Question

What happens to the consumption function if the banks decide to offer credit cards on easier terms and conditions? Why?

Short answer

The consumption function shifts upwards due to increased autonomous consumption.

Step-by-step solution

Understand the Consumption Function

The consumption function is an economic formula that represents the relationship between total consumption and gross national income. It can be expressed as: \[ C = a + bY \ \text{where } C \text{ is consumption, } a \text{ is autonomous consumption,} \ b \text{ is the marginal propensity to consume, and } Y \text{ is income.} \] The consumption function implies that as income increases, consumption will also increase, holding other factors constant.

Impact of Easier Credit Card Terms

When banks offer credit cards on easier terms and conditions, it effectively increases consumers' access to credit. This increased access allows consumers to finance additional consumption beyond their current income levels.

Effect on Autonomous Consumption

Easier credit card terms can lead to an increase in autonomous consumption \( a \). This is because consumers may feel more financially secure or simply have more financial resources available to spend, even without an increase in actual income \( Y \).

Conclusion on the Consumption Function

Overall, the consumption function will shift upwards due to the rise in autonomous consumption \( a \). This means that for any given level of income \( Y \), consumption \( C \) will be higher than it would have been without the easier credit card terms.

Key concepts

Credit Cards

Credit cards play a significant role in consumer behavior and the consumption process. They are financial instruments that allow consumers to borrow funds for purchases with the promise to repay the amount borrowed plus interest. By offering credit cards with easier terms and conditions, banks effectively lower the barriers for consumers to access credit. This means more people might qualify for credit cards, or existing cardholders could receive benefits like lower interest rates or higher credit limits.

• Easy access to credit can encourage consumers to spend more, even if their current income doesn't fully support these expenditures.
• The presence of credit facilities reinforces consumers' confidence in making purchases they might otherwise defer.

This upward shift in consumption happens without an immediate increase in actual cash flow or income. Instead, it relies on borrowed money, reflecting a direct link between credit card policies and consumption changes.

Autonomous Consumption

Autonomous consumption is a critical component of understanding the consumption function. It refers to the level of consumption that occurs even when income is zero. Essentially, it's the baseline amount of consumption necessary to fulfill basic needs, often covered by savings, borrowing, or government assistance when income is insufficient. When credit card terms become more favorable, autonomous consumption can increase. This is because consumers feel they have access to financial resources beyond their own income, thanks to credit. The availability of credit effectively increases consumers' financial stability or perceived wealth, enabling them to spend more independently of their income level.

• Autonomous consumption reflects essential spending that's not contingent on current income level.
• The increase in autonomous consumption is one reason why the consumption function shifts upwards with easier credit terms.

This means that at any given level of income, consumption will be higher, even if there's no change in income itself, due to the easier access to credit.

Marginal Propensity to Consume

The marginal propensity to consume (MPC) describes the increase in consumer spending that occurs with an increase in income. It is represented by 'b' in the consumption function formula, where it equals the change in consumption divided by the change in income. In simpler terms, if someone receives an extra dollar of income, the MPC tells us how much of that dollar will likely be spent rather than saved. An MPC close to 1 indicates that people will spend almost all additional income, whereas an MPC close to 0 implies they will save it.
With easier credit card terms, while autonomous consumption might increase, the immediate impact on MPC might be less direct. However, over time, the ease of credit could potentially influence MPC by changing consumers' habits, making them more likely to spend additional income, knowing they can rely on credit during low-income periods.

• The MPC shows the portion of extra income that goes towards consumption.
• Changes in credit policy may gradually alter consumer spending habits, affecting long-term MPC values.

Thus, while the MPC remains somewhat related, its changes may lag behind shifts in credit behavior.