If one sentence were to sum up the mechanism driving the Great Stagnation, it is this: Recent and current innovation is more geared to private goods than to public goods. That simple observation ties together the three major macroeconomic events of our time: growing income inequality, stagnant median income, and the financial crisis.
Tyler Cowen
Aggregate Expenditure and Equilibrium Output
(Part B)
by
Charles Lamson
Explaining Spending Behavior
So far, we have said nothing about behavior. We have not described the consumption and saving behavior of households, and we have not speculated about how much aggregate output firms will decide to produce in a given period. Instead, we have only a framework and a set of definitions to work with. Macroeconomics is the study of behavior. To understand the functioning of the macroeconomy we must understand the behavior of households and firms. In our simple economy in which there is no government, there are two types of spending behavior: spending by households, or consumption, and spending by firms, or investment. Household Consumption and Saving How do households decide how much to consume? In any given period, the amount of aggregate consumption in the economy depends on a number of factors. Some determinants of aggregate consumption include:
These four factors work together to determine the spending and saving behavior of households, both for individual ones and for the aggregate. This is no surprise. Households with higher income and higher wealth are likely to spend more than households with less income and less wealth. Lower interest rates reduce the cost of borrowing, so lower interest rates are likely to stimulate spending. (Higher interest rates increase the cost of borrowing and are likely to decrease spending.) Finally, positive expectations about the future are likely to increase current spending, while uncertainty about the future is likely to decrease current spending.  While all these factors are important, we will concentrate for now on the relationship between income and consumption. In The General Theory, Keynes argued that the amount of consumption undertaken by a household is directly related to its income: The higher your income is, the higher your consumption is likely to be. People with more income tend to consume more than people with less income. The relationship between consumption and income is called a consumption function. Figure 3 shows a hypothetical consumption function for an individual household. The curve is labeled c(y), which is read "c as a function of y," or "consumption as a function of income." There are several things you should notice about the curve. First, it has a positive slope. In other words, as y increases, so does c. Second, the curve intersects the c axis above 0. This means that even at an income of 0, consumption is positive. Even if a household found itself with a zero income, it still must consume to survive. It would borrow or live off its savings, but its consumption could not be 0.  Keep in mind that Figure 3 shows the relationship between consumption and income for an individual household, but also remember that macroeconomics is concerned with aggregate consumption. Specifically, macroeconomists want to know how aggregate consumption (the total consumption of all households) is likely to respond to changes in aggregate income. If all individual households increase their consumption as income increases, and we assume that they do, it is reasonable to assume that a positive relationship exists between aggregate consumption (c) and aggregate income (y).  For simplicity, assume that points of aggregate consumption, when plotted against aggregate income, lie along a straight line, as in Figure 4. Because the aggregate consumption function is a straight line, we can write the following equation to describe it: C = a + by  △C = "change in C" △Y = "change in Y" Y is aggregate output (income), C is aggregate consumption, and a is the point at which the consumption function intersects the C-axis---a constant. The letter b is the slope of the line, in this case △C/△Y [because consumption (C) is measured on the vertical axis, and income (Y) is measured on the horizontal axis]. Every time income increases (say by △Y), consumption increases by b times △Y. Thus, △C = b x △Y and △C/△Y = b. Suppose, for example, that the slope of the line in Figure 4 is .75 (that is, b = .75). An increase in income (△Y) of $100 would then increase consumption by b△Y= .75 * $100, or $75. The marginal propensity to consume (MPC) is the fraction of a change in income that is consumed. In the consumption function here, b is the MPC. An MPC of .75 means consumption changes by .75 of the change in income. The slope of the consumption function is the MPC. Marginal propensity to consume ≡ slope of consumption function ≡ △C/△Y Recall from last post that the triple equal sign means that this is an identity, or something that is always true. There are only two places income can go: consumption or saving. If $0.75 of a $1.00 increase in income goes to consumption, $0.25 must go to saving. If income decreases by $1.00, consumption will decrease by $0.75 and saving will decrease by $0.25. The marginal propensity to save (MPS) is the fraction of a change in income that is saved: △S/△Y, where △S is the change in saving. Because everything not consumed is saved, the MPC and the MPS must add up to one. MPC + MPS = 1  Because the MPC and the MPS are important concepts it may help to review their definitions. The marginal propensity to consume (MPC) is the fraction of an increase in income that is consumed (or the fraction of a decrease in income that comes out of consumption). The marginal propensity to save (MPS) is the fraction of an increase in income that is saved (or the fraction of a decrease in income that comes out of saving). Because C is aggregate consumption and Y is aggregate income, it follows that the MPC is society's marginal propensity to consume out of national income and that the MPS is society's marginal propensity to save out of national income. Numerical example The numerical examples used in the next few posts are based on the following consumption function:  The equation is simply an extension of the generic C = a + bY consumption function we have been discussing. At a national income of 0, consumption is $100 billion (a). As income rises, so does consumption. We will assume that for every $100 billion increase in income (△Y), consumption rises by $75 billion (△C). This means that the slope of the consumption function (b) is equal to △C/△Y, or $75 billion/$100 billion = .75. The marginal propensity to save is .25. Some numbers derived from this consumption function are listed and graphed in Figure 5.  Now consider saving. We already know Y ≡ C + S, income equals consumption plus saving. Once we know how much consumption will result from a given level of income, we know how much saving there will be. Recall that saving is everything that is not consumed. S ≡ Y - C  From the numbers in Figure 5, we can easily derive the saving schedule that is shown. At an income of $200 billion, consumption is $250 billion; saving is thus a negative $50 billion (S ≡ Y - C = $200 billion - $250 billion = -$50 billion). At an aggregate income of $400 billion, consumption is exactly $400 billion, and saving is zero. At $800 billion in income, saving is a positive $100 billion. The consumption and saving functions we have been discussing are shown in Figure 6. To analyze their relationship we will use the device of the 45-degree line as a way of comparing C and Y. The 45-degree line---the solid black line in the top graph---shows all the points at which the value on the horizontal axis equals the value on the vertical axis. Thus, the 45-degree line in Figure 6 represents all the points at which aggregate income equals aggregate consumption.) Where the consumption function is above the 45-degree line, consumption exceeds income, and saving is negative. Where the consumption function crosses the 45-degree line, consumption is equal to income, and saving is zero. Where the consumption function is below the 45-degree line, consumption is less than income, and saving is positive. Note that the slope of the saving function is △S/△Y, which is equal to the marginal propensity to save (MPS).  The consumption function and the saving function are mirror images of one another. No information appears in one that does not also appear in the other. These functions tell us how households in the aggregate will divide income between consumption spending and saving at every possible income level. In other words, they embody aggregate household behavior.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 433-436* end |
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