Chapter Three Consumption and Saving 1. Consumption and saving analysis Factors affect consumption Factors affect consumption current disposable income; current disposable income; foresight of income and price; foresight of income and price; interest rate for consumer ’ s interest rate for consumer ’ s credit; credit; catch up with somebody; catch up with somebody; social security system; social security system; personal wealth personal wealth

Factors affect saving Factors affect saving precaution; precaution; foresight; foresight; interest rate; interest rate; independence; independence; enterprise; enterprise; pride; pride; avarice and miser avarice and miser

2. Consumption Function Definition Definition The relationship between consumption and factors that affect consumption is described by the consumption function. The relationship between consumption and factors that affect consumption is described by the consumption function. Especially we assume the that consumption increases with the level of disposable income: Especially we assume the that consumption increases with the level of disposable income: C = a + b Y d C = a + b Y d

Autonomous consumption Autonomous consumption variable a in C function ----represents the level of consumption when income is zero---- the intercept on vertical axis of the C-curve variable a in C function ----represents the level of consumption when income is zero---- the intercept on vertical axis of the C-curve Induced Consumption Induced Consumption be varied with income level---- the slope of the consumption curve and b Y d in C function be varied with income level---- the slope of the consumption curve and b Y d in C function

Propensity to consume Propensity to consume Average propensity to consume (APC) Average propensity to consume (APC) APC = C/Yd -----is the proportion of consumption to income. APC = C/Yd -----is the proportion of consumption to income. Marginal propensity to consume (MPC) Marginal propensity to consume (MPC) MPC = ∆C/∆Y is the increase in consumption per unit increase in income. It is represented by variable b in C function. MPC = ∆C/∆Y is the increase in consumption per unit increase in income. It is represented by variable b in C function.

3. Short-run & long-run consumption curve “ Paradox of consumption “ Paradox of consumption function ” function ” The shift of the Cs curve The shift of the Cs curve Derivation of the C L -curve Derivation of the C L -curve Explain of the shift in the Explain of the shift in the short-run curves short-run curves

4. Saving Function Definition------Saving is equal to income minus consumption. Definition------Saving is equal to income minus consumption. APS & MPS : MPC+MPS=1 ; APC+APS=1 APS & MPS : MPC+MPS=1 ; APC+APS=1 Saving curve Saving curve Saving function S = Y d - C = - a + (1-b) Y d Saving function S = Y d - C = - a + (1-b) Y d

5. Modern Consumption Theory Absolute Income Theory Absolute Income Theory Relative Income Theory Relative Income Theory

Life-cycle Theory Life-cycle Theory Some assumptions Some assumptions Basic function Basic function C = a WR + c YL C = a WR + c YL where: where: a ---- MPC out of wealth a ---- MPC out of wealth WR ---- real wealth c MPC out of labor income YL----- labor income WR ---- real wealth c MPC out of labor income YL----- labor income

With lifetime consumption equal to lifetime With lifetime consumption equal to lifetime income, we have C×NL = YL ×WL C×NL = YL ×WL C = YL × WL/ NL C = YL × WL/ NL Case: Numerical example Case: Numerical example Summarize: C is constant over the consumer`s lifetime and financed by lifetime income plus initial wealth. Summarize: C is constant over the consumer`s lifetime and financed by lifetime income plus initial wealth.

During each year, a fraction,1/(NL - T), of During each year, a fraction,1/(NL - T), of wealth will be consumed, where (NL - T) is the life expectancy. Current consumption spending depends on Current consumption spending depends on current wealth and lifetime income.

Permanent income theory A) The form of the theory: Permanent income theory A) The form of the theory: C = c YP C = c YP YP----- permanent disposable income YP----- permanent disposable income c is the MPC B) Estimating of the YP: c is the MPC B) Estimating of the YP: YP = Y -1 + θ (Y - Y -1 ) YP = Y -1 + θ (Y - Y -1 ) = θY+(1-θ) Y -1 C) Permanent Income and Consumption = θY+(1-θ) Y -1 C) Permanent Income and Consumption C = cYP = c θY + c(1-θ) Y -1 C = cYP = c θY + c(1-θ) Y -1