Sessions 05-06

Economics of Consumption and Saving

(GDP=C+I+G+X-M)

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 Why is Consumption Important?
Consumption (C) is a significant component of aggregate demand
GDP = C + I + G + X – M
India’s GDP at Market Prices in ₹ Bn, 2004-05=100
C I G X M GDP
1960-61 3577.95 728.88 254.73 188.91 337.92 4360.37
(%) (82) (17) (06) (04) (08) (100)
1970-71 4776.97 1161.72 613.70 287.59 326.85 6443.89
(%) (74) (18) (10) (04) (05) (100)
1980-81 6615.62 1792.91 951.96 606.14 640.51 8663.40
(%) (76) (21) (11) (07) (07) (100)
1990-91 10008.67 3630.29 1834.88 1008.88 1150.94 14876.15
(%) (67) (24) (12) (07) (08) (100)
2000-01 15792.01 6262.08 3247.27 3232.88 3901.32 25540.04
(%) (62) (25) (13) (13) (15) (100)
2010-11 30923.73 21019.36 5835.45 11950.03 15424.28 52823.84
(%) (59) (40) (11) (23) (29) (100)
2017-18 74174.89 44791.09 13785.63 26073.10 30835.60 131798.57
(%) (56.3) (34.0) (10.5) (19.8) (23.4) (100)
2018-19 80166.74 48808.69 15060.35 29339.69 35579.01 140775.86
(%) (56.9) (34.7) (10.7) (20.8) (25.3) (100)
Data for 2017-18 & 19 are provisional and at 2011-12=100; Differences, if any, in the total figure show statistical discrepancies.
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 The Law of Consumption

The fundamental psychological Law of Consumption is

that “men are disposed, as a rule and on the average,
to increase their consumption as their income
increases, but not by as much as the increase in their
income”

J.M Keynes, The General Theory of Employment, Interest

and Money

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 0.00
5.00
% Change

-5.00
10.00
15.00
20.00
25.00
1961-62

1963-64
1965-66
1967-68
1969-70
1971-72
1973-74
1975-76
1977-78
1979-80
1981-82
1983-84

Per capita PFCE

1985-86
1987-88
1961-62 – 2012-13

Linear Trend of C
1989-90
1991-92
1993-94

1995-96
1997-98
Changes in Consumption and Disposable Income

1999-00
Linear Trend of Yd

2001-02
Per capita disposable income

2003-04
2005-06
2007-08
2009-10
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2011-12
 Keynes’s Theory of Consumption

Early Keynesian theories explained consumption as a function of

current disposable income.

• No separation for temporary and permanent income.

• This consumption function is of the form:
C = a + bYd
b is the MPC and is on the [0,1] range.
a is the autonomous consumption.

• Modern consumption theories incorporate intertemporal

dynamics.

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 C = Yd
Consumption C = a + bYd
saving
C

Yd =C
Consumption

Consumption function Yd = C + S

borrowings
a

Disposable income (Yd)

a is the outonomous consumption

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 Position and Shape of Consumption Function

C C = a + b1Yd
C = a1 + bYd

C = a + bYd C = a + bYd
a1
a

Disposable income (Yd) Disposable income (Yd)

An increase in autonomous C An increase in the MPC from

from a1 to a2 shifts up the b to b1 increases the slope of
entire C function. the C function.
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• Marginal Propensity to Consume (MPC)
• Average Propensity to Consume (APC)

MPC < 1
APC can exceed 1 at low value of Y
APC decreases as Y increases

• Autonomous consumption
• Planned/desired/induced consumption

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Yd C ∆Yd ∆C MPC APC
0 100 -
100 175 100 75 0.75 1.75
200 250 100 75 0.75 1.25
300 325 100 75 0.75 1.08
400 400 100 75 0.75 1.00
500 475 100 75 0.75 0.95
600 550 100 75 0.75 0.91
700 625 100 75 0.75 0.89
800 700 100 75 0.75 0.88
900 775 100 75 0.75 0.86
1000 850 100 75 0.75 0.85
1100 925 100 75 0.75 0.84
1200 1000 100 75 0.75 0.83
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 Determinants of consumption
• Current disposable income

• Interest rate

• Wealth

• Expectations

• Consumer credit

• Relative income (James S Deusenberry), etc.

