Lceture Slide_Consumption Savings and Investment

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Consumption, Savingsand Investment

Chapter8

Prepared by:Md. Moulude Hossain

Faculty Member, Dept of Business Administration, IST



Consumption, Savings andInvestment

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 givesrise 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 schoolsof 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 separatecategories. See consumer choice. Other economists define consumption much more broadly, as

the aggregate of all economic activity that does not entail thedesign, production and marketing of goods and services (e.g."the selection, adoption, use, disposal and recycling of goodsand services").



Definition and Concept of Consumption

Thus we can say that, Consumption represents purchases by consumers

on final goods and services. Consumption isobtained 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. Suchconsumption does not vary with changes inincome.

If income levels are actually zero, thisconsumption is financed by borrowing orusing up savings.




Induced consumption Induced consumption CI describes

consumption expenditure by households ongoods 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 theyreceive an extra unit of income.

MPC = ΔC / ΔY

MPC is the first derivation of consumption function.

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




Average propensity to consume (APC) We often want to determine the proportion of total

disposable income spent on consumer goods andservices.

The average propensity to consume (APC) isequal to total consumption on consumer goods andservices in a given time period divided by totaldisposable income.

APC = total consumption / total disposableincome = C/YD




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 = $6,490billion /$6,638 billion =0.98

98 cents out of each dollar earned was spent onconsumption in 1999. In 2001 the U.S. APCwas 1.001 indicating that consumers actuallyspent more than they received from income.




Marginal propensity to save (MPS)

We are also concerned with how much consumerssave from each additional dollar they earn.

The marginal propensity to save (MPS) is thefraction of each additional dollar of disposable

income not spent on consumption.MPS = ΔS / ΔYD 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.




Average propensity to save (APS) We are also concerned with the average rate of

consumer saving. To determine this, we calculatethe average propensity to save (APS).

The APS = S / YD or APS = 1 – APC

Suppose disposable income is $6,698 billion andconsumers saved $208 billion. What is the APS?The APS = $208 billion/$6,698 billion = .031.Consumers save an average of $0.031 out of eachdollar of disposable income.



Determinants of Consumption

Income is the most important and prime determinants of consumption. But there are other relevant factors that affectthe consumption, which are listed bellow. Among thefactors listed below from no.2 to no. 7 may be termed asnon-income determinants of consumption. Consumptionbased upon one or more of these determinants are calledautonomous 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 andconsumer expenditure. The Keynesiantheory describes a consumption function where household spending is directly linked

to people’s disposable income. A simplifiedconsumption function diagram is shownbelow.




The consumption function shows the

relationship between the level of consumptionexpenditure and the level of income.C = f (Y)

If autonomous and induced consumption is identifiedthen: 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-incomedeterminants of consumption + income-dependent

consumption, or total consumption = autonomousconsumption + 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 atvarious income levels. C = current consumption a = autonomous consumption b = marginal propensity to consume Yd = disposable income

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



The Consumption Function A Consumption Function

C = Y D

Saving

Dissaving

Disposable Income

C o n

s u m p t i o n S p e n d i n g




Y

C

0

Consumptionfunction C = f(Y)

Savings

Consumption

45˚

Y1 Y 2

CA




45˚ line: at any point on the 45˚lineconsumption exactly equals income and thehouseholds have zero saving.

MPC is the slope of the consumptionfunction, which measures the change inconsumption per unit change in income.



Study Break

Assume you are given the following data :a = $ 100 ; b = 0.8. Write the consumptionfunction and calculate APC based on thevalues 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 .8500 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 Below the break-even level of income

APC > 1 because C > Yd

Above the break-even level of incomeAPC < 1 because C < Yd

2. 0 < MPC < 1 for all level of income



Consumption Function of anImaginary Consumer

To graph the consumption function for a

individual or for an economy, we need toknow the level of autonomous consumption,the MPC, and the amount of disposableincome.

If autonomous consumption = $100, and theMPC = .50, then our equation is:

C = $100 + 0.50YD




Once we know different levels of disposable income, wecan graphically represent the consumption function.

