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Macroeconomics: Consumption Theory

Consumption theory was postulated by Milton Friedman, an American economist in the year 1950. Milton referred to the theory of consumption as a permanent-income theory of consumption. Another economist by the name of Modigliani referred to the consumption theory as the life-cycle of consumption. Both theories of consumption deduce that consumption by individuals is determined by income expectations of households over some time. This is to say that, income earned in the short run does not affect the consumption of an individual. The individuals tend to spread their income in such a way that, there are no periods when they experience excess consumption whereas in other periods are faced with shortages in income to cater for their consumption needs. The rational consumers, therefore, spread their income evenly throughout a period to cater to their consumption needs. In essence, there should be no periods where the consumers have abundant consumption while in other periods are faced with shortages.

According to Friedman and Modigliani, the expected income of the individuals affects their consumption pattern at the current period. This infers that changes in the income of the individuals in the short run do not affect the individuals’ consumption. Thus, consumption at the present period by an individual is the present value of the future labor income less the taxes paid to the government.

Similarly, using permanent income theory, investments at the present period are determined by the expected profits accrued from those investments in the future. In case the present value of the future income earned by investments made at the present period is lower than the cost of the investment, individuals will shy away from making such investments. On the other hand, if the present value of the income received from the investment in the future is higher than the cost of the investment, it means that the investment is worth investing in.

The determinants of consumption and investment are total wealth and disposable labor income. Total wealth comprises both human and non-human wealth. Nonhuman wealth in economics comprises housing wealth and financial wealth. Human wealth on the other hand refers to the present value of future income.

Another factor that affects consumption and investment is the interest rate in the market. In case the rate of interest in the market is high, the present value of the future income would be lower and vice versa is true in case the interest rate is low.

The time one expects to live also determines the level of consumption and investment. In discounting the future cash flows from the investment to show the present value of such investments, time becomes of importance. As a rule of thumb, the longer the period, the lower the present value of the investment made and vice versa in case the period of discounting is shorter. According to the permanent income hypothesis, the expected income of an individual is spread into his entire lifetime. Thus, the longer the period one expects to live, the lower the level of consumption and investment and vice versa is true in case the individual expects to live for a shorter period.

The key macroeconomics relationships that underpin the IS-LM model include production and demand for services and goods produced in the economy. Demand and supply of money is another important macroeconomic relationship that underpins the IS-LM model. In the economy, it is assumed that there are two markets; the products market or goods market and the financial market or the money market.

Goods market

Goods or products market is deemed to be at the equilibrium when the demand for services and goods in the market equals the amount of goods produced in that market. The said relationship is referred to as IS model. At given levels of productions, there are different quantities of goods demanded in the economy. Mathematically, the equilibrium in goods market is given as;

Y = C(Y-T) + I + G

Investment is a function of income and interest rate; thus if the interest rate is factored into the model given above, then the equilibrium is given as;

Y = C(Y-T) + I (Y, I) + G (1.1)

Where Y is the total production in the economy, C is the level of consumption, T is the tax levied by the government, (I) is the level of investment and G is the government spending in the economy. From the model 1.1 above, it can be deduced that the increase in production in the economy increases the disposable income and the level of investment in the country. IS curve is derived from plotting the figures arrived at after substituting in the model 1.1 above.

IS Curve
Figure 1.1 IS Curve

At the equilibrium in the goods market, the number of goods produced in the economy must be equal to the quantity demanded of those goods. Interest rates affect the number of goods demanded in the market. An increase in the interest rates reduces the number of goods demanded as the level of income is reduced and thus reducing the level of output in the goods market. This explains the downward slope of the IS curve. Changes in the factors that decrease the demand for goods in the market lead to the IS curve shifts to the left. Conversely, changes in factors that lead to the increase in the demand for services and goods in the goods market lead to the IS curve shifting to the right.

Financial markets

In financial markets, two macroeconomics determinants include the supply and the demand for money. Money in the economy is supplied by the Federal Reserve in the United States. Federal Reserve has the sole responsibility of supplying money in the economy of course after considering the monetary needs of the economy at a certain period. The financial market is at equilibrium when the supply of money equals the demand for money in the economy.

The equilibrium in the money market thus is expressed as M = $ YL (i), where M is money, Y is the nominal income and i is the interest rate. At the equilibrium, the real supply of money is equal to the real demand for money, which is a function of interest rate and the level of income. Equilibrium in the money market implies that an increase in the income of individuals in the economy causes an increase in the rate of interest. This explains the upward slope of the LM curve.

IS Curve (b) LM Curve
Figure 1.2 (a) IS Curve (b) LM Curve

In figure 1.2(b) equilibrium interest rate is plotted on the vertical axis while the level of output is plotted on the horizontal axis. The LM curve is upward sloping which depicts the relationship between output and the rate of interest in the money market. The increase in income in the money market pushes the LM curve downward. Conversely, a decrease in income pushes the LM curve upward.

When both IS and LM curves are plotted on the same chart, the IS-LM curve is derived. Point A in figure 1.3 is attained when both the money market and goods market are at equilibrium.

IS-LM models.
Figure 1.3 IS-LM models.

The financial crisis started in the year 2007 in the United States. The crisis was caused by a section of the banking industry that specialized in offering mortgages facilities. To be precise, the financial crisis was caused by a company referred to as a ‘Sub Prime Mortgage.’ This company came into existence to help people who could not qualify for mortgages initially. These people had a high chance of defaulting. Due to the rising cost of housing, mortgages became more attractive as the interest rates were low. From the year 2000, interest rates rose rapidly thus making the cost of repaying loans higher than the value of the houses. This instigated those who had taken the mortgage to ‘walk away’ thus defaulting to pay the mortgages. This made mortgages companies make enormous losses and hence collapse of the mortgage companies which stirred up the economic crisis.

Different policy responses were applied by the government and the central banks to bring to an end the crisis that threatened to collapse the financial systems in the entire world. The policy responses include monetary policies and fiscal policies. It should be noted that the monetary policies affect the LM curve while the fiscal policies affect the IS curve. Monetary policies are policies undertaken by the monetary authority in the country to control the supply of money in the economy. Monetary policies are either expansionary or contractionary policies. The expansionary monetary policies are aimed at increasing the supply of money in the market by reducing the rate of interest at which the borrowers access funds from commercial banks. As depicted by the LM curve, the lower the interest rate the higher the demand for money in the economy. The expansionary monetary policies are aimed at combating unemployment and recession. On the other hand, expansionary monetary policies cause inflation in the economy. Contractionary monetary policies are aimed at reducing the amount of money in circulation. This helps to reduce inflation in the country.

Fiscal policies include government spending, government borrowing, and taxation. These policies affect the goods market thus IS curve. In case the government wants to spur economic growth in the country, it applies expansionary fiscal policies. Expansionary fiscal policies include an increase in government spending and a reduction in taxation. These policies ensure that the individuals have high income and thus a high ability to demand more of what is produced in the economy. The expansionary fiscal policies push the IS curve downwards. On the other hand, contractionary fiscal policies reduce the ability of the individuals to demand goods produced in the economy thus pushing the IS curve downward. To combat economic crisis the government applied both expansionary monetary and fiscal policies.


Blanchard, O., 2008, Macroeconomics 5th Edition, Upper Saddle River: Pearson Prentice Hall.

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