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Consumption Function

Chapter 5. Consumption Function. Consumption/Saving Function. 1. Significance. AD and AS determine Y, u and P. Consumption is the major component of AD Saving is inevitable for investment which increases both AD and AS. 2. What is Consumption ?. Non-durable goods : fairly stable.

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Consumption Function

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  1. Chapter 5 Consumption Function

  2. Consumption/Saving Function 1. Significance • AD and AS determine Y, u and P • Consumption is the major component of AD • Saving is inevitable for investment which • increases both AD and AS 2. What is Consumption ? • Non-durable goods : fairly stable • Durable goods : most volatile • Services : medium flexibility

  3. - Does not include expenditure on housing and real estate, which are component of investment • - Most dominant but relatively stable component of aggregate demand • - Micro foundation of macroeconomics • C = Dij • -Part of disposable income that is not consumed is saved • S = Yd – C • -Forced saving, which stands for all contractual saving such as CPF 3. What determines consumption ? 3.1 Income (disposable): Constraint/ scale variable - YCY, which way causation? Feedback mechanism - Autonomous and induced C - Three alternative theories: • Absolute/Life cycle/Permanent income hypotheses

  4. 3.1.1. Absolute income hypothesis Yd = C + S (5.1) C = C0 + b Y (5.2) Fundamental psychological law: C0, b > 0 b < 1 MPC = = b APC = = + b

  5. Figure 5.1: Keynesian Consumption Function (A): Consumption Function (B): APC and MPC

  6. Saving Function S = Y - C = Y - C0 - bY  S = -C0 + (1-b)Y (5.3) Thus, MPS = = 1 - b + (1 - b) APS = • Two identities: MPC + MPS = 1 • APC + APS = 1

  7. C Y 2 2 + = + C Y 1 1 + + 1 i 1 i 3.1.2. Life Cycle Theory: forward looking *Irving Fisher’s constraint: theory of interest rate (5.4) Figure 5.2: Consumption-Saving Decisions

  8. * Examples (ignoring interest) (a) Uniform Income (b) Varying Income = 0.8[225,000] = Rs. 180,000

  9. æ ö w ç ÷ = C Y ÷ ç + w p è ø (5.5) (c) General Or, MPC = APC = < 1 (d) One Time wind fall/ Award (e) Promotion

  10. Figure 5.3: Life Cycle Theory Consumption Function

  11. Wealth effect included (5.6) MPC = W/(W+P) APC = • Limitations • - Uncertainty about future incomes • - Important capital market • - Bequest motive

  12. 3.1.3. Permanent Income Hypothesis C = k Yp (5.7) Y = YT + Yp (5.8) • Koyck’s Transformation YP = Y + (1-)Y-1 + (1-)2 Y-2 + ......... (1-) = (1-)Y-1 + (1-)2 Y-2 +..... ═>Yp =  Y + (1-) (5.9) * APC = k (Yp / Y) * Limitations - Yp only an approximation - hard to distinguish Yp and YT 3.1.4. Hall’s random wall model: Ct+1 = Ct + u

  13. 3.2. Other determinants of C • Wealth: Real balances • Relative income hypothesis • Modigliani: Past peak income • C = a + by – c(Y/Ymp) (5.10) • APC = a(1/Y) + b – c (1/Ymp) (5.11) • APS = (1-b) – a (1/Y) + c (1/Ymp) (5.12) • Duesenberry: Average neighbour income - Bandwagon effect • Interest rate / return on saving • - Target income savers : i S - Income and substitution effects • Credit availability, if liquidity constraint • Consumers’ expectations • Distribution of income / wealth • Residual factors • Tax rates • Precautionary need for saving • Bequest motive

  14. 4. Relationship between C and S functions • LCT - PIH attractive (excess smoothness), but AIH (excess sensitivity to current Y) is useful • Tax and transfer payments C = a + b (Y - T + TP) S = Y - C - T + TP = - a + (1 - b) [Y - T + TP]

  15. 5. Why saving rate varies significantly across countries ? • Per capita income • Interest rate • Fiscal deficit / PSU’s health • Social security • Ease of borrowing

  16. 6. Consumption Function C = f [Y,Ys(past), Ys(future), W, , i, CA, CE, IWD, u] (5.10) f1, f2, f3, f4, f7 > 0 > f5, f9 f6, f8 >< 0

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