R12: Consumption

Question 1

Consumption follows GDP

Accepted Answer

Consumption represents the largest part of overall spending and is a key determinantof gross domestic product (GDP) Developed economies: 65% of GDP. Non-OECD economies: 78% US 70% Sweden: 50% Consumption closely follows GDP fluctuations C a bit smoother than Y Disposable income: income including wages, interest payments and dividends, and social security payments, less tax payments) Saving: difference between income and consumption - source of investment. Level of savings in a country is a crucial determinant of its long-run steady state.

Question 2

Keynes Consumption function & Multiplier Effect

Accepted Answer

Keynes’ concept of the m.p.c. is important in understanding demand in an economy because it contributes to a multiplier effect upon an initial increase in demand. Multiplier: 1/ (1-b) Multiplier shows how much demand rises once all agents have adjusted to an event that generates a change in some component of demand. The multiplier depends upon the marginal propensity to consume The larger is the propensity to consume, the steeper is the line PE and the greater is the multiplier. A given rise in G, I, or A has a long-run affect upon output that is much greater than the original stimulus—greater in fact precisely by the magnitude 1/1 + b. Output = Consumption + Government Expenditure + Investment Y = C + G + I Y = A + bY + G + I Y = [1/(1 - b)] * A + G + I - GDP equals the sum of A plus government expenditure and investmentall divided by (1 - b). - If the government can increase G by $100 million, then according to this expression, GDP will increase by more than $100 million When the government spends $100 million, it purchases goods with this money, which increases the incomes of the firms and workers that produce these goods. Because of the m.p.c. this extra income is spent on other goods and services, further increasing income and consumption elsewhere in the economy. But this additional income is also spent, so that the initial increase in government expenditure sets in motion a sequence of rising incomes and consumption throughout the economy, which serves to magnify the initial demand boost

Question 3

IS-LM model (planned investment, government expenditure, and net exports exogenous) Closed economy

Accepted Answer

Total Planned Expenditure (PE) = C+G+I = A +bY+G+I "Planned aggregate spending depends upon actual income Actual income has to be the sum of consumption, investment, and government spending" The level of income is a multiple of the components of demand that are independent of income Shifts in those components have a multiplied impact upon demand and income. If actual income equals planned expenditure then PE = Y PE = Y = A+bY+G+I, which implies Y = (A+I+G) / (1-b) If actual income does not equal planned expenditure: Planned spending varies with actual income. PE-Slope reflects how much planned spending rises as actual income goes up one dollar. Consumption-Slope = b (since we assume the only component of demand that depends on current income is consumption) Demand increases directly through increases in consumption of $b for every $1 increase in output If firms produce Y1, they will find that they will fall short of Y1 Vertical distance aB shows the difference between actual output and planned spending at a production level of Y1 --> unplanned inventory accumulation.

Question 4

Consumer Preferences - Indifference Curves

Accepted Answer

The intertemporal budget constraint shows what the consumer can afford; it does not say what he or she prefers We can think of consumption today and consumption tomorrow as two distinct commodities The slope of the indifference curve tells us how willing a consumer is to substitute between first and second period consumption. Flat: The consumer has very little second period consumption but lots of first period consumption.This means that the consumer is prepared to give up quite a lot of first period consumption in return for only a small amount of extra second period consumption. We are in effect assuming that when a consumer has a lot of one commodity but very little of another, he places a higher value on the scarce commodity. Steep: In this case, the consumer has an abundance of second period consumption and so is prepared to forgo quite a lot of this in return for a small increase in initial consumption. Equal: between points C and D the consumer is willing to trade roughly equal amounts of first and second period consumption—when he has similar amounts of both commodities, they are valued roughly equally.

Question 5

Consumer's Choice

Accepted Answer

Intertemporal budget constraint + indifference curves Welfare Maximization: Choose the combination of first and second period consumption that puts them on the highest indifference curve that their intertemporal budget constraint makes feasible Consumers dislike volatile consumption Consumer’s optimal choice. Consumers choose the affordable consumption bundle thatgives the highest welfare. Prepared to give up a lot of second period consumption at F (see Figure 12.9) for only a small gain in terms of first period consumption. Increase in Current Income - A one-time rise in income is likely to cause consumption to rise by less than it would with a permanent income increase, and the m.p.c. will be low. ) approximately 50%—half the income is spent now and half later) --> Intertemporal budget constraint to shift outward to the right. Increase in Future Income - Impact on consumption of increase in future income. Because of borrowing, both current and future consumption increase when agent expects higher future income. Same effect = Shift outward. This would suggest that our graduating student will respond to her employment letter from Merrill Lynch by going out and spending, even though current income has not changed. Because of discounting and interest rates, the increased lifetime income is not spread exactlyequally between periods. The higher the rate at which people mentally discount future satisfaction, themore is spent today because consumers are impatient, and the higher the interest rate, the less is spent today because consumers have more of an incentive to save.

Question 6

Why, in a recession, consumption does not fall as much as GDP does, nor does it rise as much in a boom?

Accepted Answer

Permanent income = This is very different from the simple Keynesian model in which current income is all that matters. In the forward-looking model, the consumer sets consumption considering lifetime rather than current income and, given our assumptions on indifference curves, does so in a manner that tries to avoid large changes in consumption. 2 C = Y(1) + Y(2) or C = (1/2) [Y(1) + Y(2)] = average lifetime income or what is called permanent income. When first (or second) period income increases by $100,000, then permanent income (and consumption) increases by only (1/2) ($100,000) = $50,000 and the m.p.c. is 50%. forward-looking model has as its main relationship the link between consumption and permanent, rather than current, income, and the m.p.c. is determinedby the influence that current income has on permanent income. Zero interest rate = income depends on Labour income consumer lives forever, this implies that the consumer spends only the interest payments, in order to maintain a constant level of wealth.

Question 7

Borrowing Constraints

Accepted Answer

If borrowing constraints are important, it is current income rather than future or permanent income that matters. With borrowing constraints, increases in current income feed through into currentconsumption only. Borrowing constraints make consumption equal to current income. The inability to borrow reduces welfare because she is on a lower indifference curve. In the case of borrowing constraints, the m.p.c. is very high—individuals have too low first period consumption and too high second period consumption. They would like to reallocate this consumption but cannot because they cannot borrow. Therefore, when they receive more current income they will spend most of it—there is no point in saving money when consumption next period will already be too high.y.

Question 8

Interest rates

Accepted Answer

Under both Keynesian and forward-looking models, interest rates affect debtors and savers differently. Because the budget line tilts, interest rates have two conflicting effects on consumption: 2. Substitution effect: The interest rate is an intertemporal price for the consumer: every $1 of current consumption means $(1 +r) less future consumption. If the interest rate increases, this makes first period consumption more expensive and so the consumer substitutes away toward second period consumption by saving more. 2. Income effect. When interest rates increase, savers receive higher interest payments and can afford to spend more—this is the reason the intercept on the vertical axis shifts up from A to C. This higher income means the consumer can spend more over his or her lifetime and, because of consumption smoothing, this will lead to an increase in first and second period income

Question 9

Consumption smoothing

Accepted Answer

Increase in first and second period income, this higher income means the consumer can spend more over his or her lifetime

Question 10

IS Curve

Accepted Answer

The negative relation between the level of interest rates and the level of equilibrium demand for goods in the short run is the IS curve. Not only consumption, but also investment and perhaps net exports,to be negatively affected by interest rates Overall planned spending would decline with higher interest rates. the higher are interest rates then, other things being equal, the lower will be the equilibrium level of output

2 The Global Macroeconomy (Fach) / R12: Consumption (Lektion)