Consumption & Savings

2.
Consumption & Savings

Introduction
Prior to the great depression in the 1930s classical economic theory was
very popular. One of the main theories of the era was Says Law. his theory
stated that the very act of producing goods and services generates an amount
of income e!actly e"ual to the value of the goods and services produced.
his would mean that the production of any output would automatically
provide the means to ta#e that output off the mar#et. $n effect supply creates
its own demand.
Says Law implied that there would always %e sufficient demand to purchase
all the supply of goods and services produced. he economy would always
have a natural e"uili%rium with full employment. his theory was una%le to
e!plain the persistently low level of demand and high unemployment in the
&reat 'epression.
John Maynard Keynes formulated a theory called income and e!penditure
analysis during the recession years. his theory also %ecame #nown as
(eynesian economics and started a school of thought that is still popular
today. $ncome and e!penditure analysis stresses the critical role of aggregate
demand in determining domestic output and employment. )ore specifically*
the theory e!plains why aggregate demand might %e deficient with the result
that the economy would reach a recessionary e"uili%rium li#e that
e!perienced in the &reat 'epression.
he income and e!penditure analysis model uses the e"uili%rium e"uations
in the circular flow of income. (eynesian theory is %asically another way of
e!plaining the circular flow of income and the concept of e"uili%rium. he
model e!plains how e"uili%rium is achieved in the two* three* four and five
sector diagrams as well as the factors that influence each of the varia%les.
Two-Sector Eui!i"rium
Consumption
$n the (eynesian two+sector model there is income* consumption and
savings. (eynes assumed that consumption was a function of income which
means that there is a mathematical relationship %etween income and
consumption. he more income a person has the more they will spend. he
model also assumed that there were two components to consumption.
1
,irstly a part of consumption was induced -made to rise. %y the level of
income. he model assumed that consumers spent a fi!ed proportion of any
increase in income. he amount of any additional dollar that was spent on
consumption was called the marginal propensity to consume -)P/.. he
marginal propensity to consume can %e calculated %y comparing the change
in consumption to the change in income that caused it.
M#C $ %C & %'
Secondly another part of consumption was assumed to %e autonomous
-independent. of the level of income. Some aspects of consumption are
essential li#e food* clothing and other necessities. Spending on these items
would continue even if the level of national income was 0ero. (eynes
created a term called the average propensity to consume -1P/. to show that
consumption was not only influenced %y income. he average propensity to
consume can %e calculated %y dividing the level of consumption %y the level
of income at each level of output.
(#C $ C & '
(eynes was a%le to construct a consumption function or e"uation %y
com%ining %oth the induced and the autonomous components of
consumption. /onsumption is e"ual to the marginal propensity to consume
multiplied %y the level of income plus the level of autonomous consumption.
C $ M#C)'* + (utonomous C
he formula for the consumption function is %est illustrated with an
e!ample. /onsider the following ta%le showing 2 and / in dollars million3
Income Consumption
0 150
100 225
200 300
300 375
400 450
500 525
600 600
700 675
800 750
900 825
1000 900
4
o construct the consumption function you first need to calculate the
marginal propensity to consume. 1s income rises %y 100 consumption is
increasing %y 56 in the a%ove ta%le. herefore the marginal propensity to
consume is e"ual to 0.56.
M#C $ %C & %' $ ,- & .// $ /.,-
he level of autonomous consumption is that level of consumption when
national income is 0ero. his is 160 in the a%ove ta%le. 7e can now write the
consumption function. /onsumption -/. is e"ual to the marginal propensity
to consume multiplied %y the level of income plus the level of autonomous
consumption.
C $ /.,-' + .-/
he consumption function can %e used to find any level of consumption
given the level of income. $f income is 900 million then3
C $ /.,-)0//* +.-/ $ 1,- + .-/ $ 22-
he consumption function can %e graphed. /onsider the following diagram
of the ta%le a%ove.
