Chapter 10

The Income-Consumption and Income-Saving

Relationships

LO10.1 - Describe how changes in income affect consumption and saving.

The other-things-equal relationship between income and consumption is one of the best-established relationships in macroeconomics. In examining that relationship, we are also exploring the relationship between income and saving. Recall economists define personal saving as "not spending" or as "that part of disposable (after-tax) income not consumed." Saving (S) equals disposable income (DI) minus consumption (C).

Many factors determine a nation's levels of consumption and saving, but the most significant is disposable income. Consider some recent historical data for Canada. In L Figure 10-1, each dot represents consumption and disposable income for one year since 1993. The line C fitted to these points shows that consumption is directly (positively) related to disposable income; moreover, households spend a large part of their income.

The 45° (degree) line is a reference line. Because it bisects the 90° angle formed by the two axes of the graph, each point on it is equidistant from the two axes. At each point on the 45° line consumption equals disposable income, or C = DI. Therefore the vertical distance between the 45° line and any point on the horizontal axis measures either consumption or disposable income. If we use it to measure disposable income, then the vertical distance between it and the line labelled C represents the amount of saving (S) in that year.

Saving is the amount by which actual consumption in any year falls short of the 45° line (S = DI - C). For example, in 2005 disposable income was $775 billion and consumption was $749 billion, so saving was $26 billion. Observe that the vertical distance between the 45° line and line C increases as we move rightward along the horizontal axis and decreases as we move leftward. Like consumption, saving typically varies directly with the level of disposable income.

The Consumption Schedule

The dots in Figure 10-1 represent historical data-the actual amounts of DI, C, and S in Canada over a period of years. But, because we want to understand how the economy would behave under different possible scenarios, we need a hypothetical schedule showing the various amounts that households plan to consume at each level of disposable income that might prevail at some specific time. Columns 1 and 2 of Table 10-1, represented in Figure 10-2a (Key Graph), show a hypothetical consumption schedule. This consumption schedule (or "consumption function") reflects the direct consumption-disposable income suggested by the data relationship in L Figure 10.1. It is consistent with many household budget studies. In the aggregate, households increase their spending as their disposable income rises, and they spend a larger proportion of a small disposable income than of a large disposable income.

The Saving Schedule

It is relatively simple to derive a saving schedule (or "saving function"). Because saving equals disposable income less consumption (S = DI - C), we need only subtract consumption (Table 10-1, column 2) from disposable income (column 1) to find the amount saved (column 3) at each DI. Thus, columns 1 and 3 are the saving schedule, represented in l Figure 10-2b. The graph shows the direct relationship between saving and DI, It also shows that saving is a smaller proportion of a small DI than of a large DI. If households consume a smaller and smaller proportion of DI as DI increases, then they must be saving a larger and larger proportion.

Remembering that at each point on the 45° line consumption equals DI, we see dissaving (consuming in excess of after-tax income) will occur at relatively low DIs. For example, at $370 billion (row 1), consumption is $375 billion. Households can consume more than their current income by liquidating (selling for cash) accumulated wealth or by borrowing. Graphically, dissaving is shown as the vertical distance of the consumption schedule above the 45° line or as the vertical distance of the saving schedule below the horizontal axis.

We have marked the dissaving at the $370 billion level of income in Figures 10-2a and = 10-2b. Both vertical distances measure the $5 billion of dissaving that occurs at $370 billion of income.

In our example, the break-even income is $390 billion (row 2, Table 10-1). At this income level, households plan to consume their entire incomes (C = DI). Graphically, the consumption schedule cuts the 45° line, and the saving schedule cuts the horizontal axis (saving is zero) at the break-even income level.

At all higher incomes, households plan to save part of their income. Graphically, the vertical distance of the consumption schedule below the 45° line measures this saving (see Figure 10-2a), as does the vertical distance of the saving schedule above the horizontal axis. For example, at the $410 billion level of income (row 3, * Table 10-1), both these distances indicate $5 billion of saving.

Average and Marginal Propensities

Columns 4 to 7 in Table 10-1 show additional characteristics of the consumption and saving schedules.