Consumption = $100 + 0.50YD

DisposableIncome (Y D )

AutonomousConsumption

+ Income-Dependent

Consumption

= TotalConsumption

A $ 0 100 $ 0 $100

B 100 100 50 150

C 200 100 100 200

D 300 100 150 250

E 400 100 200 300




Now plotting the above data e find the followingconsumption function for the individual.

Consumption Function

$400

$50 100 150 200 250 300 350 400 450

C = Y D

Saving Dissaving

Consumption Function

C = $100 + 0.50Yd A

C D

E

B

300

200

100



Shifts in the consumptionfunction

1. Shifts of the consumption function

Shifts of the consumption function can occur when achange occurs in one of the autonomous consumptiondeterminants (expectations, wealth, credit, taxes, pricelevels). For example, significant positive returns in thestock market can increase consumer wealth which

would cause autonomous consumption to increase. Thiswould cause the consumption function to shift upwards.




Shift in the Consumption Function

C O N S U M P T I O N

( C ) ( d o l l a r s p e r y e a r )

DISPOSABLE INCOME (dollars per year) 0




2. Movement along the Consumption Function

Movement along the consumption functionoccurs when there is a change in income or achange in the MPC.

A decline in income causes a leftward

movement along the consumption function(from point A to B on the next slide).




Movements along the Consumption Function

C O N S U M P T I O N

( b i l l i o n s o f d o l l a r s p e r y e a r )

DISPOSABLE INCOME (billions of dollars per year)

0

B

A



Factors for the Shifts in theConsumption Function

A change in any factor affecting consumption other than achange in income is said to lead to a shift in theconsumption function. These factors include the following:

A change in interest rates – for example a cut in interestrates will boost consumption at each level of income andcause an upward shift in the consumption function.

A change in household wealth – for example a rise inhouse prices or in share prices encourages higher levels of

borrowing and an upward movement in the consumptioncurve A change in consumer confidence – for example,

expectations of rising unemployment and worseningexpectations of changes in income might lead to areduction in confidence and a fall in spending at each levelof income.



Factors for the Shifts in theConsumption Function



Savings

Saving is that part of income that is notconsumed. Saving equals income minusconsumption: 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 isnecessarily saved.

Y

S MPS



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 savingfunction is: S = -C

A

+ MPS.Y

Saving is a source for investment.



Saving Function

Also, saving is defined as the part of disposable

income that is not consumed . SoS = 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, weget 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

1 = MPC + MPS



MPC and MPS

Given that C = 100 + 0.8 Yd

S = Yd – CProve 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 SavingFunction

The saving

function is themirror image of the consumptionfunction. It showsthe relationship

between the levelof saving andincome.

Y

C, S

0

C = f(Y)

45˚

Y E

CA

-CA

S = f(Y)



Comparisons between Consumption

Function and Saving Function

The key to understanding how a rise in disposable incomeaffects household spending is to understand the concept of

the marginal propensity to consume (mpc).The marginal propensity to consume is the change inconsumer spending arising from a change in disposableincome.If for example your disposable income rises by £5,000and you choose to spend £3000 of this on extra goodsand 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

DisposableIncome (Yd)

Consumption(C)

AveragePropensity toConsume = C/Yd

Marginal Propensityto Consume = changein C from a £1 changein Yd

10000 8500 0.85

20000 16000 0.80 0.75 30000 23600 0.79 0.76

40000 29450 0.74 0.59

50000 33200 0.66 0.38



Consumption and AD

AD Effects of Consumption Shifts

Spending

Income

Price Level

Consumption function shifts upindicating an increase in autonomousconsumption

AD AD

Real Output

AD shifts to the right

indicating increased output



Life Cycle Hypothesis (LCH)

Franco Modigliani, Albert Ando, and RichardBloomberg

Assumes that each representative agent will die, andknows:

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 overhis/her life, spending 1/ T of his/her life-time income

each period.