3
$ncome and e!penditure analysis diagram are always drawn with a 86 degree
line. he purpose of this line is to determine the e"uili%rium level of income.
he %asic law of macroeconomics is that income and e!penditure are e"ual
at e"uili%rium. he 86 degree line shows all the points where income and
e!penditure are e"ual. $n the two sector diagram when the consumption
function cuts across the 86 degree line at this level of output income and
consumption are e"ual. his is called the %rea#even point. his is 900
million in the a%ove diagram. 1t income levels %elow this point
consumption is larger than income. 1t income levels a%ove this point
consumption is less than income.
3rea4even #oint5 ' $ C
6actors 7etermining Consumption
he level of consumption changes as a result of numerous factors. he
component of consumption e!penditure that depends directly on disposa%le
income is called induced consumption e!penditure. he remaining
component of consumption e!penditure that is independent of disposa%le
income is called autonomous consumption e!penditure. herefore all non
income factors cause changes in autonomous consumption e!penditure.
7isposa"!e Income
'isposa%le income is the money that households have to spend after
ta!ation. 'isposa%le income is the primary determinant of consumption. 1s
the level of national income increases then the level of consumption will
follow. /onsumer wants are unlimited and as the %asic wants are satisfied
consumers will start to satisfy other wants if they have the income to do so.
,or this reason (eynes assumed that consumption was a function of income.
his means that increases in income cause a movement along the
consumption function to higher levels of consumption. Similarly a fall in
national income would cause consumption to contract along the
consumption function.
E8pectations
:ousehold e!pectations a%out future money incomes* price increases and the
availa%ility of goods will influence current consumption. $f households
e!pect their income to increase in the near future then they may start to
increase consumption e!penditure immediately. :ouseholds may increase
their de%t %y using credit and e!pect to repay this de%t as their income
increases. $f future income is e!pected to fall or there is a ris# of
8
unemployment then households will start to cut %ac# on consumption
e!penditure to prepare for the lower income period.
$f households e!pect that prices will rise in the future or that goods will
%ecome unavaila%le then they will increase consumption. hey will purchase
now rather than ris# paying a higher price in the future or ris# not %eing a%le
to %uy the good at all. he opposite also holds3 e!pectations of lower prices
or surpluses of goods will lead to a postponement of current consumption.
9ea!th
he greater the amount of wealth households have accumulated* the larger
will %e the amount of consumption and the lower will %e the amount of
savings. 7ealth includes %oth real assets li#e houses and cars as well as
financial assets li#e stoc#s and %onds. One of the main reasons for saving is
to accumulate wealth. 1s wealth increases there is less need to save and the
level of savings fall. his results in higher levels of consumption and an
upward shift in the consumption function. $f the wealth of the community
were to decline then the consumption function would fall.
:ouseho!d Inde"tedness; Interest <ates and Credit (vai!a"i!ity
1 large proportion of consumption e!penditure is financed %y credit and
loan finance. $nterest rates are the cost of %orrowing money or the price of
money. 1s household de%t increases or interest rates rise it %ecomes more
difficult for households to repay their de%t. :igh de%t and interest rates will
cause consumers to reduce their consumption spending and increase their
savings which can %e used to reduce or repay de%t. $f interest rates fall or
de%t levels decrease then consumers will %e more a%le to increase their
consumption spending. $f households have more sources of credit availa%le
then they will %e a%le to increase %orrowing and hence consumption. he
opposite is e"ually true if financial intermediates reduce the availa%ility of
credit and consumer finance.
In=!ation
$nflation occurs when there is a sustained increase in the level of prices.
Prices usually rise %efore incomes and often rise %y more than income for
many households. ;ven when prices and incomes increase %y the same
percentage households can suffer from what is called money illusion. his
means that households feel that their disposa%le income has fallen and
therefore reduce consumption spending. 1s a result of price increases
6
households feel that their income %uys less and in real terms their income
has fallen.
$nflation also causes the price of financial assets li#e %onds and shares to fall
and this reduces a component of wealth. $ncreases in the value of property
assets may offset this decline in wealth. 1s wealth falls so too will the level
of consumption. 1n increase in the price level tends to push the consumption
level downwards.
