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AE & The Consumption Function

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8 views24 pages

AE & The Consumption Function

Uploaded by

Jon Newland
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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AGGREGATE EXPENDITURE AND THE

CONSUMPTION FUNCTION
SOME IMPORTANT TERMS
• Consumption Expenditure: spending on goods and services by households in the satisfaction
of their needs and wants.
• Autonomous (non-discretionary) consumption: the minimum level of consumption or
spending that must take place even if a consumer has no disposable income, such as spending
for basic necessities.
• Dissaving: Spending an amount of money greater than available income. Dissaving is
considered the opposite of saving, and can include tapping into money already in a savings
account or accumulated elsewhere.
• Induced expenditure: The components of aggregate expenditure that change when real GDP
changes.
• Disposable income is aggregate income (GDP) minus net taxes
• Net taxes are taxes paid to government minus transfer payments received from government.
THE KEYNESIAN CONSUMPTION FUNCTION

The consumption function


shows the relationship
between consumption
expenditure and disposable
income, holding all other
influences on influences on
household spending
behavior constant.
Disposable
income
+
(Expected) real
interest rate -
Real
+ = Consumption
The buying power Spending
of net assets
+
Expected future
disposable income
THE KEYNESIAN CONSUMPTION FUNCTION

 Initially we assume there is no government sector and no


overseas sector
 Only two possible ways that people can se heir disposable
income – spend it (C) or save it (S)
 Y= C + S
Yd = C + S
0 = 40 + -40
50 = 75 +
100 = 110 +
150 = 145 +
200 = 180 +
250 = 215 +
300 = 250 +
350 = 285 +
Yd = C + S
0 = 40 + -40
50 = 75 + -25
100 = 110 + -10
150 = 145 + 5
200 = 180 + 20
250 = 215 + 35
300 = 250 + 50
350 = 285 + 65
 From the previous table we can see that Y= C+S
 If Y ≥ C then savings is positive e.g. Y = 200 C = 180 S = 20
 If Y ≤ C then savings is negative e.g. Y = 50 C = 75 S = -25
 If Y = C then savings is zero
 If Y = 0 then consumption is exactly balanced by savings
Consumer
Spending
($ billion) 45˚

300
C
250

200

150

Savings
100
S
50

0
50 100 150 200 250 300 350
- 50
Level of Disposable
Dissaving Income ($ billion)
s
MARGINAL PROPENSITY TO CONSUME
(MPC)

The fraction of any change in disposable


income that is consumed.

MPC= Change in Consumption


Change in Income
MPC = ΔC
/ΔY
MARGINAL PROPENSITY TO SAVE (MPS)

The fraction of any change in disposable income that is


saved.

MPS= Change in Savings


Change in Income

MPS = ΔS
/ΔY
MARGINAL PROPENSITIES

 MPC + MPS = 1
 .: MPC = 1 – MPS
 .: MPS = 1 – MPC
If ΔY = $20 and $16 of that extra income is spent then the MPC = ? and the MPS = ?
0.8 & 0.2
 Remember, people do two things with their disposable income,
consume it or save it!
THE EQUATION OF THE C FUNCTION

C = a + bY
Where: C = consumption
a = autonomous Consumption
b = MPC (slope of line)
Y = level of disposable income
THE EQUATION OF THE C FUNCTION

What is the Equation of the line we


have just drawn?
Autonomou
s MPC
Consumptio Level of
Slope of
n Disposable
line
Income

C = 40 + 0.7
Y
SUMMARY

• Autonomous consumption (spending on


essentials) will not change regardless of
disposable income. (represented by ‘a’ on
model)
• For discretionary non-essential purchases
there is a positive relationship.
• As income increases so does consumption.
• The slope of the curve represents the
MPC. (Represented by’ b’ on model)
THE AGGREGATE EXPENDITURE MODEL
2. THE FULL KEYNESIAN AE MODEL
Yd C S I C+I
0 60 -60 60
100 120 -20 60
200 180 20 60
300 240 60 60
400 300 100 60
500 360 140 60
600 420 180 60
Yd C S I C+I
0 60 -60 60 120
100 120 -20 60 180
200 180 20 60 240
300 240 60 60 300
400 300 100 60 360
500 360 140 60 420
600 420 180 60 480
Consumer
Spending
($ billion) 45˚

600
C+I
500
C

400

300
S
200

100
I
0
10 200 300 400 500 600 700
0
- 100 Level of Disposable
Income
($ billion)
THE KEYNESIAN AGGREGATE EXPENDITURE MODEL

 Some Important Assumptions:

 C increases as real GDP increases


 I is independent of real GDP (In other words I=$50b no
matter the income level)
 G is independent of real GDP
 X is independent of real GDP
 M rises as real GDP rises
Real
GDP C I G X M AE ∆In
v
0 60 60 80 40 40
10 120 60 80 40 50
0
20 180 60 80 40 60
0
30 240 60 80 40 70
0
40 300 60 80 40 80
0
Real
GDP C I G X M AE ∆In
v
0 60 60 80 40 40 20 -
0 200
10 120 60 80 40 50 25 -
0 0 150
20 180 60 80 40 60 30 -
0 0 100
30 240 60 80 40 70 35 -50
0 0
40 300 60 80 40 80 40 0
45˚
Consumer
Spending
($ billion)

M
600 AE

500

400

300

200
I+G+
100 X
I+G
I
0
10 200 300 400 500 600 700
- 50 0
Level of Disposable
Income
($ billion)
MARGINAL PROPENSITY TO CONSUME (MPC)
The marginal propensity to consume (MPC) is the fraction of the change in
disposable income that is spent on consumption. That is:

Change in consumption expenditure


MPC =
Change in disposable income
Notice that when disposable income increases from $6 to
$8 trillion, consumption expenditure changes from $6.0 to
$7.5 trillion. Thus we have:
$1.5trillion
MPC  0.75
$2.0trillion

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