Chapter 16 Consumption.ppt

Chapter 16: Consumption John M. Keynes: Absolute Income Hypothesis Consumption is a linear function of disposable personal income, C = C + cY C = consumption expenditure Y = disposable income C = autonomous consumption (intercept of the line) c = marginal propensity to consume (slope of the line) Properties of Consumption Function Consumption is determined by current income Marginal propensity to consume (MPC = ΔC/ΔY) is between zero and one (0c1) Average propensity to consume (APC = C/Y) falls as income rises Empirical Evidence High income families have a higher marginal propensity to save (MPS = 1 – MPC) High income families have a higher average propensity to save (APS = 1 – APC); APC falls with the level of income In the long-run, autonomous consumption falls to zero (C = 0) Irving Fisher: Intertemporal Choice Consumption decisions are based on current and future income Current period income = current income plus present value of future income: Y1 + Y2 / (1 + r), where r is a discount rate Future period income = future income plus future value of current income: Y2 + (1 + r)Y1 The Intertemporal Budget Line Along BC, there is a trade-off between current and future consumption spending Along AB, C1Y1, but C2Y2: consumers would save in current period to finance consumption in second period Along AC, C1Y1, but C2Y2: consumers would borrow in current period and will pay off debt in future period Consumer Preferences Consumer preferences are shown by a family of indifference curves Any combination of current and future consumption along an indifference curve provides the same level of satisfaction for the consumer A higher indifference curve yields combinations with greater satisfaction Consumer Preferences The Consumer’s Optimum Consumer equilibrium is achieved at the tangency of the highest attainable indifference curve and the budget line The tangency determines the optimum allocation of consumption spending in both periods; i.e. highest leve