Ta8ation
$n the four sector model we will see that ta!ation changes the marginal
propensity to consume and alters the consumption function. a!ation has an
impact on disposa%le income %ecause disposa%le income is the income
availa%le after ta!ation has %een deducted.
Increases and 7ecreases in Consumption
<on income factors cause the consumption function to increase or decrease.
his can %e shown on the following diagram.
1n increase in autonomous consumption is shown as an upward shift of the
consumption function from / to /1. his increases the %rea#even point from
900 to 1000 million in the a%ove diagram.
9
1 decrease in autonomous consumption is shown as a downward shift of the
consumption function from / to /1. his reduces the %rea#even level of
income from 1000 to 900 million in the a%ove diagram.
;!am =uestions
)ultiple /hoice =uestions
1. )oney illusion occurs when3
a. Prices rise faster than personal incomes.
%. Personal incomes rise faster than prices.
c. Personal incomes and prices rise in the same proportion.
d. Personal incomes fall.
4. he marginal propensity to consume for an economy3
a. $ncreases as national income increases.
%. ,alls as national income increases.
c. >emains constant for any change in national income.
d. ,alls when national income decreases.
3. he average propensity to consume for an economy3
a. $ncreases as national income increases.
%. ,alls as national income increases.
c. >emains constant for any change in national income.
d. ,alls when national income decreases.
5
8. $f national income is a%ove the %rea#even point3
a. /onsumption e!penditure is less than national income.
%. /onsumption e!penditure is greater than national income.
c. /onsumption e!penditure is e"ual to national income.
d. /onsumption e!penditure remains constant.
6. $f an economy has the following consumption function /?0.6y @ 100 then
the level of national income at the %rea#even point would %e3
a. 100
%. 400
c. 300
d. 800
9. $f the marginal propensity to consume in the a%ove economy increased to
0.56 then the level of national income at the %rea#even point would %e3
a. 100
%. 400
c. 300
d. 800
Short 1nswer
1. 'efine the following terms3 consumption* autonomous consumption*
induced consumption* marginal propensity to consume* average
propensity to consume* and %rea#even point.
AAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAA
4. ;!plain Says Law and how it differs from (eynesian economics.
B
3. 7hy do consumer e!pectations affect the level of consumptionC
8. :ow would an increase in the availa%ility of credit affect the level of
consumptionC
;!tended >esponse
>ut!ine and e8p!ain the =actors that determine consumption.
>ule 13 'efine the terms in the "uestion3 /onsumption e!penditure.
>ule 43 $dentify D define related concepts3 <ational income* disposa%le
income* inflation* e!pectations* credit availa%ility* and wealth.
>ule 33 Lin# introduced terms to the "uestion3 $f the level of national income
in an economy increases then the level of consumption e!penditure will
increase %y a proportion of that change in income.
>ule 63 'raw relevant diagrams3 wo sector circular flow diagram.
>ule 93 e!t reference to diagram in your answer3 /onsumption e!penditure
is shown as a flow %etween firms and households in diagram 1.
>ule 53 Ese e!amples to communicate additional meaning3 $f a person has a
higher disposa%le income they may %uy a new car.
>ule 83 'raw logical conclusions3 /onsumption is a function of income %ut
is also influenced %y other factors li#e wealth and consumer e!pectations.
9
Savings
Savings is deferred consumption and that part of income which is not spent.
(eynes also assumed that savings was a function of income which means
that there is a mathematical relationship %etween income and savings.
:ouseholds need income to %e a%le to save and the more income that a
household has the more they are a%le to save.
(eynes assumed that households saved a fi!ed proportion of any additional
dollar of income and he called this the marginal propensity to save -)PS..
he marginal propensity to save was e"ual to the change in savings divided
%y the change in income.
