The Household- Consumption Sector Chapter 05 Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

5-2 Learning Objectives  After this chapter, you should be able to: 1. Define and compute the average propensity to consume and the average propensity to save. 2. Define and compute the marginal propensity to consume and the marginal propensity to save. 3. Explain the consumption function. 4. Explain the savings function. 5. Calculate autonomous and induced consumption. 6. List and discuss the determinants of consumption. 7. Interpret and assess the permanent income hypothesis. 8. Explain why we spend so much and save so little.

5-3 GDP and Big Numbers  Gross Domestic Product (GDP) is the nation’s expenditure on all final goods and services produced during the year at market prices.  Consumption, investment, and government spending are the three main sectors of GDP.  GDP for 2009 was $14.2 trillion. This can be written as  $14,200,000,000,000  $14,200 billion  $14.2 trillion Consumption by households was $ trillion in  10 trillion, 89 billion dollars

5-4 Four Parts of GDP  Consumption C (this chapter) Consumption includes spending on consumer goods and services.  Investment I (Chapter 6) Investment includes business investments in capital and inventories, as well as residential investment by households.  Government G (Chapter 7) Government spending on goods and services.  Net exports X n (Chapter 8) Exports minus imports.

5-5 Consumption  C is the largest sector of GDP. C now accounts for 7 out of every 10 dollars spent on final goods and services.  Americans spend virtually all of their income after taxes, although savings have increased slightly since Consumers spend 67.7 percent of their disposable income on services such as medical care, gasoline, eating out, video rentals, life insurance, and legal fees. The rest is spent on durable goods, such as television sets and furniture, or on nondurable goods, such as food and gasoline.

5-6 Consumption Function  A function specifies a relationship between two variables. C varies with the level of after-tax income. John Maynard Keynes noted that consumption was a stable component of income.  The consumption function 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.  We will look at the mathematical relationships behind this function and then graph it.

5-7 Example: Consumption and Disposable Income (in billions of dollars) Note that C > DI at very low income levels.

5-8 Consumption and Disposable Income Each time DI increases by $1,000, C increases by $

5-9 Saving  Saving is defined as NOT spending. DI – C = S 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!

5-10 Source: Economic Report of the President, 2010, Survey of Current Business, March 2010 Saving as a Percentage of Disposable Income

5-11 Household Saving as a Percentage of Disposable Income in 2009 The U.S. saving rate is low compared with other developed economies. Source: OECD

5-12 Questions for Thought and Discussion  Americans spend more on services than on durable and non-durable goods. Give an example of each category from your own spending habits.  How is it possible to consume more than your income?  If a country has a negative saving rate, does that mean that nobody in the country is saving?

5-13 Four Concepts  Average Propensity to Consume: the percentage of disposable income that is spent  Average Propensity to Save: the percentage of income that is saved APC + APS = 100% of DI or 1.00 in decimal form  Marginal Propensity to Consume: the percentage of an increase in disposable income that is spent change in C divided by change in DI  Marginal Propensity to Save: the percentage of an increase in disposable income that is saved change in S divided by change in DI MPC + MPS = 1.00 in decimal form

5-14 Average Propensity to Consume (APC) (The Percent of DI Spent) APC = Consumption Disposable Income

5-15 APC values and their meaning  The APC may = 1 signifying all disposable income is consumed.  The APC may be > 1 signifying you are consuming more than your disposable income by dipping into your savings.  The APC may be < 1 indicating you’re a saving a portion of your disposable income.

5-16 Sample APC Problem Disposable Income Consumption Saving $40,000 $30,000 $10,000 APC = = = =.75 C DI

5-17 Disposable Income Consumption Saving $40,000 $30,000 Sample APC Problem

5-18 Sample APC Problem Disposable Income Consumption Saving $40,000 $30,000 $10,000 APC = = = =.75 C DI APS = = = =.25 S DI

5-19 Sample APC Problem Disposable Income Consumption Saving $40,000 $30,000 $10,000 APC = = = =.75 C DI APS = = = =.25 S DI

5-20 APCs Greater Than One Disposable IncomeConsumption Saving $10,000 $12,000

5-21 APCs Greater Than One Disposable IncomeConsumption Saving $10,000 $12,000 – 2000 Where is this going to come from?

5-22 APCs Greater Than One Disposable IncomeConsumption Saving $10,000 $12,000 – 2000 APC = = = = 1.2 C $12, DI $10,000 10

5-23 APCs Greater Than One Disposable IncomeConsumption Saving $10,000 $12,000 – 2000 APC = = = = 1.2 C $12, DI $10, APS = = = –0.2 S -$2, DI $10,000 10

5-24 APCs Greater Than One Disposable IncomeConsumption Saving $10,000 $12,000 – 2000 APC = = = = 1.2 C $12, DI $10, APS = = = = –0.2 S -$2, DI $10,

5-25 Average Propensity to Consume, Selected Countries, 2009 Source: OECD

5-26 Marginal Propensity to Consume (MPC) MPC = CHANGE in C CHANGE in DI

5-27 Calculate MPC Using Hypothetical Data Year DI C S 2000 $30,000 $23,000 $7, $40,000 $31,000 $9,000

5-28 Calculating MPC Change in DI = 40,000 – 30,000 = $10,000 Change in C = 31,000 – 23,000 = $8,000 Change in C = 8,000/10,000 =.8 Change in DI The MPC is.8 This country consumes 80% of each increase in disposable income.

