CHAPTER TWO

CONSUMPTION SPENDING
• Consumption spending refers to the expenditures of
individual consumers and households.
• Consumption is an important part of human
behaviour and most of the economic activities are
influenced directly or indirectly by consumption.
• In practice, the demand for consumption goods is not
constant but, rather, increases with income:
• Families with higher incomes consume more than
families with lower incomes and countries where
income is higher have higher levels of total
consumption.
• The relationship between consumption and income is
described by the consumption function.
Theories of Consumption
• Consumption theories explain about consumption and
income relationship.
• A number of hypotheses have been developed to
explain the consumers’ behaviors and at the same
time to explain the short-run and long-run
consumption functions.
• Some of these theories or hypotheses are: Keynesian
absolute income hypothesis, Relative Income
hypothesis, Fisher’s Intertemporal Model of
Consumption, Modigliani’s Life-Cycle Hypothesis
and Friedman’s Permanent Income hypothesis.
 1. Keynesian Consumption Function
• Consumption function explains the relationship
between consumption and income.
• The Keynesian Consumption function states that
when income increases, consumption also increases
linearly.
• This hypothesis is also known as absolute income
hypothesis. It can also be stated that the current real
consumer spending is a function of current real
disposable income.
• The simple linear relationship is typically assumes
the following relations.
• C = a +cYd; a > 0, 0 < c ≤ 1
Where: C = Total real consumption of households
a = Autonomous real consumption of households
Yd = Real personal disposable income
c = Marginal propensity to consume (MPC)
• Autonomous real consumption of household ‘a’
indicates that even if income is zero, the household
will consume something by dis-saving (by
withdrawing what they have saved earlier).
• The value of autonomous consumption ‘a’ in general
represents the amount of consumption expenditure
that consumer(s) make when their income is zero.
 Properties of Keynesian Consumption Function
a) The marginal propensity to consume (MPC) is
between 0 and 1, i.e. 0 < c ≤ 1
• Since marginal propensity to consume (MPC) is the
proportion of income that goes to or is used for
consumption, it is easy to conclude that the value of MPC
is between zero and one.
• For instance, a person with very low income may consume
all his/her income. This is the maximum possible
proportion of income to be consumed where the value of
MPC is one.
• On the other hand, for a person with very large income for
him/her it is enough to consume only small proportion of
his/her income. This proportion is close to, but greater than
zero. Then, the value of MPC is between zero and one.
b) The APC falls as Income (Yd) rises
• The ratio of consumer expenditure to income (C/Y) =
APC (average propensity to consume) varies
inversely with the level of income.
• This is because all extra income is not going to be
consumed. At very low income a household may
consume all of its income. This implies that the ratio
of consumption to income is high.
• However, when income increases, the household
begins to save part of its income. This makes the ratio
of consumption to income, which means that APC
becomes smaller and smaller.
c) Marginal propensity to consume is less than
Average propensity to Consume, (MPC < APC)
• Given the consumption function (C = 500 + 0.75Yd)
and assuming MPC is 0.75, the following table gives
the calculations for consumption level and APC (APC
= C/Yd i.e. the fraction of total income which is
spent) and the level of saving.
• The greater the level of disposable income the lower
the average propensity to consume (APC) is.
• In other words, the absolute income hypothesis
implies that households spend a smaller proportion of
their income as it increases (as their income
increases).
d) At low levels of income dis-saving occurs (saving
is negative)
• During low income period, an individual has to
withdraw some of his/her earlier savings to cover
his/her consumption expenditure.
• This is termed as dissaving and represented by
negative saving. When the level of income increases
and becomes enough to cover all consumption
requirements the person stops withdrawal and
eventually begin to save.
• In a two sector economy consisting of household and
business sector, income is either spent or saved.
• When this occurs, one can explain the behaviour of
saving if one knows about consumption. In the
derivation, we also take the case where there is
efficient transfer of savings to investment through
borrowers by banks.
• Under this case, the level of saving is equal to the
level of investment; i.e. I = S. Y = C + S and S = I, So
we can write the aggregate demand or income as
Y = C + S But C = a + cY ⇒ Y = a + cY + S
⇒ S = Y − a − cY ⇒ S = −a + (1− c)Y
• When income is zero i.e. Y = 0 then S = -a, which
means that people’s saving is negative.