M#S $ %S & %'
1s with consumption (eynes assumed that savings had two components3 an
induced component and an autonomous component. he induced component
was determined %y the marginal propensity to save and the level of income.
he autonomous component was e"ual and opposite to the level of
autonomous consumption. $f households spend money when they have no
income then the level of savings must %e negative. (eynes called this
dissavings. 'issavings are e"ual %ut opposite in sign to the level of
autonomous consumption.
$t is now possi%le to construct the savings function using the two
components of savings. Savings is e"ual to the marginal propensity to save
multiplied %y the level of income minus the level of dissavings. he level of
dissavings is assumed to occur at each level of income Fust li#e autonomous
consumption.
S $ M#S)'* ? 7issavings
(eynes also calculated the average propensity to save -1PS. %y dividing the
level of savings %y the level of income.
(#S $ S & '
Savings is that part of income that is not spent. his implies that income is
e"ual to consumption plus saving.
10
' $ C + S
1s a result of this relationship saving represents what is left over after
consumption or the proportion of any additional dollar of income that is not
spent. his implies that the marginal propensity to consume plus the
marginal propensity to save is e"ual to one.
M#C + M#S $ .
hese relationships can %e illustrated with an e!ample. he following ta%le
is an e!tension of the original e!ample used in consumption. 7e can now
calculate the level of savings. $f income is e"ual to consumption plus
savings then we can transpose to find that savings is e"ual to income minus
consumption. 7e can use this e"uation to calculate the level of savings in
the following ta%le.
S $ ' ? C
Income Consumption Savings
0 150 -150
100 225 -125
200 300 -100
300 375 -75
400 450 -50
500 525 -25
600 600 0
700 675 25
800 750 50
900 825 75
1000 900 100
$n the a%ove ta%le it is possi%le to calculate the marginal propensity to save.
M#S $ %S & %' $ 2- & .// $ /.2-
he level of dissavings is e"ual to the loss of savings when income is e"ual
to 0ero. his is e"ual to an opposite in sign to the level of autonomous
consumption.
7issavings $ -.-/
11
he savings function can now %e constructed. Savings is e"ual to the
marginal propensity to save multiplied %y the level of income minus the
level of dissavings.
S $ /.2-' -.-/
/hec#ing our formula %y su%stituting income we can calculate the level of
savings at income of 900 million and chec# our answer in the a%ove ta%le.
9hen ' $ 0//@ S $ /.2-)0//* - .-/ $ 22- ? .-/ $ ,-
1s a result of the fact that income is e"ual to consumption plus savings we
now that marginal propensity to consume plus the marginal propensity to
save is e"ual to one.
M#C + M#S $ /.,- + /.2- $ .
$n the income and e!penditure analysis model the savings function is
graphed underneath the consumption function. /onsider the following
diagram3
$n the a%ove diagram we can o%serve that the savings function is flatter than
the consumption function. his is %ecause the marginal propensity to
14
consume and the marginal propensity to save are the slope of the lines. he
marginal propensity to consume is e"ual to 0.56 which is higher than the
marginal propensity to save which is e"ual to 0.46.
Our consumption function starts at the level of autonomous consumption
which is e"ual to 160. Our savings function starts at the level of dissavings
which is e"ual to +160. hese are the 2 values for the consumption and
savings functions when income is e"ual to 0ero.
7e now that the consumption function crosses the 86 degree line at the
%rea#even point when income is e"ual to consumption. $f income is e"ual to
consumption then the level of savings must %e e"ual to 0ero. 7e can see in
the a%ove diagram that the %rea#even point is 900 million. 1t this level of
income savings is 0ero.
/hanges in the level of autonomous consumption and movements of the
consumption function will alter the savings function. his can %est %e shown
with an e!ample. Esing the e!ample of an increase in consumption a%ove
we can construct the following ta%le3
Y C1 S1 C2 S2
0 150 -150 250 -250
100 225 -125 325 -225
200 300 -100 400 -200
300 375 -75 475 -175
400 450 -50 550 -150
500 525 -25 625 -125
600 600 0 700 -100
700 675 25 775 -75
800 750 50 850 -50
900 825 75 925 -25
1000 900 100 1000 0
1100 975 125 1075 25
$n the a%ove ta%le 2 is the various level of national income attaina%le %y the
economy* /1 and S1 are the original consumption and savings functions
graphed a%ove. he level of consumption then increased to /4 which was
also graphed a%ove. he consumption function shifted upwards after this
change. 7e can now o%serve the change to the savings function S4 %y
graphing it %elow.
