Fisher's model, consumption
depends on a person's lifetime income. But
Modigliani emphasized that income varies
systematically over people's lives and that
saving allows consumers to move income from
those periods in life when income is high to
those times when it is low.
The Hypothesis
Income varies over a person's life because of
retirement.
To maintain consumption after retirement, they
must save during their working years.
According toWModigliani,
 RY the consumption
function looks Tlike
33

Continued

w   Y , where

34

Continued
Implications

 The following graph shows the

relationship between consumption and
income predicted by the life cycle model.
 In this model, the intercept of the
consumption function, which shows what
would happen to consumption if Y = 0, is
not a fixed value as before, instead, it is
W and depends on the level of wealth.

35

 12/12/24  36
Continued
C w
   .
Y Y

37

Modigliani’s consumption
function

 12/12/24  38
Continued

39

Saving and consumption over the life of the
consumer

 12/12/24  40
Income and Consumption over the Life -
Cycle

 41
Continued
Two chief Explanations
 1.The elderly are concerned about
unpredictable expenses.
 Additional saving that arises from
uncertainty is called precautionary
saving
 One reason for precautionary saving by the
elderly is the possibility of living longer
than expected and thus having to provide
for longer than the average span of
retirement
 2. The elderly may want to leave bequests
to their children.
 In this case, they save during working years
42

Continued

43

1.2.4 Milton Friedman and the Permanent
Income
Continued
 The Life - cycle model assumes that
income follows a regular pattern over a
person's Life.
 However, people experience random and
temporary changes in their incomes from
year to year.
 In this regard, Friedman suggested that we
view current income as the sum of two
components: permanent income (YP) and
transitory income ( YT).
Thus, Y = YP + YT (1)
 Where, YP - the part of income that people expect to
persist into the future –
 where as YT- the part of income that people do not
expect to persist.
44
T
 YP

Y

45

Continued
 When current income (Y) temporarily rises
above the permanent income, APC
temporarily falls.
 When the current income temporarily falls
below the Yp, then APC temporarily rises.
 Friedman reasoned that studies of
household data reflect a combination of Yp
and YT.
 Households with high Yp have
proportionately higher consumption.
 Friedman reasoned that Year - to - Year
fluctuations in income are dominated by YT;
Years of high income should be years of low
APC.
 But over the long - run, say from decade to
decade, the variation came from Yp. 46
