Understanding

Consumption
In microeconomics you would have studied how individuals decide on what to consume
depending on price and income. In case of macroeconomics we will study how consumers in
aggregate decide the total consumption.
You may ask this question, why is it important to study consumption. It is important because
consumption is the largest component of GDP, and it is also the most stable part of the GDP.
Since macroeconomics deals with increasing the GDP, it is important to understand how
policy makers can increase the aggregate consumption level of the economy to increase the
overall income of the economic agents in the economy.
There are several variables that will affect the consumption at an aggregate level. Some of the
most important variables are;

Permanent income
Expected life period
Household wealth
Price level
Rate of interests:
Interest rate has two effects on consumption - substitution effect, and income effect.
Higher interest rates increase income from saving. Therefore, this gives consumers
more income to spend, and spending may rise (income effect). Similarly Higher
interest rates make saving more attractive than spending, reducing consumer spending
(substitution effect). Substitution effect will be stronger at low income level and
income effect stronger at high income level. Therefore, the effect of rate of interest
will depend on the relative importance of these two opposite effects.
Future expectation of income, price and interest rate

There are many economic theories that deal with consumption behaviour. They are broadly
categorized into two types.

Absolute income theory: We will discuss 3 most popular consumption theories

a. Keynes consumption function
b. Franco Modiglianis life cycle hypothesis
c. Friedmans permanent income hypothesis
Relative income theory: In these theories, the consumption and saving of individuals
are decided not only by his/her absolute income, rather by consumption and saving
patterns of other individuals in the economy. When income of individuals reduced in
absolute terms, the consumption does not reduce significantly. This is because the
consumption at current period dependents upon past consumption. In this course we
will not cover this concept.

Before we study theory of consumption, let us understand three simple concepts. These
concepts are disposable income (Yd), marginal propensity to consume (MPC) and average
propensity to consume (APC).
(

)
( )

( )

Where MPC is the marginal propensity to consume, c is the change in consumption and
Yd is the change in disposable income.
Therefore, we can define MPC as the change in consumption expenditure of the economy to a
unit change in aggregate disposable income of the economy. From this concept of MPC we
can also derive the marginal propensity to save (MPS), which is nothing but the amount of
saving at the aggregate level when income rises by a unit.

Similarly we can define average propensity to consume (APC) as the amount of consumption
per unit of income on an average. We can write this mathematically as;

Exercise:
Find the MPC and APC of the consumption function;

What is the significant of MPC?

Depending on the theory MPCs significant is described. According to the Keynesian theory,
role of MPC is quite significant. However, the more advanced theory of consumption
distinguishes between temporary increases in income (annual bonus) from the permanent
increase in income (promotion leading to increase in income). MPC is more relevant in case
of permanent increase in income in case of advanced theory of consumption.

Keynesian Theory of Consumption

If you do not have any income will you spend? According the Keynes individuals will spend
something even if the income zero. This consumption is called autonomous consumption
(this consumption will either happen by borrowing or depleting from past saving). Therefore,
we are likely to have some minimum level of spending even if the income level is zero. In
addition to autonomous consumption the incremental consumption will depend on the level

of income. The component of consumption that will depend on the income level is called
induced consumption.
The Keynesian consumption function has two components
1. Autonomous consumption (C0)
2. Induced consumption (IC) Marginal Propensity to Consume * Yd (MPC*Yd)
The same can be mathematically shown as;

The equation is also shown in Figure 1.

Example:
If C0 is 50 billion, c=0.7, and Yd is 1000billion what is the aggregate consumption level
according to Keynesian consumption function?
C = 50 billion + 0.7 * 1000 = 750 billion

Life Cycle Theory of Consumption

Franco Modigliani formulated this hypothesis in 1950s. According to the hypothesis at young
age people are in debt where his/her income is less than expenditure, and time progress the
income is greater than the expenditure. As people age they will again spend more than their
income. During the working period of the individuals they will create assets that will fund
their consumption when they are not working.
The theory makes three fundamental assumptions.
1. Individuals will prefer to smoothen their consumption overtime: When people are
experiencing fluctuations in income they would prefer to make sure they consume
consistently over the period rather than living lavishly when high income and living in
penury when experiencing low income.
2. Individuals are impatient: They would prefer to consume now rather that latter. What
it means, to enable individuals to save they need to be rewarded
3. Individuals are forward looking when making decision at present. They plan to
consume consistently by estimating the future income level.
This is shown in the Figure 2, where WP is working period of an individual and TP is the
total period for which individual will live. Total income (TI) is what the individual earns, and
during the earning period individuals will accumulate assets (including initial wealth). Over
the period they would consume constant amount . This amount will increase only if
individuals experience a permanent shift in income.
Let us take an over simplified example. If a government servant starts to work from the age
of 25, and will retire at the age of 65. He/she is going to work for 40 (WP) years. If he earns
Rs.5 lakhs per year, the total income over the working period is Rs.200 Lakhs. If the life
expectancy (TP) is 75 years, then the government servant has to save for the retired live from
the earnings of working life. The average consumption amount will be
(

The saving every year is Rs.1 Lakh for the retire life. After the retired life the government
servant dis-saves and lives out of the savings.
These formulations can be written mathematically as;
(

)
(

And the consumption function is;

Exercise:
What is the MPC of the government servant in our example?
What will happen to the MPC when the annual income increases by Rs.1 Lakh per year?
What will happen to the MPC when the government servant gets the sign-up bonus of Rs.1
Lakh?

If one inherits wealth (W) then the formulations can be written mathematically as;
(

)
(

Consumption function can be written as;

Permanent Income Hypothesis

This theory was put forwarded my Milton Freidman, and it is very similar to life cycle theory
of consumption. This theory hypothesizes that an individual will make an estimate of his/her
life time income and then makes decision with respect to the consumption. Individual will

prefer to smooth out the consumption over the life span, rather than living in luxury in one
period and then live in poverty in another.
According to this theory, the change in income can be of two types. First, one can experience
a transitory increase in income (onetime bonus, tax credits, in heritance of wealth, and etc).
Second, one can experience a permanent shift in income (salary increase, promotions, and
etc). The reactions of individuals to these two types of changes are not same. MPC is
critical for permanent changes income, and is of little importance in case of transitory
income.
The theory can be mathematically written as;

The consumption function according to the theory is;

.

Recent Developments
If individuals faces liquidity constraints (May not able to borrow) and not able to anticipate
the future income (myopic), these theories (life cycle theory and permanent income
hypothesis may not hold. Due to this researchers have made attempts to extend these theories
when consumers face uncertainty and liquidity constraints. In this course we will not cover
these theories.