Consumption and Savings

Consumption the expenditures made by households on goods and services main determinant of national income or factor income

Consumption Expenditure the proportion of national income spent by households on final goods and services and is the largest component of aggregate demand and spending in the circular flow of national income most stable components of aggregate demand, showing litlle fluctuations from period to period

$6000 ?

$1000

45 $1000 $6000

Consumption Function the relationship between consumption level and the level of household disposable income

Saving = $300

$6000

C
5700 $3000

$2700

Saving = = - $300 Dissaving $300

$2700 $6000

Saving

Dissaving

Graphing the Consumption Function

DI C S

Expenditure ($)

3,000

3000 1750
C

2,000

1,000

45 1,000 2,000 3,000 Disposable income ($)

Disposable Income ($)

Consumption is the vertical distance between the bottom (horizontal) axis and the C line.
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

5-32

Graphing the Consumption Function

DI C S

Expenditure ($)

3,000

3000 1750 1250

C

2,000

1,000

45 1,000 2,000 3,000 Disposable income ($) ($) Disposable Income

Saving is the vertical distance between the C line and the 45 degree line

5-33

Graphing the Consumption Function

DI
3,000

3000 1750 1250 2000 1440

C

2,000

1,000

45 1,000 2,000 3,000 Disposable income ($)

Consumption is the vertical distance between the bottom (horizontal) axis and the C line.

5-34

Graphing the Consumption Function

DI C S

Expenditure ($)

3,000

3000 1750 1250 2000 1440 560

C

2,000

1,000

45 1,000 2,000 3,000 Disposable income ($)

Saving is the vertical distance between the C line and the 45 degree line

Graphing the Consumption Function

DI
3,000

2,000

3000 1750 1250 2000 1440 560 1000 1000

1,000

45 1,000 2,000 3,000 Disposable income ($)

Consumption is the vertical distance between the bottom (horizontal) axis and the C line.

Graphing the Consumption Function

DI
3,000

2,000

3000 1750 1250 2000 1440 560 1000 1000 0

1,000

45 1,000 2,000 3,000 Disposable income ($)

Saving is 0 at 1000 DI because there is NO distance between the C line and the 45 degree line.

5-37

Graphing the Consumption Function

DI
3,000

2,000

3000 1750 1250 2000 1440 560 1000 1000 0 0 625

1,000

45 1,000 2,000 3,000 Disposable income ($)

Consumption is the vertical distance between the bottom (horizontal) axis and the C line.

5-38

Graphing the Consumption Function

DI
3,000

2,000

3000 1750 1250 2000 1440 560 1000 1000 0 0 625

1,000

45 1,000 2,000 3,000 Disposable income ($)

When DI is 0 the level of Consumption is called Autonomous Consumption (AC) 5-39

Graphing the Consumption Function

DI
3,000

2,000

3000 1750 1250 2000 1440 560 1000 1000 0 0 625 -625

1,000

45 1,000 2,000 3,000 Disposable income ($)

Saving is the vertical distance between the C line and the 45 degree line. Saving is negative to the left of where the C line crosses the 45 degree line

MPC, MPS, and Multipliers

MPC & MPS Marginal Propensity to Consume

% of additional disposable income that is consumed C/Yd

Marginal Propensity to Save

% of additional disposable income that is saved S/Yd

MPC + MPS = 1 1 MPC = MPS 1 MPS = MPC

Marginal Propensity to Consume (MPC)

The fraction of any change in disposable income that is consumed.

MPC= Change in Consumption Change in Disposable Income MPC = C/Yd

Average Propensity to Consume the proportion of income that is consumed APC= C/Yd

Saving functions considered as the mirror image of the consumption function S= Yd-C

Marginal Propensity to Save (MPS)

The fraction of any change in disposable income that is saved.

MPS= Change in Savings Change in Disposable Income

MPS = S/Yd

Average propensity to save the proportion of income that is saved

APS= S/Yd

Marginal Propensities

MPC + MPS = 1
.: MPC = 1 MPS .: MPS = 1 MPC

Remember, people do two things with their disposable income, consume it or save it!

 The process of generating income through the circular flow exchange between the households and the firms is called the multiplier. the no. of times peso circulates is known as the multiplier. The multiplier is the ratio of an induced change in the equilibrium level of national income to an initial change in the level of spending.

 The 'multiplier effect' denotes the phenomenon whereby some initial increase( or decrease) in the rate of spending will bring about a more than proportionate increase ( or decrease) in national income.

In other words, multiplier coefficient measures the average number of times every peso of income circulate and changes hands in the circular flow in the form of income.

 Let us asssume that all income is either consumed or 'withdrawn' as savings. (That is, the MPC and the marginal propensity to save (MPS) together are equal to 1). The value of the multiplier K is then given by the formula:

K=

1 or 1 1-(MPC) MPS
= multiplier coefficient =marginal propensity to consume = marginal propensity to save

where: K MPC MPS=1-MPC

The Spending Multiplier Effect

An initial change in spending (C, IG, G, XN) causes a larger change in aggregate spending, or Aggregate Demand (AD). the peso continous to be spent multiflying its impact on the economy

The Spending Multiplier Effect

Ex. If the government increases defense spending by $1 Billion, then defense contractors will hire and pay more workers, which will increase aggregate spending by more than the original $1 Billion.

Calculating the Spending Multiplier Desired change in GDP=change in spending*multiplier

The Spending Multiplier can be calculated from the MPC or the MPS. Multiplier = 1/MPS OR 1/1-MPC

MPS, MPC, & Multipliers

Historically speaking, the Japanese are big savers. Lets say that for every extra dollar of disposable income they earn they spend 25 cents. If they were each given a stimulus check by how much would aggregate demand change assuming the total stimulus was three billion dollars?
Step 1: Calculate the MPC and MPS MPC = C/DI = .20/1 = .25 MPS = 1 MPC = 1-.25=.75 Step 2: Determine which multiplier to use. Either 1/MPS OR 1/1-MPC Step 3: Calculate the Spending Multiplier 1/ 1 OR 1/1-MPC=1/1-.25=1.333 MPS = /.75 = 1.333 Step 4: Calculate the Change in AD ( C, IG, G, or XN) * Spending Multiplier ($3 billion DI) * (1.333) = $3.999 billion AD

Calculating the Spending Multiplier

1/ MPS or 1/1-MPC

The smaller the fraction of any change in income saved, the greater the respending at each round and, therefore, the greater the multiplier. The larger the fraction of any change in income spent, the greater the respending at each round and, therefore the, the greater the multiplier.

Factors of Consumption Taste and Preference Population Income Price Level Innovation and Promotion

Taste and Preference

It depends on how products satisfy one's desires. A change in collective attitude can change aggregate taste and prefernce, and in turn change the consumption levle and marginal propensity to income.

Population
Population size also determines consumption needs, and therefore affects consumption expenditures with a given income. A decrease in household size with income and other factors increasing may reduce household's propensity to consume and increase its savings at the expense of nonessential items in the consumption basket.

Income
The level of income can increase consumption with more infusions in the circular flow. On th eother hand, income distribution among consuminng units of different propensities to consume also determines. This increase in aggregate consumption subsequently multiplies into higher income levels.

Price Level Change in the general price level due to inflation can spur further consumers' reacton through a shift in the individual demand curves which ultimately results to changes in the aggregate consumption expenditure.

Innovation and Promotion

Can also expand the line to consumer's choice and extend the influence of demand factors on consumption and households' propensity to consume.