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# 5 consumption function

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### 5 consumption function

1. 1. Consumption Function
2. 2. ConsumptionIncome is used for consumption andsavings Yd = C + S
3. 3. If C = a + bYd Then S = Yd – C = Yd – a – bYd = - a + (1-b)YdWhere Yd = personal disposable income C = consumption S = savings a,b = parameters
4. 4. Components of ConsumptionNon-durable goods – foods, drinks,lighting & heatingDurable goods – furniture, kitchenappliances, washing machines, cars,ACs and other white goods.Services – non durable – transport,banking, insurance, health, education,legal etc.
5. 5. Keynes Psychological Law of consumptionWhen aggregate income increases, aggregateconsumption also increases, but by asomewhat smaller amount.Increase in income is divided in someproportion between saving and spending.Increase in income is unlikely to lead to lesssavings or less spending than before.
6. 6. Absolute Income HypothesisIn his 1936 book on ‘The General Theory ofEmployment, Interest & Money’, he advancedthe hypothesis that consumption has twocomponents: 1. Autonomous (C0) 2. Induced => varies directly with currentincome through a linear function.
7. 7. C = C0 + bYWhere C0, b > 0And b<1or 0<b<1
8. 8. Propensity to ConsumeExpresses the relationship betweenincome and consumption.Shows how consumption expenditurechanges as income varies.
9. 9. Marginal Propensity to Consume change in consumptionmpc = ----------------------------------- change in income
10. 10. DY C S mpc 600 600 0 - 800 760 40 0.81000 920 80 0.81200 1080 120 0.81400 1240 160 0.81600 1400 200 0.8
11. 11. C o n s u m p tio n & D I 2000 1500 1000 500 0 1 2 3 4 5 6 DY C
12. 12. Savings FunctionAggregate Savings is the differencebetween disposable income andconsumption expenditure.Savings function is the schedule relatingtotal consumer savings to totaldisposable income in the economy.
13. 13. Marginal Propensity to Save change in savingsmps = ------------------------ change in income mpc + mps = 1
14. 14. Under the AIH, the mpc is a constant‘b’. δC mpc = ---------- = b δY
15. 15. Average propensity to consume falls asthe income increases. C C0 APC = --------- = --------- + b Y YAPC -> MPC as Y -> infinity
16. 16. Corollarymps is a constant (=1-b)aps increases as income increases S=Y–C = Y – C0 – bY = - C0 + (1-b)Y
17. 17. δSmps = ---------- = 1-b δY CoAPS = ---------- + (1-b) YAPS -> MPS as Y -> infinity.
18. 18. MPC + MPS = 1APC + APS = 1As economy prospers, Y and savingsrate (S/Y=APS) goes up.Rich people and rich countries havehigh savings rates as compared to poorpeople and poor countries.Prosperity leads to stagnation.
19. 19. Permanent Income Hypothesis Given by Milton Friedman (1957) Consumption is determined by long term expected income rather than the current level of income long term expected income is called permanent income People experience random and temporary changes in their income from year to year
20. 20. Current income is the sum of twocomponents: permanent income YP andtransitory Income YT. Y = YP + YTPermanent income is that part of theincome that people expect to persistinto the future.Transitory income is the randomdeviation from it
21. 21. Consumption should depend primarilyon permanent income. C = α YPWhere α = fraction of permanent incomeconsumed
22. 22. Keynes Friedman C YP APC = --------- = α ------- Y Y
23. 23. Rational Expectations &Random-Walk ConsumptionForward-looking consumers base theirconsumption decisions not only on theircurrent income but also on the income theyexpect to receive in the future.Rational expectationPeople will make optimal forecasts about thefuture.
24. 24. Robert Hall was the first to derive theimplications of rational expectations forconsumption.=> changes in consumption over timeshould be unpredictable– follow a “Random Walk”=> changes in consumption reflect“surprises” about lifetime income.
25. 25. Determinants of Consumption FunctionWealth & Distribution of WealthRelative Income =>1. Current income relative to past peakincome (Y/Ymp).2. Own income relative to averageincome of the neighbourhood.(Demonstration / Bandwagon Effect)
26. 26. Determinants (cont…)Interest RateCredit availabilityConsumer’s expectations
27. 27. Consumption FunctionC = f { Y, W, Y/Ymp, i, CA, CE, IWD, µ} Y = income W = wealth Ymp = maximum past income i = interest rate CA = ease of credit availability CE = consumer’s expectations IWD = inequality of income/ wealth distribution µ = unknown/other factors
28. 28. The Multiplier
29. 29. ConceptMultiplier expresses the relationship betweenan initial increment in investment and thefinal increment in aggregate income.It is the ratio of the change in income to thechange in investment. Y K = ----------- I
30. 30. Multiplier & MPCThe size of the multiplier depends uponthe size of the mpc.The higher the mpc, the higher is thesize of the multiplier; the lower thempc, lower is the size of the multiplier.
31. 31. An exampleBuilding a woodshedInitial/primary investment = Rs. 1,000 =>income of carpenter & lumber producer (saytier one consumer ‘A’) = Rs. 1,000Let mpc = 2/3Expenditure by A on consumption goods= 2/3*1000 = 666.67Producer’s income = Rs. 666.67Expenditure (B) = 2/3 * 666.67 = 444.44
32. 32. Example (cont…)Total income generated =(1 x 1000) + 2/3(1000) + (2/3)2(1000) +(2/3)3(1000) + ---------- 1= ------------- x 1000 = 3000 1 – 2/3
33. 33. 1 1 K = ---------- = ----------- 1-m sThe size of the multiplier depends onthe size of the mpc or the mps
34. 34. Limiting case if mpc = 0 K=1If mpc = 1 K = infinity
35. 35. Aggregate DemandTotal amount of goods demanded in theeconomy. AD = C + I + G + (X-M)Equilibrium is achieved when Quantity supplied = quantity demanded Y = AD = C + I + G + (X-M)