CONSUMPTION FUNCTION, and AGGREGATE EXPENDITURE

70 per cent

What is the approximate share of consumption with respect to GDP in most advanced economies?

It goes to savings

What happens to income that is not consumed?

To understand:

• savings,

• capital stock,

• investment,

• employment,

• and income growth

Why is consumption important beyond its impact on aggregate demand?

Current disposable income

According to Keynes, what does consumption depend on?

Current income minus taxes

How is current disposable income calculated?

Marginal propensity to consume

What determines the magnitudes of government expenditure and tax multipliers?

The use of goods and services by households

What is consumption in economics?

The purchase of goods and services for use by households

What is consumption expenditure?

Consumption services

What do durable goods generate after the initial expenditure when purchased?

Aggregate saving

What does aggregate consumption determine?

The portion of income that is not consumed

What is saving defined as?

National supply of capital

What does aggregate saving contribute to through the financial system?

James Duesenberry

Who developed the Relative Income Hypothesis (RIH)?

1949

When was RIH developed? (yr)

An individual's consumption is influenced by their income relative to others

What is the main idea of the Relative Income Hypothesis?

Their peers, social groups, or past income levels

According to the Relative Income Hypothesis, to whom do people compare their income?

Comparison with Others

This is when people tend to measure their well-being based on how their income compares to that of others in their reference group

Demonstration Effect (Keeping Up with the Joneses)

What is the concept where households try to match the consumption patterns of higher-income groups?

Lower savings rates and increased debt

What are the potential financial consequences of the Demonstration Effect?

Consumption rises when income increases but does not immediately decrease when income falls

What is the concept of asymmetry in consumption behavior?

Social and lifestyle expectations

Why do people resist cutting back their spending when income decreases?

Consumption levels remain relatively stable even during economic downturns

What does asymmetry in consumption behavior explain?

People maintain a standard of living based on their highest past income level

What is a key idea behind long-term consumption patterns?

A decline in income does not immediately lead to an equivalent drop in consumption

How do long-term consumption patterns affect spending behavior?

The social and psychological aspects of consumption

What does the Relative Income Hypothesis emphasize as important in marketing and consumer behavior studies?

An economic theory that describes the spending and saving habits of people over their lifetime

What is the Life-Cycle Hypothesis (LCH)?

To smooth consumption throughout their lifetime by borrowing when income is low and saving when income is high

What does the Life-Cycle Hypothesis suggest individuals aim to do with their consumption?

Franco Modigliani

Who developed the Life-Cycle Hypothesis?

Plan their consumption and savings behavior over their lifetime to maintain a stable standard of living

According to the Life-Cycle Hypothesis, how do individuals manage their finances?

Save during their working years and spend those savings after retirement

How does the Life-Cycle Hypothesis describe saving and spending patterns over a lifetime?

Smoothing consumption

What is the concept where people make financial decisions based on expected lifetime income rather than current income?

They take on debt early in life and save later

How does the concept of smoothing consumption explain early-life financial behavior?

Milton Friedman in 1957

Who developed the Permanent Income Hypothesis (PIH)?

An individual's consumption is based on their expected long-term income rather than their current income

What is the main idea of the Permanent Income Hypothesis?

Permanent and transitory components

How does the Permanent Income Hypothesis divide income?

Stable, long-term income expected over a lifetime (e.g., salary, investment returns)

What is permanent income?

Short-term, temporary changes in income (e.g., bonuses, lottery winnings, economic downturns)

What is transitory income?

Consumption smoothing

What concept explains why individuals maintain a stable consumption pattern despite temporary income changes?

They save most of it rather than spend it all immediately

How do people typically respond to unexpected income according to the Permanent Income Hypothesis?

They will increase consumption gradually

How do people adjust their spending if they expect a permanent rise in income?

They will mostly save it rather than increase spending

How do people react to a temporary rise in income according to the Permanent Income Hypothesis?

The proportion of additional income that a person spends on consumption rather than saving

What is the Marginal Propensity to Consume (MPC)?

How much consumption increases when income increases by one unit

What does the Marginal Propensity to Consume (MPC) measure?

It reflects how much people spend when their income rises

What does the Marginal Propensity to Consume (MPC) indicate?

More spending stimulates demand

Why does a high Marginal Propensity to Consume (MPC) lead to stronger economic growth?

More income is saved rather than spent

Why does a low Marginal Propensity to Consume (MPC) slow economic growth?

The total amount of spending in an economy on final goods and services during a specific period

What is Aggregate Expenditure (AE)?

AE = C + I + G + NX

What is the formula for Aggregate Expenditure (AE)?

Household consumption spending (C), investment spending (I), government spending (G), and net exports (NX)

What are the four main components of Aggregate Expenditure?

The total level of consumption of individuals in a household

What does household consumption spending (C) represent?

Autonomous consumption and induced consumption

What are the two types of consumer spending in the consumption function?

Independent of disposable income

How is autonomous consumption characterized?

Rises as income increases

How is induced consumption characterized?

The total amount of money investors spend on business capital goods

What does investment spending (I) include?

Unplanned and planned investments

What are the two types of investment expenditures?

Government purchases at the federal, state, and local levels

What does government spending (G) include?

The difference between a country’s total exports and total imports

What are net exports (NX)?

Inventories shrink, prompting firms to increase production

What happens when Aggregate Expenditure (AE) is greater than Total Output (GDP)?

Inventories rise, leading firms to reduce production and employment

What happens when Aggregate Expenditure (AE) is less than Total Output (GDP)?