Here we study some basic economic relationships that we
think hold in a general way in the economy. Here we study
the income - consumption, income – saving, interest rate –
investment relationships and we study the idea of the
Digress: Say I am interested in why people weigh what they
do. What would you say is the relationship between a
persons weight and how much they eat for lunch?
Would you say the more eaten for lunch, the greater the
weight? Sure you would. But, you also might say that this is
true only if all other things in the persons life are the same.
SO, lot of things influence weight and we look at each
influence one at a time. This makes it easier to handle, but in
the real world many things change at once.
From the expenditure approach to GDP we saw the
goods and services produced include consumption,
investment, government spending and net exports.
Here we want to understand the pattern of household
expenditure called consumption. Consumption
depends on many things at the aggregate or national
level. But a primary influence is some notion of
Real world consumption
Consumption 45 degree line When you
study the real
about the level
of income and
in the US you
get a graph
income something like
Real world consumption
In the graph on the previous screen, note
1) Each dot represents a year and we have matched the
income and consumption in that year,
2) The dots would not all be on a straight line,
3) Higher income means higher consumption, and
4) Most dots are below the 45 degree line. Note a 45 degree
line means we are the same distance form each axis. Note
we measure income horizontally and consumption vertically.
But, if we take a horizontal income and go up to the 45
degree line that vertical distance is also the income amount.
Then by looking at heights we could compare income and
consumption. We will do this a lot.
GDP, Income, and Disposable
In this course we will build a simple model of the economy
and a major idea in the model will be the GDP produced and
the resultant income. Income in many ways will mean GDP.
Disposable income equals personal income minus personal
In a previous section we saw in the NIPA that GDP and
disposable income were not the same. But, for our work here
we can assume they are basically the same. I will just say in
general income and the context will mean disposable or GDP
in the context of the story. In other words I talk in general
and on tests and assignments you may see a specific and just
apply what I have here.
C In our theory we
450 will have the graph
here showing as
income rises as
C consumption rises,
given all else equal
in the world.
For the most part this graph is in line with observation in the
world. The consumption line or function is now interpreted
as showing the consumption plans of the household sector at
various levels of income. To see what consumption will be at
any income level go to the income level and then up to the
consumption line. 7
The graph is merely a reflection of information we could get
in a table. Say we have
In the graph on the previous screen we have income equal to
consumption at income = 390. This is called the break-even
income level. Notice to the left of this point the C line is
higher than the 45 degree line meaning consumption is
greater than income.
Our context of income here is disposable income and we
think disposable income is either consumed or saved.
(After the government takes taxes from you all you can
do is consume of save. Note for each of us how we
consume and how we save may be very different.)
In this sense saving is just that part of income not
consumed. So we can add to our table and graph by
taking income minus consumption to get saving.
Income Consumption Saving
370 375 -5
390 390 0
410 405. 5
Note that saving is negative when income is 370. What
do we call this and how could this be?
Negative saving is called dissaving (not datsaving!) and
it could happen if our income is really low and we
consume this period by using up assets we accumulated
form the past, as well as our current income.
The average propensity to consume (APC) can be
calculated at each income level by taking the consumption
at that level and dividing by the income. A few years back
some dude named Engel saw the APC fell as income rose.
Think about it. With more and more income we consume
more, but as a percentage of our income we cut back
because we have all our main comforts taken care of and
the rest is gravy.
Since our income is either consumed or saved, if the APC
is falling the APS is rising because the APC + APS = 1.
Please write down and understand the APS.
The marginal propensity to consume (MPC) equals the
change in consumption divided by the change in income
between two points in time.
It is felt that the MPC is constant over time. The main
reason here for us is that this would be consistent with
what Mr. Engel saw. Let’s see this on the next screen in a
Before we get there note that since changes in come must
either lead to a change in consumption or saving, the
MPC + MPS = 1.
Income C S MPC MPS APC APS
370 375 -5 1.01 -.01
390 390 0 .75 .25 1 0
410 405. 5 .75 .25 .99 .01
Note that MPC for income at 370 is note written in because
we do not have information from before.
How did I get the first .75? A- (390-375)/(390-370) =
With the MPC constant the APC must fall (since C does not
equal zero when income is zero)
C C and S in graphs
45 degree line
Notes about graphs
1) When C crosses 45
degree line we have
break-even income and S
income 2) To the left of this
S 45 degree line
income, C > income and
we have dissaving,
income 3) To the right of the
income in 1), C < income
The slopes of C and S are the
and we have saving –
MPC and MPS, respectively.
hey, look at datsaving. 14
In the national economy we think the level of
consumption expenditure depends on
1) output or income (which we just spent time looking at)
2) the wealth of households
4) real interest rates,
5) Household debt,
Note. When item 1 here changes we move along the C
and S lines, when items 2 through 6 change we shift C and
Consumption - wealth
If the household sector becomes wealthier (like due to a
stock market boom), then at a given level of income the
household sector will consume more and save less.
Presumably the reason the household saves is to build
wealth to use later. If they become wealthier, then there
is less reason to save in the current period and thus more
reason to consume
The C line shifts up and the S line shifts down as the
household becomes wealthier. This is called the wealth
Consumption - expectations
When households look to the future they have feelings,
what are called expectations, about what will happen. If
the outlook changes in a positive way expectations
become more favorable and C shifts up and S shifts
The reverse happens if the future outlook becomes
negative or gloomy.
Consumption – real interest rates
Higher rates of interest may make some folks consume less
and save more because they see the higher rate paying back
better in the future. Similarly a lower interest rate makes
some give up saving because what they get in return is not
enough to give up consumption today.
Interest rate up, C line down and S line up.
Consumption – household debt
Households can go into debt. To the extent that
households can go into debt at a larger amount the
consumption line can shift up.
Consumption - taxation
Remember disposable income is personal income minus
taxes and what we have left is either consumed of saved.
Also note that what we have said on the last few slides if
C goes up S goes down. Personal taxes are treated
If personal taxes go up, the household sector has less to
both consume and save. So, if personal taxes rise, both C
and S will fall.
consumption in the graph
Earlier we showed C in a
graph like this. Usually
what we do is just pick a
starting point, like point
a. At this point we have
a a level of income and C
explicitly in the graph.
income Implicitly the levels of
other influences are also at a certain level.
consumption in the graph
C If income increases, we
C saw C will increase. We
could have point b. We
b saw for every $ change
in income, C changed by
MPC. If from a to b
income changed by 15
and MPC = .8, then C
income changed by ................?
In the graph when we consider a change in income all the
other factors that influence C are assumed to not change
and we then move along the C line as I have drawn here.
If the other factors change, and they can, the curve shifts.
consumption in the graph
C If the other factors change
in such a way that C
b increases, the C line shifts
up. Similarly, it would
shift down if the other
a factors changed in a
Note along C’, consumption is higher than along C at all
levels of income.
We have seen that consumption depends on income and
other factors. The other factors are often called
autonomous factors, or nonincome determinants. For us
this means factors other than income.
Note that the slope of the consumption function is the
MPC. The slope tells us how much consumption rises
for each change in income. So for every dollar change in
income the slope tells us about the change in