Chapter

Consumption, Savings and Investment

Prepared by:
Md. Moulude Hossain Faculty Member, Dept of Business Administration, IST

Consumption, Savings and Investment

Consumption function Determinants of Consumption Engel's law Savings Determinants of Investment The Multiplier

Definition and Concept of Consumption

Consumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by opposition to production. But the precise definition can vary because different schools of economists define production quite differently.

According to mainstream economists, only the final purchase of goods and services by individuals constitutes consumption, while other types of expenditure in particular, fixed investment and government spending are placed in separate categories. See consumer choice. Other economists define consumption much more broadly, as the aggregate of all economic activity that does not entail the design, production and marketing of goods and services (e.g. "the selection, adoption, use, disposal and recycling of goods and services").

Definition and Concept of Consumption

Thus we can say that,

Consumption represents purchases by consumers on final goods and services. Consumption is obtained from consumer disposable income. Disposable income must be either spent or saved. Therefore the following formula applies: Disposable Income (YD) = Consumption (C) + Saving (S)

Some Key Concept of Consumption

Autonomous consumption
Autonomous consumption expenditure CA occurs when income levels are zero. Such consumption does not vary with changes in income. If income levels are actually zero, this consumption is financed by borrowing or using up savings.

Some Key Concept of Consumption

Induced consumption
Induced consumption CI describes consumption expenditure by households on goods and services which varies with income. Consumption is considered induced by income.

Some Key Concept of Consumption

Marginal Propensity to Consume
The marginal propensity to consume (MPC) is the extra amount that people consume when they receive an extra unit of income.
MPC = C / Y MPC is the first derivation of consumption function.

Induced consumption can be described by formula: CI = MPC . Y

Some Key Concept of Consumption

Average propensity to consume (APC) We often want to determine the proportion of total disposable income spent on consumer goods and services. The average propensity to consume (APC) is equal to total consumption on consumer goods and services in a given time period divided by total disposable income. APC = total consumption / total disposable income = C/YD

Some Key Concept of Consumption

Average propensity to consume (APC) In 1999, total consumer consumption totaled $6,490 billion, and total disposable income was $6,638 billion. Therefore the APC = $6,490 billion /$6,638 billion =0.98 98 cents out of each dollar earned was spent on consumption in 1999. In 2001 the U.S. APC was 1.001 indicating that consumers actually spent more than they received from income.

Some Key Concept of Consumption

Marginal propensity to save (MPS) We are also concerned with how much consumers save from each additional dollar they earn. The marginal propensity to save (MPS) is the fraction of each additional dollar of disposable income not spent on consumption. MPS = S / YD or MPS = 1 MPC
If consumers save $0.20 out of the last dollar earned, what is the MPS? The MPS = .20/1.00 = .20.

Some Key Concept of Consumption

Average propensity to save (APS) We are also concerned with the average rate of consumer saving. To determine this, we calculate the average propensity to save (APS). The APS = S / YD or APS = 1 APC Suppose disposable income is $6,698 billion and consumers saved $208 billion. What is the APS? The APS = $208 billion/$6,698 billion = .031. Consumers save an average of $0.031 out of each dollar of disposable income.

Determinants of Consumption
Income is the most important and prime determinants of consumption. But there are other relevant factors that affect the consumption, which are listed bellow. Among the factors listed below from no.2 to no. 7 may be termed as non-income determinants of consumption. Consumption based upon one or more of these determinants are called autonomous consumption.

The level of real disposable household income availability of credit Consumer confidence Expectations Wealth Taxes Price-levels

The Consumption Function

The consumption function is simply a theoretical relationship between income and consumer expenditure. The Keynesian theory describes a consumption function where household spending is directly linked to peoples disposable income. A simplified consumption function diagram is shown below.

The Consumption Function

The consumption function shows the relationship between the level of consumption expenditure and the level of income.
C = f (Y) If autonomous and induced consumption is identified then: C = CA + CI C = CA + MPC . Y

The Consumption Function

Recalling the previous section, we have learned that consumer spending is influenced by current income, and the non-income determinants of consumption. Therefore total consumption = non-income determinants of consumption + income-dependent consumption, or total consumption = autonomous consumption + income-dependent consumption. The formula that represents this relationship is: C = a + bYd

The Consumption Function

The equation C = a + bYd represents the consumption function. The consumption function is a mathematical relationship indicating the desired consumer spending at various income levels.

