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Current time:0:00Total duration:6:39

Video transcript

what I want to do in this video is introduce you to the idea of a consumption function and it's a very simple idea it's really just the notion that income income in aggregate and economy can drive consumption in aggregate in an economy consumption in an economy and just to make things tangible I will construct a consumption function for a hypothetical economy and we can debate whether we can construct a better one and you don't it doesn't have to be all the numbers don't have to be exactly what I'm about to do but this is just to make things concrete in your mind so maybe we have a hypothetical economy where consumption is going to be equal to well maybe there's some base level of consumption even if there's no aggregate income in our economy it's hard to imagine but let's say there isn't there will still be consumption maybe people can do it by digging into their savings so they're essentially using resources that they've already accumulated in some way and so let's say that base level of consumption let's call that 500 500 it could be billions of dollars or gold coins or clam shells or whatever the unit of measuring economic activity is in our economy so that's our base level of consumption and then let's say if there is some aggregate income if there is some aggregate income people will spend 60% of it and I'm just picking these numbers somewhat arbitrarily so let's say if there's some are above and beyond the base level they're going to spend 0.6 of any aggregate income they have and actually to be a little bit more particular I'll write not just income I'll write disposable income and I want to do that in a different color they will that's not a different color they will above and beyond the base level spend 60% of their disposable income disposable disposable income and I make the distinction just to clarify our model between income and disposable income because all of the aggregate income in economy does not end up in consumers pockets in consumers pockets and just for a simplification you might say well yeah some of it ends up in firms pockets but the firm's at the end of the day are owned by individuals so it can end up in individuals or consumers pockets but some of it goes off to the government it goes off to the government so when you think about income and if you spend any time looking at your pay stub this will become familiar to you you have your income but you don't end up with all of that in your checking account or your pocket or your savings account a good fraction of that is taken out for taxes and so what you have left over when you subtract taxes out of income that is your disposable income disposable disposable income and that's why I write this year because that's actually a more reasonable thing to say people will spend 60% of their disposable income they obviously can't spend a fraction of stuff that they don't have the stuff that's taken out for taxes and just to visualize this we can draw it this will be a line this might ring a bell from your early algebra days just the variables are different instead of a instead of a Y we have a C but that's still the dependent variable it's a function of disposable income and algebra you'll often call this the independent variable sometimes the most typical variable is X but it's really the same idea over here so let me draw this a little bit neater so we can graph this what's essentially going to be a line it doesn't have to be aligned we just constructed a consumption function that happens to be a line so this is consumption right over here and the vertical axis that could be in billions of dollars or clamshells or whatever else and then right over here we have disposable income disposable disposable income and so if there is ZERO disposable income maybe I'll draw a little table right over here if I have 0 disposals so this is I'll call it disposable income and this is consumption if there's a 0 disposable income then this whole term right over here is 0 and then you have 500 billion dollars or whatever our units are of base consumption and then that would coordinate this this would correspond to this point right over here in the vert and the horizontal axis you don't move at all because this 0 vertical axis is 500 so you have 500 and let's say disposable income is let's say that it is 1,000 whatever our units are so this is 500 let's say this is 1 thousand billion clamshells so this could be in billions of clamshells Y I don't want to keep having to say that over and over again well what is our consumption going to be in our units well our consumption is going to be equal to 500 plus 0 point six times this a thousand which is equal to five hundred plus six hundred which is equal to eleven hundred so that would correspond so this right over here would correspond to so one thousand so this might be a thousand this axis so this would be eleven hundred to this point right over here so that would be the coordinate that would be the coordinate 1011 1100 and this is a line so two points make a line and so you would have so in this particular case we have a consumption function that looks something like this looks like that we pick two points to draw it if you remember a little bit of your slope you could view this as your your y-intercept or in this case your C intercept and that your slope would be the point six and we'll talk more about that in future videos when we dig into the marginal propensity to consume a little bit more but the one thing I just want to highlight is it's a very simple idea and it this does not have to be the consumption function the consumption functions that we tend to study in introductory economics classes will look like this it'll be a line that has some intersection some base level of consumption but one could argue it might be very different maybe the consumption function looks like this maybe when maybe when income is low for every incremental dollar of income people are willing are probably going to spend a lot and as they become richer and richer and richer as their income goes higher and higher they're going to spend less and less a fraction of the disposable income so essentially what I'm describing here is a marginal propensity to consume changes in our first model we had a very basic marginal propensity to consume it was constant for every incremental dollar 0.6 of that got spent so we had a marginal propensity to consume that was constant of 0.6 marginal propensity to consume but you could argue that maybe a more complex models of justified then one you have we have a very high marginal propensity to consume when people have very little because they have a very low standard of living they really want to just get a little bit more just so they can live a decent life but as they get more and more income they say hey I already gotten kind of starting to max out my standard of living I'll save more and more of it for a rainy day