Deconstructing Aggregate Demand - IB-Econ-Dubai-2011-12

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Transcript Deconstructing Aggregate Demand - IB-Econ-Dubai-2011-12

Deconstructing Aggregate Demand
This presentation will go through the
Consumption element of Aggregate
Demand. It will be made available on the
G13 Wiki
• The consumption function
The consumption function is simply a
theoretical relationship between income and
consumer expenditure. The Keynesian theory
describes a consumption function where
household spending is directly linked to
people’s disposable income. A simplified
consumption function diagram is shown
Diagram showing Consumption
Consumer Spending
Consumption = Disposable Income
Change in Consumption
Change in Income
450 line
Disposable Income $ Billion
Some Math!
The standard Keynesian consumption function is written as follows:
C = a + c (Yd) – where
C is total consumer spending
a is autonomous spending
And c (Yd) is the propensity to spend out of disposable income
Autonomous spending (a) is consumption which does not depend on the level of income. For example
people can fund some of their spending by using their savings or by borrowing money from banks and
other lenders. A change in autonomous spending would in fact cause a shift in the consumption function
leading to a change in consumer demand at all levels of income.
The key to understanding how a rise in disposable income affects household spending is to understand
the concept of the marginal propensity to consume (mpc). The marginal propensity to consume is the
change in consumer spending arising from a change in disposable income. If for example your disposable
income rises by $5,000 and you choose to spend $3000 of this on extra goods and services, then the mpc
is $3000/$50000 or 0.66. If you chose instead to spend only $2500 of the increase in income, then the
mpc would be 0.5.
The gradient of the consumption function shown in the previous diagram is determined by the value for
marginal propensity to consume. A change in the mpc (shown in the next diagram) would cause a pivotal
change in the consumption function. For example, a decision to save less of any increase in income would
lead to a rise in the mpc and a steeper consumption curve.
Shifts in the Consumption Function
Consumer Spending
Consumption = Disposable Income
Consumption =a2 +c(Yd)
Consumption =a +c(Yd)
450 line
Disposable Income $ Billion
Shifts in the Consumption Function
A change in any factor affecting consumption other than a change in income is said to
lead to a shift in the consumption function. These factors include the following:
A change in interest rates – for example a cut in interest rates will boost consumption at
each level of income and cause an upward shift in the consumption function. Lower
interest rates act to lower the cost of servicing the debt on a mortgage and thereby
increase the effective disposable income of homeowners. In contrast a period of higher
interest rates is designed to curb consumer spending.
A change in household wealth – for example a rise in house prices or in share prices
encourages higher levels of borrowing and an upward movement in the consumption
A change in consumer confidence – for example, expectations of rising unemployment
and worsening expectations of changes in income might lead to a reduction in
confidence and a fall in spending at each level of income. Conversely an improvement in
consumer expectations about the health of the economy will increase confidence and
planned spending.
Consumer spending in Britain had grown consistently strongly up to 2008, but the credit
crunch, financial crises & restrictive fiscal policies has seen the first decrease in
household disposable income since the 1970’s.
A simple Numerical Example
Disposable Income
Consumption (C)
Average Propensity Marginal Propensity
to Consume = C/Yd
to Consume =
change in C from a
£1 change in Yd
Disposable Income
• In our example above, as disposable income rises
in blocks of $10,000, so does total consumption.
But the rate at which consumer spending is
increasing is declining. The marginal propensity
to consume is falling and this brings down the
average propensity to consume. The Keynesian
theory did actually argue that the marginal
propensity to consume would fall as income
increases, but the evidence for the UK over many
years disputes this – perhaps people were
spending more than their current disposable
income? How is this possible?
The Savings Function
We assume that any disposable income that is
not spent is saved, so we can deduce from our
numerical example above, that because the
marginal propensity to consume is falling, then
the marginal propensity to save must be rising
as is the average propensity to save (otherwise
known as the household savings ratio).
This is shown in the savings function table which
is drawn from the data on consumption and
income used in the first table.
The Savings Function
The Savings Function - a simple numerical example
Disposable Income
(Yd) £
(= Yd – C)
Average Propensity Marginal Propensity
to Save = S/Yd to Save = change in
S from a £1 change
in Yd
Alternative Theories of Consumption
The life—cycle model
The life-cycle model of consumption was developed by Franco
Modigliani who argued that households form a view about their
likely or expected income over a large slice of their life-cycle, and
then base their spending decisions around this.
This helps to explain why people in reasonably well paid jobs in their
early twenties are prepared to borrow heavily to finance current
consumption (a new car, furnishings for a property) because they
expect to be able to repay loans as their disposable income
increases. Similarly people reaching middle age frequently tend to
become net savers because they are anticipating saving for their
One of the results of the life-cycle model is that changes in the age
structure of the population can have sizeable effects on total
consumer spending in the economy.
Alternative Theories of Consumption
The permanent income model
This model of consumption is associated with the US economist Milton
Friedman and it is, in many ways, a development of the life-cycle mode.
Friedman believed that people base their spending decisions on expectations
of permanent income. Permanent income might be described as the average
income that people can earn over their lifetime. A distinction is made
between transitory income (e.g. a windfall gain in income which has not been
earned) and permanent income. Friedman believed that changes in transitory
income would not fundamentally affect spending and saving decisions. But
that shifts in permanent income would be important in shaping our spending
• For example, a rise in household wealth increases the ability of people to
spend perhaps through borrowing secured on the value of a property. Lower
interest rates tend to increase both share and house prices adding to
household wealth. That said lower interest rates also cut the income flowing to
people with net savings.
• According to the permanent income model, only changes in permanent
income have any long term effect on consumption. But transitory changes in
spending power can lead to a more volatile pattern for the propensity to
• Blink & Dorton
• Read pages 170-179
• On P179 answer student work point 14.6
• Answer all 3 questions on Germany
• E-mail me or hand in on Sunday 9th P4.
[email protected]
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