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The consumption function is a mathematical formula laid out by famed economist John
Maynard Keynes. The formula was designed to show the relationship between real disposable
income and consumer spending, the latter variable being what Keynes considered the most
important determinant of short-term demand in an economy.

The consumption function is represented as:

Where:
C = Consumer spending
A = Autonomous consumption, or the level of consumption that would still exist even if
income was $0
M = Marginal propensity to consume, which is the ratio of consumption changes to income
changes
D = Real disposable income

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An economic theory stating that active government intervention in the marketplace and
monetary policy is the best method of ensuring economic growth and stability.

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An approach to economics that relates supply and demand to an individual's rationality and his or
her ability to maximize utility or profit. Neoclassical economics also increased the use of
mathematical equations in the study of various aspects of the economy. This approach was
developed in the late-nineteenth century, based on books by William Stanley Jevons, Carl Menger
and Leon Walras.

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Since its inception, neoclassical economics has grown to become the primary take on modern-day
economics. Although it is now the most widely taught form of economics, this school of thought still
has its detractors. Most criticism points out that neoclassical economics makes many unfounded and
unrealistic assumptions that do not represent real situations. For example, the assumption that all
parties will behave rationally overlooks the fact that human nature is vulnerable to other forces,
which cause people to make irrational choices. Therefore, many critics believe that this approach
cannot be used to describe actual economies.

Neoclassical economics is also sometimes blamed for inequalities in global debt and trade
relations because the theory holds that such matters as labor rights will improve naturally, as
a result of economic conditions.
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A supporter of Keynesian economics believes it is the government's job to smooth out the bumps in
business cycles. Intervention would come in the form of government spending and tax breaks in
order to stimulate the economy, and government spending cuts and tax hikes in good times, in order
to curb inflation.

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Circular flow of income takes place between business firms, households and
the government. To produce goods and services, households provide their
services and in return they get wages. Similarly, when households buy goods
and services, they pay for them and the producers receive the money as their
income. So, there is circular flow of income. This is the circular flow of income
in a two sector economy.

However, this circular flow can also be shown to take place in a three sector or
four sector model of the economy. National income is the total income earned
by current factors of production. The understanding of national income helps in
measuring the performance of an economy. There are three approaches to
measure national income: product, income and expenditure approaches.

Apart from national income, there are other aggregate measures which are also used to
measure the performance of an economy. On the basis of gross and net, domestic and
national concepts, and market price and factor costs, different aggregates can be calculated.
They are Gross Domestic Product at market price and factor costs, Gross National Product at
market price and factor costs, personal income and disposable income, etc. There are some
difficulties in measuring national income.

They are: imputed value, the underground economy, 'side effects' and economic 'bads,' leisure
and human costs and double counting. National income statistics can be used as: an
instrument of economic planning and review, as means of indicating changes in a country's
standard of living, for comparing the economic performance of different countries, to indicate
changes in the economic growth of a country.

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The monetary value of all the finished goods and services produced within a country's borders in a
specific time period, though GDP is usually calculated on an annual basis. It includes all of private
and public consumption, government outlays, investments and exports less imports that occur
within a defined territory.

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where:

"" is equal to all private consumption, or consumer spending, in a nation's economy

"" is the sum of government spending
"Ñ" is the sum of all the country's businesses spending on capital
"" is the nation's total net exports, calculated as total exports minus total imports. (NX = Exports ʹ
Imports

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GDP is commonly used as an indicator of the economic health of a country, as well as to gauge a
country's standard of living. Critics of using GDP as an economic measure say the statistic does not
take into account the underground economy - transactions that, for whatever reason, are not
reported to the government. Others say that GDP is not intended to gauge material well-being, but
serves as a measure of a nation's productivity, which is unrelated

Gross Domestic Product

(GDP)

Economic growth is measured in terms of an increase in the size of a nation's

economy. A broad measure of an economy's size is its output. The most widely -used
measure of economic output is the 

 

  (abbreviated 
).

GDP generally is defined as the market value of the goods and services produced by
a country. One way to calculate a nation's GDP is to sum all expenditures in the
country. This method is known as the expenditure approach and is described below.

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The expenditure approach calculates GDP by summing the four possible types of
expenditures as follows:

GDP = Consumption

+ Investment

+ Government Purchases

+ Net Exports

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is the largest component of the GDP. In the U.S., the largest and most
stable component of consumption is services. Consumption is calculated by adding
durable and non -durable goods and services expenditures. It is unaffected by the
estimated value of imported goods.

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 includes investment in fixed assets and increases in inventory.