APC AND APS

The fraction, or percentage, of total income that is consumed is the average propensity to consume (APC). The fraction of total income that is saved is the average propensity to save (APS):

APC = consumption/income

APS = saving/income

For example, at $470 billion of income (row 6) in L Table 10-1, the APC is 450/470 = 45/47, or about 0.96 (= 96 percent), and the APS is 20/470 = 2/47, or about 0.04 (= 4 percent). Columns 4 and 5 in & Table 10-1 show the APC and APS at each of the ten levels of DI. The APC falls as DI increases, while the APS rises as DI goes up.

Because disposable income is either consumed or saved, the fraction of any DI consumed plus the fraction saved (not consumed) must exhaust that income. Mathematically, APC + APS = 1 at any level of disposable income, as columns 4 and 5 in Table 10-1 illustrate. So, if 0.96 of the $470 billion of income in row 6 is consumed, 0.04 must be saved. That is why APC + APS = 1.

MPC AND MPS

The fact that households consume a certain proportion of a particular total income, for example, 45/47 of a $470 billion disposable income, does not guarantee they will consume the same proportion of any change in income they might receive. The proportion, or fraction, of any change in income consumed is called the marginal propensity to consume (MPC), with marginal meaning extra or a change in. The MPC is the ratio of a change in consumption to the change in the income that caused the consumption change:

MPC = change in consumption / change in income

The fraction of any change in income saved is the marginal propensity to save (MPS). The MPS is the ratio of a change in saving to the change in income that brought it about:

MPS = change in saving / change in income

If disposable income is $470 billion (row 6 horizontally in Table 10-1) and household income rises by $20 billion to $490 billion (row 7), households will consume 15/20 or 3/4 , and save 5/20, or 1/4, of that increase in income. In other words the MPC is 3/4 or 0.75 and the MPS is 1/4, or 0.25, as shown in columns 6 and 7.

The sum of the MPC and the MPS for any change in disposable income must always be 1. Consuming or saving out of extra income is an either/or proposition; the fraction of any change in income not consumed is, by definition, saved. If 0.75 of extra disposable income is consumed, 0.25 must be saved. The fraction consumed (MPC) plus the fraction saved (MPS) must exhaust the whole change in income:

MPC + MPS = 1

In our example, 0.75 + 0.25 = 1

MPC AND MPS AS SLOPES

The MPC is the numerical value of the slope of the consumption schedule, and the MPS is the numerical value of the slope of the saving schedule. We know from the appendix to Chapter 1 that the slope of any line is the ratio of the vertical change to the horizontal change occasioned in moving from one point to another on that line.

Quick Review 10.1

• Both consumption spending and saving rise when disposable income increases; both fall when disposable income decreases.

• The average propensity to consume (APC) is the fraction of any specific level of disposable income that is spent on consumer goods; the average propensity to save (APS) is the fraction of any specific level of disposable income that is saved. As disposable income increases, the APC falls and the APS rises.

• The marginal propensity to consume (MPC) is the fraction of a change in disposable income that is consumed, and it is the slope of the consumption schedule. The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved, and it is the slope of the saving

Non-income Determinants of Consumption and Saving

LO10.2 List and explain factors other than income that can affect consumption.

Disposable income is the main determinant of the amounts households will consume and save. But other determinants might prompt households to consume more or less at each possible level of income. Those other determinants are wealth, borrowing, expectations, and real interest rates.

• Wealth A household's wealth is the dollar amount of all the assets that it owns minus the dollar amount of its liabilities (all the Page 232 debt that it owes). Households build wealth by saving money out of current income. The point of building wealth is to increase consumption possibilities. The larger the stock of wealth that a household can build up, the larger will be its present and future consumption possibilities.
  When events suddenly boost the value of existing wealth, households tend to increase their spending and reduce their saving. This wealth effect shifts the consumption schedule upward and the saving schedule downward. The schedules move in response to households taking advantage of the increased consumption possibilities made possible by the sudden increase in wealth. For example, in the late 1990s skyrocketing stock values expanded the value of household wealth by increasing the value of household assets. Predictably, households spent more and saved less. In contrast, a strong "reverse wealth effect" occurred in 2008. Plunging stock market prices joined together to erase billions of dollars of household wealth. Consumers quickly reacted by reducing their consumption spending. The consumption schedule shifted downward.

