MACRO ECONOMIC ANALYSIS AND POLICY

UNIT 02: Macro Analysis of Consumer Behaviour

Macro analysis in consumer behaviour focuses on understanding how large-scale economic factors affect the way consumers make decisions about buying and spending. Consumption is a function of income: C=f(Y)

In the short run, it's assumed that as income increases, consumption increases too, but not proportionately. People save more as income rises.

❖ Key Factors

Economic Growth: During periods of economic growth, consumers tend to have more disposable income and are more likely to spend, leading to increased demand for goods and services.
Recessions/Downturns: Conversely, during economic downturns or recessions, consumers may become more cautious with their spending, focusing on essential purchases and delaying discretionary spending.
Inflation: Rising inflation erodes purchasing power, making consumers more price-sensitive and potentially leading to reduced spending.
Interest Rates: Interest rates affect borrowing costs, which can influence consumer spending on big-ticket items like housing and automobiles.
Unemployment: High unemployment rates can lead to decreased consumer confidence and spending, as individuals worry about job security and income stability.
Government Policies: Government policies, such as tax changes and fiscal stimulus, can also have a significant impact on consumer spending and economic activity.

Cyclical and Secular Consumption

Items	Definition	Focus	Correlation to Economic Cycle
Cyclical Consumption	Cyclical consumption refers to spending on goods and services that are not considered necessities but are discretionary purchases, meaning people are more likely to cut back on these purchases during economic downturns or recessions.	Cyclical consumption is focused on the short-term fluctuations in economic activity.	The performance of cyclical consumption is highly related to the state of the economy. During economic expansions, consumer spending on these items tends to increase, while during contractions or recessions, people have less disposable income to spend on these items.
Secular Consumption	Secular consumption refers to long-term trends in consumption patterns, independent of short-term economic cycles.	Secular consumption is focused on the long-term structural changes in the economy and consumer behaviour.	Not directly affected by short-term cycles, but gradually influenced over time. Even during economic ups and downs, the general direction of secular consumption can be upward if structural factors support it.

Examples

Cyclical Consumption:

Examples of cyclical consumption include spending on luxury goods, entertainment, travel, and non-essential consumer durables like cars and electronics.

Secular Consumption:

Examples of secular consumption trends include shifts in consumer preferences, technological advancements, demographic changes, and income inequality.

Income-Consumption Relationship

It refers to the relationship between a person's or nation's level of income (Y) and their level of consumption (C).

In simple terms: As income increases, people spend more—but not all of the additional income is spent. A portion is saved.

❖ The Consumption Function

The relationship is generally expressed using a linear consumption function:

C = a + bY

Where:

C = Consumption
a = Autonomous consumption (consumption when income = 0)
b = Marginal Propensity to Consume (MPC)
Y = Income

❖ Key Concepts in the Relationship

Autonomous Consumption (a): This is the level of consumption when income is zero. It represents basic needs or consumption financed by borrowing or using savings. Even without income, people consume food, housing, etc.
Marginal Propensity to Consume (MPC): Measures how much additional consumption occurs when income increases by ₹1. MPC is between 0 and 1.
MPC = ΔC/ΔY
If MPC = 0.8 → for every ₹1 increase in income, ₹0.80 is spent and ₹0.20 is saved.
Average Propensity to Consume (APC): Shows the proportion of total income that is consumed. As income increases, APC tends to fall because a larger share of income is saved.
APC = C/Y
Saving Function (S)
Since income is either consumed or saved:
Y = C + S ⇒ S = Y − C
And using the consumption function:
S = Y − (a + bY) = −a + (1−b) Y
Where:
• (1−b) (1 - b) is the Marginal Propensity to Save (MPS)

❖ Graphical Representation

On a graph:

X-axis: Income (Y)
Y-axis: Consumption (C)
The consumption function is a straight line starting from the point a on the Y-axis, with a slope equal to b (MPC).
The 45° line represents all points where C=Y, i.e., no saving.
Where the consumption curve lies below the 45° line → saving occurs.
Where it lies above the 45° line → dissaving (spending more than income).

❖ Example

Let's say:

a = ₹200 (autonomous consumption)
b = 0.8 (MPC)

Then the consumption function is:

C = 200 + 0.8Y

At Y = ₹1,000:

C = 200+0.8(1000) = ₹1,000

So at an income of ₹1,000, the entire income is spent (C = Y), and savings = 0.

Absolute, Relative & Permanent Income Hypotheses

1. Absolute Income Hypothesis

Keynes's Idea:
This hypothesis, often associated with John Maynard Keynes, posits that an individual's consumption spending is primarily determined by their current level of income.

Basic Principle:
As income rises, consumption also rises, but the increase in consumption is less than the increase in income.

Example:
If a person's income doubles, their consumption spending will increase, but not necessarily double.

Keynes's Psychological Law:
It is also known as the Fundamental psychological law.

2. Relative Income Hypothesis

Duesenberry's Contribution:
James Duesenberry's relative income hypothesis argues that consumption is influenced by an individual's income relative to the income of others in society.

Focus on Relative Position:
The theory suggests that people's consumption decisions are based on their position in the income distribution, rather than their absolute income level.

Example:
If a person's income increases, but the incomes of others around them also increase at the same rate, their consumption spending may not change significantly.

Implication:
The relative income hypothesis suggests that a family's spending habits are more influenced by how they compare to others in the income distribution than by their absolute income level.

3. Permanent Income Hypothesis:

Friedman's Perspective:
Milton Friedman's permanent income hypothesis (PIH) proposes that consumption is determined by an individual's expected long-term or "permanent" income, rather than their current or transitory income.

Focus on Long-Term Income:
The PIH suggests that people smooth their consumption over time, saving during periods of high income and borrowing during periods of low income to maintain a relatively stable consumption level.

Permanent vs. Transitory Income:
Permanent income is the average income an individual expects to earn over their lifetime, while transitory income is income that is temporary or unexpected.

Example:
If a person receives a large, one-time bonus, they are unlikely to increase their consumption spending by the full amount of the bonus, as they understand it is a temporary increase in income.

Smoothing Consumption:
The PIH suggests that individuals aim to maintain a stable consumption level over their lifetime, even if their income fluctuates.

Simple Keynesian Model of Income Determination

This model explains how national income (output) is determined by aggregate demand (AD).

❖ Key Assumptions

Economy is demand-driven (supply adjusts to meet demand).
Prices remain constant (short-run analysis).
Focus is on 2-sector model (no government, no foreign trade).

❖ Equilibrium Condition

Y = C + I

Where:

Y: National income/output
C: Consumption
I: Investment (assumed autonomous)

Now, using the consumption function: C = a + bY

❖ Interpretation

If investment (I) increases, income increases.
If autonomous consumption (a) increases, income increases.
The size of this increase depends on the MPC (b).

Multiplier Analysis

The multiplier shows how a small change in investment or government spending leads to a much larger change in income.

❖ Formula

Multiplier (k) = 1 / (1−MPC)

Where: MPC is the Marginal Propensity to Consume

❖ How it Works

Suppose: Government increases spending by ₹100 crore and MPC = 0.8

K = 1 / (1−0.8) = 5

So, total increase in income = ₹100 × 5 = ₹500 crore

❖ Why does this happen?

The initial ₹100 crore becomes income for someone else.
They spend ₹80 crore (if MPC = 0.8), which becomes income for others.
This chain continues, but the amount gets smaller each time.