The consumption function is used to predict how changes in disposable income (YD) will affect consumer spending. It also shows the effect of changes in one or more nonincome determinants (autonomous consumption) on consumer spending.

C = current consumption a = autonomous consumption b = marginal propensity to consume Yd = disposable income

The Consumption Function

A Consumption Function C = YD Consumption Spending

Saving

Dissaving

Disposable Income

The Consumption Function

C Savings Consumption function C = f(Y)

CA
45

Consumption

Y1

The Consumption Function

45 line: at any point on the 45line consumption exactly equals income and the households have zero saving. MPC is the slope of the consumption function, which measures the change in consumption per unit change in income.

Study Break
Assume you are given the following data : a = $ 100 ; b = 0.8. Write the consumption function and calculate APC based on the values of YD shown in the table.

Study Break
Solution

The desired consumption function is: C = 100+ 0.8YD YD a bYD C APC MPC 0 100 0 100 .8 100 100 80 180 1.8 .8 500 100 400 500 1.0 .8 1000 100 800 900 0.9 .8

The Properties of Consumption Function

1. There is a break even level of income at which

APC = 1

when C = Yd APC > 1 because C > Yd

Below the break-even level of income

Above the break-even level of income

APC < 1 because C < Yd 2. 0 < MPC < 1 for all level of income

Consumption Function of an Imaginary Consumer

To graph the consumption function for a individual or for an economy, we need to know the level of autonomous consumption, the MPC, and the amount of disposable income. If autonomous consumption = $100, and the MPC = .50, then our equation is: C = $100 + 0.50YD

Consumption Function of an Imaginary Consumer

Once we know different levels of disposable income, we can graphically represent the consumption function.
Consumption = $100 + 0.50YD
Disposable Income (YD) A B C D E $ 0 100 200 300 400 Autonomous Consumption 100 100 100 100 100

IncomeDependent Consumption $ 0 50 100 150 200

Total Consumption $100 150 200 250 300

Consumption Function of an Imaginary Consumer

Now plotting the above data e find the following consumption function for the individual.
Consumption Function

$400

C = YD
E C D

300

Saving

200 A 100

Dissaving

B
Consumption Function C = $100 + 0.50Yd

$50

100

150

200

250

300

350

400

450

Shifts in the consumption function

1. Shifts of the consumption function
Shifts of the consumption function can occur when a change occurs in one of the autonomous consumption determinants (expectations, wealth, credit, taxes, price levels). For example, significant positive returns in the stock market can increase consumer wealth which would cause autonomous consumption to increase. This would cause the consumption function to shift upwards.

Shifts in the consumption function

Shift in the Consumption Function

CONSUMPTION (C) (dollars per year)

DISPOSABLE INCOME (dollars per year)

Shifts in the consumption function

2. Movement along the Consumption Function Movement along the consumption function occurs when there is a change in income or a change in the MPC. A decline in income causes a leftward movement along the consumption function (from point A to B on the next slide).

Shifts in the consumption function

Movements along the Consumption Function

A
CONSUMPTION (billions of dollars per year)

DISPOSABLE INCOME (billions of dollars per year)

Factors for the Shifts in the Consumption Function

A change in any factor affecting consumption other than a change in income is said to lead to a shift in the consumption function. These factors include the following: A change in interest rates for example a cut in interest rates will boost consumption at each level of income and cause an upward shift in the consumption function. A change in household wealth for example a rise in house prices or in share prices encourages higher levels of borrowing and an upward movement in the consumption curve A change in consumer confidence for example, expectations of rising unemployment and worsening expectations of changes in income might lead to a reduction in confidence and a fall in spending at each level of income.

Factors for the Shifts in the Consumption Function

Savings
Saving is that part of income that is not consumed. Saving equals income minus consumption: S = Y C Income is the sum of consumption and savings: Y = C + S then
C S 1 Y Y

and

C S 1 Y Y

Savings
The marginal propensity to save
S MPS Y

is defined as the fraction of an extra unit of income that goes to extra saving. MPC + MPS = 1 because the part of each unit of income that is not consumed is necessarily saved.

