The Consumption Function

Macroeconomic Model only

Assumption: Assume I G X are not influenced by domestic income

!!! Any AE disequilibrium model requiring questions: mention inventories. !!!

!!! Shifts of AE model: Mention Multiplier !!!

The AE Model: The Consumption Function

The Keynesian expenditure model is based on the relationship between the level of disposable income received by households and the level of consumption and saving.

• This is known as the CONSUMPTION FUNCTION
• Initially we assume that there is no government sector and no overseas sector – so there are only two possible ways that people can use their disposable income: spend it or save it

Assumption: Y= C + S, Income = Consumption + Savings

Y-axis: Consumption Spending, X-axis: Disposable Spending

The 45 degree line is equidistant between the two axes and thus shows all possible points where planned expenditure equals total income

• When the consumption function intersects the 45 degree line - The economy is in ‘equilibrium’
• This means that the level of income output and spending in the economy is in balance – the level of economic activity is stable

At a point higher than the equilibrium, savings is positive

• The amount earned is not equal to the amount spent.
• The gap between the consumption curve and the 45 degree curve is the amount saved

At a point lower than hte equilibrium, savings is negative

• The amount earned is not equal to the amount spent.
• The gap between the consumption curve and the 45 degree curve is the amount dissaved (usage of accumulated savings)

\[C = a + bY\]

The right hand side of the equation has two parts.

• The variable ‘a’ is the vertical intercept – the point where the consumption function meets the y-axis
  • This (a) is described as autonomous consumption (not affected by income usually non-discretionary) – there would be some level of aggregate spending even if consumers had no income (presumably households would draw on savings or claim transfer payments)
• The second part of the right hand side (the variable ‘b’) is the rate at which consumption (C) changes when income (Y) rises – the slope of the consumption line.

If the equation is C = 60 + 0.6Y

• This means that if income was zero, the autonomous level of consumption for the economy would be $60
• For every $1 increase in disposable income, households will spend 60 cents and save 40 cents;
• The 0.6 is the Marginal Propensity to Consume (MPC)
  • The MPC is the proportion of any change in income that is spent on consumption
  • MPC = change in C divided by change in Y
• Hence the Marginal Propensity to Save (MPS) is, the fraction of any change in income that is saved, and in this case is 0.4
• MPC + MPS = 1
• The size of the MPC depends on the attitude of consumers to spending and saving.

The AE Model: The Financial Sector

At an income level of 400 billion dollars for example planned (total C+I) spending equals 360 billion dollars.

• Firms will have unsold output (inventories) of $40 billion - inducing them to cut their output in the next time period resulting in a fall in income earned.
• Cutting output would shift along the C+I curve -> until it reaches equilibrium (income = expenditure)

On the other hand, if the level of income was 200 billion dollars (below equilibrium level) total planned spending would be equal 240 billion dollars.

• This means that firms will have sold all their current output and will have to sell $40 billion worth of output from inventories
• Inventories will thus fall and firms will react by increasing production in the next time period.
• Rising production will increase the level of income earned.

Equilibrium? Doesn’t tell you anything about the whole economy. Don’t link to the macroeconomic indicators.

Full AE Model - Disequilibrium - Y≠Ex

M and C is upward sloping. I G X are flat, and are assumed to be unaffected by income.

• Gradient of M curve is the marginal propensity to import (MPI)

Income = Expenditure = Output (May seem the same but need to distinguish the difference)

AE models meet the definition of equilibrium - no tendency for change in the levels of income or output at that point in time.

“In this diagram, equilibrium occurs when total spending equals total output”

At a lower level of income than the equilibrium such as Y1 planned spending is greater than output and there is a decrease in inventories

• Firms will increase aggregate output so income and employment will rise

At a higher income level like Y2, planned spending is now less than output so that there is an increase in inventories.

• Again this will automatically lead to a decrease in production and the level of output and income will fall back to the equilibrium level Ye (point E)