© 2005 Thomson C hapter 21 Consumption and Investment

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CChapter 21hapter 21

Consumption and Consumption and InvestmentInvestment

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Gottheil - Principles of Economics, 4e

Economic PrinciplesEconomic Principles

Keynes’s absolute income hypothesis

Duesenberry’s relative income hypothesis

Friedman’s permanent income hypothesis

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Economic PrinciplesEconomic Principles

Modigliani’s life-cycle hypothesis

The marginal propensity to consume

The marginal propensity to save

Autonomous investment

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What Determines What Determines Consumption Consumption

Spending?Spending?Consumption-spending and consumption-production decisions are made simultaneously and independently of each other.

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Spending?Spending?The result is that sometimes consumers don’t buy enough of everything produced and other times producers do not produce as much as people want to consume.

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Spending?Spending?Consumption function

• The relationship between consumption and income. It is written as C = f(Y), where C represents consumption and Y represents income.

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Spending?Spending?The single most important factor influencing a person’s consumption spending is his or her level of disposable income. The greater the disposable income, the greater the consumption spending.

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Spending?Spending?A number of hypotheses have been offered to explain how changes in an individual’s income, and, taken collectively, changes in national income affect individual and national consumption.

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Keynes’s Absolute Keynes’s Absolute Income HypothesisIncome Hypothesis

Absolute income hypothesis

• As national income increases, consumption spending increases, but by diminishing amounts. That is, as national income increases, the marginal propensity to consume (MPC) decreases.

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Marginal propensity to consume (MPC)

• The ratio of the change in consumption spending to a given change in income.

• MPC = (change in C)/(change in Y).

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Marginal propensity to consume (MPC)

• Consumption increases by diminishing amounts as the income level increases.

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Keynes believed that although people who earn high incomes spend more on consumption than people who earn less, they are less inclined to spend as much out of a given increase in income than those earning less.

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Keynes relied on the psychological law that the satisfaction of “immediate primary needs” is a stronger motive for consumption than “accumulation.”

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For example, if a millionaire and a welfare recipient each received $500, the millionaire would likely just add the money to her savings account since her primary needs are already met.

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The welfare recipient, on the other hand, would likely immediately spend the money on food, clothing, and shelter.

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EXHIBIT 1 THE INDIVIDUAL’S MARGINAL PROPENSITY TO CONSUME

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Exhibit 1: The Exhibit 1: The Individual’s Marginal Individual’s Marginal

Propensity to ConsumePropensity to Consume1. What is the change in consumption as total income increases from $1,000 to $2,000 in Exhibit 1?• Consumption increases by $800 (from $1,400 to $2,200) as total income increases by $1,000.

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Exhibit 1: The Individual’s Exhibit 1: The Individual’s Marginal Propensity to Marginal Propensity to

ConsumeConsume2. What is the change in consumption as total income increases from $2,000 to $3,000?• Consumption increases by $700 (from $2,200 to $2,900) as total income increases by $1,000.

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To Keynes, national economies behave like individuals. He hypothesized that a nation’s MPC depends on its level of national income.

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EXHIBIT 2 THE NATION’S MARGINAL PROPENSITY TO CONSUME ($ BILLIONS)

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Exhibit 2: The Nation’s Exhibit 2: The Nation’s Marginal Propensity to Marginal Propensity to

ConsumeConsumeWhat happens to the national MPC as national income increases in Exhibit 2?• The national MPC increases, but by diminishing amounts.

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The pioneering work of Simon Kuznets showed that Keynes’s hypothesis was wrong. A nation’s MPC tends to remain fairly constant regardless of the absolute level of national income.

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Duesenberry’s Duesenberry’s Relative Income Relative Income

HypothesisHypothesisRelative income hypothesis

• As national income increases, consumption spending increases as well, always by the same amount. That is, as national income increases, MPC remains constant.

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HypothesisHypothesisAccording to Duesenberry, consumption spending is rooted in status. High-income people not only consume more than others, but also set consumption standards for everyone else.

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HypothesisHypothesisAn individual’s MPC, then, remains the same, as long as the individual’s relative income position remains unchanged.

