Chapter 13: Consumption and Saving

The Relationship between Consumption and Income

1. A temporary change in income leads to a small change in consumption. 2. A permanent change in income leads to a large increase in consumption. MPC Permanent = Change in consumption/change in income 3. An anticipated change in income leads to no change in consumption. Anticipated changes are already used in your estimate of your permanent income. 4. Learning about a future income change leads to a change in consumption. Unexpected changes in income are not included in your current permanent income estimate. An unexpected change increases that estimate. 5. It is hard to forecast changes in consumption. Unanticipated changes are by their nature difficult to predict.

What motivates saving?

1. Changing income over the life cycle 2. Changing needs over the life cycle 3. Bequests 4. Precautionary saving

Two Categories of Consumers

1. Hand-to-mouth consumers spend their current income. (financially constraint) 2. Consumption smoothers spend permanent income For hand-to-mouth consumer: if it is anticipated(probably it's already rising or obvious signal), will spend a lot, but when it's new shock of future(not arising), he will not spend a lot. Temporary rise: today's rise not tomorrow

What shifts consumption?

1. Real interest rates 2. Expectations 3. Taxes 4. Wealth

Saving Motive 1: Changing income over the life cycle

Due to typical income patterns over the life cycle, national saving depends on demographics (age).

Consumption and Income

A consumption function is a curve plotting the level of consumption associated with each level of income. The slope of the consumption function is the marginal propensity to consume, which is the fraction of each extra dollar of income that households spend on consumption.

5. List four smart saving strategies.

ANSWER: (i) Set a budget, and stick to it. (ii) Build a rainy day fund. (iii) Sign up for your employer's retirement plan. (iv) Plan to save more tomorrow. (v) Minimize fees paid on retirement and savings accounts, and take advantage of government programs designed to encourage saving.

2. Fill in the blanks. (a) If the average marginal propensity to consume is 0.65, then a $10 million increase in total income will lead to a _____ increase in consumption. (b) If the average marginal propensity to consume is _____, then a $100 million increase in total income will lead to a $67 million increase in consumption.

ANSWER: (a) $6.5 million; (b) 0.67

1. Define the following concepts: (a) consumption. (b) consumption function. (c) marginal propensity to consume.

ANSWER: (a) Consumption refers to household spending on final goods and services. (b) The consumption function is a curve that plots the level of consumption associated with each level of income. (c) The marginal propensity to consume is the fraction of each extra dollar of income that households spend on consumption. It is calculated by dividing the change in consumption by the change in income.

9. The table shows the salary of a lecturer in Nairobi, Kenya. (a) For each year, calculate saving at each level of income. (b) Calculate the marginal propensity to consume.

ANSWER: (a) Income-consumption (b) 0.95 Change in consumption/ change in income

5. Define the following concepts: (a) saving. (b) dissaving. (c) net wealth.

ANSWER: (a) Saving is the portion of income that is not consumed. (b) Dissaving is the excess amount consumed above income in a given period, which is funded either through borrowing or using earlier saving. (c) Net wealth is the amount by which assets exceed debts.

8. Define the following concepts: (a) Rational Rule for Consumers. (b) consumption smoothing. (c) permanent income hypothesis.

ANSWER: (a) The Rational Rule for Consumers says that people should consume more today if the marginal benefit of a dollar of consumption today is greater than (or equal to) the marginal benefit of spending a dollar plus interest in the future. (b) Consumption smoothing means maintaining a steady or smooth path of consumption spending over time. (c) The permanent income hypothesis is the idea that consumption is driven by permanent income rather than current income.

2. Consider the following data. What is the approximate marginal propensity to consume?

ANSWER: 0.78 or 0.8 Marginal propensity to consume: Slope of consumption function => change in consumption/ change in income

4. Consider the following data. What is the approximate marginal propensity to consume?

ANSWER: 0.83 or 0.85 Change in consumption/ change in income

6. Explain the difference between the income effect and the substitution effect of interest rates on consumption.

ANSWER: The income effect causes a decrease in saving when the real interest rate rises. This is because higher interest rates boost income for lenders; thus, those consumers who are lenders increase their consumption. On the other hand, the substitution effect causes an increase in savings when the real interest rate rises. This is because of the increasing opportunity cost of current consumption. When one overweighs the other, the consumption will shift toward the that one. Borrower and lender is receive different effects on these two effects.

