VARIOUS FACTORS THAT SHIFT THE CONSUMPTION FUNCTION

ILMA LATANSA
008201400043
ECONOMICS
February 25th 2015
PRIYA JAMES

FOREWORD

First of all, I want to thank God that I could finish this assignment to complete the final
project for Economics subject.
I hope that this final project report useful to the people who need knowledge about factors
that shift consumption function.

Cikarang, February 25th 2015

Ilma
Latansa

I.

Introduction
The Consumption Function is a graph that visually represents how
consumers will spend each additional money they make. This is important to
study because we need to make a differentiation on how spending changes with
income. In economics, the relationship between consumer spending and the
various factors determining it. At the household or family level, these factors
may include income, wealth, expectations about the level and riskiness of
future income or wealth, interest rates, age, education, and family size. The
consumption function is also influenced by the consumers preferences
(example: patience), by the consumers attitude toward risk. The characteristics
of consumption functions are important for many questions in
both macroeconomics and microeconomics.

In macroeconomic models the consumption function tracks total aggregate

consumption expenditures; for simplicity it is assumed to depend on a basic
subset of the factors economists believe are important at the household level.
Analysis of consumption expenditure is important for understanding short-term
(business cycle) fluctuations and for examining long-run issues such as the
level of interest rates and the size of the capital stock (the amount of buildings,
machinery, and other reproducible assets useful in producing goods and
services). In principle, the consumption function provides answers to both
short-run and long-run questions. In the long run, since income that is not
consumed is saved, the responsiveness of households to any tax policy (such as
those meant to spur aggregate saving and increase the capital stock) will
depend on the structure of the consumption function and particularly what it
says about how saving responds to interest rates. In the short run, the
effectiveness of tax cuts or other income-boosting policies (such as those
meant to stimulate a recessionary economy) will depend on what the
consumption function says about how much the typical recipient spends or
saves out of the extra income.

At the microeconomic level the structure of the consumption function is of

interest in itself, but it also has a powerful influence on many other kinds of
economic behavior. For example, individuals with only a small stock of
savings who are laid off from their jobs may be forced to take new jobs
quickly, even if those jobs are a poor match for their skills. On the other hand,
laid-off consumers with substantial savings may be able to wait until they can
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find a better job match. Whether a consumer is likely to have much savings
when laid off will depend on the degree of patience reflected in the
consumption function.

II.

The Consumption Function

The Consumption Function shows the relationship between consumption and

disposable income. Disposable income is that portion of your income that you
have control over after you have paid your taxes. To simplify, I will assume
that Consumption is a linear function of Disposable Income, just as it was
graphically shown above.
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C = a + b Yd
a is the intercept of the line and b is the slope. Lets explore their meanings in
economics. The intercept is the value of C when Yd is equal to zero. Whenever
some of students may have no income, and yet you are still consuming because of
borrowing or transfers of wealth from your parents or others to you. In any case,
a is the amount of consumption when disposable income is zero and it is called
consumption that is independent of disposable income.
In the consumption function, b is called the slope. It represents the expected
increase in Consumption that results from a one unit increase in Disposable
Income. If Income is measured in dollars, you might ask the question, How much
would your Consumption increase if your Income were increased by one dollar?
The slope, b, would provide the answer to that question. It is the change in
consumption resulting from a change in income. (Remember the idea of a slope
being the rise over the run? Go back to the graph of the consumption function and
satisfy yourself that the rise is the change in Consumption and the run is the
change in Income, and you will see that this definition of b is consistent with the
definition of a slope.) In economics, b is a particularly important variable
because it illustrates the concept of the Marginal Propensity to Consume (MPC).
Keynes's consumption function is a simple relationship between national
consumptionand accordingly national savingon the one hand, and national
income on the other. He called this relationship the propensity to consume and
derived certain conclusions as to its form from what he asserted to be a
psychological lawthat the community will divide an increase in income in
some regular proportion between an increase in consumption and an increase in
saving. That is, both the marginal propensity to consume (mpc) and the
marginal propensity to save (mps) are between zero and one. (By definition the
two marginal propensities sum to one.) This is all his theory required, but Keynes
went further and speculated that the average propensity to consume (apc), the
share of national income consumed, would be found to decline with increases in
total income. This decline could reflect either or both of the following: (a)
the mpc falls with income; (b) a certain component of consumption expenditure is
independent of income. This means that the apc will be lower for higher incomes
even if the mpc is constant.
A mathematical model
C = a + (MPC) (Y)
where C = consumption
a = constant
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Y = Income
MPC = Marginal Propensity to Consume, a number between zero and one
assumed to be constant.
The constant a is literally the amount of consumption that would take place if
income were zero. But we really dont know what consumption would be if
income were zero. In practice, a represents other factors affecting consumption
besides income. An exogenous consumption shock will change a. For
example an intense marketing campaign by automakers may cause consumption of
cars to increase even though incomes have not changed.
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Movements along the consumption function with changes in disposable income

Holding all else constant, if Disposable Y changes, then you only move along
the graph
2 Relation between slope of the consumption function and MPC
The algebraic consumption function describes a standard linear equation in slopeintercept form. The constant a is the intercept and the MPC is the slope.
C

slope = MPC

b) Shifts of the Consumption Function

Extra Material: Some General Principles in Working with Graphs. There
are three types graphical movements you need to know:

- A movement along the graph: holding all else constant, if Disposable Y changes,
then you only move along the graph.

