Question

The Federal Reserve reported that household wealth decreased by \(\$ 2.4\) trillion or \(\$ 21,000\) per household in the third quarter of \(2011 .\) This drop is the steepest since 2008 and the second consecutive quarterly drop. Foreclosures lowered household debt slightly but credit card debt increased. Many households are struggling to buy the essentials and spending on food has decreased. Separately, the Bureau of Economic Analysis reported that consumption expenditure increased by \(\$ 39\) billion in the third quarter of 2011 Sources: The New American, December 11,2011 , and the Bureau of Economic Analysis Explain and draw a graph to illustrate how a fall in household wealth would be expected to influence the consumption function and saving function.

Short answer

A decrease in household wealth leads to a downward shift in the consumption function and an upward shift in the saving function.

Step-by-step solution

Understanding Household Wealth Impact

Household wealth affects consumers' confidence and their ability to spend. A decrease in household wealth usually leads to a decrease in consumer spending and an increase in saving as households try to rebuild their wealth.

Define the Consumption Function

The consumption function shows the relationship between total consumer spending and disposable income. It is typically represented as: \[ C = a + b \times Y_d \]Where: -\(C\) is total consumption -\(a\) is autonomous consumption (consumption when income is zero) -\(b\) is the marginal propensity to consume (the percentage of additional income that is spent) -\(Y_d\) is disposable income.

Define the Saving Function

The saving function shows the relationship between total savings and disposable income. It can be derived from the consumption function as savings (\(S\)) is the part of disposable income (\(Y_d\)) that is not consumed. \[ S = Y_d - C \]Or: \[ S = -a + (1 - b) \times Y_d \]

Effect of Decreased Household Wealth

A fall in household wealth decreases consumer confidence and leads to reduced spending. This shifts the consumption function downward. For the consumption function \(C = a + b \times Y_d\), a decrease in household wealth reduces \(a\) (autonomous consumption). Similarly, savings increase as households try to recover their lost wealth, leading to an upward shift in the saving function.

Drawing the Graph

Draw two graphs—one for the consumption function and one for the saving function: 1. Graph the original consumption function 2. Graph the new consumption function (lower intercept indicating reduced \(a\)). 3. Graph the original saving function 4. Graph the new saving function (higher intercept indicating increased savings). Label the shifts clearly to show the effects of decreased wealth.

Key concepts

headline of the respective core concept

The consumption function is a fundamental concept in economics. It explains how household consumption (spending on goods and services) depends on disposable income. The basic form of the consumption function is expressed as: Where: - is total consumption - is autonomous consumption (spending when income is zero) - is the marginal propensity to consume (fraction of additional income spent) - is disposable income. Let's break it down. High autonomous consumption indicates that households will still spend even with zero income. Marginal propensity to consume () shows us how much of any extra income will be spent. When household wealth drops, autonomous consumption () decreases because people feel less wealthy and cut back on spending. This leads to a downward shift in the consumption function curve. Decreased wealth means less spending for the same level of disposable income. This reduction in consumption can affect overall economic activity, as consumer spending is a major part of aggregate demand. Less spending leads to less demand for goods and services, which can slow economic growth.

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The saving function illustrates the relationship between total savings and disposable income. It is derived from the consumption function since any disposable income not spent is saved. The saving function is usually written as: Where: - is total savings - is autonomous saving (negative when autonomous consumption is positive) - is the marginal propensity to save (1 - marginal propensity to consume) - is disposable income. The saving function and consumption function are closely related. When the consumption function shifts downward due to a reduction in wealth, the saving function moves upward. This happens because people save more to recover their financial stability. To understand it better, imagine a household experiencing a drop in wealth. They will cut back on non-essential spending to save more for the future. This behavior increases autonomous saving (). Since marginal propensity to save () is the part of income not spent, it induces further savings. Hence, in times of reduced wealth, saving functions show an upward shift, representing increased savings at every income level.

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Changes in household wealth have significant implications for the economy. Wealth influences confidence, spending, and saving behaviors, which in turn impact overall economic activity. When household wealth decreases, as reported for the third quarter of 2011, several economic effects could follow: - Reduced consumer confidence: Households feel poorer, leading them to spend less and save more. - Decreased consumption: This forms a major part of aggregate demand. Lower spending can cause businesses to reduce production, leading to economic slowdown. - Increased saving: As people become more cautious, they save more to rebuild their financial buffer. These behaviors shift the consumption and saving functions. Lower spending (downward consumption shift) and higher saving (upward saving shift) affect overall economic performance. In extreme cases, if widespread, these changes can lead to economic downturns. This scenario is similar to the Great Recession, where massive loss of wealth led to significant drops in spending and consumption, severely impacting economic growth. Policy measures like stimulus packages can aim to counteract these effects by boosting consumer spending and restoring confidence.

headline of the respective core concept

Marginal propensity to consume (MPC) is a key concept that measures how much consumption will change with a change in disposable income. It is the slope of the consumption function, represented by: MPC is the fraction of additional income spent on consumption. For instance, if MPC is 0.8, it means that for every additional dollar earned, 80 cents is spent. When household wealth decreases, not only does autonomous consumption drop, but MPC can also be affected. People may become more cautious, reducing their marginal propensity to consume. Lower MPC means households are spending a smaller fraction of their income gains, which affects total economic activity. Given that consumption expenditure forms a big part of aggregate demand, lower MPC can lead to reduced economic growth. Policymakers monitor MPC closely to understand and predict consumer behavior, especially during economic downturns.