MACROECONOMICS: Consumption Function and Aggregate Expenditure

Overview of Key Terms

• Consumption: The use of goods and services by households.

• Function: Refers to how consumption behaves in relation to various economic factors.

• Aggregate Expenditure: Total spending in an economy on final goods and services.

The Theory of Consumption

• Importance of Consumption:

  • Accounts for approximately 70% of GDP in advanced economies.

  • Critical for understanding aggregate demand which influences output and employment levels.

• Savings and Economic Growth:

  • Income not spent becomes savings, impacting capital stock, investment, and employment.

  • The nature of consumption function relates closely to the effectiveness of economic policy.

Key Factors Influencing Consumption

• Disposable Income: Consumption depends on current disposable income (income after taxes).

• Marginal Propensity to Consume (MPC): Change in consumer spending due to income change influences fiscal multipliers and overall economic output.

• Fiscal Policy Effectiveness: Consumption behavior is essential in understanding the effects of government spending and taxation on the economy.

Distinction Between Consumption and Consumption Expenditure

• Consumption: Ongoing use of goods and services by households.

• Consumption Expenditure: Refers to purchases made for immediate use.

• Durable Goods: Goods that generate ongoing services; expenditure occurs at purchase, but consumption persists over time.

• Macroeconomic Insights:

  • Aggregate consumption determines saving and influences national capital supply.

  • Essential for understanding macroeconomic fluctuations and business cycles.

• Three Key Theories of Consumption:

  1. Relative Income Theory: Focuses on income comparison among individuals.

  2. Life Cycle Theory: Examines spending and saving throughout an individual's life.

  3. Permanent Income Theory: Relates consumption to long-term income expectations.

Relative Income Hypothesis (RIH)

• Concept: Consumption influenced by one's income compared to others, developed by James Duesenberry in 1949.

• Key Ideas:

  1. Comparison with Others: Well-being measured against peers; feeling poorer influences spending.

  2. Demonstration Effect: Households often adopt consumption patterns of wealthier groups leading to decreased savings.

Behavioral Asymmetry in Consumption

• Income Changes:

  • Consumption increases with income, but individuals resist cutting spending during income drops.

  • Stability in consumption levels despite economic downturns.

• Long-Term Consumption Patterns: Individuals maintain spending patterns based on past higher income levels.

Example

• Case Study: John ($50,000 income with peer income of $80,000) vs. Mark ($50,000 income with peer income of $40,000).

  • John feels poorer and spends more to keep up; Mark feels wealthier and saves.

Implications of the Relative Income Hypothesis

• Policy Considerations: Important for designing economic policies considering income distribution.

• Savings Behavior: Explains differences in savings rates across income groups.

• Social Influences: Highlights the impact of social and psychological factors on consumption.

Life-Cycle Hypothesis (LCH)

• Theory Overview: Individuals smooth consumption over a lifetime, borrowing low and saving high income.

• Key Insight: Developed by Franco Modigliani; predicts savings during working years to support retirement spending.

Key Concepts

1. Income and Lifetime Consumption: Borrowing as youth, saving in middle age, and spending in retirement.

2. Smoothing Consumption: Spending decisions based on expected lifetime income over current income.

3. Demographic Effects on Savings: Aging populations affect national savings rates.

Example of Life-Cycle Hypothesis

• Scenarios:

  • 25-year-old takes student loans for education.

  • 40-year-old saves aggressively for retirement.

  • 70-year-old withdraws savings post-retirement.

Understanding the Life-Cycle Hypothesis

• Planning Consumption: Individuals anticipate future income, borrowing when young and saving later.

• Consumption Pattern: Shows a hump-shaped pattern over a lifespan with low savings in youth and old age.

Permanent Income Hypothesis (PIH)

• Theory Overview: Developed by Milton Friedman; consumption based on expected long-term income rather than current fluctuations.

Key Ideas

1. Income Components: Permanent income (stable, expected income) vs. transitory income (temporary changes).

2. Disability to Change Spending: Preference for stable spending patterns; resistance to alter consumption based on temporary income changes.

3. Long-Term Expectations: Gradual changes in consumption expected with permanent income increases.

Example of the Permanent Income Hypothesis

• Scenarios:

  • John receiving a permanent raise vs. Mark winning a lottery; John increases spending, Mark saves most of his windfall.

Implications of the PIH

• Consumer Behavior: Explains why not all windfalls are spent.

• Effective Long-Term Policies: Suggests policies targeting permanent income increases are more effective than temporary measures.

Marginal Propensity to Consume (MPC)

• Definition: The proportion of additional income spent on consumption rather than saved.

Example of MPC Calculation

• Scenario: $1,000 income increase leads to $800 spending:

  • MPC = 800 / 1000 = 0.8 (80% spent, 20% saved).

Economic Importance of MPC

• High MPC: Stimulates economic growth through increased spending.

• Low MPC: Slows growth as individuals save more than they spend.

• Fiscal Policy Application: Essential for designing impactful fiscal policies.

Aggregate Expenditure (AE)

• Definition: Total spending on final goods/services in an economy over a specified period.

Key Components of Aggregate Expenditure

• Components:

  1. Household Consumption (C): Comprises autonomous and induced consumption.

  2. Investment Spending (I): Total spending on capital goods.

  3. Government Spending (G): Purchases at all government levels.

  4. Net Exports (NX): Exports minus imports.

Key Characteristics of Aggregate Expenditure

1. Economic Growth: AE increases lead to production hikes and GDP boosts.

2. Keynesian Insights: AE versus GDP influences production levels.

3. Influence of Components: Variables such as income, confidence, interest rates and global demand impact AE components.

• Hypothetical Values:

  • Consumption = $5 trillion, Investment = $2 trillion, Government = $3 trillion, Net Exports = -$1 trillion.

  • Calculation: AE = 5 + 2 + 3 - 1 = $9 trillion; equilibrium achieved.

Economic Importance of Aggregate Expenditure

• GDP Determination: Influences overall economic stability and growth.

• Guides Policy: Shapes government responses, especially during downturns.