Unit 15: Consumption

Question 1

Consumption

Answer 1

expenditure on commodities by households to satisfy their immediate needs and wants

Question 2

Absolute Income Hypothesis

Answer 2

Proposed by Keynes

Keynes argues that the current level of consumption is completely determined by the current year’s level of disposable income

Question 3

Keynes’ Consumption Function

Answer 3

C=a+bY

C - current level of consumption
a - autonomous consumption
b - MPC
Y - current level of income

Question 4

Keynesian 45 degree line

Answer 4

shows all points where consumption (expenditure) is equal to income

Question 5

Keynes’ Saving Function

Answer 5

S= -a + (1-b)Y

S - current level of savings
a - autonomous dissaving
(1-b) - MPS
Y - current level of income

Question 6

Propensities

Answer 6

help measure how households adjust their consumption behavior in response to changes in income

Question 7

Average Propensity to Save (APS)

Answer 7

the proportion of disposable income that households save. APS can be negative if savings are negative i.e. dissaving, such as when individuals borrow or dip into savings

saving/income

Question 8

Average Propensity to Consume (APC)

Answer 8

the percentage of disposable income that households consume.

Consumption/Income

Question 9

APC + APS

Answer 9

= 1

Question 10

Marginal Propensity to Save (MPS)

Answer 10

percentage of a change in disposable income that is saved. MPS cannot be less than 0 or more than 1, as it reflects that any additional income is either entirely consumed, completely saved or divided between the two

change in savings/change in income

Question 11

Marginal Propensity to Consume (MPC)

Answer 11

percentage of a change in disposable income that households consume

change in consumption/change in income

Question 12

MPC + MPS

Answer 12

= 1

Question 13

Movement along vs Shift

Answer 13

Movement along: change in income
Shift: change in anything other than income

Question 14

Types of Shifts

Answer 14

Parallel shift: change in autonomous consumption

Pivot - change in MPC

Question 15

Determinants of a shift of the consumption curve

Answer 15

1. Wealth (physical and financial)
2. Consumer confidence
3. Availability of credit
4. Interest rates (Substitution effect and Income effect)
5. Future expectations
6. Direct taxes
7. Distribution of Income
8. Attitudes
9. Availability of goods

Question 16

Interest Rates (S.E and Y.E)

Answer 16

Substitution effect: if interest rates fall, the opportunity cost of spending now falls, households will substitute more towards current consumption and away from future consumption

Income effect: as a debtor, if interest rates fall, interest payments also fall, being better off, consumption increases. As a creditor, if interest rates fall, interest receivable falls, being worse off consumption falls

Question 17

Relative Income Hypothesis

Answer 17

Proposed by James Duesenberry

He argued that consumption is influenced by relative income i.e. relative to others and relative to one’s past

Relative to others - demonstrating effect
Relative to one’s past - ratchet effect

Question 18

Permanent Income Hypothesis

Answer 18

Proposed by Milton Friedman

Consumption depends on lifetime income, people make consumption decisions based on their expected long term, stable income called permanent income rather their fluctuating short term income called transitory income

Question 19

Permanent income

Answer 19

the income an individual expects to earn consistently over a long period

Question 20

Transitory Income

Answer 20

Temporary deviations from permanent income

Question 21

Life Cycle Hypothesis

Answer 21

Proposed by Franco Modigliani

He argued that people aim to maintain a stable standard of living throughout their lives by smoothing consumption over periods of varying income. During high income phases, people save to fund consumption during low income phases

Youth: income is low, and individuals borrow or depend on others to finance consumption

Working years: income is higher and individuals save for future needs including retirement

Retirement: income declines and individuals dissave by using their accumulated savings to finance consumption

Question 22

Advantages of Absolute Income Hypothesis

Answer 22

1. Simple
2. Realistic for short run consumption as households tend to spend according to their current income levels as they adjust their lifestyle based on available resources
3. Supports the effectiveness of fiscal policy in stimulating AD by increasing consumption because it suggests that income changes directly influence consumption

Question 23

Limitations of Absolute Income Hypothesis

Answer 23

1. ignores the role of wealth and future income expectations in consumption decisions
2. assumes a linear relationship
3. limited in explaining long term behaviours

Question 24

Advantages of Relative Income Hypothesis

Answer 24

1. accounts for the social aspect of consumption
2. reflects real world behaviours

Question 25

Limitations of Relative Income Hypothesis

Answer 25

1. difficult to measure
2. overemphasizes social comparison

Question 26

Advantages of Permanent Income Hypothesis

Answer 26

1. explains long term consumption patterns
2. suggests that fiscal policy may have less impact on consumption if people perceive them as short-term changes, this can guide policy makers

e.g. During covid-19, people in the US viewed the stimulus checks as temporary, hence, people saved a significant portion of the money

Question 27

Limitations of Permanent Income Hypothesis

Answer 27

1. assumes people can accurately forecast future income
2. ignores short term behaviour
3. difficult to measure

Question 28

Advantages of Life-Cycle Hypothesis

Answer 28

1. depicts more realistically how people manage their finances over a lifetime
2. useful for designing policies related to pensions, taxes, etc.

e.g. people contributing to retirement saving plans follow this theory

Question 29

Limitations of Life-Cycle Hypothesis

Answer 29

1. assumes people can accurately forecast future income and expenditure
2. over simplifies behaviours