Aggregate Expenditure Model
What is Consumption Function?
The consumption function shows the changes in consumer spending from increases in disposable incomes.
What does it Look Like?
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Elements of a Consumption Function
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The 45º line cuts directly in half, resulting in the same sides and hence, consumption equals disposable income at this line. 45º Line This line is what it is, a 45º degree line (doesn't have to be exact). At any point of the 45º line, disposable income equals consumer spending. Think of it as a square, at 45º the line cuts two even triangles that have exactly the same area and sides, hence at this point consumption equals disposable income. Note: When drawing the models, you don't need to be exact with the 45º. As long as you show it is 45º with annotation, you'll be fine.
The consumption function is the line representing the level of consumption as disposable income increases. As disposable income increases, consumption increases. The gradient of the line can be determined through the Marginal Propensity to Consume (MPC) - more on that later. Autonomous consumption (the point a), is usually given.
The savings function can be excluded but it is shown in this model to better show dissaving. The savings function shows the increase in savings as disposable income increases. Obviously, people don't spend all their income. As income increases, people have a greater ability to save. The gradient of the savings line is determined by the Marginal Propensity to Save (MPS). The MPS is simply 1-MPC in a two-factor economy. Autonomous savings (the point -a) is usually given.
Intersection with Consumption and 45º
It is important that at this level, the savings line is 0 for consumer spending. This is because at this intersection, 100% of disposable income is spent on consumption, causing 0 savings to be generated. This needs to be shown clearly on the model.
Why does the Savings Line become negative consumer spending?
This is used to show dissaving. During tough economic conditions, people tend to still consume for a subsistence standard of living and maintain what is known as autonomous consumption. Autonomous consumption is the lowest level of consumption that can be achieved as households still need to consume items such as food, clothing and utilities as well as other essential services such as childcare. When disposable income falls below consumption requirements, households will consume from their savings, resulting in dissaving and the savings function becoming negative on consumer spending.