Consumption Spending and building blocks of Flexible-Price Model

Consumption Spending:

Individual households make the spending as well as saving decisions that ultimately determine the flow of consumption spending. In this section we will first study how household divide their income up among saving, taxes and consumption spending. Then we will observe how consumption spending varies in response to changes in income and in other aspects of the economic environment.

The wages of workers plus the profits--rent, dividends, interest and retained earnings--of property owners add up to national income. For the reason that at this level of analysis we are uninterested in any accounting distinctions between national income and real GDP, we utilize the letter “Y” to represent both. (Remind that the circular flow principle guarantees that whatever businesses produce and sell should show up as income for households.

Households recompense some of their income to the government in net taxes--taxes less transfer payments from the government--which we will write as T. To keep the analysis easy, throughout this section we will presume that net taxes are equal to the constant average tax rate t multiplied by national income:

T = t x Y

In the real world taxes aren’t proportional to income. Our tax system is fairly progressive, which signifies that richer taxpayers on average pay more of their income in taxes than do the relatively poor. Once more but, the complications encouraged by the fact that are tax system isn’t proportional to income aren’t central to the analysis. And therefore we follow economists’ standard practice of simplifying wherever possible.

What is left subsequent to households pay their taxes is their disposable income written as YD:

YD = Y - T = (1-t)Y

Households as well save some of their income to boost their wealth and future spending. We will indicate these private household savings by SH—S for “savings” as well as H for “household”. (Reminder that these household savings comprise the retained earnings of corporations- the NIPA treats corporate earnings not spread but retained by the corporation as if they were distributed to the shareholding households and then instantly reinvested back into the corporation.) Households use up the rest of their income--everything that isn’t saved or paid to the government in taxes--buying consumption goods:

C = YD - SH = Y - T - SH

In the United States today, consumption spending C--purchases by households for their own use, from pine nuts and flour to washing machines and automobiles--adds up to roughly two-thirds of GDP.

We will break expenditure spending down into a baseline level of consumption (defined to be the value of a parameter C0) plus a fraction (a parameter Cy) of disposable income YD, or a fraction Cy x (1-t) of total income Y.

C = C0 + Cy x YD = C0 + Cy x (1-t)Y

Therefore we assume that consumption spending C is a linear function of real GDP Y.

Perceive that in writing this particular consumption function we have once more followed economists' principle (or vice) of ruthless simplification. In this complex world expenditure spending doesn’t depend on disposable income alone. Other factors affecting it comprise changes in the real interest rate, in household total stock market as well as real estate wealth, in income distribution, in the demographic structure of the population, in expected future income growth, in consumers' relative optimism, in tolerance for risk and in whether consumers see changes in disposable income as transitory or permanent. (If consumers anticipate an income increase to be transitory, they will save the majority of it and spend only a little; if they expect an income rises to be permanent, they will spend the majority of it.) However here and during the book we will sweep these complications under the rug. We will think merely about baseline consumption C0, the marginal tendency to consume Cy and disposable income YD as the determinants of consumption spending (although we will infrequently sneak in other factors by saying that they change baseline consumption C0).

The parameter C0, - The baseline level of consumption, is the amount households would use up on consumption goods if they had no income at all. i.e., it is the amount by which they would draw down their means in the absence of income, in order to keep body as well as soul together.

The marginal propensity to consume as well called the MPC the same parameter Cy in the consumption function, is the amount by which expenditure spending rises in response to a $1 increase in disposable income. We are definite that Cy is greater than zero: if incomes increase, households will utilize some of their extra income to boost their consumption spending. We are as well sure that Cy is less than one: as incomes increase, households will raise their savings as well; they will not expend all their extra income on consumption goods.

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