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 28.4; 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.
KEY TAKEAWAYS
- Consumption is closely related to disposable personal income and is represented by the consumption function, which can be presented in a table, in a graph, or in an equation.
- Personal saving is disposable personal income not spent on consumption.
- The marginal propensity to consume is MPC = ΔC/ΔYd and the marginal propensity to save is MPS = ΔS/ΔYd. The sum of the MPC and MPS is 1.
- The current income hypothesis holds that consumption is a function of current disposable personal income, whereas the permanent income hypothesis holds that consumption is a function of permanent income, which is the income households expect to receive annually during their lifetime. The permanent income hypothesis predicts that a temporary change in income will have a smaller effect on consumption than is predicted by the current income hypothesis.
- Other factors that affect consumption include real wealth and expectations.
TRY IT!
For each of the following events, draw a curve representing the consumption function and show how the event would affect the curve.
- A sharp increase in stock prices increases the real wealth of most households.
- Consumers decide that a recession is ahead and that their incomes are likely to fall.
- The price level falls.
Case in Point: Consumption and the Tax Rebate of 2001
The first round of the Bush tax cuts was passed in 2001. Democrats in Congress insisted on a rebate aimed at stimulating consumption. In the summer of 2001, rebates of $300 per single
taxpayer and of $600 for married couples were distributed. The Department of Treasury reported that 92 million people received the rebates. While the rebates were intended to stimulate
consumption, the extent to which the tax rebates stimulated consumption, especially during the recession, is an empirical question.
It is difficult to analyze the impact of a tax rebate that is a single event experienced by all households at the same time. If spending does change at that moment, is it because of the tax
rebate or because of some other event that occurred at that time?
Fortunately for researchers Sumit Agarwal, Chunlin Liu, and Nicholas Souleles, using data from credit card accounts, the 2001 tax rebate checks were distributed over 10 successive weeks from
July to September of 2001. The timing of receipt was random, since it was based on the next-to-last digit of one’s Social Security number, and taxpayers were informed well in advance that the
checks were coming. The researchers found that consumers initially saved much of their rebates, by paying down their credit card debts, but over a nine month period, spending increased to
about 40% of the rebate. They also found that consumers who were most liquidity constrained (for example, close to their credit card debt limits) spent more than consumers who were less
constrained.
The researchers thus conclude that their findings do not support the permanent income hypothesis, since consumers responded to spending based on when they received their checks and because
the results indicate that consumers do respond to what they call “lumpy” changes in income, such as those generated by a tax rebate. In other words, current income does seem to matter.
Two other studies of the 2001 tax rebate reached somewhat different conclusions. Using survey data, researchers Matthew D. Shapiro and Joel Slemrod estimated an MPC of about one-third. They
note that this low increased spending is particularly surprising, since the rebate was part of a general tax cut that was expected to last a long time. At the other end, David S. Johnson,
Jonathan A. Parker, and Nicholas S. Souleles, using yet another data set, found that looking over a six-month period, the MPC was about two-thirds. So, while there is disagreement on the size
of the MPC, all conclude that the impact was non-negligible.
Sources: Sumit Agarwal, Chunlin Liu, and Nicholas S. Souleles, “The Reaction of Consumer Spending and Debt to Tax Rebates—Evidence from Consumer Credit Data,” NBER Working Paper No.
13694, December 2007; David S. Johnson, Jonathan A. Parker, and Nicholas S. Souleles, “Household Expenditure and the Income Tax Rebates of 2001,” American Economic Review 96, no. 5 (December
2006): 1589–1610; Matthew D. Shapiro and Joel Slemrod, “Consumer Response to Tax Rebates,” American Economic Review 93, no. 1 (March 2003): 381–96; and Matthew D. Shapiro and Joel
Slemrod, “Did the 2001 Rebate Stimulate Spending? Evidence from Taxpayer Surveys," NBER Tax Policy & the Economy 17, no. 1 (2003): 83–109.
ANSWER TO TRYI T! PROBLEMS
- A sharp increase in stock prices makes people wealthier and shifts the consumption function upward, as in Panel (a) of Figure 28.4.
- This would be reported as a reduction in consumer confidence. Consumers are likely to respond by reducing their purchases, particularly of durable items such as cars and washing machines. The consumption function will shift downward, as in Panel (b) of Figure 28.4.
- A reduction in the price level increases real wealth and thus boosts consumption. The consumption function will shift upward, as in Panel (a) of Figure 28.4.
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