Procedia Economics and Finance The relation between consumption, income and GDP is stronger for low and middle income countries, a logical conclusion. Keynes's theory of the determination of equilibrium real GDP, employment, and prices focuses on the relationship between aggregate income and expenditure. that aggregate consumption expenditures can be summarized by the equation. “C” (consumption) is normally the largest GDP component in the economy, Formula: GDP (gross domestic product) at market price = value of output in an Income generated in the relationship between firms and households is taxed and .
Keynes argues that aggregate consumption expenditures are determined primarily by current real national income. He suggests that aggregate consumption expenditures can be summarized by the equation where C denotes autonomous consumption expenditure and Y is the level of current real income, which is equivalent to the value of current real GDP.
The marginal propensity to consume mpcwhich multiplies Y, is the fraction of a change in real income that is currently consumed. In most economies, the mpc is quite high, ranging anywhere from. Note that as the level of Y increases, so too does the level of aggregate consumption. Different levels of autonomous expenditure, A, and real national income, Y, correspond to different levels of aggregate expenditure, AE.
Because the mpc is the fraction of a change in real national income that is consumed, it always takes on values between 0 and 1. This figure shows three different aggregate expenditure curves, labeled AE 1, AE 2, and A 3, which correspond to three different levels of autonomous expenditure, A 1, A 2, and A 3.
The Keynesian Theory
The upward slope of these AE curves is due to the positive value of the mpc. As real national income Y rises, so does the level of aggregate expenditure. Note that each AE curve corresponds to a different equilibrium level for Y. Note also that each Y is a multiple of the level of autonomous aggregate expenditure, A, as was found in the algebraic determination of the level of equilibrium real GDP.
Graphical illustration of the Keynesian theory. Suppose that the economy is initially at the natural level of real GDP that corresponds to Y 1 in Figure. This decline in autonomous expenditure is also represented by a reduction in aggregate demand from AD 1 to AD 2. For instance, a family having bought a car will reduce expenditure on public transport in favour e. According to age of the decision-maker, individual and household consumption varies, both in values and composition. Thus, aggregate consumption may be influenced by demographic factors, such as an older and older population, even though one should not rely too much on these relationships since demographic variables are extremely slow in changes, whereas consumption clearly reacts to economic climate.
Other things equal, a higher price level inflation reduces the real current income, thus real consumption. Impact on other variables A GDP component as it is, consumption has an immediate impact on it. An increase of consumption raises GDP by the same amount, other things equal.
Moreover, since current income GDP is an important determinant of consumption, the increase of income will be followed by a further rise in consumption: An autonomous increase of consumption, if at the same level of income, would reduce savingsbut the positive loop just described known as the "Keynesian multiplier" will imply an increase of income level with a positive impact on future savings. If directed to goods and services produced abroad, an increase of consumption will immediately push up importswhile a similar indirect effect will result from consuming domestic products requiring foreign raw materials, energysemi-manufactured goods.
Since usually the States separately tax consumption say with a VAT taxan increase of consumption will also boost this type of State revenueas well as import duties revenue in the case of imported goods. The growth mechanism of consumption-income will also provide State revenue through income taxes.
To the extent firms decide to invest by forecasting future demand and by comparing it with present production capacity, an increase of consumption may induce new investment. If exports are a second-best solution for domestic firm, an increase of domestic consumption might decrease exportsince at the same level of production firms would prefer to sell inside the country.
To verify this by yourself, try and play " You are an exporter ". Consumer dissatisfaction with current products can lead to faster adoption of new products, thus intertwining the whole new product development cycle. An increased total market demand may induce firms to increase prices, the more so when they operate at full production capacity or they operate on monopolized markets.
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Thus increased price level and accelerated inflation can be an effect of booming consumption. Consumption can lead to CO2 emissions in the atmosphere, thus contributing to climate change. Long-term trends In Western countries, consumption has always grown in the last 50 years, except in few deep recessions.Consumption function basics - Macroeconomics - Khan Academy
Its growth is smoother than investment's rise or net exports' growth. In particular, services have always systematically grown at a fairly steady pace, non-durables have often mirrored the business cycle and durables have often over-shot the fluctuations in GDP.
Sustainable lifestyles, based on satisfaction of basic needs, green consumer goods, dematerialisation, and carbon footprint off-setting, will be more and more relevant in the future.
The Keynesian Theory
Business cycle behaviour As the main component of GDP, it is pro-cyclical almost by definition: Consumption has a smoother dynamics than GDP. During a recoveryit sustains and stabilises the trend.
Durable goods, however, are strongly pro-cyclical and they may peak shortly before GDP. Particular tax reductions and subsidies can be directed to temporarily sustain sales in order to promote extraordinary purchases. If large enough, they may help in economic turn-around from recession to recovery.