## 2.1 Consumption

Consumption is a term in economics that refers to expenditure on consumer goods.

In economic models, consumption is often the primary driver of utility. People choose consumption at each point in time through their life to maximise a utility function that depends on both current consumption and future consumption.

The starting point for economists thinking about consumption over time is that people and households save and borrow to smooth consumption over the lifecycle. This is most famously captured in Milton Friedman’s (( 1957)) permanent income hypothesis, which in a simplified form states that it is only changes in “permanent income” - the combination of current and all future income - that leads to changes in consumption. Permanent income might also be thought of as someone’s long-term income.

Suppose an agent has a two period life. Utility depends on consumption today and in the future, so we might write her utility function as follows:

$U=u(C_0)+\beta u(C_1)$

where $$U$$ is utility, and $$C_0$$ and $$C_1$$ are consumption in the first and second periods respectively. $$\beta$$ is a discount factor (typically less than but close to one) reflecting how much the agent weights consumption in the future relative to today. If the utility function $$u(C_t)$$ is concave, meaning that there is diminishing marginal utility for each additional increment of consumption, the agent would prefer to spread their consumption across the two periods, but with a tendency for slightly more consumption today.

## 2.2 Saving

Saving is deferred consumption. We can save by putting money in a bank deposit account, a savings account, or stashing cash under our mattress. In economics, savings is often defined as income minus consumption.

Suppose an agent receives $100 in salary today, but does not expect any income in the second period. The agent could save some of this$100, possibly receiving interest payments on her savings. This will then allow her to smooth her consumption across the two periods, giving her higher total utility.

Savings can also take the form of the purchase of a financial asset such as shares. This is known as investing, and is discussed in Chapter 3.

## 2.3 Borrowing

Borrowing is consumption brought forward. We borrow through avenues as diverse as personal loans, mortgages, credit cards, buy-now pay-later, overdrafts, and payday loans.

Suppose an agent has no money today but will receive $100 in salary in the next period. She can borrow at a 10% interest rate between the two periods. This means that the agent could, if she wished, borrow to consume$91 today, and then pay the $91 plus$9 interest when she receives her salary in the next period. However, due to the agent’s utility function and her desire to smooth consumption, she would likely borrow around half her income, with the precise amount depending on the agent’s particular discount rate, the interest rate and the form of the utility function.

Click here to open an external resource. Look at Figures 10.2 and 10.3a