Example:

This is a movement
along the graph when
income increases from
Y0 to Y1. Consumption
changes from C0 to C1.
Neither a nor MPC is

C1

C0

Y0

Y1

- A change in the slope of the graph: this is caused ONLY by a change in the MPC.

Example:

A greater MPC will make

the slope of the graph
increase. At a given
value of Y, a greater MPC
will cause C to shift from
C0 to C1. Note that a does
not change.

C1
C0

A change in the vertical-axis intercept: caused by a change in a. a will

change due to a change in an exogenous variable (a consumption shock).
Examples of typical shocks appear later in the notes.
A consumption shock
will change a. In this
case, we have a positive
consumption shock that
shifts a from a0 to a1.
Therefore, at any value
of Y, consumption

Example:

C1
C0

Y
III.

Various Factors
Change in price causes a movement along the demand curve, but a change
in any other factor that influences quantity demanded causes a shift of the
entire demand curve. Because factors other than disposable income influence
consumer spending, a similar distinction is vital to understanding real-world
consumption functions.
FACTORS THAT SHIFT THE CONSUMPTION FUNCTION:
Wealth
Similar to the demand curve, all the assets you have that arent
related to your income allow you to spend more money. For instance,
someone who has a significant amount of money tied into stocks will
spend more even with a smaller income. A change in the price level
changes real wealth. We learned in an earlier chapter that the relationship
among the price level, real wealth, and consumption is called the wealth
effect. In economics wealth and income are two separate variables. An
increase in wealth will increase your consumption even at the same
income level. Obviously, a decrease in wealth will have the opposite
effect.
The Price
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Higher prices make people feel poorer, and they reduce spending. The
consumption-income relation is intended to link real per capita, measured
in constant prices. An increase in national income, for example, represents
an increase in production and purchasing power rather than an increase in
the prices at which production is valued. The community cannot be
expected to react to a doubling of money income in the same way when it
reflects a doubling of prices and wages (with real output constant) as when
it reflects a doubling of output (with prices constant). Consequently both
the level of prices and their rate of change may affect the relation between
real consumption and real income; some of these possible effects will be
mentioned below. For more example, if the price level rises by 10 percent,
a $1,000 government bond will buy about 10 percent less than it could
when prices were lower. This is no trivial matter. Consumers in many
countries hold money-fixed assets worth well over $8 trillion, so that each
1 percent rise in the price level reduces the purchasing power of consumer
wealth by more than $80 billion. This process, of course, operates equally
well in reverse, because a decline in the price level increases the purchasing
power of money-fixed assets. In conclusion, price changes play important
roles in recent theories of the consumption function.

The Real Interest Rate

The interest rate is effectively the reward for saving. Therefore, when
the Fed lowers interest rates, they are lowering the reward for saving. This
encourages consumption. Furthermore, lower interest rates will reduce the
amount of money households need to service their existing debt, which
will make more money available for them to consume.
Future Income Expectations
The relationship between consumption and consumer expectations
concerning future economic conditions tends to be a form of self-fulfilling
prophecy. If consumers expect economic conditions to worsen, they will
cut their consumptionand economic conditions will worse. Political
leaders often try to persuade people that economic prospects are good. In
part, such efforts are an attempt to increase economic activity by boosting
consumption.

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You can likely think of other factors that are unrelated to income that could shift
the Consumption. In general, anything that influences consumption that is NOT
disposable income will shift the Functions upward or downward. Any change in
disposable income will move you along the Functions.
IV.

