Chapter 4

Consumption Spending
4.1 Consumption, Income and Saving (Y, C, & S)
• A household can do two, and only two, things with its income in case
of simple economy without government: It can buy goods and
services—that is, it can consume—or it can save.
• Saving is the part of its income that a household does not consume in
a given period. Distinguished from savings, which is the current stock
of accumulated saving.

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S Y  C 1
 Explaining Spending Behavior

• SOME DETERMINANTS OF AGGREGATE CONSUMPTION

INCLUDE:
1. Household income
2. Household wealth
3. Interest rates
4. Households’ expectations about the future
• In The General Theory, Keynes argued that household
consumption is directly related to its income.

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A Consumption Function for a Household

• The relationship between consumption and

income is called the consumption function.

• The consumption function

for an individual household
shows the level of
consumption at each level
of household income.

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 An Aggregate Consumption Function
• For simplicity, we assume that points of aggregate
consumption, when plotted against aggregate income,
lie along a straight line.
C = a  bY
• The slope of the consumption
function (b) is called the marginal
propensity to consume (MPC), or
the fraction of a change in income
that is consumed, or spent.

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0  b< 1 4
 An Aggregate Consumption Function
Derived from the Equation C = 100 + .75Y
C  1 0 0  .7 5 Y
• At a national income of
zero, consumption is $100
billion (a).
• For every $100 billion
increase in income (DY),
consumption rises by $75
billion (DC).

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 An Aggregate Consumption Function
Derived from the Equation C = 100 + .75Y

C  1 0 0  .7 5 Y
AGGREGATE AGGREGATE
INCOME, Y CONSUMPTION, C
(BILLIONS OF (BILLIONS OF
DOLLARS) DOLLARS)
0 100
80 160
100 175
200 250
400 400
400 550
• 800 700
1,000 850

6
 4.2 Consumption and Saving
Since there are only two places income can go(in case of simple
economy with out gov’t): consumption or saving, the fraction of
additional income that is not consumed is the fraction saved. The
fraction of a change in income that is saved is called the marginal
propensity to save (MPS).

M P C + M P S 1
• Once we know how much consumption will result from a given level
of income, we know how much saving there will be. Therefore,

S Y  C
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 Deriving a Saving Function from a Consumption Function

C  1 0 0  .7 5 Y
S Y  C
AGGREGATE AGGREGATE AGGREGATE
INCOME, Y CONSUMPTION, SAVING, S
C
(ALL IN BILLIONS OF DOLLARS)
0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
400 550 50
800 700 100
1,000 850 150
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 4.5. Consumption Theories
At the micro level the focus is on how much of the
individual family income is devoted to consumption and
saving at various income levels. The idea is to isolate the
influence of income, and occasionally of wealth on
consumer spending, holding constant the effect of other
possible relevant, less important variables age, family,
composition, residence, education, etc. On the other
hand, the income consumption relationship indicated by
the aggregate data of macro analysis is based on the
measured year-to-year values for consumption, which
result from all the factors that influence consumption.

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Different macroeconomic theoreticians forwarded their own view
about the relationship of consumption expenditure and income with
the valuable evidence.

The four general theories that currently exist on the determinants of

total consumer spending are:
1. The absolute income hypothesis (AIH)
2. The relative income hypothesis (RIH)
3. The permanent income hypothesis (PIH)
4. The life cycle hypothesis

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 A) Absolute income hypothesis
• The absolute income hypothesis was developed by
John Maynard Keynes. It explains that the
individual consumer determines what fraction of
his/her current income he/she will spent to
consumption of goods and services on the basis of
the absolute level of that income. In this theory it
is assumed that a rise in individual absolute
income will lead to a decrease in the fraction of
that income spent to consumption.

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 1.John Maynard Keynes
Conjectures:
1. MPC is between 0 & 1
→Consumption increases when Income increases but
not as much as the increase in Income

The power of Fiscal Policy to influence the economy

arises from the reaction between income &
consumption

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 2.The Ratio of Consumption to Income/APC

Average Propensity to Consume falls as Income rises

→Saving(Yd – C) was a luxury,

…so the rich is expected to save a high proportion of
their income than the poor

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3.Income is the primary determinant of consumption
& that the interest rate does not have any important
role, even if it does in the SR, it is a matter of theory,
not practical.
The Keynesian consumption is often written as:

C C C  cY , C  0;0  c  1

C/Y

Y
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The fact that households with higher income
saved more implies that the MPC is less than 1

Both micro & macro data confirmed all the

Keynes’s conjectures b/n the two world war.
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 Consumption Puzzle:
• As incomes in the economy grew over time,
households would consume a smaller & smaller
fraction of their incomes
• They feared that there might not be enough
profitable investment projects to absorb all this
saving.
If So, the low consumption would lead to an
inadequate demand for goods & services, resulting in
a depression.