• This indicates that in order to consume people should
use their past savings. Marginal propensity to save is
equal to (1 – c) or (1 – MPC).
• If MPC = ∆C/ ∆Y is equal to 0.75, then MPS is equal
to ∆S/ ∆Y =(1-0.75=0.25).
• Since the entire income or all disposable income is
either consumed or saved (Y = C + S), if some part of
income is consumed then the remaining part will be
saved.
• This implies that the sum of MPC and MPS equals
one (MPC + MPS = 1). This can be represented using
Relationship between Consumption and saving function
• The above figure clearly put that both the
consumption and saving functions are positively
sloped because both increase as income increases
even if the rates may be different.
• The figure also shows that the consumption function
has positive intercept. The existence of positive
intercept means that for a person to survive there
must be positive consumption even if his /her income
is zero.
• However, the saving function has negative intercept
implying that a person has borrowed or withdrawn
his/her earlier savings for the purpose of consumption
during the period of zero income.
• Example: Given consumption function of a two
sector economy as C = 40 + 0.7Y
find a) Saving function b) MPC c) MPS d) Compare the
values of MPC and MPS
Solution:
a) Y = C + S S = Y – C but C = 40 + 0.7Y S = Y – (40
+ 0.7Y) = Y – 40 – 0.7Y
S = – 40 + Y – 0.7Y = – 40 + 0.3Y
b) MPC = dC/dY = 0.70. It is simply equal to the slope
of the consumption function
c) MPS = dS/dY = 0.3. MPS is also equal to the slope
of the saving function
d) d) MPC + MPS = 0.7 + 0.3 = 1. This implies that
 2. Relative Income Hypothesis
• Under relative income hypothesis, consumption is a
function of current income relative to the highest
level of income previously attained and the income of
the household relative to the average income of the
community.
• If income falls from Y1 to Y2, then people move in
their short run consumption function and reduce their
consumption to C1. This is due to the fact that people
try to maintain their previous standard of living.
• When their income increases, then people will
increase consumption in the short run till the previous
peak is reached. Then, they move on long run path to
achieve the higher peak.
Relative income hypothesis and consumption function
• According to this theory when income of a person
declines from Y1 to Y2, the person will not consume
C2 level; rather, he/she will consume a higher level
C1 by moving to on the short run consumption
function.
• This is because the decline in income makes him/her
a person with a relatively low income in the
community and so spends relatively more on
consumption.
• Normally, when a family lives in a locality with
higher income groups then the family with lower
income spends more by seeing the spending pattern
of other families in the same locality.
 3. Fisher’s Intertemporal Model of Consumption
• When people decide how much to consume and how
much to save, they consider both the present and the
future. The more consumption they enjoy today, the less
they will be able to enjoy tomorrow.
• In making this tradeoff, households must look ahead to
the income they expect to receive in the future and to the
consumption of goods and services they hope to be able
to afford.
• The economist Irving Fisher developed the model
economists use to analyze how rational, forwardlooking
consumers make intertemporal choices-that is, choices
involving different periods of time.
• Fisher's model shows the constraints consumers face and
how they choose consumption and saving.
• Most people would prefer to increase the quantity or
quality of the goods and services they consume.
• The reason people consume less than they desire is
that their consumption is constrained by their income.
• In other words, consumers face a limit on how much
they can spend, called a budget constraint.
• When they are deciding how much to consume today
versus how much to save for the future, they face an
intertemporal budget constraint, which measures the
total resources available for consumption today and
in the future.
• For simplicity, assume a consumer who lives for two
periods. Period one represents the consumer's youth
and period two represents the consumer's old age.
• The consumer earns income Y1 and consumes C1 in
period one, and earns income Y2 and consumes C2 in
period two (All variables are real terms -that is,
adjusted for inflation).
• Because the consumer has the opportunity to borrow
and save, consumption in any single period can be
either greater or less than income in that period.
• Consider how the consumer's income in the two
periods constrains consumption in the two periods.
• In the first period, saving (S) equals income minus
consumption. That is: S =Y1-C1 ……….2.3
• In the second period, consumption equals the
accumulated saving, including the interest earned on
that saving, plus second-period income.
