Chapter 13: Consumption and Saving

household spending on final goods and services

consumption

Spending on just about anything people buy in their personal lives (Food, clothes, medical bills, cars, internet services, rent, electricity, etc.)

consumption

the single largest component of GDP

consumption

a curve plotting the level of consumption associated with each level of income

consumption function

more income leads to more

consumption

Draw the consumption function

y

the fraction of each extra dollar of income that households spend on consumption

Marginal propensity to consume

Marginal propensity to consume formula

Change in consumption/change in income

If you receive an additional $1,000 in income, and you spend all $1,000, then your marginal propensity to consume is

1

If you receive an additional $1,000 in income, and you spend $600, then your marginal propensity to consume is

0.6

Determines the slope of the consumption function

marginal propensity to consume

the portion of income that you don’t spend in a given period

saving

savings =

income - consumption

the excess amount you consume above your income in a given period that you therefore must pay for by either withdrawing money from your savings or borrowing money

dissaving

Also referred to as negative saving

dissaving

putting unspent income in the bank

saving

using your unspent income to pay down existing debt

saving

When you graduate and start paying your student loans out of your income, you are

saving

Borrowing money to fund the gap between your spending as a student and your income

dissaving

New saving, consumption, and income in a specific period of time are considered

flows

the amount by which your assets exceed your debts

net wealth

Consume more today if the marginal benefit of a dollar of consumption today is greater than (or equal to) the marginal benefit of spending a dollar plus interest in the future

rational rule for consumers

maintaining a steady or smooth path for your consumption spending over time

consumption smoothing

requires redistributing spending from times of plenty to times of poverty

consumption smoothing

the marginal benefit of an extra dollar during times of poverty (BLANK) the marginal benefit of an extra dollar during times of plenty

exceeds

Draw the marginal benefit curve

y

your best estimate of your long-term average income

permanent income

Measures the resources available for you to consume, on average, over the course of your lifetime

permanent income

A couple with a child applies for a home loan. Both are in graduate school, but close to finishing: While their current income is (BLANK), their permanent income is expected to be (BLANK)

low, high

the idea that consumption is driven by permanent income rather than current income

permanent income hypothesis

(BLANK) when your current income is below your permanent income

borrow (or dip into your savings)

(BLANK) whenever your current income exceeds your permanent income

save

Draw the income and saving over the typical life cycle

y

A temporary change in income leads to a (BLANK) change in consumption

small

A permanent change in income leads to a (BLANK) change in consumption

large

An anticipated change in income leads to (BLANK) change in consumption

no

News of a future rise in income leads to a (BLANK) change in consumption

large

It’s (BLANK) to forecast changes in consumption

hard

One-time signing bonus from a job
Monetary gift from a relative
One-time government payment

temporary change

You get a $10,000 gift from a relative, and decide to spend an additional $1,000 over the next 10 years. Your temporary Marginal Propensity to Consume is

0.1

Your new job unexpectedly pays $20,000 a year more than your old job

permanent change

Your new job unexpectedly pays $20,000 a year more than your old job. What is the permanent Marginal Propensity to Consume?

1

April through October you earn $70,000, but only $20,000 from small projects the rest of the year

anticipated change

If your company unexpectedly tells employees about company-wide plans for layoffs next month, then you immediately start cutting back on your consumption today

learning about future income changes

Changes in macroeconomic policy begin to affect consumption from the moment the policy is (BLANK), rather than when the policy is implemented

announced

Changes in consumption are driven by reactions to

unexpected news

limits on how much you can borrow

credit constraints

spend their income as they receive it

hand-to-mouth consumers

the marginal propensity to consume of hand-to-mouth consumers is

1

Hand-to-mouth consumers (BLANK) smooth consumption

don’t

Hand-to-mouth consumers’ consumption reflects their (BLANK) rather than their permanent income

current income

A temporary change in income for hand-to-mouth consumers leads to a (BLANK) change in consumption

large

A permanent change in income for hand-to-mouth consumers leads to a (BLANK) change in consumption

large

An anticipated change in income for hand-to-mouth consumers leads to a (BLANK) change in consumption

large

Learning about a future change in income for hand-to-mouth consumers leads to a (BLANK) change in consumption

no

Forecasting changes in consumption depends on the share of

hand-to-mouth consumers

An increase in income leads to

higher consumption

The four factors that shift the consumption curve:

1. Real interest rates
2. Expectations

3. Taxes

4. Wealth

A shift in the consumption curve does not change

income

Draw consumption curve

y

High real interest rates (BLANK) current consumption

reduce

Draw if interest rates are low and if they are high on a consumption graph

y

a high real interest rate boosts income for lenders, but decreases income for borrowers

income effect

Draw optimistic about future income vs. pessimistic about future income on the consumption curve

y

Optimistic about future economic growth translates into (BLANK) consumption

higher

Pessimistic about future economic growth translates into (BLANK) consumption

lower

your after-tax income

disposable income

Tax cuts translate into (BLANK) consumption

higher

Higher taxes translate into (BLANK) consumption

lower

Draw low taxes vs. high taxes on consumption curve

y

Greater wealth translates into (BLANK) consumption

higher

Lower wealth translates into (BLANK) consumption

lower

Draw high wealth vs low wealth on the consumption curve

y