CHAPTER 5 CONSUMPTION AND SAVINGS

Consumption Defined

• Consumption means the expenditure made by households on goods and services.

Consumption Function

Consumption and Income; basic assumption

As you may have observed, personal or household consumption is the main determinant of national or
factor income. The consumption expenditure is in fact the proportion of national income or disposable
income spent by household on final good and services and is the largest component of aggregate
demand and spending in the circular flow of national income.

The equation below sums up the component of the national income minus the inflows of investment (I),
government spending (G), and net exports (X)

• Y= Cb + C

• Where;

Y= factor income

Cb= borrowings from the economy’s stock of savings

C= change in consumption

Given our equation, first let us presume that the economy initially dissaves by making use of its stock of
available saving to meet current consumption needs in the absence of income. This means that
households are spending more than what they earn by borrowing from the rest of society resulting to
aggregate consumption exceeding aggregate income.

This initial consumption expenditure, which is used in purchasing consumptions good and services, is
also the initial factor income that the circular flow of national income generates as it totally flows back
to the household in exchange for the use of their factor resources.

The Multiplier Concept

The process of generating income through the circular flow exchange between the households and the
firms is called multiplier. In general, the multiplier is the ratio of an induced change in the equilibrium
level of national income to an initial change in level of spending.

• Two important features of multiplier

a) It is a cumulative process rather than instantaneous effect and as such it is best viewed in terms
of a series of successive rounds of additions to income

b) The value of the multiplier depends on the fraction of extra income that is spent on
consumption (called marginal propensity to consume or MPC) at each successive round.
Formula for multipier(K)

K = __1___ 1____

1-(MPC) MPS

Where;

K = multiplier coefficient

MPC = marginal propensity to consume

MPS = 1 – MPC = marginal propensity to save

The multiplier coefficient depends on the fraction of every additional income generated in the exchange
that flows out of the circular flow as saving. This outflow determines the portion left consumption and
recirculation to further generate income.

The consumption factor of the multiplier is expressed as coefficient called marginal propensity to
consume (MPC) ( _x_) while saving factor is called marginal propensity to save (MPS) ( _X_)
Y

• Observe also that the denominator of the multiplier equation

(1 – MPC) is actually the MPS since,

MPS + MPC =1

Therefore an increase in the savings rate decreases the MPC and the multiplier causing more outflows
and less money flows to generate income in the circular flow.

S=I

I=Y- C

Where additionally;

S = aggregate savings from currently generated income

I = inflow

Reducing income to 1 with the same propensity to save does not change the multiplier value and should
conform to our first coefficient presented as follows

M = 1_

MPS

Since; mps = 1 – MPC, then M = _1_

1-MPC
How the multiplier works to generate income is illustrated as follows;

Consumption Income

100 100

80 80

64 64

0 0

500 500

Consumption and Savings

We already noted that the additional income that the circular flow generates by the multiplier process
yields saving outflows. Hence, if income is initially generated through borrowings, the corresponding
savings outflow can be used to repay debts that have been previously incurred. Therefore, generating
more savings outflows required to retire more debts and reduce what the economy owes during the
past accumulated savings

• Factors of Consumption

Tastes or Preference – depends on how products satisfy one’s desires. A change in collective attitude
can change aggregate taste and preference, and in turn change in the consumption level and marginal
propensity to consume.

Population – also determines consumption needs and therefore affects consumption expenditures with
a given income. A decrease in household size with income and other factors increasing may reduce
households propensity to consume and increase its savings at the expense of non essential items in the
consumption basket.

Income – the level of income can increase consumption with more infusions in the circular flow. On the
other hand, income distribution among propensities to consume also determines.

Price Level – Individual product demand is inversely related to price due to the change in purchasing
power and substitution with other products. On the aggregate, consumers seeks the best mix in the
aggregate income, price and purchasing power.

Innovation and Promotion – can also expand the line of the consumers choice and expand the influence
of demand factors on consumption and households propensity to consume. The introduction of new
product, in particular, can create demand and increase aggregate consumption with the same taste and
preference and level of income.