Class Summary on Consumption and Investment

8/13/2019 Class Summary on Consumption and Investment

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Class Summary of 3rdSeptember 2013: CONSUMPTION

John Maynard Keynes, the globally lauded British Economist was concerned with the

short-run as compared to the Classical economist whose primary regard was long-run. In his

book, The General Theory of Employment, Interest and Money, Keynes coined an interesting

term, Animal Spirits which dealt with human emotions that drive consumer confidence. He

further argued that free market forces could considerable time to adjust. In the short-run there

could be long eons of underemployment. Based on psychological law Keynes also gave his

insight on the fact that short-run in the times of economic depression is influenced by aggregate

demand.

Aggregate demand is a concept where there is full employment and all the resources

are gainfully employed. It can also be stated that aggregate demand is the amount of goods and

services in a particular economy that can be purchased at all possible price levels. Aggregate

demand satisfies resource allocation, defining framework of economic activity and proxy for

national income. Aggregate demand is often synonymous to effective demand, but this

equivalence is only restricted to aggregated market for goods in general. However, effective

demand is the maximum potential output that can be created.

Now aggregate demand follows an aggregate demand curve which is the sum of the

individual demand curves for different sector of the economy.

AD= C + I + G + (XM)

Here, AD = aggregate demand; C = Consumption; I = investment, G = Government Spending;

XM = Net Export, where, X = total exports and M = total imports

CONSUMPTION

Household Private Sector Government

Demand

AbsorptionExternal

Demand

Household Final

Consumption

Expenditure; at least one

wage earner in a

household, unit of

economic activity

Use of resources to run

their day to day activities

is the consumption of theprivate sector

Government consumes

to run its day to day

activities; largest sector

in Government

Expenditure: Defence


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Another intriguing concept that we came across was Pump Priming. The term pump

priming is derived from mechanical engineering paradigm dealing with the operation of older

pumps; a suction valve had to be primed with water so that the pump would start functioning

properly once again. As with these pumps, pump priming presumes that the economy must be

primed to function properly once again. In this regard, government spending is assumed to

stimulate private spending, which in turn should lead to economic expansion.

Since, we talked about economic despondency, Marshall Plan during the early 1930s

needs a specific mention, where the Americans aided European nations with economic support

to revive after World War II in order to stalemate the spread the Soviet Communism.

Now after the Marshall Plan comes the concept of full employment. It is a situation

where all available work force resources are being used in the most economically efficient way.

Economic activity is at its optimum during the time of full employment where there is proper

resource allocation and rightful employment.

Since terms like, resource, allocations and investments or in other words creating

new assets, are being pervasively used herein, the concept of SEZ or Special Economic

Zone appears automatically. SEZs primary objectives are to facilitate export of goods and

provide employments. SEZs consists of Industrial Parks, Free Trade Zones, and Export

Processing Zones. Conducting a business in a SEZ means that a company will receive tax

incentives and the opportunity to pay lower tariffs. Of all the countries that expedite SEZ, China

has been most successful, where an entire province named Hainan is being declared to be an

SEZ.

Some more concepts:

Concept of Crowding out:This is an economic concept where increased public sectorspending replaces, or drives down, private sector spending. The theory behind crowding

out assumes that governmental borrowing uses up a larger and larger proportion of the

total supply ofsavings available forinvestment.Because demand for savings increases

while supply stays the same, the price ofmoney or the interest rate goes up.

Autonomous and Induced Consumptions: Autonomous consumption is theminimum level of consumption that would exist even if a consumer has no income, thus

it is independent of income. Whereas, Induced Consumption is the consumption

expenditure on households goods as well as services that alters with income making it

income dependent.
http://www.investinganswers.com/financial-dictionary/personal-finance/savings-6081http://www.investinganswers.com/financial-dictionary/investing/investment-4904http://www.investinganswers.com/financial-dictionary/economics/money-5074http://www.investinganswers.com/financial-dictionary/economics/money-5074http://www.investinganswers.com/financial-dictionary/investing/investment-4904http://www.investinganswers.com/financial-dictionary/personal-finance/savings-6081


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Different segments of labours: Agricultural labour, Industrial Worker (Blue CollarWorkers whose jobs requires manual labour) and Rural Workers.

And most importantly, CONSUMPTION IS NEVER ZEROIn conclusion, the notion of a circular flow (of income and expenditures) is developed to

illustrate the Keynesian vision of an inherently unstable market economy. Tracking income

and expenditures graphically helps to conceptualize the market mechanisms that take the

economy from an initial state of full-employment into deep depression and back again and then

into an inflationary spiral.

Class Summary as of September 4th2013: Private Investment

AD= C + I + G + (X M)

As discussed before, all these components of aggregate demand (AD) are expressed in

nominal (economic value expressed in monetary terms) or real (nominal value adjusted for

inflation) terms. Here, all the variables above indicate expenditure. So, when income is

subtracted by these, what we get is savings. It should be noted that savings is a residual

variable, so, decisions on the investment are not made on the basis of savings. Households

save, Private Companies save their profits/retained earnings, even Governments save a part of

their income from the public sector (this when accumulated becomes gross national

savings).The more the saving, the less faith in the future. An interesting fact: Germany and

Japan save more than any other nations.

