MACROECONOMICS: Consumption Function and Aggregate Expenditure

Consumption

is a major component of aggregate demand, accounting for 70 percent of GDP in modern economies.

Three Major Theories of Consumption

Relative Income Hypothesis (James Duesenberry, 1949), Life-Cycle Hypothesis (LCH) — (Franco Modigliani), Permanent Income Hypothesis (PIH) — (Milton Friedman, 1957)

GDP increases or decreases depending when…

(1) when the government increases or decreases spending in the economy, depends on how much we spend on consumption. It also determines the magnitude of private investment multiplier. (2) when private investment increases or decreases in the economy, depends on how much we spend on consumption.

Effectiveness of Fiscal Policy

changes in taxation and government spending, to smooth out economic downturns – and thus large fluctuations of produced output and employment – is linked to the level of fiscal multipliers and therefore to the nature of the consumption function.