Essay Plans

What is the consumption function? Are there any differences between the short run consumption function and the long run one?

SYNOPSIS:

POINTS:

  1. Define consumption function : this shows the relationship between the amount consumed and disposable income. It shows how much people PLAN to consume at variable disposable income levels.

  2. A change in real disposable income causes a move along the consumption function; a change in non-income determinants (wealth, case of credit, interest rates, expectations, distribution of income) will cause a SHIFT.

  3. The pre-Keynesian consumption function : consumption is a function of the rate of interest; consumption is thus a negative function of the rate of interest. Interest rates rise, consumption falls.

  4. The Keynesian consumption function : consumption is a function of income BUT consumption is made up of:-

    • Autonomous consumption - does NOT vary with income.

    • Income induced consumption
      Thus C = plus cY
      cY = income-induced
      c = Marginal Propensity to Consume (shown by the slope of the consumption function)
      a = autonomous

  5. (The absolute income hypothesis states that consumption will rise with income but the rise in income will be greater than the rise in consumption - Keynes).

  6. Government policy affects consumption through fiscal and monetary policy and these affected disposable income.

  7. The Keynesian consumption function is based on 2 assumptions:-

    • There is a single consumption function, people move up and down according to how their income changes.

    • Consumer habits are not determined by other consumers.

  8. Duesenburry - a consumer whose income falls will not IN THE SHORT RUN adjust expenditure.

  9. The short run expenditure function is therefore fairly horizontal. The same level of consumption will be achieved by a reduction in savings.

  10. Thus if income increases for five years the short run consumption function will SHIFT; the long-run consumption function is derived from these shifts.

  11. (Thus this contradicts the Keynesian view that consumption is a function of current income).

  12. In addition, advertising and the behaviour of peer groups will affect consumption.

  13. After diagrams, if you have time, mention should be made of:

    • Permanent income hypothesis (Friedman) consumer spending is determined by anticipated life time income. Thus consumption is stable.

    • Life-cycle hypothesis (Ando, Brumbert, Modigliani) - consumption is affected by age. Household consumption will be below income level from the time work starts until the family has children. This period is now dis-saving. Children mature, become self-supporting, family returns to saving (consumption is now below income). This continues until retirement when dis-saving starts again (assuming no earnings during retirement). Consumption in absolute terms is lower after retirement than before but as a proportion of income (now nil) it is, of course, higher.

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