Saving Function
Like consumption saving is also the function of income: S = f(Y) If autonomous consumption exists then autonomous saving exists as well and saving function is: S = -CA + MPS.Y Saving is a source for investment.

Saving Function
Also, saving is defined as the part of disposable income that is not consumed . So S = YD - C and since C = a + b YD Thus S = YD ( a + b YD) so S = YD a b YD Therefore S = -a + (1-b) YD

APC and APS

Since YD = C + S (1) dividing both sides of equation (1) by Yd, we get the following : Yd = C + S (2) Yd Yd Yd 1 = APC + APS

MPC and MPS

Since YD = C + S (1) Change in YD = change in C + change in S (2) Dividing both sides of equation (2) by change in Yd ,we get :
change in YD = change in consumption + change in saving change in YD = change in YD change in YD

MPC

MPS

MPC and MPS

Given that C = 100 + 0.8 Yd S = Yd C Prove that APC + APS = 1 ?

MPC and MPS

Solution Yd C S APC APS APC + APS 0 100 -100 100 180 - 80 1.8 - 0.8 1 500 500 0 1.0 0 1 1000 900 100 0.9 0.1 1

The Consumption and Saving Function

C, S C = f(Y) The saving function is the mirror image of the consumption function. It shows the relationship between the level of saving and income.

CA 0 -CA
45 Y
E

S = f(Y)

Comparisons between Consumption Function and Saving Function

The key to understanding how a rise in disposable income affects household spending is to understand the concept of the marginal propensity to consume (mpc). The marginal propensity to consume is the change in consumer spending arising from a change in disposable income. If for example your disposable income rises by 5,000 and you choose to spend 3000 of this on extra goods and services, then the mpc is 3000/50000 or 0.66. If you chose instead to spend only 2500 of the increase in income, then the mpc would be 0.5.

Comparisons between Consumption Function and Saving Function

The consumption function - a simple numerical example Disposable Consumption Average Marginal Propensity Propensity toto Consume = change Income (Yd) (C) Consume = C/Yd in C from a 1 change in Yd 10000 20000 30000 40000 8500 16000 23600 29450 0.85 0.80 0.79 0.74 0.75 0.76 0.59

50000

33200

0.66

0.38

Consumption and AD
AD Effects of Consumption Shifts
AD shifts to the right indicating increased output AD

Spending

Price Level

AD

Consumption function shifts up indicating an increase in autonomous consumption

Income

Real Output

Life Cycle Hypothesis (LCH)

Franco Modigliani, Albert Ando, and Richard Bloomberg Assumes that each representative agent will die, and knows:

when he/she will die, how many periods T he/she will live, and How much his/her life-time income will be.

The consumer smooths consumption expenditure over his/her life, spending 1/T of his/her life-time income each period.

Income and Consumption LCH

death

Consumption

Saving

Income Dissaving

Criticisms of LCH
The households, at all times, have a definite, conscious vision of:

The familys future size and composition, including the life expectancy of each member, The entire lifetime profile of the labor income of each memberafter the applicable taxes, The present and future extent and terms of any credit available, and The future emergencies, opportunities, and social pressures which might affect its consumption spending.

It does not take into account liquidity constraints.

Policy Implications of LCH

Changes in current income have a strong effect on current consumption ONLY if they affect expected lifetime income. In Q2 1975, a one-time tax rebate of $8 billion was paid out to taxpayers to stimulate AD.

The rebate had little effect.

Maybe George W. hadnt heard about this? The only way there can be a significant effect is if there is a strong liquidity constraint operating. This has implications for monetary policy.

Investment
Investment pays two roles in macroeconomics:

It can have a major impact on AD (real output and employment) It leads to capital accumulation (it increases the nation's potential output and promotes economic growth in the long run)

The meaning of investment to an economist

Investment to an economist is a precise term which involves the acquisition of capital goods designed to provide us with consumer goods and services in the future. Investment spending involves a decision to postpone consumption and to seek to accumulate capital which can raise the productive potential of an economy. But investment is similar to consumption as it is an important component of aggregate demand.

It is important to remember that investment has important effects on both the demand-side and the supply-side of the economy.

The meaning of investment to an economist

Net and gross investment

Net investment in any given year = gross investment minus an estimate for replacement investment i.e. that investment required to replace obsolete capital. The level of net investment in any one year tells us what is happening to the final stock of fixed capital available for production. Gross fixed investment is spending on fixed assets. The biggest single item of investment spending is on new buildings, plant and machinery and vehicles. The real value of business investment in the UK economy over recent years is shown in the next data chart.