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 Saving Function
Once we have a theory of consumption, we have a
theory of savings (savings is income less consumption)

S = Yd - C

Saving Function: The relationship between the level

of saving and personal disposable income.
S = f(Y)
S = -a + (1-b)Yd

• Average propensity to save (APS)

• Marginal propensity to save (MPS)
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 •Saving function is the mirror image of the consumption function
saving Saving function

S = -a + (1-b)Yd

saving

0 Disposable income

Saving function is obtained by subtracting vertically the consumption

function from the 450 line.
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 Savings-Investment Gap in India
In ` billion at current prices
1980-81 1990-91 2000-01 2010-11 2017-18
1. GDP at market price 1496.42 5862.12 21774.13 77841.15 170950.05

2. GDCF 286.84 1526.04 5282.99 28414.57 55268.53

(% of GDP) (32.3)

3. GDS (a+b+c) 265.90 1344.08 5155.45 26217.42 52160.22

(% of GDP) (30.5)

a) Household S 181.16 1086.03 4637.50 18001.74 29382.03

(% of GDS) (56.3)

b) Private Corporate Sector S 23.39 151.64 810.62 6203.00 19863.18

(% of GDP) (38.1)

c) Public Sector S 61.35 106.41 -292.66 2012.68 2915.01

(% of GDP) (5.6)

4. Saving-Investment Gap (3-2) -20.94 -181.96 -127.54 -2197.15 -3108.31

(-1.8)
Source: Ministry of Finance, GoI, Economic Survey, 2018-19, Vol. 2, Table 1.8, p. A22.
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 Yd, C and S in India
In ` billion at current prices
1970-71 1980-81 1990-91 2000-01 2010-11
Personal Disposable Income Yd 400.42 1277.03 4797.12 18314.92 59494.44
Consumption (C, PFCE) 384.74 1180.68 3985.29 14066.61 43383.92
Household saving (S=Yd -C) 45.31 181.16 1086.03 4637.50 17493.11
Physical Savings 31.60 95.06 589.63 2485.30 9816.20
Financial Savings 13.71 86.10 496.40 2152.19 7676.91
Currency 4.04 16.25 62.51 156.32 1371.31
Bank deposits 10.24 55.50 187.77 947.09 4404.65
Non-bank deposits 1.04 3.78 12.86 30.04 43.92
Life insurance fund 2.51 9.15 55.99 338.61 2207.34
PF and pension fund 4.74 21.22 111.55 508.63 1389.75
Shares & debentures 0.20 4.12 49.72 111.48 17.29
Units of UTI 0.12 0.31 34.38 -9.34 0.00
Source: Reserve Bank of India, Handbook of Statistics on Indian Economy 2011-12, Mumbai. 14
Modern Theories of Consumption

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 Life-cycle hypothesis – Franco Modigliani
• Individuals plan their C and S over long periods with the intention of
allocating their C in the best possible way over their entire lifetimes.

• Individuals do not like consumption to change dramatically from year to

year.

• The simplest form of this assumption is to consume the same amount in

every year.

• The theory implies different MPC out of permanent income, transitory

income, and wealth.

• It links C and S behaviour to demographic considerations.

• MPC varies depending on the age of individuals.

• Economies with different age mixtures have different overall marginal

propensity to save and consume.
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 The path of C and S using the life cycle theory

• Wealth peaks at retirement.

