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CONSUMPTION SPENDING

The largest component of total spending is consumption spending—spending by households for food, clothing, automobiles, education, and all the other goods and services that consumers buy. The most important factor influencing the amount of consumer spending is the level of disposable income. Disposable income is your take-home pay, the amount you have left after taxes have been deducted. Because there is no government sector in this chapter's hypothetical economy, no taxes are collected, which means that disposable income will equal total income, or GDP. For both individual households and society as a whole, a positive relationship exists between the amount of disposable income and the amount of consumption spending: The more people earn, the more they spend.

The Consumption Function

The relationship between disposable income and consumption spending is called the consumption function. A consumption function shows the amounts that households plan to spend at different levels of disposable income. Exhibit 1 shows a hypothetical consumption function that is consistent with Keynesian theory. Note that the amount households plan to spend increases with income but by a smaller amount than the increase in income. In other words, households will spend part of any increase in income and save the rest. Whatever disposable income is not spent by households is saved.

EXHIBIT 1. A Hypothetical Consumption Function (in billions)

TOTAL INCOME* AND OUTPUT (GDP)

PLANNED CONSUMPTION EXPENDITURES

PLANNED SAVING

$300

$325

$-25

400

400

0

500

475

25

600

550

50

700

625

75

800

700

100

*In our simplified economy total income = total disposable income = GDP.

Saving is the act of not spending; putting money in a savings account, buying stocks and bonds, and stashing cash in a cookie jar are all acts of saving.

According to Exh. 1, when income is $300 billion, households desire to spend $325 billion. At that income they are dissaving $25 billion; that is, they are dipping into their savings accounts or borrowing to help finance some minimum standard of living. Higher levels of income involve more consumption spending and more saving, or less dissaving. In our example $400 billion represents the income level at which every dollar earned is spent; there is neither saving nor dissaving. At higher incomes, households wish to save a portion of their income. For instance, at an income of $500 billion, households plan to save $25 billion; at an income of $600 billion, they desire to save $50 billion.

Exhibit 2 plots the consumption function depicted in Exh. 1. The consumption function slopes upward and to the right because consumption spending increases with income. We determine the income level where every dollar is spent by using the 45-degree line drawn in the diagram. Because the vertical and horizontal axes meet at a 90-degree angle, the 45-degree line represents a series of points that are equidistant from the horizontal axis (income) and the vertical axis (consumption). Therefore, at every point along the 45-degree line, consumption expenditures equal income. Where the consumption function crosses the 45-degree line, consumers plan to spend everything they earn and save nothing. In our example that happens at an income of $400 billion.

At incomes less than $400 billion, there is dissaving, or negative saving. You can see that when income is $300 billion, consumers plan to dissave

EXHIBIT 2. Graphing a Consumption Function

Graphing a Consumption Function

$25 billion. The vertical distance between the 45-degree line and the consumption function represents the amount of dissaving at that income. At incomes in excess of $400 billion, there is positive saving. When income is $500 billion, saving is equal to $25 billion. The distance between the 45-degree line and the consumption function gets wider as income increases because the amount of saving increases with income.

 
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