13
,rom the a%ove graph we can see that the consumption function has
increased from its original position and now starts at a 2 value of 460
million. he savings function has fallen %y a corresponding amount and now
starts at +460 million. he %rea#even point is now at 1000 million where 2 ?
/ and S ? 0.
6actors 7etermining Savings
7isposa"!e Income
'isposa%le income is the money that households have to spend after
ta!ation. 'isposa%le income is the primary determinant of savings. 1s the
level of national income increases then the level of savings will follow. ,or
this reason (eynes assumed that savings was a function of income. his
means that increases in income cause a movement along the savings
function to higher levels of savings. Similarly a fall in national income
would cause savings to contract along the savings function.
Ta8ation
$n the four sector model we will see that ta!ation changes the marginal
propensity to save and alters the savings function. a!ation has an impact on
disposa%le income %ecause disposa%le income is the income availa%le after
ta!ation has %een deducted. /hanges in the level of disposa%le income will
affect the level of savings %ecause savings is a function of income.
18
Consumption
Savings is that part of income that is not consumed. herefore the level of
consumption will affect the level of savings. 1s the level of autonomous
consumption changed in the diagrams a%ove this had an e"ual and opposite
affect on the level of savings. herefore all the factors that affect
autonomous consumption will also affect the level of savings. 7e also #now
that the marginal propensity to consume plus the marginal propensity to save
is e"ual to one. his means that if the rate of consumption or the marginal
propensity to consume changes this will affect the si0e of the marginal
propensity to save.
9ea!th
One of the main reasons for saving is to accumulate wealth. 1s wealth
increases there is less need to save and the level of savings will fall. his is
assuming that the wealth has no effect on the level of income. $f income
were to rise then we now that the level of savings would increase.
;!am =uestions
)ultiple /hoice =uestions
1. 1n increase in ta!ation on individuals would3
a. $ncrease disposa%le income and increase savings.
%. $ncrease disposa%le income and reduce savings.
c. 'ecrease disposa%le income and increase savings.
d. 'ecrease disposa%le income and decrease savings.
4. Gelow the %rea#even level of national income savings is3
a. Positive.
%. <egative.
c. Hero.
d. Ena%le to %e determined.
3. $f an economy has the following consumption function /?0.6y @ 100 then
the level of national income when savings e"uals 0ero is3
a. 100
%. 400
c. 300
d. 800
16
Short 1nswer
1. 'efine the following terms3 marginal propensity to save* average
propensity to save* and dissavings.
4. 7hat is the relationship %etween consumption and savingsC
3. 7hy does the marginal propensity to consume plus the marginal
propensity to save e"ual one in the two sector modelC
;!tended >esponse
>ut!ine and e8p!ain the =actors that determine savings.
>ule 13 'efine the terms in the "uestion3 Savings.
>ule 43 $dentify D define related concepts3 <ational income* disposa%le
income* ta!ation* consumption e!penditure and wealth.
>ule 33 Lin# introduced terms to the "uestion3 $f the level of national income
in an economy increases then the level of savings will increase %y a
proportion of that change in income.
>ule 63 'raw relevant diagrams3 hree sector circular flow diagram.
>ule 93 e!t reference to diagram in your answer3 Saving is shown as a flow
%etween households and the financial sector in diagram 1.
>ule 53 Ese e!amples to communicate additional meaning3 1s the level of
national income increases the level of savings will increase according to the
si0e of the marginal propensity to save.
>ule 83 'raw logical conclusions3 Savings is a function of income %ut is also
influenced %y other factors li#e wealth and ta!ation.
19

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Consumption & Savings

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