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Chapter 5

The Household-Consumption Sector

McGraw-Hill/Irwin
Companies, All Rights Reserved

2009 The McGraw-Hill

Learning Objectives

In this chapter we will introduce ten economic


concepts:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

The average propensity to consume.


The average propensity to save.
The marginal propensity to consume.
The marginal propensity to save.
The consumption function.
The saving function.
The determinants of consumption.
The permanent income hypothesis.
Autonomous and induced consumption.
Why we spend so much and save so little.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-2

GDP and Big Numbers

Gross Domestic Product (GDP) is the nations


expenditures on all final goods and services produced
during the year at market prices.

GDP for 2002 was 10,446.2 billion dollars.


This can be written as

$10,442,020,000,000
$10,446.2 billion
$10.5 trillion

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-3

Four Parts of GDP

Consumption ------------ C (this chapter)

Investment ---------------- I (Chapter 6)

Government -------------- G (Chapter 7)

Net exports --------------- Xn (Chapter 8)

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-4

Consumption

Americans spend over 95% of their income after taxes.

The total of everyones expenditures is called consumption.

Consumption is designated by the letter C.

C is the largest sector of GDP.

Now C is just over two-thirds of GDP.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-5

Consumption (continued)

The consumption functions states that

As income rises, consumption (C) rises, but not as quickly.


Therefore, consumption varies with disposable income (DI).

DI increases . . . C increases but by a smaller amount.


DI decreases . . . C decreases but by a smaller amount.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-6

Consumption and Disposable Income

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-7

Consumption and Disposable Income

Disposable Income

Consumption

1,000

1,400

2,000
3,000
4,000
5,000

+ 1000
+ 1000
+ 1000
+ 1000

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2,200
3,000
3,800
4,600

+ 800
+ 800
+ 800
+ 800

5-8

Questions for Thought and Discussion

How is it possible to consume more than your income?

What sort of economy would have to develop to make


consumption a lesser part of GDP than investment,
government spending, and exports?

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-9

Saving

Saving is NOT spending.

The more we spend, the less we save.

A low savings rate leads to a low productivity growth


rate.

Without savings ($) to invest in NEW plant and equipment,


we cannot raise our productivity fast enough!

Savings includes personal saving, business saving,


and a government surplus (if they have one).

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-10

Saving as a Percentage of Disposable Income

Source: Economic Report of the President, 2008, Survey of Current Business, March 2008
2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-11

Average Propensity to Consume (APC)


(The Percent of DI Spent)

Consumption
APC =
Disposable Income

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-12

APC, APS, MPC, and MPS values and their


meaning

The APC or MPC may = 1 signifying all disposable


income is consumed.
The APC or MPC may be > 1 signifying you are
consuming more than your disposable income by
dipping into your savings.
The APC or MPC may be < 1 indicating youre a saving
a portion of your disposable income.
APC + APS = 1
MPC + MPS = 1

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-13

Sample APC Problem

Disposable Income

Consumption Saving

$40,000

$30,000

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-14

Sample APC Problem


Disposable Income

Consumption Saving

$40,000

$30,000

APC =

C
DI

30000
=
40000

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

$10,000
3
=
= .75
4

5-15

Sample APC Problem


Disposable Income

Consumption Saving

$40,000

$30,000

APC =
APS =

C
DI

30000
= 40000

S
DI

10000
40000

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

$10,000

3
=
.75
4

1
= .25
4

5-16

Sample APC Problem


Disposable Income

Consumption Saving

$40,000

$30,000

APC =

C
DI

30000
= 40000

$10,000
3
4

= .75

+
APS =

S
DI

10000
40000

1
4

= .25

1.0
2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-17

APCs Greater Than One

Disposable Income

Consumption

$10,000

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Saving

$12,000

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APCs Greater Than One

Disposable Income

Consumption

$10,000

$12,000

Saving
2000

Where is this going to come from?

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-19

APCs Greater Than One


Disposable Income

Consumption

$10,000

$12,000

APC = DI

Saving

$12,000

=
$10,000

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2000

12
10

= 1.2

5-20

APCs Greater Than One


Disposable Income

Consumption

$10,000

$12,000

APC =

C
DI

$12,000
= $10,000 =

APS =

S
DI

-$2,000
=
$10,000

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Saving
2000

12
10 = 1.2
-2
=
0.2
10

5-21

APCs Greater Than One


Disposable Income

Consumption

$10,000

$12,000

APC = DI
S

APS =

DI

$12,000

$10,000

Saving
2000

12

10

= 1.2

-2

= $10,000 = 10

= 0.2

-$2,000

1.0
2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-22

Questions for Thought and Discussion

What is the relationship between the average


propensity to consume and the average propensity to
save?

What happens if APC is greater than 1?

