Consumption, Savings and InvestmentConsumption functionSavingsThe Multiplier

Autonomous consumptionAutonomous 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 consumptionInduced 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 = C / YMPC is the first derivation of consumption function.Induced consumption can be described by formula: CI = MPC . Y

The Consumption FunctionThe 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

YC0Consumption function C = f(Y)SavingsConsumption45Y1 Y 2CA

The Consumption Function45 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.

SavingsSaving is that part of income that is not consumed. Saving equals income minus consumption: S = Y CIncome is the sum of consumption and savings: Y = C + S

then and

SavingsThe 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.

Saving FunctionLike 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

YC, S0C = f(Y)45Y ECA-CAS = f(Y)The saving function is the mirror image of the consumption function. It shows the relationship between the level of saving and income.

The Simple Theory of InvestmentIn the simple Keynesian model, investment is independent of national income (autonomous investment).The investment function will be a horizontal straight line.

The Investment Function

YI0I1In the short-run it is reasonable to assume that investment is independent of national income.

I2I2I1

Consumption and Investment FunctionsThe 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

YC, I0C = CA + MPC . Y C + I = CA + MPC . Y + III

Consumption and Investment Determine OutputIf the level of output is e. g. Y1 at this level of output the C+I spending line is above 45line, 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

YC, I045C + I = CA + MPC . Y + IEY1 YE Y2Consumption and investment determine output

Saving and Investment Determine OutputEquilibrium 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

YS, I0S = f (Y)E Y1 YE Y2I-

Saving and Investment Determine OutputAt 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 YE.

Investment MultiplierThe 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

YC, I045C +I1C + I2 Y1I2 = I1 + I

Y = k . I

Y2YIE1 E2

Investment Multiplier

YS0S = f (Y) Y1 I1-I2IY Y2 E1 E2

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