5-29 Calculating MPS Change in DI = 40, ,000 = $10,000 Change in S = 9,000 – 7,000 = $2,000 Change in S = 2,000/10,000 =.2 Change in DI MPS =.2 This country saves 20% of each increase in DI.

5-30 Graphing the Consumption Function: The 45- Degree Line  Notice that the scales of the vertical and horizontal axes are the same.  At each point along the 45- degree line, the measurement on the two axes is the same.  The line represents every point where Expenditures equal Disposable Income.  Example: On the 45-degree line, when DI = 2,000, what does Expenditures equal?  Answer: 2,000  Consumption is one category of expenditures, so start by graphing C.

5-31 Graphing the Consumption Function  Consumption is the vertical distance between the bottom (horizontal) axis and the “C” line.  If DI = $3 trillion, how much is C? This is where the C function crosses the 45-degree line. C = DI = $3 trillion  If DI is $6 trillion, C will be $4.5 trillion.  If DI is $1 trillion, C is $2 trillion. Some of the C is financed by borrowing (Example: Denmark).  Can you use these numbers to calculate APC and MPC?

5-32 The Saving Function  This graph uses the same data as the Consumption Function.  S = DI  C.  Can you calculate APS and APC?

5-33 Autonomous Consumption vs. Induced Consumption  Autonomous consumption (AC) is the level of consumption when disposable income is “0”. It is called autonomous because it is independent of change in disposable income. AC = $2 trillion on graph  Induced consumption (IC) is that part of consumption that varies with the level of disposable income. As disposable income rises, induced income rises. As disposable income fall, induced income falls.  IC = C – AC for each level of DI

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.  How many values for C and DI do you need to calculate the APC? How many values for C and DI do you need to calculate the MPC? Explain the difference.  Why does the consumption function have a positive slope?

5-35 Consumer Spending, 1955 and 2009 ($billions) The major change in consumer spending has been a massive shift from nondurables to services. Source: Survey of Current Business, 2010.

5-36 Expenditures of the Average American Household, 2009 Bureau of Labor Statistics Source:

5-37 Consumption as a Percentage of GDP Between 1982 and early 2008, there was a steady upward trend. Source:

5-38 Determinants of the Level of Consumption 1. Disposable Income The most important determinant of consumption. 2. Credit Availability Ability to borrow affects spending. Decrease in home equity loans since 2006 has cut C. 3. Stock of Liquid Assets in the hands of consumers Stocks, bonds, savings accounts, CDs, money market funds 4. Stock of Durable Goods in the hands of consumers Market saturation leads to drop in C.

5-39 Determinants of the Level of Consumption (Continued) 5. Keeping up with the Jones's Veblen’s theory of conspicuous consumption Consuming things adds to our social status. 6. Maintaining a basic standard of living Social definition of basic standard of living changes over time. The bar keeps rising. Two-income trap? 7. Consumer Expectations Buy now if expect prices to rise. Buy later if expect prices to fall in recession. 8. The Wealth Effect When the value of your home or stocks increases, you feel wealthier and spend more. Fall in housing prices led to falling C.

5-40 Permanent Income Hypothesis  Idea proposed by Milton Friedman, a prominent conservative economist in the late 20 th century.  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.

5-41  Americans have been on a spending binge for the last 30 years. Government policies encouraged consumption:  Mortgage interest and property taxes are tax-deductable. The tremendous expansion of bank credit cards, installment credit, and consumer loans has further fueled the consumer binge. Savings as Percentage of GDP, Why Do We Spend So Much and Save So Little? Source: Survey of Current Business, March 2010.

5-42 Why does it matter?  Every economy depends on saving for capital formation.  Individual saving + business saving + government saving = Total Saving Until the recession of 1981–82, as a nation we generally saved about 20 percent of U.S. GDP. Declines in household saving has been offset somewhat from 1993 – 2000 by a sharp rise in government saving and business saving. Since 2001, government savings have declined.  Since Americans were not saving enough, we have needed to borrow almost $2 billion a day from foreigners.

5-43 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 after World War II.  The American consumer has made China’s 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. Private Consumption as a Percentage of GDP, Selected Countries, 2008 Sources: CEIC; OECD; World Bank.

5-44 Questions for Thought and Discussion  What motivates consumption and what do Americans spend their money on?  How have American savings rates changed overtime? What would be the consequences of present trends continuing?