Consumption and SavingsYogesh Bhawnani

The Relationship Between Income and ConsumptionDisposable (after-tax) income equals savings (S) plus consumption (C).

Economists define personal saving as not spending or that part of disposable income not consumed.

The Consumption Schedule or Consumption FunctionIn the aggregate, households increase their spending as their disposable income rises and spend a larger proportion of a small disposable income than of a large disposable income.

Consumption Schedule

IncomeConsumption0206070120120180170240220

The Consumption Function

YC0Consumption function C = f(Y)SavingsConsumption45Y1 Y 2CA

The Consumption Function45 line: at any point on the 45line consumption exactly equals income and the households have zero saving.MPC is the slope of the consumption function, which measures the change in consumption per unit change in income.

Determinants of ConsumptionCurrent disposable income: it is the central factor determining a nation's consumption.Permanent income: it is the level of income that households would receive when temporary influences are removed.Wealth: it is the net value of tangible and financial items owned by a nation or person at a point of time.Other (interest rate, inflation, expectations).

SavingsSaving is that part of income that is not consumed. Saving equals income minus consumption: S = Y CIncome is the sum of consumption and savings: Y = C + S

The Saving Schedule or Saving FunctionThere is a direct relationship between saving and disposable income but saving is a smaller proportion of a small DI than of a large DI. Households consume a smaller and smaller proportion of DI as DI increases; therefore, they must be saving a larger and larger proportion.

Dissaving (consuming in excess of after-tax income) will occur at relatively low DIs.

Households can consume more than their incomes by liquidating (selling for cash) accumulated wealth or by borrowing.

SavingsThe marginal propensity to save

is defined as the fraction of an extra unit of income that goes to extra saving.MPC + MPS = 1 because the part of each unit of income that is not consumed is necessarily saved.

The Consumption and Saving Function

YC, S0C = f(Y)45Y ECA-CAS = f(Y)The saving function is the mirror image of the consumption function. It shows the relationship between the level of saving and income.

Consumption and Savings Schedule

Income( Y)Consumption( C)Savings (S)020-206070-101201200180170102402202030027030

Marginal Propensity to Consume (MPC)The proportion, or fraction, of any change in income consumed is called the marginal propensity to consume (MPC). The MPC is the ratio of a change in consumption to a change in the income that caused the consumption change.

MPC = change in consumption change in income

Marginal Propensity to Save (MPS)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

Marginal PropensitiesHow much of every additional dollar in income is consumed? MPCHow much of every additional dollar iin income is saved? MPSMPC + MPS = $1 of additional income.: MPC = 1 MPS.: MPS = 1 MPCRemember, people do two things with their disposable income, consume it or save it!

CriticismProportional relationship between consumption and income is not always true.It neglects other factors that influence , consumer spending such as asset holdings, urbanisation, appearance of new products, etc. Expectations and level of aspirations also play an important role in consumer spending.