That is: C2 = (1+r)S+Y2 ………..2.4
• Where, r is the real interest rate. Because there is no
third period, the consumer does not save in the
second period.
• Note that these two equations still apply if the
consumer is borrowing rather than saving in the first
period.
• The variable S represents both saving and borrowing.
• If first-period consumption is less than first-period
income, the consumer is saving, and S is greater than
zero.
• If first-period consumption exceeds first-period
income, the consumer is borrowing, and S is less than
zero. For simplicity, we assume that the interest rate
for borrowing is the same as the interest rate for
saving.
• To derive the consumer's budget constraint, combine
the two equations above. Substitute the first equation
(2.3) for S into the second equation (2.4) to obtain:
• C2 = (1 + r) (Y1 - C1) + Y2 Rearranging terms: (1 + r)
C1 + C2 = (1 + r) Y1 + Y2. Now divide both sides by
(1+r) to obtain the consumer's intertemporal budget
constraint given below:

This equation relates consumption in the two periods

to income in the two periods.
It is the standard way of expressing the consumer's
intertemporal budget constraint.
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 1+r.
• Because the consumer earns interest on current
income that is saved, future income is worth less than
current income.
• 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 to obtain 1
unit of second-period consumption.
• At point A, first-period consumption is Y1 and
second period consumption is Y2, so there is neither
saving nor borrowing between the two periods.
• At point B, the consumer consumes nothing in the
first period and saves all income, so second-period
consumption is (1+r)Y1+Y2.
• At point C, the consumer plans to consume nothing in
the second period and borrows as much as possible
against second-period income, so first-period
consumption is Y1+Y2/(l+r).
• If he chooses points between A and B, he consumes less than
his income in the first period and saves the rest for the second
period. If he chooses points between A and C, he consumes
more than his income in the first period and borrows to make
up the difference.
• The consumer's preferences regarding consumption in the two
periods can be represented by indifference curves.
• An indifference curve shows the combinations of first period
and second period consumption that make the consumer
equally happy.
• The slope at any point on the indifference curve is the
marginal rate of substitution (MRS) between first-
period consumption and second-period consumption.
• It tells us the rate at which the consumer is willing to
substitute second period consumption for first-period
consumption. The MRS depends on the levels of
consumption in the two periods.
• The consumer is indifferent among combinations W,
X, and Y, because they are all on the same curve.
• If the consumer's first-period consumption is reduced,
say from point W to point X, second-period
consumption must increase to keep him equally
happy.
• If first-period consumption is reduced again, from
point X to point Y, the amount of extra second-period
consumption he requires for compensation is greater.
• The consumer would like to end up with the best
possible combination of consumption in the two
periods-that is, on the highest possible indifference
curve.
• But the budget constraint requires that the consumer
also end up on or below the budget line, because the
budget line measures the total resources available to
him.
Figure: Optimization
• The highest indifference curve that the consumer can
obtain without violating the budget constraint is the
indifference curve that is tangent to the budget line,
point O.
• This is the best combination of consumption in the two
periods available to the consumer. At this point the
slope of the indifference curve equals the slope of the
budget line.
• The slope of the indifference curve is the marginal rate
of substitution (MRS) and the slope of the budget line is
1 plus the real interest rate (1 + r). Therefore, at point O;
MRS = (1+r).
• The consumer chooses consumption in the two periods
so that the marginal rate of substitution equals 1 plus the
 4. Modigliani Life Cycle Hypothesis (Ando -
Modigliani Approach)
• During the dawn of 1950s, F. Modigliani, Ando Albert
and Richards Brumberg explained the declining APC
function based on Fisher’s consumption model.
• They classified the society into different age groups.
• The main argument is that income varies systematically
over these age groups.
• To convert these systematically varying incomes into
more or less linear consumption, consumers use saving
and borrowing; and these situations enable consumers
to move income from those times in life when income
is high to those times when income is low.
• Thus, according to this assumption, a typical
individual has an income stream that is relatively low
at the beginning (very young age) and at the end of
her/his life (during old age).
• The individual might be expected to maintain more or
less constant or perhaps slightly increasing level of
consumption (See the figure below).
• Modigliani considered time preference in
consumption by mentioning current preference is
better than delayed preference. Thus, the
consumption curve is upward sloping.