Household income rises by 5% this year but is expected to return to its normal growth rate of 2% next year. As a result, A. consumption smoothers and hand-to-mouth consumers increase consumption by much less than 5%, and total consumption rises by much less than 5%. B. consumption smoothers increase consumption by much less than 5%, hand-to-mouth consumers increase consumption by close to 5%, and total consumption rises by less than 5%. C. consumption smoothers and hand-to-mouth consumers increase consumption by close to 5%, and total consumption increases by close to 5%.

B is correct, smoother increase < htm.

Dave won $15 million in the Georgia state lottery in 2014, but by 2016 he burned through it all and needed to get a new job and sell his house. Is Dave a consumption smoother? A. yes B. no

B. no

4. Draw a diagram showing the relationship between income, consumption, and saving over time for a consumption smoother.

Borrowing - Saving - Spending

Consumption Shifter 3: Taxes

Disposable income is your after-tax income. An increase in taxes reduces your disposable income. A reduction in disposable income reduces current consumption.

Consumption Shifter 4: Wealth

Greater wealth leads to increased consumption at any given level of income. Financial and housing markets thus play important roles in the behavior of current consumption.

Consumption Shifter 1: Real interest rates

Higher real interest rates ▪ incentivize saving today and reduce consumption (substitution effect). ▪ increase income for lenders (income effect) and raise their consumption. ▪ decrease income for borrowers (income effect) and reduce their consumption. Net effect could go either way.

What is consumption?

Household spending on final goods and services is called consumption

How do credit constraints impact consumption?

Limits on how much you can borrow are called credit constraints. Consumption smoothing is not possible with credit constraints.

consumption smoothing.

Maintaining a steady or smooth path for your consumption spending over time

Saving Motive 2: Changing needs over the life cycle

Needs, like income, vary over the life cycle. Save more in periods where needs are less, and spend more when needs are greater.

Consumption Shifter 2: Expectations

Optimism about the future, often measured by consumer sentiment, increases permanent income. An increase in permanent income increases consumption today.

Permanent Income Hypothesis

Permanent income is your best estimate of your longterm average income. Focus on your permanent income rather than your current income.

7. Fill in the missing cells in the table below with the following choices: large increase in consumption, no change in consumption, small increase in consumption.

Permanent increase: Smoother&hand-to-mouth: Large Anticipated: Smoother: No change; hand-to-mouth: Large Temporary: Smoother: Small change; hand-to-mouth: Large

Saving Motive 4: Precautionary saving

Saving to be prepared for a financial emergency is called precautionary saving. The idea is to hope for the best but prepare for the worst.

Using economic reasoning to make smart spending decisions

The interdependence principle says that choices available to you in the future depend on the decisions that you make today. The answer to each increment should be yes if the marginal benefit exceeds the marginal cost. This is the cost-benefit principle at work. The Rational Rule for Consumers says that you should consume more today if the marginal benefit of a dollar of consumption today is greater than (or equal to) the marginal benefit of spending a dollar plus interest in the future.

Saving and Income

The portion of income that you set aside, rather than spending on consumption, is called saving. Saving = Income − Consumption

Consumption's Share of GDP

developed - higher; real GDP per person higher, consumption higher

Saving Motive 3: Bequests

You might want to leave something to someone or some group when you die, which is called a bequest. You need a will to direct how your assets are dispersed on your death.

1. Using graphs of the consumption function, show how consumption reacts to each of these factors. (a) The stock market booms. (b) Consumers become more optimistic about the state of the economy. (c) The minimum wage falls in the economy.

c) Wage/ Income falls: Movement

3. Using graphs of the consumption function, show how consumption reacts to each of these factors. (a) Taxes rise in the economy. (b) The substitution effect of a rise in interest rates outweighs the income effect. (c) Consumers expect future incomes to rise.

a. downward b. downward c. upward

Dissaving

is the excess amount you consume above your income in a given period that you therefore must pay for either by withdrawing money from your savings or by borrowing money.

Movement Along the Consumption Function versus Shifts in the Consumption Function

movement- income

3. Fill in column A in the table below with the following choices: permanent, anticipated, temporary.

permanent, anticipated, temporary.

Two of the main forces driving total consumption in the economy are

▪ permanent income. ▪ consumption smoothing