Consumption and Saving Review for AP Economics (page 2)
Review questions for this study guide can be found at:
Main Topics: Consumption and Saving Functions, Marginal Propensity to Consume and Save, Changes in Consumption Functions
The circular flow model illustrates the importance of consumption in the production of goods and the employment of resources. A better understanding of consumption allows us to build a model of the macroeconomy and see the role of policy in affecting macroeconomic indicators like GDP, employment, and inflation.
Consumption and Saving Functions
Though not the only factor, the most important element affecting consumption (and savings) is disposable income. Disposable income (DI)is what consumers have left over to spend or save once they have paid out their net taxes.
With no government transfers or taxation, DI = C+ S. Though not all consumers save part of their income, typical consumers spend the majority of their disposable income and save whatever is left over. To see the relationship between disposable income and consumption we create a consumption function.
Consumption and Saving Schedules
The consumption and saving schedulesare the direct relationships between disposable income and consumption and savings. As DI increases for a typical household, Cand Sboth increase. Table 13.1 provides an example.
Even with zero disposable income, households still consume as they liquidate wealth (sell assets), spend some savings, or borrow (dissavings). For every additional $100 of disposable income, consumers increase their spending by $80 and increase saving by $20. We can convert the above consumption schedule to a linear equation or consumption function:
C= 40 + .80(DI)
The constant $40 is referred to as autonomous consumptionbecause it does not change as DI changes. The slope of the consumption function is .80. This function is plotted in Figure 13.1.
At every level of DI, the consumption function tells us how much is consumed. Both Table 13.1 and Figure.13.1 tell us that at incomes below $200, the consumer is consuming more than his income; as a result saving is negative and this is referred to as dissaving. But at incomes above $200, the consumer is spending less than his income; and so saving is positive.
The saving schedule above can also be converted into a linear equation, or saving function:
S= – 40 + .20(DI)
The constant $ – 40 is referred to as autonomous savingbecause it does not change as DI changes. With zero disposable income, the household would need to borrow $40 to consume $40 worth of goods. The slope of the saving function is .20. This function is plotted in Figure 13.2
Marginal Propensity to Consume and Save
An important lesson from the study of microeconomics is the marginal concept. You can think of it in two equivalent ways. Marginal always means an incremental change caused by an external force, or it is always the slope of a "total" function. The same is true here.
The marginal propensity to consume (MPC)is the change in consumption caused by a change in disposable income. Another way to think about it is the slope of the consumption function.
MPC = ΔC/ΔDI = slope of consumption function
Using Table 13.1, we see that for every additional $100 of DI, Cincreases by $80 so the MPC = .80.
The marginal propensity to save (MPS)is the change in saving caused by a change in disposable income. Another way to think about it is the slope of the saving function.
MPS = ΔS/ΔDI = slope of saving function
Using Table 13.1, we can see that for every additional $100 of DI, Sincreases by $20 so the MPS = .20.
There is a nice relationship between the MPC and the MPS. For every additional dollar not consumed, it is saved. So if the consumer gains $100 in disposable income, he increases his consumption by $80 and increases saving by $20. In other words, MPC + MPS = 1. If you know one, you can find the other.
Changes in Consumption and Saving
A change in disposable income causes a movement along the consumption and savings functions. Economists typically recognize four external determinants of household consumption and saving that shift the functions upward or downward.
Determinants of Consumption and Saving
- Wealth.When the value of accumulated wealth increases, consumption functions shift upward, and the saving function shifts downward, because households can sell stock or other assets to consume more goods at their current level of disposable income.
- Expectations.Uncertainty or a low expectation about future income usually prompts a household to decrease consumption and increase saving. An expectation of a higher future price level spurs higher consumption right now and less saving.
- Household Debt.Households can increase consumption with borrowing, or debt. However, as households accumulate more and more debt, they need to use more and more disposable income to pay off the debt, and thus decrease consumption.
- Taxes and Transfers.A change in taxes impacts both consumption and saving in the same direction. If the government increases taxes, households see both consumption and saving decrease because more of their gross income is sent to the government. On the other hand, an increase in government transfer payments increases both consumption and saving functions. In the case of taxes and transfers, consumption and saving functions shift in the same way.
An upward shift in consumption tells us that at all levels of disposable income, consumption is greater (CHigh). If consumption is greater at all levels of disposable income, saving must be lower (SLow), and vice versa. The only exception is the case of taxes and transfers described above. Figures 13.3 and 13.4 illustrate these simultaneous shifts in the opposite directions.
- With the exception of taxes and transfers, when the consumption function shifts upward, the saving function shifts downward.
- With the exception of taxes and transfers, when the consumption function shifts downward, the saving function shifts upward.
- When taxes increase (or transfers decrease), both consumption and saving functions shift downward.
- When taxes decrease (or transfers increase), both consumption and saving functions shift upward.
Review questions for this study guide can be found at:
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