 



   are equal to the government expenditures less government
transfer payments (welfare, unemployment payouts, etc.)

  
 are exports minus imports. Imports are subtracted since GDP is defined
as the output of the domestic economy.




     

There are three approaches to calculating GDP:

d   
  - described above; calculates the final spending on

goods and services.
d 
 
  - calculates the market value of goods and services
produced.
d 

  - sums the income received by all producers in the
country.

These three approaches are e quivalent, with each rendering the same result.

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0ote that an increase in inventory will increase the GDP but possibly result in a lower
future GDP as the excess inventory is depleted. To eliminate this effect, the final
sales can be calculated by subtracting the increase in inventory from GDP. The final
sales can be either larger or smaller than GDP. The change in inventory is an
important signal of the next period's GDP.

    

Without any adjustment, the GDP calculation is distorted by inflation. This

unadjusted GDP is known as the


. In practice, GDP is adjusted by
dividing the nominal GDP by a price deflator to arrive at the

.

In an inflationary environment, the nominal GDP is greater t han the real GDP. If the
price deflator is not known, an implicit price deflator can be calculated by dividing the
nominal GDP by the real GDP:

Implicit Price Deflator = 0ominal GDP / Real GDP

The composition of this deflator is different from that of the consumer price index in
that the GDP deflator includes government goods, investment goods, and exports
rather than the traditional consumer -oriented basket of goods.

GDP usually is reported each quarter on a seasonally adjusted annualized basis.

 

Countries seek to increase their GDP in order to increase their standard of living.
0ote that growth in GDP does not result in increased purchasing power if the growth
is due to inflation or p opulation increase. For purchasing power, it is the real, per
capita GDP that is important.

While investment is an important factor in a nation's GDP growth, even more

important is greater respect for laws and contracts.

  

GDP measures the output of goods and services within the borders of the country.
Gross 0ational Product (G0P) measures the output of a nation's factors of
production, regardless of whether the factors are located within the country's
borders. For example, the output of worke rs located in another country would be
included in the workers' home country G0P but not its GDP. The Gross 0ational
Product can be either larger or smaller than the country's GDP depending on the
number of its citizens working outside its borders and the number of other country's
citizens working within its borders.

In the United States, the 




 (G0P) was used until the early
1990's, when it was changed to GDP in order to be consistent with other nations.

Consumer Price Index

(CPI)

The most commonly reported measure of the consumer price levels in the United
States is the m
 
  m
 . Published by the U.S. Department of
Labor 's Bureau of Labor Statistics, the CPI is a fixed -weight price index using a fixed
basket of goods that are representative of what a typical consumer purchases each
month.

There are many different CPI's calculated by region, types of products, types of
consumers, etc. The most commonly reported CPI is the CPI-U, which is the CPI for
all urban consumers.

Increases in the CPI level serve as a measure of the consumer inflation rate. The
rate of inflation over a period of time is simply the percentage increase in the CPI
over the period, often reported on an annualized basis.
-   

The CPI has many important uses, including the following:

d Economic indicator - the CPI is the most commonly reported measure of

consumer prices.
d Reference for escalation agreements - labor contracts and other payment
agreements that are indexed to inflation rely on the CPI.
d Deflator for economic series - when a series of data is to be adjusted so that it
is reported in constant dollars, the CPI often is used as the deflator.

Because of the widespread use of the CPI, especially for adjusting payments to
inflation, its accuracy can have a significant impact on the economy. In recent years,
the accuracy of the CPI has been questioned due to a number of biases that cause it
to overstate the effective rate of inflation.

 

The CPI tends to overstate inflation beca use of the following biases:

d £
 - when the price of a product in the consumer basket

increases substantially, consumers tend to substitute lower -priced
alternatives. For example, if a freeze in Florida causes the price of oranges to
skyrocket, consumers may substitute Texas grapefruits for Florida oranges.
Since the CPI is a fixed-weight price index, it would not accurately predict the
impact of the price increase on the consumer's budget.
d Î - over time, technological advances increase the life and
usefulness of products. For example, the useful life of automobile tires
increased substantially over the past few decades, decreasing the tire cost on
a per mile basis, but the CPI does not reflect such improvements.
d 0
  - new products are not introduced into the index until they
become commonplace, so the dramatic price decreases often associated with
new technology products are not reflected in the index.
d  - the consumer shift to new outlets such as wholesale clu bs and
online retailers is not well -represented by the CPI.

Some economists estimate that such biases overstate the CPI by about 1% per year.

The U.S. Department of Labor has responded to these biases by more frequently
changing the base period when the it ems in the index and their weights are adjusted.
Also, the government now is quicker to add new products to the CPI basket and has
made quality adjustments to the index.