Chapter Sixteen1 CHAPTER 16 Consumption Chapter Sixteen2 The consumption function was central to Keynes theory of economic fluctuations presented in The General Theory in 1936 Keynes conjectured that the marginal propensity to consume the amount consumed out of an additional dollar of income is between zero and one He claimed that the fundamental law is that out of every dollar of earned income people will consume part of it and save the rest Keynes also proposed the average propensity to consume the ratio of consumption to income falls as income rises Keynes also held that income is the primary determinant of consumption and that the interest rate does not have an important role Chapter Sixteen3 Consumption spending by households depends on autonomous consumption marginal propensity to consume MPC disposable income C C c Y C 0 0 c 1 C Y C C determines the intercept on the vertical axis The slope of the consumption function is lower case c the MPC C C cC C c Y Y Chapter Sixteen4 C Y C APC C Y C Y c 1 1 APC1 APC2 This consumption function exhibits three properties that Keynes conjectured First the marginal propensity to consume c is between zero and one Second the average propensity to consume falls as income rises Third consumption is determined by current income Y As Y rises C Y falls and so the average propensity to consume C Y falls Notice that the interest rate is not included in this equation as a determinant of consumption Chapter Sixteen5 To understand the marginal propensity to consume MPC consider a shopping scenario A person who loves to shop probably has a large MPC let s say 99 This means that for every extra dollar he or she earns after tax deductions he or she spends 99 of it The MPC measures the sensitivity of the change in one variable consumption with respect to a change in the other variable income Chapter Sixteen6 During World War II on the basis of Keynes s consumption function economists predicted that the economy would experience what they called secular stagnation a long depression of infinite duration unless the government used fiscal policy to stimulate aggregate demand It turned out that the end of the war did not throw the United States into another depression but it did suggest that Keynes s conjecture that the average propensity to consume would fall as income rose appeared not to hold Simon Kuznets constructed new aggregate data on consumption and investment dating back to 1869 His work would later earn him a Nobel Prize Kuznets discovered that the ratio of consumption to income was stable over time despite large increases in income again Keynes s conjecture was called into question This brings us to the puzzle Chapter Sixteen7 The failure of the secular stagnation hypothesis and the findings of Kuznets both indicated that the average propensity to consume is fairly constant over time This presented a puzzle Why did Keynes s conjectures hold up well in the studies of household data and in the studies of short time series but fail when long time series were examined C Y Short run consumption function falling APC Long run consumption function constant APC Studies of household data and short time series found a relationship between consumption and income similar to the one Keynes conjectured this is called the short run consumption function But studies using long time series found that the APC did not vary systematically with income this relationship is called the long run consumption function Chapter Sixteen8 The economist Irving Fisher developed the model with which economists analyze how rational forward looking consumers make intertemporal choices that is choices involving different periods of time The model illuminates the constraints consumers face the preferences they have and how these constraints and preferences together determine their choices about consumption and saving When consumers are deciding how much to consume today versus how much to consume in the future they face an intertemporal budget constraint which measures the total resources available for consumption today and in the future Chapter Sixteen9 Here is an interpretation of the consumer s budget constraint The consumer s budget constraint implies that if the interest rate is zero the budget constraint shows that total consumption in the two periods equals total income in the two periods In the usual case in which the interest rate is greater than zero future consumption and future income are discounted by a factor of 1 r This discounting arises from the interest earned on savings Because the consumer earns interest on current income that is saved future income is worth less than current income Also because future consumption is paid for out of savings that have earned interest future consumption costs less than current consumption The factor 1 1 r is the price of second period consumption measured in terms of first period consumption it is the amount of first period consumption that the consumer must forgo