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 The Consumption Function

Based on “Macroeconomics” byDornbusch and Fischer and

“Elements of Economics” by Tullao

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Introduction Consumption

activity pursued by

individuals indisposing the nalgoods and servicesproduced by theeconomy

e!pands the "ealthof a nation

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Factors #$ecting

Consumption E!penditure taste or preference for present goods

against future goods

socioeconomic characteristics such asnumber of %% members& age group&educational attainment& employment

status of %% head interest rate& "hich can be vie"ed as

the price of present goods relative tofuture goods

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Factors #$ecting

Consumption E!penditure in(ation rate decreases the

amount real goods andservices that %% income canbuy

e!pectations

income

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 Theories on the

Consumption Function positive relationship bet"een the level

of consumption and the level of

income represented by the marginal propensity to

consume )mpc* mpc+ additional consumption due to an e!tra

unit of income varies across income levels& periods& age& etc,

provide appro!imate e!planation forchanges in #D and aggregate supply

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 Theories on the

Consumption Function #bsolute Income %ypothesis )-eynes*

.roperties consumption is stable relative to current

income short'run mpc / long'run mpc long'run mpc / average propensity to

consume change in "ealth of %%s has a positive

e$ect on the consumption function

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 Theories on the

Consumption Function #bsolute Income %ypothesis )-eynes*

Implication increase in national income "ould lead to an

increase in aggregate consumptione!penditure

0imitation

there are cases "hen consumptione!penditures of individuals and %%s arebelo" or above their current income

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 Theories on the

Consumption Function 1elative Income %ypothesis

)Deusenberry* #ssertion

consumption is a function of currentincome relative to income in previousperiods and relative to the income of

income groups considered as model ofthe %%

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 Theories on the

Consumption Function 1elative Income %ypothesis

)Deusenberry* #ssertion

ratchet e$ect the di2culty in reversing previous

consumption due to a current shortfallin income

%%3s relate their consumption "ith thatof their neighbors3

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 Theories on the

Consumption Function .ermanent Income %ypothesis

)Friedman* #ssumptions

current income is composed of apermanent and a transitory component

consumption is not based on current

income but on permanent income permanent income is based on

e!pected income in the future and isin(uenced by the e!pected return on

the human and nonhuman "ealth

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 Theories on the

Consumption Function .ermanent Income %ypothesis

)Friedman* #ssertions

sudden decline in transitory income "illnot a$ect permanent consumption

permanent consumption "ill go do"n if the

reduction is in permanent income consumption in the short'run "ill not go

do"n despite the reduction in income if thedecline in the latter is transitory in nature

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 Theories on the

Consumption Function 0ife Cycle %ypothesis )Modigliani*

#ssertions

consumption is based on permanentincome

permanent income is dependent on thereturns to human and nonhuman assets or"ealth

%%s smoothen their consumption overtime by allocating consumptione!penditures e4ually over time

 Thus& consumption may di$er from a %%3s

current income

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5olatility of Consumption

E!penditures consumption is a$ected mainly by

income and "ealth "ealth is determined by e!pectations&

interest rates& in(ation rates& etc,

aggregate demand ' ultimately

aggregate supply ' variesaccording to changes inconsumption