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-23

Household Saving as a Percentage of Disposable


Income, 2008 Forecast

Source: OECD, The Economist,


Economist Feb. 4, 2006, p. 93
2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-24

Average Propensity to Consume,


Selected Countries, 2008 Forecast

Source: OECD
2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-25

Marginal Propensity to Consume (MPC)


CHANGE in Consumption

MPC

CHANGE in Income

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-26

Can You Calculate Marginal Propensity


to Consume (MPC) and Marginal Propensity to
Save (MPS)?
1998 and 1999 Data
Year

DI

1998

$30000

$23000

$7000

1999

$40000

$31000

$9000

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-27

Calculating MPC
Change in income
40,000 30,000 = $10,000
Change in consumption
31,000 23,000 = $8,000
Change in Consumption divided by Change in income
8,000/10,000 = .8.
Indicating your MPC is .8 or eighty% of disposable
income.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-28

Calculating MPS
Change in Disposable Income
40,000 - 30,000 = $10,000
Change in Savings
9,000 7,000 = $2,000
Change in Savings divided by Disposable Income
2,000/10,000 = .2
MPS = .2 or you save 20% of Disposable Income

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-29

Graphing the Consumption Function: The 45Degree Line

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-30

Graphing the Consumption Function: The 45Degree Line (Continued)

If all disposable income


was consumed, it would
be graphed as a 45degree line

The

45-degree line is also


the series of points where
GDP is equal to aggregate
expenditures

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-31

Graphing the Consumption Function

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-32

The Consumption Function and Equilibrium

Consumption is the vertical


distance between the
bottom (horizontal) axis and
the C line.
If GDP is 0 Consumption is
$3 trillion (consumers go into
savings).
If GDP is $6 trillion,
consumption will be $6
trillion.
If GDP is $12 trillion
consumption is $9 trillion
(consumers save more than
they consume).

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-33

Autonomous Consumption vs. Induced


Consumption

Autonomous consumption (AC) is the level of


consumption when disposable income is 0.

Induced consumption (IC) is that part of consumption


that varies with the level of disposable income.

It is called autonomous because it is independent of change in


disposable income.

As disposable income rises, induced income rises.


As disposable income fall, induced income falls.

IC = C AC

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-34

Questions for Thought and Discussion

What does the 45-degree line represent? Discuss the


important features of the consumption function in
relation to this line.

If you know the MPC can you calculate the MPS?

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-35

Consumer Spending, 1955 and 2007 ($billions)

The major change in consumer spending has been a


massive shift from nondurables to services.
Source: Economic Report of the President, 2006.
2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-36

Expenditures of the Average American


Household, 2005 Bureau of Labor Statistics

Source: www.bea.gov
2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-37

Determinants of the Level of Consumption

Disposable Income

The most important determinant of consumption.

Credit Availability
Stock of Liquid Assets (in the hands of consumers)
Stock of Durable Goods (in the hands of consumers)
Keeping up with the Jones's
Consumer Expectations

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-38

Permanent Income Hypothesis


(Milton Friedman)

People gear their consumption to their expected


lifetime average earnings more than to their current
income.

Apparently there are quite a few deviations from the behavior


predicted by the permanent income hypothesis.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-39

The Determinants of Saving

There is no single reason why people save.


Some spend virtually all of their disposable income.
Some spend more than they earn.
Americans now save less than 5% of disposable
income.
Americans used to save 710% of disposable income.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-40

Savings as Percentage of GDP, 1959-2007

Source: Survey of Current Business, January 2008.


2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-41

Why Do We Spend So Much and Save So


Little?

Americans have been on a spending binge for the last


20 years

Mottos:

Buy now, pay later.


Shop till you drop.
We want it all, and we want it all now!

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-42

Why Do We Spend So Much and Save So Little?


(Continued)

The Federal Government has underwritten Americas


spending binge.

Until 1987 interest paid on consumer loans was fully


deductible from income taxes.

Mortgage interest and property taxes remain fully deductible.

Credit cards, installment credit, and consumer loans have


expanded tremendously.

19902000 household debt doubled to $7 trillion.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-43

Why Do We Spend So Much and Save So Little?


(Continued)

Two factors have become increasingly important:

Social Security causes many to NOT feel a pressing need to


save for their old age.

Home ownership is seen as a form of saving (especially during


a period of rising real estate prices).

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-44

Total Saving

Every economy depends on saving for capital


formation.
Individual saving + business saving + government
saving = Total Saving

Declines in household saving has been offset somewhat since


1993 by a sharp rise in government saving and business
saving.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-45

Current Issue: The American Consumer:


World Class Shopper

The consumer is the prime mover of our economy and


increasingly, that of the world economy as well.

The American consumer made the Japanese recovery


possible.

The American consumer has made Chinas economic


growth of about 10% over the last 20 years possible.

The negative aspect of this is our tremendous trade


deficits with much of the rest of the world.

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-46

Questions for Thought and Discussion

What motivates consumption and what do Americans


spend their money on?

How realistic is Milton Friedmans Permanent Income


Hypothesis?

How have American savings rates changed overtime?


What would be the consequences of present trends
continuing?

2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

5-47