The meaning of investment to an economist

Autonomous and induced investment

Autonomous investment is capital expenditure on producer goods unrelated to the level of national income. For example, the cost of purchasing new items of capital equipment would affect autonomous investment. Induced investment is related to levels of national income. An increase in GDP increases induced investment but leaves autonomous investment unaffected. The accelerator theory of investment which we will consider shortly is an example of this.

Definition of Capital Investment

Capital investment is defined as spending on capital goods such as new machinery, buildings and technology so that the economy can produce more consumer goods in the future. A broader definition of investment would encompass spending on improving the human capital of the workforce - for example extra investment in training and education to improve the skills and competences of workers. Most economists agree that investment is vital to promoting long-run economic growth through improvements in productivity and a countrys productive capacity.

The Economic Importance of Capital Investment

Investment affects AD as well as Aggregate Supply (AS)

A rise in capital investment will therefore have important effects on both the demand and supplyside of the economy including a positive multiplier effect on national income.

Demand side effects: Increase spending on capital goods affects industries that manufacture the technology / hardware / construction sector Supply side effects: Investment is linked to higher productivity, an expansion of a countrys productive capacity, a reduction in unit costs (e.g. through the exploitation of economies of scale) and therefore a source of an increase in LRAS (trend growth)

Investment affects AD as well as Aggregate Supply (AS)

Investment Demand Function/relationship between Interest Rate and Planned Investment/ The marginal efficiency of capital (MEC)/ the demand curve for investment

Investment Demand Function/relationship between Interest Rate and Planned Investment/ The marginal efficiency of capital (MEC)/ the demand curve for investment

Expected rates of return on investment matter when businesses are making investment decisions and this is where the concept of the marginal efficiency of capital comes in. The marginal efficiency of capital (MEC) is defined as the rate of interest which makes a proposed investment project viable at the margin. This is illustrated in the diagram above. At lower rates of interest (i.e. R2 rather than R1) more capital projects appear financially viable because the cost of borrowing money to finance the investment is lower and the opportunity cost of using retained profits as an internal source of investment finance is also reduced. A fall in interest rates should (ceteris paribus) lead to an expansion along the investment demand curve. Similarly higher interest rates (R3) may lead to some projects being postponed or cancelled.

Real Interest Rate

Determinants of Investment
As with consumption and saving, we find that there are plenty of theories as to the main factors driving investment decisions in the economy. A change in consumer spending is not the only factor that affects aggregate demand. The other factors (investment, government services, and net exports) can offset changes in consumer spending. There are also determinants of investment, such as:

Interest rates Expectations and confidence Profits External economic factors Technology and Innovation Corporate taxes The rate of growth of demand

Shifts in Investment Demand Curve

Investment Demand and Interest Rates 11 10 9 8 7 6 5 4 3 2 1 0 Better expectations cause a shift rightward Movement up the existing curve is caused by an increase in interest rates Interest Rate (percent per year)

I2 Initial expectations 11 Worse expectations The curve shifts left 100 200 300 400 I3 500

Planned Investment Spending (billions of dollars per year)

The Accelerator Model of Investment

This is another theory of investment. Put simply, the accelerator model suggests a positive relationship between investment and the rate of growth of demand or output. Accelerator theories of investment assume that there is a desired capital stock for a given level of output and interest rates. A rise in output or a fall in interest rates may prompt increased levels of investment as firms adjust to reach the new optimal capital stock level.

The Accelerator Model of Investment

Investment Multiplier
The Keynesian investment multiplier model shows that an increase in investment will increase output by a multiplied amount by an amount greater than itself. The multiplier is the number by which the change in investment must be multiplied in order to determine the resulting change in total output.

Investment Multiplier
C, I E2 C + I2

I2 = I1 + I C +I1
Y = k . I
Y k I

E1 I
45

Y1 Y

Y2

Investment Multiplier
S

S = f (Y)

E2 I
0 Y1 Y Y2

I2

E1

I1
Y

Investment Multiplier
The size of the multiplier k depends upon how large the MPC is.
Y Y 1 1 1 k I Y C 1 C 1 MPC MPS Y