Question

Explain how expectations about future prices and income will affect consumption.

Short answer

Consumption can be affected by people's expectations of future prices and income due to economic principles such as the substitution effect, income effect, and theory of rational expectations. If people expect prices to rise in the future, they may consume more now to take advantage of current lower prices. Similarly, if people expect their income to increase in the future, they may decide to consume more now because they feel more secure about their future financial situation.

Step-by-step solution

Define Consumption

Consumption is all spending by households on goods and services during a certain period. Normally, it's the largest component of aggregate demand in an economy.

The Role of Expectations

Expectations about future prices and income play a crucial part in the decision-making process for consumers. If consumers expect that prices will rise in the future, they might choose to consume more now. This is essentially due to the fact that the consumer seeks to maximize utility within budget constraints. This behavior can be linked to the substitution effect which states that as prices rise (or income decreases), consumers will replace more expensive items with less costly alternatives. So if future prices of goods are expected to rise, current consumption may increase because goods will be cheaper in comparison to the future.

Future Income Expectations

On the other hand, if consumers expect their future income to increase, they might decide to consume more in the present. This is due to the income effect, which describes how the change in an individual's income alters the consumption patterns. Therefore, if individuals expect an increase in income, they may feel more secure about their future financial position and consume more today.

Rational Expectations

This behavior can be explained through the theory of rational expectations. This economic theory suggests that people make choices based on their rational outlook, available information and past experiences. Thus, people will adjust their current consumption based on the expectations about future economic conditions.