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 On the basis of the Keynesian conjecture
(APC falls as Y↑ implying high saving) economists
predicted that the economy would experience what
they called secular stagnation
i.e., a long depression of indefinite duration unless
fiscal policy is used to expand AD

The conjecture APC falls as income rises

didn’t hold true

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 2.Simon Kuznet, using new data dated back to
1869,discovered that the ratio of consumption to
income/APC was remarkably stable from decade to
decade..
...despite large increases in income over the period
he studied
He received Nobel Prize for this

The second conjecture did not hold too

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 The Consumption Puzzle:
The LR consumption appeared to have a constant
APC
Yet, for the household data, the SR Keynesian
consumption function appeared to work well
Consumption
LR
Consumption

SR
Consumption

Income

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 B) Intertemporal Choice(Irving Fisher)
Fisher developed consumption model used to
analyze how a Rational, & Forward looking
consumer make inter temporal choice
i.e., Choices involving different time periods

Irving Fisher’s theory of the consumer argue

…..that consumption should not depend on current
income alone

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 c) Life cycle Hypothesis (LCH)

Modigliani, who developed the life cycle

hypotheses model, emphasized that income
varies systematically over people’s lives and
that saving allows consumers to move income
from those times in life when income is high to
those times when it is low

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 Emphasizes that Income follows a regular pattern
over a person’s lifetime

According to LCH, a typical individual has an Income

stream that is relatively low..
..at the beginning & at the end of her/his life

Most people plan to stop working at about age 65, &

they expect their incomes to fall when they retire

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• For simplicity, we are assuming an
interest rate of zero; if the interest
rate were greater than zero, we would
need to take account of interest
earned on savings as well.)
• The consumer can divide up her
lifetime resources among her T
remaining years of life.
• We assume that she wishes to achieve
the smoothest possible path of
consumption over her lifetime. There
fore, she divides this total of W+RY
• Consider a consumer who expects to live another T years, has wealth of
W, and expects to earn income Y until she retires R years from now.
• What level of consumption will the consumer choose if she
wishes to maintain a smooth level of consumption over her life?
• The consumer’s lifetime resources are composed of initial wealth W
and lifetime earnings of R × Y. (For simplicity, we are assuming an
interest rate of zero; if the interest rate were greater than zero, we
would need to take account of interest earned on savings as well.)

• The consumer can divide up her life time resources among her T
remaining years of life. We assume that she wishes to achieve the
smoothest possible path of consumption over her lifetime.
• Therefore, she divides this total of W + RY equally among
the T years and each year consumes C = (W + RY)/T.
• We can write this person’s consumption function
as
C = (1/T)W + (R/T)Y.
• For example, if the consumer expects to live for 50
more years and work for 30 of them, then T = 50
and R = 30, so her consumption function is
C = 0.02W + 0.6Y
• This equation says that consumption depends on
both income and wealth. An extra $1 of income
per year raises consumption by $0.60 per year,
and an extra $1 of wealth raises consumption by
$0.02 per year.
 Net Y Savin
borrower g C
C

g
Disavin
t

Life Cycle
Hypothesis(LCH)

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 Observations from LCH
1.At a younger age, a person is net borrower

2.At the middle age, a person is net saver

3.At old age(retirement),a person is a net dissaver

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 Along cross section, as Income increases, APC
declines

APC declines at the middle age b/c Saving is high

…as high Income is to the middle age

APC increases at either younger/older age

…as low income is to these age
Thus, these points may justify why APC>MPC

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 D) Permanent Income Hypothesis:
Friedman’s Approach

PIH emphasizes that people experience random &

temporary changes in their incomes from year to year

He suggested that we view current as the sum of

permanent income(YP) & transitory(windfall)
income(YT )
i.e.,
P T
Y Y  Y

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 Permanent income is the part of income that people
expect to persist in to the future/average income

Transitory income is the part of income that people

not expect to persist in to the future

PIH complements Modigliani’s LCH b/c..

… both use Irving Fisher’s theory of the consumer to
argue the consumption should not depend on
current income alone

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 But unlike the life-cycle hypothesis/LCH,
….which emphasizes the income follows a regular
pattern over a person’s lifetime

The permanent-income hypothesis/PIH,

….emphasizes that people experience random &
temporary changes in their incomes from year to year

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 Friedman reasoned that consumption should
depend
primarily on permanent income,
…b/c consumers use saving & borrowing to
smooth
consumption in response to transitory changes
in income

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• Consider the studies of household data
Friedman reasoned that these data reflect a
combination of permanent & transitory income

Households with high permanent income would

have proportionately higher consumption

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• THE END