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EXHIBIT 3 THE MARGINAL PROPENSITY TO CONSUME REMAINS CONSTANT

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Exhibit 3: The Marginal Exhibit 3: The Marginal Propensity to Consume Propensity to Consume

Remains ConstantRemains Constant

• Keynes’s consumption curve flattens near the top, reflecting his belief that MPC increases by diminishing amounts as income increases.

How does Duesenberry’s consumption curve in Exhibit 3 compare to Keynes’s consumption curve in Exhibit 2?

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Exhibit 3: The Marginal Exhibit 3: The Marginal Propensity to Consume Propensity to Consume

Remains ConstantRemains ConstantHow does Duesenberry’s consumption curve in Exhibit 3 compare to Keynes’s consumption curve in Exhibit 2? • Duesenberry’s consumption curve is a straight line, reflecting his belief that MPC increases by the same amount as income increases.

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Friedman’s Friedman’s Permanent Income Permanent Income

HypothesisHypothesisPermanent income hypothesis

• A person’s consumption spending is related to his or her permanent income.

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HypothesisHypothesisPermanent income

• Permanent income is the regular income a person expects to earn annually. It may differ by some unexpected gain or loss from the actual income earned.

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HypothesisHypothesisTransitory income

• The unexpected gain or loss of income that a person experiences. It is the difference between a person’s regular and actual income in any year.

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HypothesisHypothesisAccording to Friedman, an unexpected gain or loss in income in one year does not influence an individual’s overall MPC from year to year.

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Modigliani’s Life-Modigliani’s Life-Cycle HypothesisCycle Hypothesis

Life-cycle hypothesis

• Typically, a person’s MPC is relatively high during young adulthood, decreases during the middle-age years, and increases when the person is near or in retirement.

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Spending?Spending?Autonomous consumption

• Consumption spending that is independent of the level of income.

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Spending?Spending?Some consumption spending is simply unavoidable. While individuals may spend less on food, clothing, and shelter when income falls, there are limits to how much one can cut and still survive.

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Spending?Spending?A change in national income induces a change in consumption. The change in consumption is considered movement along the consumption curve.

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Spending?Spending?The consumption curve can also shift. Shifts in the consumption curve are unrelated to national income. There are several factors that can shift the consumption curve.

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Spending?Spending?1. Real asset and money holdings.

• An increase or decrease in real assets or money holdings causes the consumption curve to shift. For example, a substantial inheritance of money or property would cause the curve to shift upward.

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Spending?Spending?2. Expectations of price changes.

• An expectation of inflation could cause an increase in the current level of consumption, even though incomes are not expected to change. The increase in consumption would shift the curve upward.

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Spending?Spending?3. Credit and interest rates.

• If credit is more easily available or if the credit terms are made more attractive, people are likely to increase their spending on durable goods, even if their incomes haven’t changed. The consumption curve would shift upward.

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Spending?Spending?4. Taxation.

• If government decided to increase the income tax, people would end up with a smaller pay check, even though their salaries remained unchanged. This would cause a decrease in consumption and a downward shift in the consumption curve.

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EXHIBIT 4 SHIFTS IN THE CONSUMPTION CURVE

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Exhibit 4: Shifts in Exhibit 4: Shifts in the Consumption the Consumption

CurveCurve

i. True

ii. False

The consumption curve shifts depicted in Exhibit 4 can be attributed to increases and decreases in national income.

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Exhibit 4: Shifts in Exhibit 4: Shifts in the Consumption the Consumption

CurveCurveThe consumption curve shifts depicted in Exhibit 4 can be attributed to increases and decreases in national income.i. True

ii. False. Shifts in the consumption curve are unrelated to changes in national income.

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The Consumption The Consumption EquationEquation

There are two key factors that influence the character of our consumption spending: autonomous consumption and our income level.

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Consumption induced by our level of income is referred to as induced consumption.

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The consumption function takes the following form:

C = a + bY

Where a equals autonomous consumption spending, b equals MPC and Y equals level of national income.

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What Determines What Determines the Level of Saving?the Level of Saving?

People do two things with their income. They either spend it on consumption or they save it.

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Saving

• The part of national income not spent on consumption.

