04.2 Consumption Function and Theories

Consumption Function

C = f (Yd)

where C= Personal Consumption and Yd=Disposable Income

Disposable Income

Expenditure after taxes

Consumption is?

positively correlated by disposable income

Purpose of Consumption Function

Consumption expenditure depends on, varies with, is influenced by, or is explained or affected by disposable income

Main Determinants of Consumption

• Marginal Propensity to Consume (MPC)

• Average Propensity to Consume (APC)

• Savings

• Marginal Propensity to Save (MPS)

Marginal Propensity to Consume Formula

Purpose of MPC

• measures change in consumption with respect to change in disposable income

• slope of the consumption function or curve

Average Propensity to Consume Formula

Average Propensity to Consume, Definition

ratio of consumption to income

Savings

Portion of income that is not spent or the difference of disposable income and consumption

Marginal Propensity to Save

Marginal Propensity to Save, Definition

• ratio of the change in savings to the change in disposable income.

• Measures by how much savings change when income changes

Other determinants of Consumption

• Wealth

• Expected Income

• Expected Price Level

• Actual Price Level

• Interest Rates

• Age of Household Head

• Attitude Toward Thrift, and etc.

Consumption Theories

• Current Income Hypothesis

• Permanent Income Hypothesis

• Relative Income Hypothesis

• Life Cycle Hypothesis

Current Income Hypothesis

• Proposed by John Maynard Keynes

• C = f(Yd)

• Consumption depends on current Disposable Income

Permanent Income Hypothesis

• Proposed by Milton Friedman

• Consumption depends on permanent income, rather than transitory income

Relative Income Hypothesis

• Proposed by James Duesenberry

• 2 explanation of consumption behavior of individuals:

  • Consumption of goods is greatly influenced by imitating neighbors spending

  • Households will try to maintain the highest standard of living in the past

Life Cycle Hypothesis

• Proposed by Albert Ando, Richard Brumberg, Franco Modigliani

• Views that individuals plan their consumption and saving behavior over long periods with intention of allocating their income over lifetime