Factors that Shifts Consumption Function in Indonesia

On a global scale, Indonesia is the fourth-most populated country, and is
home to the largest Muslim population in the world. Indonesia is also the
world's largest archipelago nation. A kaleidoscope of cultures and lifestyles,
Indonesians are among the most optimistic citizens in the world with regard
to their country's future, and with good reason. In recent years, food
consumption patterns in Indonesia have begun to change, as populations shift
away from starchy staples such as rice, and toward greater consumption of
fruits, vegetables, and prepared food products. Indonesians are also showing a
new interest in fortified and functional food products. Socio-demographic
shifts, such as increased urbanization, coupled with economic development,
are largely responsible for these important changes to the Indonesian diet.
The retail landscape is also changing: significant investment is being made by
large international retail players as consumers, increasingly wary of hygiene
levels at local markets, turn to modern retailers, particularly mini-markets, for
their grocery needs.
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There are four economic factors that determine the level of consumption,
namely:
a. Household Income
Household income is very large influence on the level of consumption.
Usually the higher the income level, the level of consumption will also
increase. Why is that? Due to rising income levels, the ability of households to
purchase a variety of consumer needs are also getting bigger. Moreover, highincome lifestyle will increasingly consumerist society. For example, if Mr.
Daniel very low income families only then able to buy rice for consumption
with low quality. Side dishes used was probably just a cheap anchovies. Means
of entertainment in the home is also just a black and white television alone. But
if Mr. Daniels income increases, the selected rice is the number one quality
rice, salted fish dishes replaced with chicken meat. Likewise, black and white
television entertainment facilities removed replaced with color television, flat
screen.
b. Household wealth
Which are included in household wealth is real wealth and financial wealth.
Real property, such as houses, and cars. While financial wealth is the letter of
securities, stocks, and time deposits. Riches can increase consumption, because
it adds revenue. Deposit interest and dividends received each month of each
year will increase household income.

High Wealth
Low Wealth

a0
a1
Y

A drop in stock market

prices causes a
decrease in wealth.
When consumer wealth
goes down,
consumption decreases
at every value of Y.
This is an exogenous
consumption shock,

c. Interest Rate
High interest rates can reduce the consumption desires. With high
interest rates,
consumption activities become increasingly expensive.
Especially for those who want to eat with the credit system, for example by
borrowing bank or credit card. The cost of high interest for loans caused the
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cost of consumption as well if the home, land, and owned the car is leased.
Non-wage income into income (income nonwages). The additional income
will be used as consumption. Obviously this will increase consumption
expenditure increasingly expensive. They had better postpone or reduce
consumption. Moreover, high interest rates cause more community feel
lucky if saving money in the bank than is spent on consumption. Since
most of the money deposited in the bank and the money available for
consumption is reduced.

d. Estimated Future
If the household expects his future the better they will feel free to
consume. Because it tends to increase consumption expenditure. But on the
contrary, if the estimated future conditions worse, they square off to
suppress consumption expenditure. Internal factors to estimate future
prospects of households, among others, whether father or mother still
works Is a career and salary increases? Or is there any other family
members who would work? While external factors that affect future
estimates include economic conditions in the country and the government's
economic policies are implemented.

e. Tax Changes
Tax changes are another factor that shift the consumption function. From
what I find and summarize, it is sensible to assume that consumption depends on
disposable income, which is income households have after their taxes are deducted
(or paid directly to the government for self-employed people). Sometimes
disposable income is called take-home pay. When taxes are cut, people have
more money in their pockets for a given level of pre-tax income. Consumption
rises. Assuming that the horizontal axis of the consumption function measures pretax income, the consumption function would shift upward.

3. Consumption and Saving

When consumption rises, by definition, saving declines. Therefore, the factors that
affect consumption also affect saving. Why should we care about saving?
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 Saving and individual wealth accumulation

Most obviously, saving determines the rate at which individuals build up
personal wealth. Thus, society often conveys a message that saving is good and
virtuous. People will benefit in the future by sacrificing consumption today.
One primary reason for saving is to provide resources for a household to maintain
its consumption spending after retirement

Saving as source of funds for investment

Saving affects individual wealth.

In particular, it determines how the

ownership of an economys assets is distributed across individuals. But the larger

question for performance of the aggregate macroeconomic system is how saving
affects output and growth. Some people save and others borrow.

These

transactions cancel out. But the household sector as a whole usually chooses to
save more than it spends. You can think of the whole household sector as if it
makes a deposit into the banking system. The more the households save, the
more the banking system can lend to other parts of the economy.

4. Consumption Statistics
a) Consumer spending constitutes largest portion of sales
Consumption is the largest part of aggregate demand, by far. In consists of
everything bought by households except new houses (these are counted as
residential investment). Consumption can be divided up into "durable" and "nondurable" categories.

Durables include longer-lasting goods like cars and

appliances. Non-durables include food and clothing and many services. But
usually we refer to consumption as a whole.
b) Trends in shares of consumption in total output
The share of consumption in demand has risen from about 62 percent in the
1960s to about 71 percent in recent years (see the graph below).

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REFERENCES:
1. http://www.britannica.com/EBchecked/topic/134598/consumption-function
2. http://www.encyclopedia.com/topic/Consumption_%28Economics%29.aspx
3. https://courses.byui.edu/econ_151/presentations/Lesson_06.htm

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