• S = Y - C.

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Saving

• When C is greater than Y, saving is negative and is called dissaving. People can consume more than their income allows by running down their savings or other forms of accumulated wealth.

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Marginal propensity to save (MPS)

• The change in saving induced by a change in income.

• MPS = (change in S)/(change in Y).

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What Determines What Determines the Level of the Level of

Saving?Saving?The marginal propensities to consume and to save add up to 100 percent.• MPC + MPS = 1.

• MPS = 1 - MPC.

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Income curve or 45o line

• A line, drawn at a 45° angle, showing all points at which the distance to the horizontal axis equals the distance to the vertical axis. The line is also called the income curve.

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EXHIBIT 5A THE SAVINGS CURVE

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EXHIBIT 5B THE SAVINGS CURVE

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Exhibit 5: The Saving Exhibit 5: The Saving CurveCurve

What is saving when income is $400 billion in Exhibit 5?

• S = Y – C or S = Y – (a + bY).

• Saving = $400 billion – [$60 billion + (0.8 × $400 billion)] = $20 billion.

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The Investment The Investment FunctionFunction

Producers in the economy must decide how much income to spend on new investment.

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Producers may invest in replacing used up or obsolete machinery, expanding production, increasing raw material or finished goods inventories, and building new facilities for new products.

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Each producer makes investment decisions independently of others.

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Intended investment

• Investment spending that producers intend to undertake. These intended investments do not always end up being realized.

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What Determines What Determines Investment?Investment?

The level of national income doesn’t play the decisive role in determining investment that it plays in determining consumption spending.

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Autonomous investment

• Investment that is independent of the level of income.

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EXHIBIT 6 THE INVESTMENT CURVE

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Exhibit 6: The Investment Exhibit 6: The Investment CurveCurve

How does the investment curve (I) in Exhibit 6 change as the level of national income changes?• The investment curve does not change. It remains at $75 billion at every level of national income.

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Four factors determine the size of the economy’s autonomous investment.

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1. Technology level.

• The introduction of new technologies is one of the mainsprings of investment. Technological leaps produce extensive networks of investment spending.

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2. Interest rate.

• Producers undertake investment when they believe the rate of return generated by the investment will exceed the interest rate, that is, the cost of borrowing investment funds.

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2. Interest rate.

• There is an inverse relationship between the rate of interest and the quantity of investment spending.

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EXHIBIT 7 THE EFFECT OF CHANGES IN THE RATE OF INTEREST ON THE LEVEL OF INVESTMENT

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Exhibit 7: The Effect of Exhibit 7: The Effect of Changes in the Rate of Changes in the Rate of Interest on the Level of Interest on the Level of

InvestmentInvestmentWhy is the demand curve for investment in panel a of Exhibit 7 downward sloping?• The demand curve for investment is downward sloping because as the rate of interest decreases, the level of investment in the economy increases.

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3. Expectations of future economic growth.

• Investment spending reflects how producers view the future. Future expectations are shaped by past performance.

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4. Rate of capacity utilization.

• Producers seldom choose to operate at 100 percent capacity. Operating at less than 100 percent capacity gives them the ability to expand production on demand.

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4. Rate of capacity utilization.

• How much flexibility producers end up choosing influences the economy’s level of production. For producers who choose to operate close to full capacity, a moderate increase in sales may shift them quickly into investment spending.

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The level of investment spending in the U.S. economy is volatile. Sometimes the factors that effect investment spending pull in opposite directions. Other times, they work in unison and lead to impressive economic growth.

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EXHIBIT 8 THE VOLATILITY OF INVESTMENT

Source: Economic Report of the President 1994 (Washington, D.C.: United States Government Printing Office, 1994), p. 270; and U.S. Department of Commerce, Survey of Current Business 76 (January/February 1996), Table 2.

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Exhibit 8: The Exhibit 8: The Volatility Volatility

of Investmentof InvestmentHow does the rate of investment spending in Exhibit 8 compare to the rate of consumption spending?• While the rate of consumption spending is fairly stable over time, the rate of investment spending is volatile.

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© 2005 Thomson C hapter 21 Consumption and Investment