Question 4 Suppose we draw the consumption function for a two-sector economy, with disposable income, Y DIS , on the horizontal axis and planned consumption, C , on the vertical axis. Question 5 Which of the following factors might cause a country's consumption function to shift upwards? Question 6 Consider a two-sector economy. Question 7 In a four-sector economy, which of the following is assumed always to increase when GDP increases?
Question 8 In a four-sector economy, which of the following would not cause a change in MPE y? Thus, to calculate consumptio n at any level of income, multiply the income level by 0. Figure 1. The Consumption Function. In the expenditure-output model, how does consumption increase with the level of national income? Output on the horizontal axis is conceptually the same as national income, since the value of all final output that is produced and sold must be income to someone, somewhere in the economy.
A change in the marginal propensity to consume will change the slope of the consumption function. A number of factors other than income can also cause the entire consumption function to shift. These factors were summarized in the earlier discussion of consumption.
For example, changes in consumer expectations about the future, or changes in household wealth would cause the consumption function to shift up or down to a a new consumption function that is parallel to the original one. Watch the selected three-minute clip from this video to take another look at the consumption function and the marginal propensity to consume.
Note that his graph is a rough sketch and not drawn entirely to scale. More generally, the slope of the saving function equals the change in personal saving divided by the change in disposable personal income. Thus, if a person with an MPS of 0. Since people have only two choices of what to do with additional disposable personal income—that is, they can use it either for consumption or for personal saving—the fraction of disposable personal income that people consume MPC plus the fraction of disposable personal income that people save MPS must add to The discussion so far has related consumption in a particular period to income in that same period.
The current income hypothesis Consumption in any one period depends on income during that period. Although it seems obvious that consumption should be related to disposable personal income, it is not so obvious that consumers base their consumption in any one period on the income they receive during that period. In buying a new car, for example, consumers might base their decision not only on their current income but on the income they expect to receive during the three or four years they expect to be making payments on the car.
Parents who purchase a college education for their children might base their decision on their own expected lifetime income. Indeed, it seems likely that virtually all consumption choices could be affected by expectations of income over a very long period.
One reason people save is to provide funds to live on during their retirement years. Another is to build an estate they can leave to their heirs through bequests. The amount people save for their retirement or for bequests depends on the income they expect to receive for the rest of their lives. For these and other reasons, then, personal saving and thus consumption in any one year is influenced by permanent income. Permanent income The average annual income people expect to receive for the rest of their lives.
People who have the same current income but different permanent incomes might reach very different saving decisions. Someone with a relatively low current income but a high permanent income a college student planning to go to medical school, for example might save little or nothing now, expecting to save for retirement and for bequests later.
A person with the same low income but no expectation of higher income later might try to save some money now to provide for retirement or bequests later. Because a decision to save a certain amount determines how much will be available for consumption, consumption decisions can also be affected by expected lifetime income.
Thus, an alternative approach to explaining consumption behavior is the permanent income hypothesis Consumption in any period depends on permanent income. An important implication of the permanent income hypothesis is that a change in income regarded as temporary will not affect consumption much, since it will have little effect on average lifetime income; a change regarded as permanent will have an effect.
The current income hypothesis, though, predicts that it does not matter whether consumers view a change in disposable personal income as permanent or temporary; they will move along the consumption function and change consumption accordingly. The question of whether permanent or current income is a determinant of consumption arose in when President George H.
Bush ordered a change in the withholding rate for personal income taxes. Workers have a fraction of their paychecks withheld for taxes each pay period; Mr.
Bush directed that this fraction be reduced in The change in the withholding rate did not change income tax rates; by withholding less in , taxpayers would either receive smaller refund checks in or owe more taxes. Economists who subscribed to the permanent income hypothesis predicted that the change would not have any effect on consumption. Those who subscribed to the current income hypothesis predicted that the measure would boost consumption substantially in Matthew D.
That is considerably less than would be predicted by the current income hypothesis, but more than the zero change predicted by the permanent income hypothesis. This result, together with related evidence, suggests that temporary changes in income can affect consumption, but that changes regarded as permanent will have a much stronger impact. Many of the tax cuts passed during the administration of President George W.
Bush are set to expire in The proposal to make these tax cuts permanent is aimed toward having a stronger impact on consumption, since tax cuts regarded as permanent have larger effects than do changes regarded as temporary. The consumption function graphed in Figure Changes in disposable personal income cause movements along this curve; they do not shift the curve.
The curve shifts when other determinants of consumption change. Examples of changes that could shift the consumption function are changes in real wealth and changes in expectations. An increase in the level of consumption at each level of disposable personal income shifts the consumption function upward in Panel a.
Among the events that would shift the curve upward are an increase in real wealth and an increase in consumer confidence. Over time, other economists have made adjustments to the Keynesian consumption function. Variables such as employment uncertainty, borrowing limits, or even life expectancy can be incorporated to modify the older, cruder function.
His model made adjustments based on how income and liquid cash balances affect an individual's marginal propensity to consume. This hypothesis stipulated that poorer individuals likely spend new income at a higher rate than wealthy individuals. More sophisticated functions may even substitute disposable income, which takes into account taxes, transfers, and other sources of income. Statistics show frequent and sometimes dramatic adjustments in the consumption function.
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