Consumption is said to drive the economy, especially the developed world where it accounts for more than 60% of aggregate demand and output. Here we are curious as to what consumption patterns are dependent upon.

Why is Consumption?

Economists have come up with an assortment of explanations and theories, the more prominent being the following:

Keynesian Consumption Function

Consumption is said to be determined by income through a causal relationship, rising in direct correlation from a basic survival level often defined as ‘autonomous’ consumption ‘A’. Therefore Keynes assumed the marginal propensity to consume as constant throughout all income levels


Average —> Marginal Propensity to consume

Keynes went on to explain that consumption as a % of income, the average propensity to consume, begins on a higher level (due to ‘A’) and steadily converges to the mpc at increasing income levels.

Empiricism shows the Keynesian Consumption function to be somewhat accurate, a relatively stable consumption ratio which accommodates a stable mpc:

Real Consumption versus Real GDP

Despite stability in the propensities, realistically, we expect some oscillation albeit about a certain average

The Wealth Effect

Consumption is strongly linked to changes in household’s real wealth.

Empiricism of the Wealth Effect

In order to prove this analysis, firstly we feature the fact being households wealth is mainly tied up in house prices, bank accounts and the stock market. Henceforth, we expect household’s levels of wealth to fluctuate with housing and stock market cycles, and observe how the propensity to consume varies accordingly: Note, the country data chosen is the U.S

Observe, how over time the general trend has been a rising consumption ratio, taking off mainly in the 1970s which was round about the time real house prices started to rise. A startling similarity is the somewhat exponential climb in the consumption ratio mid-1990’s onwards coincided with an equally exponential pattern in house prices. Also recognise the knick in the consumption ratio around 2000; the time of the ‘dot-com’ stock market crash.

The Theory

They say one should ‘save for a rainy day’; put enough savings aside for a crisis whether that be losing ones job, an accident, a large bill for instance. In addition people save for financial goals, for instance to send their children to university or buy their first house: A certain level of wealth is comfortable to an individual, and when this is exceeded or not met, spending and saving patterns adjust to gear towards that level

Now say for instance wealth rises systemically i.e. throughout. The average propensity to consume shall ascend due to

  1. Households, with a larger ‘safety-cushion’ consume a greater portion of current income
  2. Households cash-in on their greater wealth by withdrawing equity to spend

Those are the most poignant forces, others are more subtle but influential. A high stock-market adds to consumption as is generally a causal factor for greater pay among executives, and better performance of pension funds and savings plans (while it lasts!)

The Life Cycle

Originated by the influential Franco Modigliani and Albert Ando, The Life Cycle hypothesis characterises a households spending and saving patterns in light of retirement. The theory generalises that people save at a constant rate until retirement, when they build up a stock of assets to consume out of the remainder of their lives.

Here, consumption stays constant across one’s lifetime.

The Permanent Income Hypotheses

A creation of Milton Friedman. Permanent income is the average level of income a person expects to earn over their life, and they will consume accordingly. Consumption is fairly stable, even where income may not be.

A graduate expecting to enter a successful career will save less than a 21 year old full time worker struggling to make ends meet, hence spend more. A senior advisor of the IMF made unemployed will spend more than a factory worker. The theory has weaknesses, however, as of course a highly academic student will spend less than a senior advisor, even if they expect that career path, as they do not have that income.

Pigou’s Wealth Effect and Deflation

The classical economist Arthur Pigou explained how wealth effects can limit a period of deflation. Where the prices of goods are falling, peoples wealth in assets are worth more in terms of goods, a rising real wealth.

The wealth effect will drive up consumption, hence causing demand pull inflationary pressures on goods, limiting the period of deflation. For this reason periods of deflation are temporary.

Faults in the Theory  is the assumption that wealth stays fairly constant during a period of deflation, and by experience we know that is not true. The causes of deflation are mostly a fall in aggregate demand, and this in history has accompanied a great fall in asset and share prices.

When deflation sets in, asset prices and wealth usually fall further, and the recessions of the last 50 years have shown that the wealth effect threatens a deeper downturn, rather than a recovery of GDP and prices.

Japan-Perhaps deflation is caused by excess productive capacity. We only have to think of Japan and see that a price contraction which was not necessarily due to a collapse in demand was not alleviated by a wealth effect. Deflation persisted for over 15 years.


The Average Propensity to Consume is the ratio of a consumer’s income that they spend. It can be greater than one, say, if the consumer borrows aswell as spends all their income.

The Marginal Propensity to Consume is the ratio of any change in income that is spent. The MPC defines the size of the mulitplier, and hence the eventual impact a change in spending has on everyones incomes.

Consumer Durables:. Benefit lasts a long time(cars, computers) and generally price elastic and income elastic. No wonder why it is that market which suffers so much in a recession

One Response to Consumption

  1. Pingback: Thinktank « Zahablog's Economic Page

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