International Finance Theory and Policy
by Steven M. Suranovic

Finance 50-2

# Consumption Demand

Consumption demand represents the demand for goods and services by individuals and households in the economy. This is the major category in the national income accounts for most countries, typically comprising from 50% to 70% of the GNP.

In this model, the main determinant of consumption demand is disposable income. Disposable income is all the income households have at their disposal to spend. It is defined as national income (GNP), minus taxes taken away by the government, plus transfer payments that the government pays out to people. More formally this is written as,

Yd = Y - T + TR

where Yd refers to disposable income, Y is real GNP, T is taxes and TR represents transfer payments.

In this relationship, disposable income is defined in the same way as in the circular flow diagram presented in section 5-9. Recall that taxes withdrawn from GNP are assumed to be all taxes collected by the government from all sources. Thus, income taxes, social security taxes, profit taxes, sales taxes and property taxes are all assumed to be included in taxes (T). Also, transfer payments refer to all payments made by the government that does not result in the provision of a good or service. All social security payments, welfare payments, unemployment compensation, among others things, are included in transfers (TR).

In the G&S model, demand for consumption G&S is assumed to be positively related to disposable income. This means that when disposable income rises, demand for consumption G&S will also rise, and vice versa. This makes sense since households who have more money to spend will quite likely wish to buy more G&S.
We can write consumption demand in functional form as follows,

This expression says that consumption demand is a function CD that depends positively (+) on disposable income (Yd). The second term simply substitutes the variables that define disposable income in place of Yd. It i a more complete way of writing the function. Note well that "CD" here denotes a function, not a variable. The expression is the same as if we had written f(x), but instead we substitute a CD for the f and Yd for the x.

It is always important to keep track of which variables are exogenous and which endogenous. In this model, real GNP (Y) is the key endogenous variable since it will be determined in the equilibrium. Taxes (T) and transfer payments (TR) are exogenous variables, determined outside the model. Since consumption demand CD is dependent on the value of Y, which is endogenous, CD is also endogenous. By the same logic Yd is endogenous as well.

A Linear Consumption Function

It is common in most introductory textbooks to present the consumption function in linear form. For our purposes here, this is not absolutely necessary, but doing so will allow us to present a few important points.

In linear form the consumption function is written as,

Here C0 represents autonomous consumption and mpc refers to the marginal propensity to consume.

Autonomous consumption (C0) is the amount of consumption that would be demanded even if income were zero. (autonomous simply means "independent" of income) Graphically, it corresponds to the y-intercept of the linear function. Autonomous consumption will be positive since households will spend some money (drawing on saving if necessary) to purchase consumption goods (like food) even if income were zero.

The marginal propensity to consume (mpc) represents the additional (or marginal) demand for G&S given an additional dollar of disposable income. Graphically, it corresponds to the slope of the consumption function. This variable must be in the range of 0 to 1 and is most likely to be between 0.5 and 0.8 for most economies. If mpc were equal to one, then households would spend every additional dollar of income. However, because most households put some of their income into savings (i.e., into the bank, or pensions), not every extra dollar of income will lead to a dollar increase in consumption demand. That fraction of the dollar not used for consumption but put into saving is called the marginal propensity to save (or mps). Since each additional dollar must be spent or saved the following relationship must hold,

mpc + mps = 1

that is, the sum of the marginal propensity to consume and the marginal propensity to save must equal 1.

International Finance Theory and Policy - Chapter 50-2: Last Updated on 1/20/05