Theory Of Consumption - Rahul Jain

Aggregate Demand and Supply Approach AD=AS C+I=C+S Y=C+I Hence, Y=1/(1-b) *(a+I)

Consumption Use of goods and services to satisfy human wants C= a+bY MPC, APC = C/Y MPS=1-MPC

4 What is the Marginal Propensity to Save(MPS)? The change in saving induced by a change in income

5 Note that MPC + MPS must equal 1

Theories of Consumption Absolute Income theory- By Keynes  Current consumption is a function of current real income  MPC is between 0 and 1  MPC declines with increase in Income

7 What is Keynes’ Absolute Income Hypothesis? As income increases, consumption spending increases, but by diminishing amounts

8 Concerned how households allocate their income between consumption and saving  households earn a stream of income over a lifetime  households may consume more or less than their income for any given year Life-cycle hypothesis- By Ando & Modiglani

9 What is Modigliani’s Life Cycle Hypothesis? Typically, a person’s MPC is relatively high during young adulthood, decreases during middle age, and then increases

Chapter 4 10  household consumption depends on rate of interest expectations regarding future income  decision-making is intertemporal, meaning that households carefully consider how their present expenditures affect future consumption

11 What can cause a shift in the Consumption Function? Real assets & money holdings Expectations of price changes Credit & interest rates Taxation

12 Real Disposable Income Real Consumption C1C1 C2C2

Chapter 4 13 The Permanent income hypothesis People maximize utility based on their permanent (expected life-time) income Allocate their income intertemporally

Chapter 4 14 Permanent-Income Theory of Consumption Consumption depends on permanent income, which depends on current income and expected future income Households try to smooth out consumption over a lifetime

15 What is Duesenberry’s Relative Income Hypothesis? People consume according to their relative position in society, consistent with the idea that the MPC remains fairly constant as national income increases

Relative Income Hypothesis Relative income hypothesis states that individual’s attitude consumption and saving is dictated more by his income in relation to others than by abstract standard of living.