All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

The largest component of aggregate demand - and the most stable is consumption spending. When you buy that CD you have been wanting, pizza that you had for dinner, the dentists visit that you have next week, and the car that will be buying after graduation are all examples of consumption spending. This is what we will be talking about in this unit. More specifically, we will talk about the following

• decompostion of spending
• theories of consuption spending
• determinants of spending

Decompostion of Consumption Spending

There are three primary components of consumption spending.

, the Theoretical analysis of consumption began with Keynes who took the eminently plausible position that the single most important determinant of consumption was income. An increase in income could be expected to increase consumption by some fraction of the increase in income. This certainly seemed to be born out by the data as evident in the scatter diagram of personal consumption expenditures and GNP. The consumption function, usually of the form C = a + b*Y, became a standard feature of macroeconomic models. The implications of this observation for macro policy can not be overestimated as it produced a complete reversal of the perception of government spending's impact on the economy. Where we once viewed an increase in government spending as crowding-out private spending, we now saw increasaes in government spending acting as a catalyst to econonomic expansion.

But there were some problems. First, there was the fear of stagnation that seemed to be the logical conclusion to be drawn from the model. To understand the nature of the perceived problem, let us simply divide the consumption equation above by Y to obtain the equation specifying consumption's share of total income.

C/Y = a/Y + b

As the economy expands, Y increases, consumption's share of total income will fall becaus the term a/Y falls. If this happens, then one of the other components of aggregate demand would need to increase faster than the economy to keep the economy from stagnating.

There was also the problem of explaining what appeared at first to be inconsistent results. Some studies of consumption found evidence that the value of the parameter a was not 0 while others found it to be 0, which would allow us to ignore the concerns of the stagnationists. Explanations tended to center around the importance of time. The Permanent Income Hypothesis focused attention on lifetime earnings rather than current income as the primary determinant of consumption. At its center was the view that a medical student would consume more than a carpenter because of the higher expected lifetime income of the student. Similarly, if there was a slowdown in the economy, a recession, individuals would be unlikely to adjust downward their estimates of lifetime income and therefore they would tend to adjust to the income loss with lower saving rather than lower consumption spending.

A different slant on the problem was provided by the the Life-Cycle Model of consumption which was built on the assumption that lifetime consumption was linked to lifetime income through an 'intertemporal budget constraint. The implications of both models was that in the short run we may find income changes producing less than proportional changes in consumption spending (non zero value for a), but in the long run the changes would be proportional (a equal zero).

It is clear from these data that consumption is by far the largest component of aggregate demand. In the period 1950 to 1989 there is evidence of a slight increase in the share of output going to consumption, but generally it tends to vary minimally in a small range above 60 percent. As for the separate elements of consumption nondurables' share of consumption spending has decreased from approximately 1/2 to 1/3, while the share accounted for by durables has increased from 1/9 to 1/6 and services' share has increased from 2/5 to 1/2. Furthermore, throughout the entire period we find that expenditures on durables tend to be quite volatile while expenditures on services tend to be quite stable. We also find that there is a stable relationship between consumption and income, a relationship which forms the heart of the Keynesian macro model.

The preoccupation with aggregate demand has meant that saving has been largely ignored, at least by the liberal Keynesians. It has only been in the Classical revival of the 1980s that attention was once again focused on this key element. To understand saving's importance, it is useful to draw some parallels between your individual situation and that of the nation. At the individual level the concept of saving is straight forward, if you save something today you will have more tomorrow. If you forgo some consumption now, you will have more to consume later, at least if you invest your saving wisely. But what about a national economy? If as a nation we are not consuming all that we produce, then this will allow us to direct that saving into 'investments' that will generate a return in terms of higher future output potential, a process that we will examine in detail in the section on economic growth.

Key in the process of economic growth is saving-investment, but states today not too useful

Ruggles, ""Accounting for Saving and capital formation in the United States, 1947-1991", JEP Spring 1993

pension contributions counted as income, pension payout also excluded

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