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ECON 0110 (84)

Section 15 Notes.doc

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ECON 0110

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SECTION 15: THE CONSUMPTION FUNCTION Three things to do with income (Y) 1. Spend it (Consumption = C) 2. Save it (Saving = S) 3. Pay taxes (Taxes = T) Y = C + S + T DISPOSABLE INCOME: Y d = Income available after paying taxes Yd= Y - T = C + S There are only two things to do with disposable income 1. Spend it (consumption = C) 2. Save it (saving = S) Y d C + S CONSUMPTION FUNCTION Expresses consumption spending as a function of disposable income Holding all other variables constant Other variables also influence the level of consumption Wealth Expected future income Expected inflation rates Level of interest rates WEALTH VERSUS INCOME WEALTH (OR NET WORTH): Value of what you own minus what you owe INCOME: Amount you earn in a given time period Wealth is what you have saved over your lifetime An old person could be extremely wealthy and have almost no income CONSUMPTION FUNCTION FOR A HOUSEHOLD Consumption spending increases as income increases C = f(Y) Or C = f(Yd) The relationship between consumption and income is close to linear Slope of function decreases as income increases. CONSUMPTION FUNCTION FOR THE U.S. ECONOMY Consumption spending (C) increases as GDP increases. C = f(GDP) = f(Y) Or C = f(Yd) where aggregate income (Y) = GDP CONSUMPTION FUNCTION FOR THE U.S. ECONOMY Historically, the relationship has been almost exactly linear. Frequently, we express C as a function of Y, rather than Y d PLOTTING THE CONSUMPTION FUNCTION Example: C = 6 + .7 Yd Plot C on the vertical axis Plot Y or Ydon the horizontal axis Intercept = 6 = Value of C when Y =d0 = Autonomous consumption Slope = .7 = (Change in C) / (Change in Y d = Marginal Propensity to Consume An easy way to plot the consumption function is to select some values of Y and find the corresponding values of C. Plot these points and draw a line through them. PLOTTING THE CONSUMPTION FUNCTION Example: C = 6 + .7 Yd Value of Y 0 10 20 30 40 Value of C 6 13 20 27 34 Plot the points (C, Y): (6, 0); (13, 10); (20, 20), etc. These points fall on a straight line INTERCEPT= AUTONOMOUS CONSUMPTION The intercept on the vertical axis is C = 6 AUTONOMOUS CONSUMPTION Consumption spending that does not depend on the level of income (or GDP) AUTONOMOUS SPENDING Any spending that does not depend on the level of income or GDP Consumption Investment Government Foreign spending SLOPE = MARGINAL PROPENSITY TO CONSUME If Y increases by 10, C increases by 7 Slope = (Change in C)/(Change in Y) = 7/10 = .7 Amount that C increases when Ydincreases by 1 unit The proportion of an increase in income that is spent by consumers MPC = (Change in C) / (Change i
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