Figure: Life Cycle Consumption Hypothesis
• The Modigliani’s model classified ages of individuals into
three paths of age (young, middle, and old age) and so
called life cycle hypothesis.
• According to the model, an individual is a net borrower in
earlier years of his/her life and saves during the middle
age to repay young age loans and to provide for old age
consumption.
• In the model, consumption is linear while income is non
linear over time. This is because individuals have no
income or have very low income during their young age,
for instance, when they are in schools for training.
• However, once they complete their education or training
and get employed they will get relatively larger income.
• During old age again people usually need recreation which
means the person has to work lower hours and as a result
receive lower income; or they may eventually retire from
their job.
• This situation implies that they may get very low income. For
better clarity, consider a consumer who expects to live
another T years, has wealth (initial assets received through
gifts or bequests) of W, and expects to earn income Y until he
retires R years from now.
• The consumer can divide up his lifetime resources among his
T remaining years of life. We assume that he wishes to
achieve the smoothest possible path of consumption over his
lifetime.
• Therefore, he divides this total of W+RY equally among the T
years and each year consumes C=(W+RY)/T. We can write
this person’s consumption function as, C= (1/T)W + (R/T)Y.
• If every individual in the economy plans consumption
like this, then the aggregate consumption function is
much the same as the individual one. In particular,
aggregate consumption depends on both wealth and
income.
• That is, the economy’s consumption function is C = aW
+ bY, where, a=1/T, and b=(R/T). Because wealth does
not vary proportionately with income from person to
person or from year to year, we should find that high
income corresponds to a low average propensity to
consume when looking at data across individuals or over
short periods of time.
• But, over long periods of time, wealth and income grow
together, resulting in a constant ratio W/Y and thus a
• This hypothesis tries to give justification for the two
conflicting results about the trend of APC
(consumption puzzle).
• Thus, the life cycle hypothesis supports the
Keynes’s idea that average propensity to consume
(APC) is a declining function of income and the
marginal propensity to consume (MPC) is less than
the average propensity to consume (APC) in the
short run, while it supports the Kuznet’s idea that
the average propensity to consume (APC) is
constant in the long run.
 5. Permanent Income Hypothesis (Friedman
Approach)
• In a book published in 1957, Milton Friedman
proposed the permanent income hypothesis to explain
consumer behavior.
• Friedman’s permanent income hypothesis
complements Modigliani’s life-cycle hypothesis: both
use Irving Fisher’s theory of the consumer to argue
that consumption should not depend on current
income alone.
• But unlike the life-cycle hypothesis, which
emphasizes that income follows a regular pattern over
a person’s lifetime, the permanent-income hypothesis
emphasizes that people experience random and
• Friedman suggested that we view current income Y as
the sum of two components, permanent income (YP )
and transitory or temporary income (YT ).
That is, Y = YP + YT
• Permanent income is the amount of income that a
person receives in constant collection base and with
knowledge of the amount of income to be collected in
the nearer future.
• Transitory income on the other hand is unanticipated
income; it may be positive or negative. Put
differently, permanent income is average income, and
transitory income is the random deviation from that
average.
• Friedman reasoned that consumption should depend
primarily on permanent income, because consumers
use saving and borrowing to smooth consumption in
response to transitory changes in income.
• For example, if a person received a permanent raise
of Birr 10,000 per year, his consumption would rise
by about as much. Yet if a person won Birr 10,000 in
a lottery, he would not consume it all in one year.
Instead, he would spread the extra consumption over
the rest of his life.
• Assuming an interest rate of zero and a remaining life
span of 50 years, consumption would rise by only
Birr 200 per year in response to the Birr 10,000 prize.
Figure: Permanent income and transitory income
• Friedman concluded that we should view the
consumption function as approximately C=aYP ,
where ‘a’ is a constant that measures the fraction of
permanent income consumed.
• The permanent-income hypothesis, as expressed by
this equation, states that consumption is proportional
to permanent income. Let’s see what Friedman’s
hypothesis implies for the average propensity to
consume.
• Divide both sides of his consumption function by Y
to obtain:
• According to the permanent-income hypothesis, the
average propensity to consume depends on the ratio
of permanent income to current income.
• When current income temporarily rises above
permanent income, the average propensity to
consume temporarily falls; when current income
temporarily falls below permanent income, the
average propensity to consume temporarily rises.