Income and Consumption —

LCH death

T

Consumption

Income

Dissaving

Saving



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

vision of:

The family’s future size and composition, including the lifeexpectancy of each member,

The entire lifetime profile of the labor income of eachmember — after the applicable taxes,

The present and future extent and terms of any creditavailable, and

The future emergencies, opportunities, and social pressureswhich 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. hadn’t 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 promoteseconomic 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. Investmentspending involves a decision to postpone consumption and toseek to accumulate capital which can raise the productivepotential of an economy. But investment is similar toconsumption 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 thesupply-side of the economy.




an economist Net and gross investment

Net investment in any given year = gross investment minus

an estimate for replacement investment – i.e. that investmentrequired to replace obsolete capital. The level of netinvestment in any one year tells us what is happening to thefinal stock of fixed capital available for production.

Gross fixed investment is spending on fixed assets. The

biggest single item of investment spending is on newbuildings, plant and machinery and vehicles. The real valueof business investment in the UK economy over recent yearsis shown in the next data chart.




an economist Autonomous and induced investment

Autonomous investment is capital expenditure on producer

goods unrelated to the level of national income. Forexample, the cost of purchasing new items of capitalequipment 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 acceleratortheory of investment which we will consider shortly is anexample of this.



Definition of Capital

Investment Capital investment is defined as spending on

capital goods such as new machinery, buildingsand technology so that the economy can producemore consumer goods in the future.

A broader definition of investment wouldencompass spending on improving the humancapital of the workforce - for example extrainvestment in training and education to improvethe skills and competences of workers.

Most economists agree that investment is vital topromoting long-run economic growth throughimprovements in productivity and a country’sproductive 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 supply-side of the economy – including a positivemultiplier 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 country’s productive capacity, a reduction inunit 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 betweenInterest Rate and Planned Investment/ The marginal

efficiency of capital (MEC)/ the demand curve forinvestment



Investment Demand Function/relationship betweenInterest Rate and Planned Investment/ The marginal

efficiency of capital (MEC)/ the demand curve forinvestment

Expected rates of return on investment matter whenbusinesses are making investment decisions and this is wherethe concept of the marginal efficiency of capital comes in.

The marginal efficiency of capital (MEC) is defined as therate of interest which makes a proposed investment projectviable ―at the margin‖. This is illustrated in the diagramabove. At lower rates of interest (i.e. R2 rather than R1)more capital projects appear financially viable because thecost of borrowing money to finance the investment is lower

and the opportunity cost of using retained profits as aninternal source of investment finance is also reduced. A fallin interest rates should (ceteris paribus) lead to an expansionalong the investment demand curve. Similarly higher interestrates (R3) may lead to some projects being postponed orcancelled.



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 investmentdecisions in the economy. A change in consumer spending is

not the only factor that affects aggregate demand. The otherfactors (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

I n t e r e s t R a t e ( p e r c e n t p e r

y e a r )

Planned Investment Spending (billions of dollars per year)

100 200 300 400 500

10 9

8

7

6

5

4 3

2

1

0

I 2

I 3

11

Movement up the existing curve iscaused by an increase in interest rates

Initial expectations

Worse expectations -The curve shifts left

Better expectations cause a shift rightward



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. Acceleratortheories of investment assume that there is adesired capital stock for a given level of outputand interest rates. A rise in output or a fall ininterest 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 willincrease output by a multiplied amount – byan amount greater than itself.

The multiplier is the number by which

the change in investment must bemultiplied in order to determine theresulting change in total output.




Y

C, I

0

45˚

C +I1

C + I2

Y1

I2 = I1 + ΔI

ΔY = k . ΔI

Y2ΔY

ΔI

E1

E2

I

Y k




Y

S

0

S = f (Y)

Y1

I1

-

I2

ΔI

ΔY Y2

E1

E2




The size of the multiplier k depends upon how

large the MPC is.

MPS MPC

Y

C C Y

Y

I

Y k

1

1

1

1

1

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Lceture Slide_Consumption Savings and Investment