This chapter explores the relationship between consumption, saving, and income, applying core economic principles to understand consumer behavior at both micro and macro levels.
Key Concepts
- Consumption is the largest component of GDP (more than three-fifths)
- The marginal propensity to consume (MPC) determines how much consumption changes with income
- Consumption smoothing leads people to maintain steady spending over time
- The permanent income hypothesis says consumption is based on long-term average income, not current income
- Both consumption smoothers and hand-to-mouth consumers exist in the economy
Consumption, Saving, and Income
The Consumption Function
Consumption
Household spending on final goods and services: food, rent, clothes, dental bills, cars, internet services, electricity, etc.
The consumption function is a curve plotting the level of consumption associated with each level of income.
- It is upward-sloping because more income leads to more consumption
- The slope equals the marginal propensity to consume
Marginal Propensity to Consume (MPC)
Marginal Propensity to Consume
The fraction of each extra dollar of income that households spend on consumption.
The MPC falls between 0 and 1.
MPC Calculation
If you receive an additional
$1,000in income and spend$600:If the average MPC is
0.4and total income increases by 800 million: $$\Delta \text{Consumption} = \800\text{m} \times 0.4 = $320\text{ million}$$
Saving and Dissaving
Saving
The portion of income that you don’t spend in a given period.
Dissaving
The excess amount you consume above your income, paid for by withdrawing from savings or borrowing.
What counts as saving:
- Putting unspent income in the bank
- Using unspent income to pay down existing debt
- Paying off student loans
What counts as dissaving:
- Taking out student loans
- Borrowing to cover a gap between spending and income
Exam Alert
Your stock of savings is your wealth (all the money saved over time). Net wealth = Assets - Debts. New saving, consumption, and income are flows; accumulated savings is a stock.
The Micro Foundations of Consumption
Applying the Four Core Principles
- Interdependence principle - Future choices depend on today’s decisions
- Marginal principle - Should I spend one more dollar?
- Cost-benefit principle - Does the benefit of spending exceed the cost?
- Opportunity cost principle - Instead of consuming, you could save, earn interest, and spend more later
The Rational Rule for Consumers
Exam Alert
Rational Rule for Consumers: Consume more today if the marginal benefit of a dollar of consumption today is greater than (or equal to) the marginal benefit of spending a dollar-plus-interest in the future.
Key insights:
- Tells you when to consume
- Reminds you to be forward thinking
- Result: Spend each dollar when it yields the largest possible benefit
- Keep spending until marginal benefit is the same over time
Consumption Smoothing
Consumption Smoothing
Maintaining a steady or smooth path for your consumption spending over time.
Why smooth consumption?
- Due to diminishing marginal benefit, the first dollars of spending yield high benefit, which then declines
- Reallocating from times of plenty (high consumption, low marginal benefit) to times of poverty (low consumption, high marginal benefit) increases total benefits
Everyday examples:
- Running a marathon: pace yourself over 42.195 km
- Managing homework: distribute time over the week
- Eating cookies: don’t eat the whole box today
The Permanent Income Hypothesis
Permanent Income
Your best estimate of your long-term average income, measuring resources available for consumption over your lifetime.
Permanent Income Hypothesis
The idea that consumption is driven by permanent income rather than current income.
How to smooth consumption:
- Borrow (or dip into savings) when current income is below permanent income
- Save when current income exceeds permanent income
Graduate Students and Home Loans
A couple in grad school has low current income but high permanent income (law school + dental school graduates). A bank approves them for a sizable home loan based on their expected permanent income.
Income and Saving Over the Life Cycle
Borrowing, saving, and dissaving make up the difference between current consumption and current income:
| Life Stage | Behavior |
|---|---|
| Young | Accumulate debt (dissaving) |
| Middle | Pay debt, build retirement savings |
| Retiree | Live off savings (dissaving) |
The Macroeconomics of Consumption
Five Insights on Consumption and Income
Exam Alert
These five insights describe how consumption smoothers respond to income changes.
Insight 1: Temporary Change in Income → Small Change in Consumption
- Not smart to spend it all at once
- Spread the temporary spike over many years
- Example: 1,000/year over 10 years
Insight 2: Permanent Change in Income → Large Change in Consumption
- You enjoy increased consumption every year for life
- Example: New job pays $20,000 more annually → consumption rises significantly
Insight 3: Anticipated Change in Income → No Change in Consumption
- Permanent income already reflects expectations about future income
- You’ve already factored it in!
- Example: A novelist earning 40k in off years maintains $60k consumption
Insight 4: Learning About Future Income Change → Change in Consumption
- Getting the news triggers the change
- Don’t have to wait until money arrives
- Macro implication: Policy changes affect consumption from announcement, not implementation
Insight 5: Hard to Forecast Changes in Consumption
- Changes driven by reactions to unexpected news
- Since individual consumption changes are hard to forecast, total consumption is too
Hand-to-Mouth Consumers
Hand-to-Mouth Consumers
Consumers who spend their income as they receive it, with MPC = 1.
