Theory Of Consumption

- Rahul Jain

Aggregate Demand and Supply Approach

AD=ASC+I=C+SY=C+IHence, Y=1/(1-b) *(a+I)

Consumption

Use of goods and services to satisfy human wants

C= a+bY

MPC, APC = C/Y

MPS=1-MPC

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What is the Marginal Propensity to Save(MPS)?

The change in saving induced by a change in income

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Note that MPC + MPSmust equal 1

Theories of Consumption

Absolute Income theory- By KeynesCurrent consumption is a function of current

real incomeMPC is between 0 and 1MPC declines with increase in Income

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What is Keynes’ Absolute Income Hypothesis?

As income increases, consumption spending increases, but by diminishing amounts

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Concerned how households allocate their income between consumption and saving households earn a stream of income over

a lifetimehouseholds may consume more or less

than their income for any given year

Life-cycle hypothesis- By Ando & Modiglani

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What is Modigliani’s Life Cycle Hypothesis?

Typically, a person’s MPC is relatively high during young adulthood, decreases during middle age, and then increases

Chapter 410

household consumption depends on rate of interest expectations regarding future income

decision-making is intertemporal, meaning that households carefully consider how their present expenditures affect future consumption

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What can cause a shift in the Consumption Function?

• Real assets & money holdings• Expectations of price changes• Credit & interest rates• Taxation

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Real Disposable Income

Rea

l Con

sum

ptio

n C1

C2

Chapter 413

The Permanent income hypothesis People maximize utility based on their

permanent (expected life-time) income Allocate their income intertemporally

Chapter 414

Permanent-Income Theory of Consumption Consumption depends on permanent

income, which depends on current income and expected future income

Households try to smooth out consumption over a lifetime

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What is Duesenberry’s Relative Income Hypothesis?People consume according to

their relative position in society, consistent with the idea that the MPC remains fairly constant as national income increases

Relative Income Hypothesis

Relative income hypothesis states that individual’s attitude  consumption and saving is dictated more by his income in relation to others than by abstract standard of living.