Consumption is:what households, not businesses, do. This involves expenditure on goods and services, such as petrol, shopping and a new fridge. However, consumption can be split down further into durable and non-durable purchases.
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1) Cost of CreditIf credit becomes difficult, mainly through expense of interest rates, some households may postpone their credit financed purchases. There will be a reduction in consumption until circumstances change, i.e. accumulate more savings, or a fall in interest rates 2) AssetsMost households appear to have target levels of assets/wealth at each stage of their life cycle. If assets fall unexpectedly, households will increase their saving and reduce consumption. This works in reverse for situations like a sudden increase in wealth. 3) Disposable IncomeDisposable income (income is often expressed as 'Y') is income after taxes. It is the amount of total income that can be spent with reasonable freedom by the household. Thus, disposable income is total income minus taxes (and sometimes also regarded as including other fixed payments, such as mortgage repayments). It is that income which can be 'disposed of' with near freedom. 4) ExpectationsIndividuals' attitudes to the functionality of the economy effects the level of aggregate expenditure. For example, households increase purchases of consumer durables if they believe interest rates will remain low or job security improves, etc. Expectations are the source of both business and household economic indicators. Strictly speaking, an expectation is a leading economic indicator, since it predicts changes in an economy and changes occur before corresponding changes in the economy. A leading indicator is an economic statistic that suggests transactions in the future. For example, building permits suggest construction activity in the near term, and hence the hiring of construction workers and purchases of building materials. Purchases of raw materials by manufacturing industries ordinarily suggest a level of likely production. Increases in either suggest increased activity; decreases suggest decreases in near-term activity. Stock prices fit this category because high prices for corporate stocks create the impression of wealth that spurs consumption. A coinciding indicator ordinarily indicates activity at the time. It is often a defining characteristic of the economy such as payroll or sales volume. A lagging indicator is a statistic that ordinarily follows economic changes. Unemployment rates are a prime example; decisions by most employers to hire workers follow increases in activity and the parallel decision to lay off workers follows decreases in activity. 5) TaxationA change in the level of taxation on income (income tax) will reduce the amount of disposable income available. Because of this, C could fall. However, if an equal or greater sum were given out in benefits to households, particularly to unemployed, then consumption could even rise. It is important to note that an increase in taxation will not necessarily cause a contraction in consumption. Further, if taxation and benefits were used to redistribute income/wealth from richer to poorer households, consumption might rise. This is because less wealthy households are more likely to spend a greater proportion of their disposable income than extremely rich individuals. |
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C = a + b(ΔY)
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Example 1
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Example 2
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Saving(S) is not part of A.E. due to it being a leakage, (we analyse it because it helps us determine consumption and impacts on Y levels). The savings function (S = Y - C) can be derived from the consumption function (c.f.).
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S = -a + b(Y) |
