Consumption, Savings and Investment Consumption function Determinants of Consumption Engel's...

Consumption, Savings and Investment

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

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.

Induced consumption

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

Consumption is considered induced by income.

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 = ΔC / ΔYMPC is the first derivation of consumption

function. Induced consumption can be described by

formula: CI = MPC . Y

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

Y

C

0

Consumption function C = f(Y)

Savings

Consumption

45˚

Y1 Y 2

CA

The Consumption Function

45˚ line: at any point on the 45˚line 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.

Engel's Law

The nineteen century Prussian statistician Ernst Engel noticed that as income increases, expenditures on many items go up, but there are limits to the extra money people will spend on food when their income rise.

Engel's Law: The proportion of total spending devoted to food declines as income increases.

Nonlinear Consumption function

Y

C

C = f(Y)

CA

45°

E

YE

Determinants of Consumption

Current disposable income: it is the central factor determining a nation's consumption.

Permanent income: it is the level of income that households would receive when temporary influences are removed.

Wealth: it is the net value of tangible and financial items owned by a nation or person at a point of time.

Other (interest rate, inflation, expectations).

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 and 1Y

S

Y

C 1

Y

S

Y

C

Savings

The marginal propensity to save

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.

Y

SMPS

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.

The Consumption and Saving Function

Y

C, S

0

C = f(Y)

45˚

Y E

CA

-CA

S = f(Y)

The saving function is the mirror image of the consumption function. It shows the relationship between the level of saving and income.

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)

Determinants of Investment

Revenues: an investment should bring the firm additional revenue.

Costs: interest rate influences the costs of the investment.

Consumer demand: the bigger the increase in consumer demand, the more investment will be needed.

Expectation: business expectation about future state of economy.

The Investment Demand Curve

Investment spending

Interest rate i

D

D1

Higher Output

The Investment Demand Curve

Investment spending

Interest rate i

D1

D

Higher Taxes

The Investment Demand Curve

Investment spending

Interest rate i

D1

D

Pessimistic Expectation

The Simple Theory of Investment

In the simple Keynesian model, investment is independent of national income (autonomous investment).

The investment function will be a horizontal straight line.

The Investment Function

Y

I

0

I1

In the short-run it is reasonable to assume that investment is independent of national income.I2

I2

I1

Consumption and Investment Functions

The spending curve shows the level of desired expenditure by consumers (CA + MPC.Y) and businesses (I) corresponding to each level of output.

Consumption and Investment Functions

Y

C, I

0

C = CA + MPC . Y

C + I = CA + MPC . Y + I

I

I

Consumption and Investment Determine Output

If the level of output is e. g. Y1 at this level

of output the C+I spending line is above 45˚line, so planned spending is greater than planned output.

This means that consumers would be buying more goods than the businesses were producing. Thus spending disequilibrium leads to a change in output.

Equilibrium National Income

Y

C, I

0

45˚

C + I = CA + MPC . Y + I

E

Y1

YE

Y2

Consumption and investment determine output

Saving and Investment Determine Output

Equilibrium occurs when desired saving of households equals the desired investment of businesses.

When desired saving and desired investment are not equal, output will tent to adjust up or down.

Saving and Investment Determine Output

Y

S, I

0

S = f (Y)

E

Y1

YE

Y2

I

-

Saving and Investment Determine Output

At output level Y2 families are saving more

than businesses are willing to go on investing. Firms will have too few customers and large inventories of unsold goods than they want. Then, businesses will cut back production and lay off workers. This move output gradually downward and economy returns to equilibrium Y

E.

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

Y

C, I

0

45˚

C +I1

C + I2

Y1

I2 = I

1 + ΔI

ΔY = k . ΔI

Y2

ΔY

ΔI

E1

E2

I

Yk

Investment Multiplier

Y

S

0

S = f (Y)

Y1

I1

-

I2ΔI

ΔY Y

2

E1

E2

Investment Multiplier

The size of the multiplier k depends upon how large the MPC is.

MPSMPCYCCY

Y

I

Yk

1

1

1

1

1