Saving and Consumption Function

7/28/2019 Saving and Consumption Function

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Aggregate Expenditure and Equilibrium

National OutputAggregate expenditure (AE)

total amount that all economic agents want or plan tospend on domestic goods and services.

the planned spending of households,

firms,

government, and

foreigners.


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Aggregate ExpenditureAE = C + I + G + (X-M)

consumption (C),

investment (I), government spending (G), and

exports less imports (X-M).

Note thatAE is not the same as GDP.

AErepresentsplannedspending

GDP represents actualspending or output.


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Aggregate Expenditure (AE) and National

Output (Y)AE and Y are not necessarily equal:

Firms formulate their production plans with an estimateof the quantities that people want to buy.

A mistake on their part will cause production to exceedor fall below the amounts that people want to buy.


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What if AE and Y are not equal? If AE < Y

people want to buy less than what has beenproduced so firms will accumulate inventories.

firms will reduce production

If AE >Y What people want to buy is greater than actual

production so inventories will decline. firms will increase production


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Equilibrium National IncomeAE = Y

Can be depicted by the intersection between the

AE schedule and the 45 degree line


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The 450

line The 45-degree line is a tool that assists us in

identifying the economy's equilibrium position.

Property: every point along this line depicts asituation wherein the value of the variable on thehorizontal axis (in this case actual output, (Y) is equalto its counterpart on the vertical axis (AE).


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0100

100

450 line

450

200

200


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45

E0AE20

AE

0 20

Output, income (in pesos)

Aggregateexpen

diture

(inpesos)

Y

Y*


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Equilibrium Income (Y*)WhenAEis equal to Y

there is no reason for firms to adjust production.

this suggests that the economy is in equilibrium.

Equilibrium requires the equality betweenincome and aggregate expenditure. That is,

Y = AE.


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45

AE0E0

E1

AE1

20

30

AE

0 20 30Y

Output, income (in thousands)

Aggregateexpen

diture

(inpesos)

Y0 Y1


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Consumption and Income Keynes (1936) suggested that consumption spending

(C) tends to increase with income.

In other words, households with higher incomes tend tospend more.

There is a positive relationship between consumptionspending and income


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TABLE 9.1. Consumption and income (in Rs-thousands).

(1) (2) (3) (4) (5)

Income Consumption Change In

income

Change in

consumption

Mpc

(Y) (C) (Y) (C) (C/Y)

0 200 _

200 350 200 150 0.75

400 500 200 150 0.75

600 650 200 150 0.75

800 800 200 150 0.751,000 950 200 150 0.75

1,200 1,100 200 150 0.75

1,400 1,250 200 150 0.75

1,600 1,400 200 150 0.75


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Consumption and income Higher levels of income correspond to higher levels of

consumption spending

When income is equal to zero, consumption spending is

equal to 200.

Consumption spending and income are equal at each otherwhen income = 800. When income is less than 800, consumption is higher than income.

When income is greater than 800, consumption less than income


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0

450200

Consum

ptionSpending

(inp

esos)

Output, Income (in thousands)

400

600

800

1000

800 1200 1600

400

1200

1400

1600

C

Y

THE CONSUMPTION SCHEDULE

Y


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Consumption and Income Observations from values above:

(a) autonomous consumption spending-

component of consumption spending that doesnot depend on income

- equal to 200 in example

(b) marginal propensity to consume (mpc) -shows the increase in consumption spending for aone peso increase in income;


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Marginal Propensity to Consume MPC or the marginal propensity to consume represents the change

in consumption spending that arises from a one rupee change inincome.

Value of MPCis between 0 and 1.

MPC=0.75 means that a one peso increase in income leads to a 75-

centavo increase in consumption spending.

Cmpc

Y


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Marginal propensity to consume In example above,

C = 150 for Y = 200. Hence,

1500.75

200

CMPC

Y


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Consumption Function Consumption Function:

C = c + mpc.Y

C = 200 + 0.75Y


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Savings and Income Sum of consumption spending and savings (S) must

equal income. In symbols,Y = C + S.

Subtracting C from both sides of this equation leads toS = Y - C.


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(1) (2) (3) (4) (5) (6) MPS

Y C S Y C S S

Y

0 200 -200 - - - -

200 350 -150 200 150 50 0.25

400 500 -100 200 150 50 0.25

600 650 -50 200 150 50 0.25

800 800 0 200 150 50 0.25

1000 950 50 200 150 50 0.251200 1000 100 200 150 50 0.25

1400 1200 150 200 150 50 0.25

1600 1400 200 200 150 50 0.25

Relationship bet. Income and Savings


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E0

S

I

-200

1000

800 1,200 1,600

Income (in Rs.-thousands

Y

Y*

(B)

S, I

(A)

E0

Fig 9.5

C+I = AE

C

0 400 800 1,200 1,600Y

45

AE

300

200

Y*


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Savings and income Savings - that component of income that is not

allocated to consumption.S = Y C

How is savings linked to income?

YS.


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Savings and Income Marginal propensity to save (MPS) is the

increase in savings for a one Rs.increase in

income; In the example above, S = 50 for Y = 200.

Implies that

500.25

200

SMPSY


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Savings function Note: MPC+MPS = 1

Savings schedule listing of values of savings at eachlevels of income

Savings function in equation form

S = -200 + .25Y


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Relationship between mpc and mpc

1

Y C S

Y C S

Y C S

Y Y Y

mpc mps


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S

-200

-50

150

0

400 800 1,200 1,600

Income (in thousands

Savings

(inpesos)

Y

S F9.4

Propensity to Save


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Table 9.3 Consumption, Investment and Equilibrium Income.

Y C S I AE

400 500 -100 100 600

600 650 -50 100 750

800 800 0 100 900

1,000 950 50 100 1,050

1,200 1,100 100 100 1,200

1,400 1,250 150 100 1,350

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Saving and Consumption Function