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Chapter 5.2

ECON202 Chapter Notes - Chapter 5.2: Consumption Function, Capital Good, Autonomous Consumption

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Harvey King

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5.2 The Determinants of Consumption and Saving
As we saw from the circular flow, households earn income and allocate it jointly between taxes,
consumption and saving: Y = C + S + T .
In this model, we will assume that households take taxes as exogenous, as outside the
household control (probably true for most households).
We thus introduce the concept of disposable income: YD = Y T .
We note that this is allocated between consumption and saving: YD = C + S .
Consumption is the demand for goods and services for consumption purposes (beer, pizza,
clothing, cars).
We include new housing as part of the investment decision, since it is more like the purchase of
a capital good.
What factors affect the consumption decision?
There are a variety of variables (interest rates, wealth, household composition, expected future
income), but we will focus initially on the variable that research shows is most crucial:
disposable income.
Therefore, we will develop the concepts of the consumption function and the saving function,
which discuss consumption and saving in relationship to YD.
5.2.1 The Consumption Function and the Saving Function
The relation between consumption and YD is called the consumption function, while the
relation between saving and YD is called the saving function.
Since C + S = YD , we can rewrite this as S = YD C .
If C < YD, then S > 0 households save today.
If C = YD, then S = 0 neither a saver nor a borrower.
If C > YD, then S < 0 households consume more than their income.
How do households manage to consume more than income?
They can use up some existing assets, or dissave. This is what retired people do.
They can borrow against future income, as many of you are currently doing.
o This might include borrowing from your parents or using their saving, to be repaid by
being nice to them when they get older and retire (you could build them a nice
Australian Granny Flat (http://www.kithomes.net.au/grannyflats) in the back yard.)
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To help us out, let us do the following (illustrative) numerical schedule and graphical
representation of a typical national consumption function (all figures in billions).
Disposable Income
First of all, we can see from the numerical schedule how Saving is derived from the formula
S = YD C .
Second, we can see from the numerical schedule, that as YD rises, C and S both rise.
For example, as YD rises from $100 billion to $200 billion (+$100 billion), C rises $60 billion and S
rises $40 billion.
That is, not only does C + S = YD , but ΔC + ΔS = ΔYD .
Optional Reading:
If you are having trouble sketching and understanding graphs, you might like to look at the
textbook's Math Appendix. You might also like to look at the Graph Skills review material by
Jerry Evensky of Syracuse University. And don't be afraid of the math. At least, not as afraid
as the woman in this story.
Let us now turn to Figure 5.1 below.
Part (a) shows us the consumption function from our schedule, while part (b) shows us the
saving function.
If we have zero income, we will still want to consume a minimum amount by borrowing or
o In our example, this is $80 billion, and is called autonomous consumption this part of
consumption is independent of your level of current disposable income.
o On the graph, this amount is shown as the intercept of the consumption function.
Secondly, as our income rises, so does our desired consumption.
o In this example, the change in consumption is $60 for every $100 in extra disposable
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