Now, motives of savings are different. Keynes identified eight different motives of savings:

i. Precautionary motiveii. Life-cycle motiveiii. Intertermporal substitution motiveiv. Improvement motivev. Independent motivevi. Bequest motivevii. Avarice motiveviii. Enterprise motive


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Economists like Browing, Lusardi and Katona also identified many other motives behind

savings. But the most common motives for savings are precautionary motives and when

external borrowing is costly. Economic history plays an important role in savings as well.

Here a question can be asked, what is the desirable level of saving? It should be always

remembered that savings is nothing but deferred consumption. We save because we want to

consume and to make more money out of our savings in the future. Savings is a function of the

rate of interest

S= f (i)

Interest in future is more than the value that consumption gives us today. That is why,

if depositors are given better prospects are willing to save. An increase in income encourages

higher investment, whereas a higher interest rate may discourage investment as it becomes

more costly to borrow money. Even if a firm chooses to use its own funds in an investment,

the interest rate represents anopportunity cost of investing those funds rather than lending out

that amount of money for interest.

Now, Investment has got different notions in the fields of Economics and Finance. As per

Economics, investment can be phrased as the purchase of assets that are not consumed today,

but are used to create wealth in the future. So, how do the private investors weigh their

options of investment? The answer lies within the following premises:

What to borrow for? (Machinery, raw materials etc.) What I need to invest? When do I get it from? Is there a market value of the product? (market analysis) Any opportunity costs? (cost of current activity versus return of future activity)Since, the discussion is on investments, the term whi te goods pops up automatically.

Now, in an economic jargon, white goods are consumer resources purchased with no intention

of resale, they are procured with a purpose of consumption alone (not just goods, but durables

as well: foods are bought for consumption only, but they are generally not durable, in fact they

are perishables). If we consider an institution buying an air conditioner, it is either for

investment or meant for business, so it will be taxed higher, hence, it is not a white good. Again,

if a household buys an air conditioner, it will be bought for consumption and not for resale, so
http://en.wikipedia.org/wiki/Opportunity_costhttp://en.wikipedia.org/wiki/Opportunity_cost


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it will be a white good. Thus, tradabilityis the factor on which the classification of white

goods rests upon.

Moving along, there are certain reasons for either business or investments,

An acumen to do business Not always because there is money/subsidies After deciding to do business the subsidies might act as incentives to keep the business

motivated

Some Interesting Facts:

Marginal Efficiency of Investment (MEI): Expected rates of return on investment as

additional units ofinvestment are made under specified conditions and over a stated period of

time. A comparison of these rates with the going rate of interest may be used to indicate the

profitability of investment. The rate of return is computed as the rate at which the expected

stream of future earnings from an investment project must be discounted to make their present

value equal to the cost of the project.

Marginal Efficiency of Capital (MEC):Keynes defines marginal efficiency of capital as the

rate of discount which makes the present value of the prospective yield from the capital asset

equal to its supplyprice.

Incremental Capital Output Ratio (ICOR): It is the rate at which marginal productivity

increases. Overall, a higher ICOR value is not preferred because it indicates that the entity's

production is inefficient. The measure is used predominantly in determining a country's level

of production efficiency. ICOR = Annual Investment Annual Increase in GDP

Total Factor Productivity (TFP):It is the portion of output not explained by the amount of

inputs used in production, i.e. it acts as a variable which accounts for effects in totaloutput notcaused by traditionally measured inputs of labour and capital. TFP plays a critical role on

economic fluctuations, economic growth and cross-country per capita income differences. At

business cycle frequencies, TFP is strongly correlated with output and hours worked.

Glossary

In these two classes, we all have covered the following concepts and theories:

1.

Animal Spirits2. Keynesian Model
http://www.britannica.com/EBchecked/topic/292475/investmenthttp://www.britannica.com/EBchecked/topic/292475/investmenthttp://en.wikipedia.org/wiki/Output_%28economics%29http://en.wikipedia.org/wiki/Output_%28economics%29http://www.britannica.com/EBchecked/topic/292475/investmenthttp://www.britannica.com/EBchecked/topic/292475/investment


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3. Aggregate Demand4. Effective Demand5. Consumption6. Types of Consumption (Household, Private Sector & Government)7. Pump Priming8. Marshall Plan9. Special Economic Zones (SEZs)10.Concept of Crowding Out11.Autonomous & Induced Consumption12.Labour Segmentation13.Concept of CONSUMPTION CAN NEVER BE ZERO14.Consumption as a function of Income15.Savings16.Motives of Savings17.Savings as a function of interest18.Investments19.White Goods20.Tradability21.Marginal Efficiency of Capital (MEC)22.Marginal Efficiency of Investment (MEI)23.Incremental Capital Output Ratio (ICOR)24.Total Factor Productivity (TFP)

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Class Summary on Consumption and Investment