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Income & Consumption Causality

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PostPosted: Thu Aug 06, 2015 3:47 pm    Post subject: Income & Consumption Causality Reply with quote

Philip George:

The assumption here (as in Keynesís propensity to consume hypothesis and Friedmanís permanent income hypothesis) is that consumption is dependent on income. And for the individual that is indeed so. But for the aggregate economy it is not so, as I have shown in my book Macroeconomics Redefined. Income is a function of consumption and not the other way around.

When there is a financial asset market crash consumers lose a large chunk of their net worth and so curtail their consumption expenditure (because they raise their saving rate in a bid to recoup lost savings). When businesses see this they curtail their output, so aggregate income falls. Consumer expenditure lags this fall in business output by a short period. This is because businesses first cut output but retain their employees because they are not sure whether the fall in demand is long-lived or not.

In the 2008 crash the median household lost 18 years of its net worth. To regain this it would need to double its saving rate for 18 years, other things being equal. That is why recoveries following financial asset crashes are as protracted as they are. As savings are recouped both consumption expenditures and income recover.

That is also apparent from the first graph which shows that consumption expenditures remain stable even when there are sudden rises in disposable income. All such income increases go straight to savings.

In any case the consumption line after the crash is displaced from the line before the crash. So the same equation cannot be used to describe both.




I think, itís accepted income causes consumption and consumption causes income.

Typically, an asset crash coincides with an economic downturn.

A boost in disposable income raises household savings initially, e.g. paying-off debt, which eventually raises household discretionary income.

However, rising unemployment, in the economic downturn, reduces income.

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