consumption function

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2 Every day you make choices on what to do with the money you have. Should you splurge on a restaurant meal or save money by eating at home? Should you buy a new car, if so how expensive of a model? Should you redo that bathroom or live with it for another year? In the real world, households are constantly confronted with such choices. These choices end up having a powerful effect on the economy. Y D Y is used to represent income. This is standard practice in macroeconomics, even though income isn t actually spelled yncome. The reason is that I is reserved for investment spending. Once you pay your taxes and receive any government transfers there are only two options you can do with your money: Consume or Save. Disposable income is counted as consumer spending in the circular flow. While not all consumers save part of their income, typical consumers spend the majority of their disposable income and save whatever is left over. To see the relationship between disposable income and consumption we create a consumption function. 2

3 Even with zero disposable income, households still consume as they liquidate wealth (sell assets), spend some savings, or borrow (dissavings). For every additional $100 of disposable income, consumers increase their spending by $80 and increase saving by $20. We can convert the above consumption schedule to a linear equation or consumption function. 3

4 We assume that a is greater than zero because a household with no disposable income is able to fund some consumption by borrowing or using its savings. 4

5 At every level of disposable income, the consumption function tells us how much is consumed. This graph tells us that at incomes below $200, the consumer is consuming more than his income. As a result savings is a negative and this is referred to as dissavings. But at incomes above $200, the consumer is spending less than his income; and so saving is positive. 5

6 The saving schedule (slide 3) can also be converted into a linear equation, or savings function. The constant $ 40 is referred to as autonomous saving because it does not change as disposable income changes. With zero disposable income, the household would need to borrow $40 to consume $40 worth of goods. The slope of the saving function is.20 6

7 There is an important lesson from the study of the marginal concept. You can think of it in two equivalent ways. Marginal always means an incremental change caused by an external force, or it is always the slope of a total function. The same is true here. Another way to think of MPC is the slope of the consumption function. Or think of it as the increase in consumer spending when disposable income rises by $1. MPC is the change in consumer spending divided by the change in disposable income. The symbol (delta) means change in. For example, if consumer spending goes up by $6 billion when disposable income goes up by $10 billion, MPC is $6billion/$10 billion =.6 7

8 The additional disposable income that consumers don t spend is saved. 8

9 Now that we have some background knowledge, we can now learn about the multiplier effect on an economy! 9

10 *For right now we will ignore the government (or public sector) and we will ignore net exports (or foreign sector) in the economy. After just 5 rounds of spending, we ve created $2,361.60, more than DOUBLE the original injection of spending!!! If we had continued until someone was trying to spend 80% of nothing, Ted s initial $1000 purchase would have multiplied to a total of $5000 in income/spending. How do we know it will eventually multiply 5 x s it s original spending? We find the multiplier! 10

11 AAS is the autonomous change in aggregate spending Y is the total change in real GDP Remember, the multiplier is the result of a chain reaction in which higher real GDP leads to higher disposable income, which leads to higher consumer spending, which leads to further increases in real GDP. 11

12 Government can also have an impact on aggregate expenditures and real GDP by changing taxes and/or transfers. Ahousehold s taxable income rises when real GDP rises. When you make more, you have to pay more taxes! 12

13 At about 2/3 of total spending in the US, consumer spending is a critical driver of the macroeconomy. As we have already seen, we can model consumer spending with a consumption function that is positively relate to disposable income. What determines how much consumers spend? 13

14 Change in Expected Future Disposable Income Ex. Good News: Suppose a college senior was about to graduate and already had a job lined up. In other words, she knows that her current disposable income is going to rise. This expectation of more income in the future shifts her consumption function upward. Ex. Bad News: Suppose you have a good job but learn that the company is planning on downsizing your division, praising the possibility that you may lose your job and have to take a lower paying one elsewhere. Even though your disposable income hasn t gone down yet, you might as well cut back on spending even while still employed, to save money for a rainy day. When the economy grows, by contrast, current and expected future incomes rise together. Higher current income tends to lead to higher savings today, but higher expected future income tends to lead to lower savings today. As a result, there s a weaker relationship between current income and the savings rate. In conclusion, consumer spending ultimately depends mainly on the income people expect to have over the long term rather than on their current income. Changes in Aggregate wealth Ex. We have two people: Maria and Mark. They both make $40,000 this year, but they have very different stories. Maria has been working steadily for the past 10 years, owns a home, and has $200,000 in the bank. Maria is doing pretty well! Mark is the same age as Maria, but he has been in and out of work, does not own a home, and has very little in savings. While they have the same exact income, will they spend the same amount? NO! This is because Maria has something Mark doesn t have WEALTH, and wealth, my friends, has a big impact on consumer spending. Ex. Suppose that the stock market has a bad year and the value of your wealth substantially declines. This lost wealth, even if it is only on paper, usually causes people to reduce their consumption. The consumption function shifts downward. 14

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16 Although consumer spending is much larger than investment spending, booms and busts in investment spending tend to drive the business cycle. In fact most recessions originate as a fall in investment spending. When a firm considers investment spending, they are really doing a little benefit cost analysis on the dollars they are about to spend. Ex. A firm is considering building a new factory. This will increase sales, but it will also require borrowing to fund the investment. The factory will only go ahead if the firm expects a rate of return higher than the cost of the funds they would have to borrow to finance that project. If the interest rate rises, fewer projects will pass the test, and as a result investment spending will be lower. Therefore, there is a negative relationship between the interest rate and dollars of investment spending. 16

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18 Expected Future Real GDP Ex. Suppose a firm believes that the economy was really going to take off next year. This firm might increase investment spending in anticipation of increased sales. After all, you can t build a factory overnight; the firm must begin the factory now to take advantage of more customers in the coming year. Production Capacity Ex. Suppose a firm can produce 100, units if the factory is producing 24/7. The firm s full capacity is 100,000 units. Right now, the firm has enough customers to produce only 50%, or 50,000 units, of full capacity. A firm in this situation would not likely be looking to increase investment. After all, if orders from customers were to increase, it would be easy to satisfy those orders without increasing the size of the factory. The best conditions for new investment spending consist of firms that are near production capacity with expectations of strong real GDP in the future. 18

19 Firms hold inventories so they can quickly satisfy buyers a consumer can purchase an item off the shelf rather than waiting for it to be manufactured. A firm that chooses to increase inventories is engaging in a form of investment spending. Ex. Suppose the US auto industry produces 800,000 cars per month but sells only 700,000. What happens to the remaining 100,000 cars? They are added to inventory at auto company warehouses or car dealerships, ready to be sold in the future. Inventory investment can be a negative when the auto industry reduces its inventory over the course of a month. We would call this engaging in negative inventory investment. Another example Grocery stores While firms may try their best to manage inventories carefully sales fluctuate. Because firms can t always predict future sales, they may end up with holding either larger or smaller inventories than they intended. They are experiencing unplanned inventory investment: occurs when actual sales are less than businesses expected, leading to unplanned increases in inventories. Sales in excess of expectations results in negative unplanned inventory investment. Risinginventoriestypicallyindicate inventories typically indicate positive unplanned inventory investmentanda a slowing economy, as sales are less than had been forecast. Falling inventories typically indicate negative unplanned inventory investment and a growing exonomy, as sales are greater than forecast. 19

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