Consumption and the Aggregate Expenditures Model

Read this chapter to examine consumption and its determinants within the aggregate expenditures model. Consumption is the largest component of Aggregate Demand the United States, therefore, the factors that determine consumption, also determine the success of the economy.

13.1 Determining the Level of Consumption

Other Determinants of Consumption

The consumption function graphed in Figure 13.2 "Plotting a Consumption Function" and Figure 13.3 "Consumption and Personal Saving" relates consumption spending to the level of disposable personal income. Changes in disposable personal income cause movements along this curve; they do not shift the curve. The curve shifts when other determinants of consumption change. Examples of changes that could shift the consumption function are changes in real wealth and changes in expectations. Figure 13.4 "Shifts in the Consumption Function" illustrates how these changes can cause shifts in the curve.

Figure 13.4 Shifts in the Consumption Function

An increase in the level of consumption at each level of disposable personal income shifts the consumption function upward in Panel (a). Among the events that would shift the curve upward are an increase in real wealth and an increase in consumer confidence. A reduction in the level of consumption at each level of disposable personal income shifts the curve downward in Panel (b). The events that could shift the curve downward include a reduction in real wealth and a decline in consumer confidence.

Changes in Real Wealth

An increase in stock and bond prices, for example, would make holders of these assets wealthier, and they would be likely to increase their consumption. An increase in real wealth shifts the consumption function upward, as illustrated in Panel (a) of Figure 13.4 "Shifts in the Consumption Function". A reduction in real wealth shifts it downward, as shown in Panel (b).

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. A reduction in the price level increases real wealth and shifts the consumption function upward, as shown in Panel (a). An increase in the price level shifts the curve downward, as shown in Panel (b).

Changes in Expectations

Consumers are likely to be more willing to spend money when they are optimistic about the future. Surveyors attempt to gauge this optimism using "consumer confidence" surveys that ask respondents to report whether they are optimistic or pessimistic about their own economic situation and about the prospects for the economy as a whole. An increase in consumer optimism tends to shift the consumption function upward as in Panel (a) of Figure 13.4 "Shifts in the Consumption Function"; an increase in pessimism tends to shift it downward as in Panel (b). The sharp reduction in consumer confidence in 2008 and early in 2009 contributed to a downward shift in the consumption function and thus to the severity of the recession.

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 consumption – and economic conditions will worsen! 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.