Consumption Function of Money: Meaning and Relationship with Income | Micro Economics
Figure – The relationship between income and consumption. Proxy measures of consumption. Some practical issues in constructing living standards variables. Finally, we find evidence that measurement error may bias the relationship Asking income and consumption questions in the same survey: what are the risks ?. Undo. Related Questions (More Answers Below). What are the relationships What is the consumption income relationship? Views · What is the functional .
There are many factors that determine why consumers choose to spend more on goods not required for day-to-day living expenses. These include stock market trends, tax laws, and even consumer optimism.
Economic experts look at historical data to predict future trends based on new market conditions. The Effect of Consumer Confidence Consumers won't spend money unless they are confident in their personal economic situation and strength.
This means consumers feel good about having and keeping a job with the potential of promotion.
Pay increases, stock portfolio rises and tax cuts can put more money in each person's pocket. As these conditions merge, consumer confidence increases. Consumer confidence is the trust a buyer has that he can afford a purchase either today or in the near future. For example, consumer confidence is shown by homebuyer trends.
This is a major purchase that takes decades to pay off. A buyer must feel good about the economy, as well as feeling secure about his personal financial situation to take on such a major purchase. Your family takes out a mortgage and buy a new house. Ans a As it is clear that purchasing of any asset is a part of investment not a saving because saving means to get money store in banks or lockers.
So, my family takes out a mortgage and buy a new house is an investment. Ans b It is also clear that anything deposited in a bank is a part of saving not a investment. Here it is savings. Ans a What is government spending? It means that government expenditure. When there is an increase in govt. So, it further states that govt.
An increase in the money supply Ans b In the economy we know that if there is demand in the market the price of the goods and services will effect, it will increase. And which lead to effect the LM curve. An increase in money supply always reduce the rate of interest. If there is any increase in money supply than ,LM curve also leads to shift rightward. It can be easily explained with the help of diagram that when there is no increase in money then LM curve is ,LM1 and when money supply increases then there is shift in LM curve from LM1 — LM2.
Discuss what policy instruments are available to a government to achieve these targets. They are given an inflation target by the government. The first step is for the MPC to try and predict future inflation. They look at various economic statistics and try to decide whether the economy is overheating.
If inflation is forecast to increase above the target, the MPC will increase interest rates. Fiscal policy involves the government changing tax and spending levels, in order to influence the level of Aggregate Demand.
To reduce inflationary pressures the government can increase tax and reduce government spending. This will reduce AD.
It was felt that by keeping the value of the pound high, it would help reduce inflationary pressures. The Relative Income Hypothesis 3. The Life-Cycle Hypothesis 4.
The Permanent Income Hypothesis. Data collected and examined in the post-Second World War period confirmed the Keynesian consumption function. Time series data collected over long periods showed that the relation between income and consumption was different from what cross-section data revealed.
In the short run, there was a non-proportional relation between income and consumption. But in the long run the relation was proportional. By constructing new aggregate data on consumption and income from and examining the same, Simon Kuznets discovered that the ratio of consumption to income was fairly stable from decade to decade, despite large increases in income over the period he studied.
This fact presented a puzzle which is illustrated in Fig. Studies of cross-section household data and short time series confirmed the Keynesian hypothesis — the relationship between consumption and income, as indicated by the consumption function Cs in Fig. All these economists proposed explanations of these seemingly contradictory findings. These hypotheses may now be discussed one by one. The Relative Income Hypothesis: InJames Duesenberry presented the relative income hypothesis.
According to this hypothesis, saving consumption depends on relative income.
The Relationship Between Income & Expenditure
This is called relative income. Thus current consumption or saving is not a function-of current income but relative income. Duensenberry pointed out that during depression when income falls consumption does not fall much. People try to protect their living standards either by reducing their past savings or accumulated wealth or by borrowing. However as the economy gradually moves initially into the recovery and then in to the prosperity phase of the business cycle consumption does not rise even if income increases.
People use a portion of their income either to restore the old saving rate or to repay their old debt. People find it more difficult to reduce their consumption level than to raise it. This asymmetrical behaviour of consumers is known as the ratchet effect. In the late s and early s Franco Modigliani and his co-workers Albert Ando and Richard Brumberg related consumption expenditure to demography. This interpretation of household consumption behaviour forms the basis of his life-cycle hypothesis.
The life cycle hypothesis henceforth LCH represents an attempt to deal with the way in which consumers dispose off their income over time.
In this hypothesis wealth is assigned a crucial role in consumption decision.
Wealth includes not only property houses, stocks, bonds, savings accounts, etc. Thus consumers visualise themselves as having a stock of initial wealth, a flow of income generated by that wealth over their lifetime and a target which may be zero as their end-of-life wealth.
Consumption decisions are made with the whole series of financial flows in mind. The theory has empirically testable implications for the relation between saving and age of a person as also for the role of wealth in influencing aggregate consumer spending.
- Consumption function definition
- Consumption Function of Money: Meaning and Relationship with Income | Micro Economics
- Top 4 Types of Hypothesis in Consumption (With Diagram)
Since most people do not want their current living standard as measured by consumption to fall after retirement they save a portion of their income every year over their entire service period. Suppose a representative consumer expects to live another T years, has wealth of W, and expects to earn income Y per year until he she retires R years from now. What should be the optimal level of consumption of the individual if he wishes to maintain a smooth level of consumption over his entire life?
Top 4 Types of Hypothesis in Consumption (With Diagram)
To be more specific, aggregate consumption depends on both wealth and income. For any initial level of wealth w, the consumption function looks like the Keynesian function. So one main prediction of the LCH is that consumption depends on wealth as well as income, as is shown by the intercept of the consumption function. Solving the consumption puzzle: The LCH can solve the consumption puzzle in a simple way. According to this hypothesis, the APC is: If wealth remains constant as in the short run the life cycle consumption function looks like the Keynesian consumption function, consumption function shifts upward as shown in Fig.
This prevents the APC from falling as income increases. This means that the short-run consumption income relation which takes wealth as constant will not continue to hold in the long run when wealth increases.
The MPC out of life-time income changes with age. If a person has no wealth at the beginning of his service life, then he will accumulate wealth over his working years and then run down his wealth after his retirement. If a consumer smoothest consumption over his life as indicated by the horizontal consumption linehe will save and accumulate wealth during his working years and then dissave and run down his wealth after retirement.
Asking income and consumption questions in the same survey: what are the risks?
In other words, since people want to smooth consumption over their lives, the young — who are working — save, while the old — who have retired — dissave. In the long run the consumption-income ratio is very stable, but in the short run it fluctuates. The life cycle approach explains this by pointing out that people seek to maintain a smooth profile of consumption even if their lifetime income flow is uneven, and thus emphasises the role of wealth in the consumption function.
Do Old People Dissave? Some recent findings present a genuine problem for the LCH. Old people are found not to dissave as much as the hypothesis predicts. This means that the elderly do not reduce their wealth as fast as one would expect, if they were trying to smooth their consumption over their remaining years of life. Two reasons explain why the old people do not dissave as much as the LCH predicts: