Determinants of Consumption and Saving - Online Tutor, Practice Problems & Exam Prep

The consumption function illustrates how consumption increases with disposable income, influenced by factors beyond income itself. Key determinants include unexpected changes in wealth, such as stock price fluctuations, which can shift consumption upward or downward. Borrowing increases current consumption but may reduce future consumption due to interest costs. Expectations about future income or prices also affect current consumption decisions. Additionally, low real interest rates encourage borrowing and spending, further impacting consumption patterns. Understanding these dynamics is crucial for grasping macroeconomic behavior and the aggregate demand curve.

Determinants of Consumption and Saving

So now let's think about the determinants of consumption and saving. What causes the consumption function to look the way that it does? So when we think about the consumption function, remember we had: let me go down here and I'll draw a little consumption function right here. So, we had our graph where we had our consumption increasing as disposable income increased, right? What could cause that consumption function to change, right? Remember, this is the marginal propensity to consume being the slope, right? The slope being the marginal propensity to consume, but what could cause us to move, say, from this consumption function maybe up here to a different consumption function way up there while we're still keeping the same balance of how much we're saving or consuming, what can cause it to shift up or down? So let's think about some of those determinants of our consumption and saving. The consumption function could shift up or down when factors other than the disposable income change. Right? So, this kind of follows when we were talking about shifting supply and demand, right? It was factors other than price that were changing. In this case, well that's going to affect our consumption function. So let's see what some of those might be.

The first one here is a sudden change in wealth. Wealth is the accumulation of money that you have, right? So when we have in these examples, we have an unexpected increase in stock prices. So you own all these stocks, you have some of your savings in stocks, and all of a sudden those stocks bump up 25%. You weren't expecting to have all that extra wealth, right? So you have this extra value, this extra wealth. Well, it's going to lead to an increase in consumption, right? This can cause a shift up. This can cause a shift up in the consumption function where we're consuming more. The opposite would be a crash, right? An unexpected crash like in the real estate market in 2009. Well, that caused a decrease in consumption, right? So that would be a shift down. So these unexpected changes in wealth are going to affect our consumption just like that.

What about borrowing? Borrowing is another one here that can affect the consumption function. If we're borrowing money, well, that's going to lead to an increase in current consumption, right? If we're borrowing money, that means we've got more money available now. We're going to spend a little bit more now, but at what cost? It's going to come at the cost of future consumption because we have to pay interest, right? Just like I say, down here, the interest cost of borrowing leads to a decrease in our future wealth. So later on, when we have to repay the loan, well we're going to have to decrease our consumption to match that. But borrowing tends to lead to current increases.

The next one is our expectations. We can have expectations about the future, and if those expectations can cause our consumption to change based on whether we expect an increase or a decrease. So if we expect prices to increase in the future, so say you were thinking about buying a house and you're like, should I buy a house now or should I buy a house later? Well, if you expect prices to be higher later, you would probably want to buy the house now, right? So if prices are expected to increase in the future, current consumption would increase, right? We would want to consume now rather than later. If we think prices are going to be higher later, well, we're going to buy them now at the cheaper prices. This increase is going to shift us up. Just like an increase in income, if we're expecting to have more income in the future, so now your boss tells you, right? Oh, you're going to get a 20% raise next year. So you have an expectation about higher money in the future, higher salary in the future. Well, you might increase your consumption now. You might start counting those eggs a little early, and you would increase your current consumption. On the flip side of it, well, what if you're expecting a recession, right? What if you're expecting everything to come crashing down? Well, you would probably decrease your current consumption because you want to be ready for that recession. You want to have some extra savings, right? For when things are a little tougher. So, notice that a lot of these things are very logical, right? You would expect these things to kind of follow, and that happens a lot in macroeconomics, where your gut feeling of how things are going to flow that's generally what's going to happen.

What about this last one? Real interest rates. A low real interest rate leads to: what happens when we have low interest rates? Low interest rates are going to increase current borrowing, right? Because it's a low-interest rate, it doesn't cost a lot to borrow, so you're going to increase your current borrowing and increase your consumption. So you might buy more goods purchased with credit, right? Purchased with credit-like a car, and you have less of an incentive to save because of the low-interest rate, right? Low-interest rate, there's no reason to save. So you would increase your consumption there. So these things are pretty straightforward, right? They all seem like they make sense of why they would affect consumption here. So let's go ahead and pause and let's do a practice problem down below.

The country of Consumptia has had a booming economy for nearly a decade. However, prices have been rising faster than income, leading analysts to believe that a recession is on the horizon. If the citizens of Consumptia expect a recession in the coming years, then:

• A. Current consumption will increase
• B. Current consumption will decrease
• C. Current savings will decrease
• D. Recessions are not related to the consumption/savings functions.

Here’s what students ask on this topic:

What are the main determinants of consumption and saving?

The main determinants of consumption and saving include unexpected changes in wealth, borrowing, expectations about future income or prices, and real interest rates. An unexpected increase in wealth, such as a rise in stock prices, can lead to higher consumption. Borrowing increases current consumption but may reduce future consumption due to interest costs. Expectations about future income or prices can also influence current consumption decisions; for example, expecting higher future income may lead to increased current spending. Lastly, low real interest rates encourage borrowing and spending, reducing the incentive to save.

How do unexpected changes in wealth affect the consumption function?

Unexpected changes in wealth, such as a sudden increase in stock prices, can shift the consumption function upward, leading to higher consumption. Conversely, a sudden decrease in wealth, like a real estate market crash, can shift the consumption function downward, resulting in lower consumption. These changes occur because individuals adjust their spending based on their perceived wealth, which influences their consumption patterns.

How does borrowing influence current and future consumption?

Borrowing increases current consumption because it provides additional funds that can be spent immediately. However, this comes at the cost of future consumption, as borrowed money must be repaid with interest. The interest cost reduces future disposable income, leading to decreased future consumption. Therefore, while borrowing boosts current spending, it imposes a financial burden that affects future consumption levels.

What role do expectations about future income or prices play in determining current consumption?

Expectations about future income or prices significantly influence current consumption. If individuals expect higher future income, they may increase their current consumption, anticipating that they will have more money later. Similarly, if they expect prices to rise in the future, they may choose to buy goods now to avoid higher costs later. Conversely, if they expect a recession or lower future income, they may reduce current consumption to save for tougher times ahead.

How do real interest rates impact consumption and saving?

Real interest rates affect consumption and saving by influencing borrowing and the incentive to save. Low real interest rates make borrowing cheaper, encouraging individuals to take loans and increase their current consumption. At the same time, low interest rates reduce the returns on savings, decreasing the incentive to save. Conversely, high real interest rates make borrowing more expensive and increase the returns on savings, leading to higher saving rates and lower current consumption.