Unit 15: Consumption Flashcards
Consumption
expenditure on commodities by households to satisfy their immediate needs and wants
Absolute Income Hypothesis
Proposed by Keynes
Keynes argues that the current level of consumption is completely determined by the current year’s level of disposable income
Keynes’ Consumption Function
C=a+bY
C - current level of consumption
a - autonomous consumption
b - MPC
Y - current level of income
Keynesian 45 degree line
shows all points where consumption (expenditure) is equal to income
Keynes’ Saving Function
S= -a + (1-b)Y
S - current level of savings
a - autonomous dissaving
(1-b) - MPS
Y - current level of income
Propensities
help measure how households adjust their consumption behavior in response to changes in income
Average Propensity to Save (APS)
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
Average Propensity to Consume (APC)
the percentage of disposable income that households consume.
Consumption/Income
APC + APS
= 1
Marginal Propensity to Save (MPS)
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
Marginal Propensity to Consume (MPC)
percentage of a change in disposable income that households consume
change in consumption/change in income
MPC + MPS
= 1
Movement along vs Shift
Movement along: change in income
Shift: change in anything other than income
Types of Shifts
Parallel shift: change in autonomous consumption
Pivot - change in MPC
Determinants of a shift of the consumption curve
- Wealth (physical and financial)
- Consumer confidence
- Availability of credit
- Interest rates (Substitution effect and Income effect)
- Future expectations
- Direct taxes
- Distribution of Income
- Attitudes
- Availability of goods
Interest Rates (S.E and Y.E)
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
Relative Income Hypothesis
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
Permanent Income Hypothesis
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
Permanent income
the income an individual expects to earn consistently over a long period
Transitory Income
Temporary deviations from permanent income
Life Cycle Hypothesis
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
Advantages of Absolute Income Hypothesis
- Simple
- 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
- Supports the effectiveness of fiscal policy in stimulating AD by increasing consumption because it suggests that income changes directly influence consumption
Limitations of Absolute Income Hypothesis
- ignores the role of wealth and future income expectations in consumption decisions
- assumes a linear relationship
- limited in explaining long term behaviours
Advantages of Relative Income Hypothesis
- accounts for the social aspect of consumption
- reflects real world behaviours
Limitations of Relative Income Hypothesis
- difficult to measure
- overemphasizes social comparison
Advantages of Permanent Income Hypothesis
- explains long term consumption patterns
- 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
Limitations of Permanent Income Hypothesis
- assumes people can accurately forecast future income
- ignores short term behaviour
- difficult to measure
Advantages of Life-Cycle Hypothesis
- depicts more realistically how people manage their finances over a lifetime
- useful for designing policies related to pensions, taxes, etc.
e.g. people contributing to retirement saving plans follow this theory
Limitations of Life-Cycle Hypothesis
- assumes people can accurately forecast future income and expenditure
- over simplifies behaviours