• Wealth is zero at death.
• Accumulate savings in working years, dissave through retirement.
• Income is positive in working years, and zero in retirement.
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• MPC Varies depending on the age of individuals

Suppose an individual:
• Starts working life at age 20
• Plans to work until age 65
• Will die at age 80
• Has annual labor income of YL = `30,000
• Lifetime resources are `30,000 x 45 = `1,350,000
• Spreading lifetime resources over the number of years of
life (80-25 = 60) allows for C = `1,350,000/60 = `22,500
The general formula is

WL
C   YL
NL 18
We can compute different marginal propensities to consume for various
measures of income: permanent and transitory income

• Suppose income increases permanently by `3,000:

 The extra `3,000 for each 45 years spread out over 60 years of life increases
consumption by
45
3 , 000   2 , 250
60
 The marginal propensity to consume out of permanent income is

WL 45
  0 . 75
NL 60

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We can compute different marginal propensities to consume for various
measures of income: permanent and transitory income

Transitory income
• Suppose income increased by `3,000 for only one year:
 The extra `3,000 over 60 years would increase consumption by

1
3 , 000   50
60

 The MPC out of transitory income is

1
 0 . 017
60

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 Life Cycle Theory: Implications
• The MPC out of permanent income is large.
• The MPC out of transitory income is small and fairly close to
zero.
• The life-cycle theory implies that the MPC out of wealth
should equal the MPC out of transitory income.

WHY?
Spending out of wealth is spread out over remaining years
of life.
The MPC out of wealth is used to link changes in the value
of assets to current consumption.

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 Permanent income hypothesis – Milton Friedman

Permanent income theory of consumption is like the life cycle hypothesis in

that current consumption is not dependent upon current income, but on a
longer-term estimate of income.

• Milton Friedman called this permanent income.

• Permanent income is the steady rate of expenditure a person could maintain

for the rest of his life given the personal level of wealth and the income
earned now and in the future.

• The consumption function is then: C=cYP, where YP is permanent

disposable income.

• The MPC out of permanent income is large and the MPC out of transitory
income is small, fairly close to zero.
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 Consumption Under Uncertainty

• If permanent income were known, according the PI-LCH,

consumption would never change.

• According to the modern consumption theory, changes in

consumption arise from surprise changes in income.
– Absent such surprises, consumption this period is the same
as last period and is the same as next period.

– Consumption can be modeled as: C t 1  C t   , where

consumption tomorrow is equal to consumption today plus
a truly random error.

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 Traditional Vs Modern
Theories of Consumption
• The Keynesian (Traditional) consumption function assumes that the
individual’s consumption behavior in a given period is related to their
income in that period.

• The traditional theory predicts that income spikes should be matched by

consumption spikes and therefore, consumption is not smooth.

• Modern theory predicts a smoother C than Y because spending out of

transitory income is spread over many years.

• According to the modern theory, If permanent income were known exactly,

C would never change!

What is the reality?

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 Liquidity Constraints and Myopia
• Liquidity Constraints: Consumers are liquidity constrained as they cannot borrow to
sustain current C in the expectation of higher future income.
– When permanent income is higher than current income, consumers are unable to
borrow to consume at the higher level predicted by PI-LCH
– Consumption more closely linked to current income

• Myopia: Consumers simply are not as forward looking as the PI-LCH suggests.
For example, govt. announcement of increased social security benefits does not lead
to change in consumption either because
a) recipients do not have the assets to enable them to adjust spending before they
receive higher payments (liquidity constraints), or because
b) public fails to pay attention to the announcement (myopia), or because they do
not believe the announcement.

Conclusion
C is more closely related to current Yd than is implied by the modern theory.

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 Further aspects of Consumption Behavior

• Consumption and stock market.

• Does savings rise when interest rate increases?

• Are Government deficits and Household savings related?

• “Deficits don’t matter” - The Ricardo-Barro Problem (The Ricardian

Equivalence).

• Govt. deficit financing through borrowing merely postpones taxation and

therefore is strictly equivalent to current taxation.

• Govt. bonds are therefore not net wealth. These bonds will have to be
paid off by the government with future increases in taxes.

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 References
• DFS, Macroeconomics, chapter 14.

• Relationship among income, consumption and savings, exercise-4.

• “Falling housing prices, the wealth effect, and decreased consumer

spending in the US”, available @google drive.

• “Declining savings in the US during 1990s”, available @google drive

• Consumption and savings behavior of the Indian households,

assignment#2.

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