Characteristics:
- Do not smooth consumption
- Consumption reflects current income, not permanent income
- Find it hard to borrow and difficult to save
- Spend all income on necessities
- Live paycheck-to-paycheck
Credit Constraints and Behavioral Limitations
Credit Constraints
Limits on how much you can borrow.
Banks are reluctant to lend without collateral (an asset they can take if you default).
Behavioral limitations:
- Temptation and impulse purchases
- Procrastination
- Unexpected needs
- Impatience regarding today vs. tomorrow trade-offs
Modified Insights: Combining Both Consumer Types
| Effect of… | Consumption Smoothers | Hand-to-Mouth | Total Consumption |
|---|---|---|---|
| Temporary rise in income | Small ↑ C | Large ↑ C | Intermediate ↑ C |
| Permanent rise in income | Large ↑ C | Large ↑ C | Large ↑ C |
| Anticipated rise in income | No change | Large ↑ C | Intermediate ↑ C |
| News of future rise in income | Large ↑ C | No change | Intermediate ↑ C |
| Forecastability | Hard to forecast | Look at income changes | Difficult, not impossible |
What Shifts Consumption?
Movement Along vs. Shift of the Consumption Function
- A change in income → movement along the curve
- Changes in other factors → shift of the curve
Four Consumption Shifters
Shifter 1: Real Interest Rates
- High real interest rate → increase in saving
- Substitution effect: High rates → reduce current consumption (save for dollar-plus-interest later)
- Income effect: High rates boost income for lenders, decrease for borrowers
- Net effect: High real interest rates decrease consumption
Shifter 2: Expectations
- Optimistic expectations about future economy → higher consumption
- Pessimistic expectations → lower consumption
- COVID pandemic: Pessimistic expectations led to “excess savings”
Shifter 3: Taxes
Disposable Income
Your after-tax income.
- Tax cut → higher disposable income → higher consumption
- Higher taxes → lower disposable income → lower consumption
- Tax cuts as stimulus: Effective for hand-to-mouth consumers, not effective for consumption smoothers
Shifter 4: Wealth
- Greater wealth → higher consumption
- Lower wealth → lower consumption
- Factors influencing wealth: stock markets, housing prices
Shifting Consumption - Quick Check
- Housing prices sky-rocket → Consumption function shifts up (wealth effect)
- Bank of Canada raises interest rates → Consumption function shifts down
- You get a raise at work → Movement up along the consumption function
Saving
Four Motivations to Save
1. Changing Income Over the Life Cycle
- Save when income is predictably higher
- Most people borrow young, save in midlife, spend down in retirement
2. Changing Needs Over the Life Cycle
- Save when you have fewer needs
- Spend when there is greater need
- Evolution: college → wedding → household → children
- Rational rule implication: Shift spending to times with largest marginal benefit
3. Bequests
- Build wealth to pass on when you die
- Inheritance for children
- Money for causes you care about
4. Precautionary Saving
Precautionary Saving
Saving to be prepared for a financial emergency.
“Hope for the best but prepare for the worst.”
- Losing your job, health crisis, car repair
Remember
Try to have three to six months of living expenses saved in your emergency fund.
Smart Saving Strategies
- Set a budget and stick to it - Easier to make good decisions in advance
- Make sure you can handle an unexpected cost - Maintain an emergency fund
- Sign up for your employer’s retirement plan - Employers often match contributions
- Plan to save more tomorrow - Commit to saving out of future income
- Keep as much of your money as you can - Look for lowest fees, avoid late fees
Definitions
Consumption Household spending on final goods and services.
Consumption Function A curve plotting the level of consumption associated with each level of income.
Marginal Propensity to Consume (MPC) The fraction of each extra dollar of income that households spend on consumption; equals the slope of the consumption function.
Saving The portion of income that you don’t spend in a given period.
Dissaving The excess amount you consume above your income, paid for by withdrawing from savings or borrowing.
Net Wealth The amount by which your assets exceed your debts.
Consumption Smoothing Maintaining a steady or smooth path for your consumption spending over time.
Permanent Income Your best estimate of your long-term average income.
Permanent Income Hypothesis The idea that consumption is driven by permanent income rather than current income.
Hand-to-Mouth Consumers Consumers who spend their income as they receive it, with MPC = 1.
Credit Constraints Limits on how much you can borrow.
Collateral An asset a lender can take over if you fall behind on loan repayments.
Disposable Income Your after-tax income.
Precautionary Saving Saving to be prepared for a financial emergency.
Rational Rule for Consumers Consume more today if the marginal benefit of a dollar of consumption today is greater than (or equal to) the marginal benefit of spending a dollar-plus-interest in the future.