• Borrowing When a household borrows, it can increase current consumption beyond its disposable income. By allowing households to spend more, borrowing shifts the current consumption schedule upward. But note that there is no "free lunch." While borrowing in the present allows for higher consumption in the present, it necessitates lower consumption in the future when the debts must be repaid. Stated differently, increased borrowing increases debt (liabilities), which in turn reduces household wealth (since wealth = assets -
  liabilities). This reduction in wealth reduces future consumption possibilities.

• Expectations. Household expectations about future prices and income affect current spending and saving. For example, expectations of higher prices tomorrow may cause households to buy more today while prices are still low. Thus, the current consumption schedule shifts up and the current saving schedule shifts down. In contrast, expectations of a recession and thus lower income in the future may lead households to reduce consumption and and save more today. Greater present saving will help households build wealth that will help them ride out the expected bad times. The consumption schedule will therefore shift down and the saving schedule will shift up.

• Real interest rates. When real interest rates (those adjusted for inflation) fall, households tend to borrow more, consume more, and save less. A lower interest rate, for example, decreases monthly loan payments and induces consumers to purchase automobiles and other goods bought on credit. A lower interest rate also diminishes the incentive to save because of the reduced interest "payment" to the saver.
  These effects on consumption and saving, however, are very modest. They mainly shift consumption toward some products (those bought on credit) and away from others. At best, lower interest rates shift the consumption schedule slightly upward and the saving schedule slightly downward. Higher interest rates do the opposite.

OTHER IMPORTANT CONSIDERATIONS

We must make several additional important points about the consumption and saving schedules:

• Switching to Real GDP: When developing macroeconomic models, economists change their focus from the relationship between consumption (and saving) and disposable income to the relationship between consumption (and saving) and real domestic output (real GDP).

• Changes Along Schedules: The movement from one point to another on a consumption schedule (for example, from a to b on Co in Figure 10-4a)- is change in the amount consumed and is caused solely by a change in disposable income (or GDP). On the other hand, an upward or downward shift of the entire schedule-for example, a shift from Co to C, or C, in E Figure 10-4a-is a shift of the consumption schedule and is caused by changes in any one or more of the four non-income determinants of consumption just discussed.
  Similar terminology applies to the saving schedule in L Figure 10-4b.

• Simultaneous Shifts: Changes in wealth, borrowing, expectations, and real interest rates shift the consumption schedule in one direction and the saving schedule in the opposite direction. If households decide to consume more at each possible level of real GDP they must save less, and vice versa. (Even when they spend more by borrowing, they are in effect reducing their current saving by the amount borrowed since borrowing is, effectively, negative saving.) Graphically, if the consumption schedule shifts from Go to C, in & Figure 10-4a, the saving schedule will shift downward, from So to S, in l Figure 10-4b. Similarly, a downward shift of the consumption schedule from Co to C, means an upward shift of the saving schedule from So to S2.

• Taxation: A change in taxes shifts the consumption and saving schedules in the same direction. Taxes are paid partly at the expense of consumption and partly at the expense of saving. So an increase in taxes will reduce both consumption and saving, shifting the consumption schedule in & Figure 10-4a and the saving schedule in " Figure 10-4b downward. Conversely, households will partly consume and partly save any decrease in taxes. Both the consumption schedule and saving schedule will shift upward.

• Stability: The consumption and saving schedules are usually relatively stable unless altered by major tax increases or decreases. Their stability may be because consumption-saving decisions are strongly influenced by long-term considerations such as saving to meet emergencies or saving for retirement. It may also be because changes in the non-income determinants frequently work in opposite directions and therefore may be self-cancelling.

Quick Review 10.2

• Changes in consumer wealth, consumer expectations, interest rates, household debt, and taxes can shift the consumption and saving schedules (as they relate to real GDP).

• A specific investment will be undertaken if the expected rate of return, r, equals or exceeds the real interest rate, i.

• The investment demand curve shows the total monetary amounts that will be invested by an economy at various possible real interest rates.