Quiz 23 :
Saving, Investment and the Financial System
a.Relationship between increase in Net taxes and Consumption function An increase in net taxes will reduce the disposable income of a household. Fall in disposable income implies less availability of cash to spend on consumption. This would cause a downward movement along the same consumption function. b.Relationship between increase in Interest rate and Consumption function An increase in interest rate would induce the households to save more. When households prefer to save more than consume, then the consumption function will shift downward. c.Relationship between increase in Consumer optimism or Confidence and Consumption function Boost in consumer optimism or confidence will increase the household demand for goods and services. Increase in household demand will induce the household spending on goods and services. This will cause an upward shift in the consumption function. d.Relationship between increase in Price level and Consumption function An inverse relationship exists between price level and consumption function. An increase in price level will make the goods and services more costly to the household; this would lead to the consumption function to shift downward. e.Relationship between increase in Consumer's net wealth and Consumption function An increase in net wealth means increase in purchasing power as well as increase in the quantity demand for various goods and services. Thus, increase in consumer's net wealth will cause his consumption function to shift upwards. f.Relationship between increase in Disposable income and Consumption function Disposable income and consumption function are positively related. An increase in disposable income will cause the consumption curve to move along with income.
Consumption Function Consumption function describes the relationship between households' consumption expenditure and level of disposable income in an economy, other things remaining constant. In simple words, consumption is the function of income.Movement along the Consumption Function The change in level of disposable income of a household would cause movement along the same consumption function. Example: An increase in household's disposable income will cause less proportionate increase in household spending than the increase in its disposable income and vice-versa.Shift of the Consumption Function Consumption function curve shifts due to changes in the following factors: • Net wealth of households • Prevailing price level in an economy • Prevailing interest rate in an economy • Consumer expectations Net Wealth and Shift of the Consumption Function Net wealth of households and consumption function are positively related. An increase in the stock of net wealth would shift the consumption function upward because increase in net wealth will raise the incentive to spend more and save less. Similarly, a fall in the stock of net wealth would shift the consumption function downward.Prevailing Price Level and Shift of the Consumption Function Price level prevailing in an economy and the consumption function are negatively related. An increase in the prevailing price level of an economy would cause a downward shift in the consumption function because it will lower the purchasing power of all households. Similarly, a fall in prevailing price level of an economy would cause an upward shift in the consumption function. Prevailing Interest Rate and Shift of the Consumption Function Prevailing interest rate of an economy and the consumption function are negatively related. At a higher interest rate, household prefers to save more and spend less and vice-versa.Thus, an increase in interest rate will cause a downward shift in the consumption function, and a fall in the interest rate will result in an upward shift in the consumption function. Consumer Expectations and Shift of the Consumption Function Consumer expectations can have both a positive and negative relation with the consumption function. Example: Suppose a household expects price level to rise in the future, then the individuals of that household would prefer to save more and consume less at present, which will lead to the downward shift in the consumption function and vice-versa.Similarly, if a household expects its future stream income to rise, then its consumption pattern will change at present time and may continue until the expectation is reached. Hence, the consumption function will shift upward.
In broad terms, the saving rate of an individual with high income will be higher than that of an individual with low income. To add to this concept, the life-cycle model of saving hypothesis predicts the pattern of saving as one ages. It claims that young people borrow to pay for an education and home, middle-aged people will save more and pay off these debts, and elderly people will use their savings, known as dissaving. Thus, when evaluating a whole economy's saving rate, it is important to analyze the age data of the population; doing so may provide insight into the factors that affect the saving rate. For example, a country with a huge elderly population would, exhibit a very low saving rate compared to a country with a large youth population.
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