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Chapter 6Chapter 6Chapter 6Chapter 6
Consumption & Consumption & InvestmentInvestment
04/18/23
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GDP = C + I + G + ( X – M)GDP = C + I + G + ( X – M)
GDP = C + I + GGDP = C + I + G
GDP = C + IGDP = C + I
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What determines What determines Consumption Spending?Consumption Spending?What determines What determines Consumption Spending?Consumption Spending?
Consumption is a function of income
C = f(Y)
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John Maynard Keynes:John Maynard Keynes:John Maynard Keynes:John Maynard Keynes:
Author of “The General Theory of Employment, Interest and Money”
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What was What was Keynes central Keynes central idea?idea?
What was What was Keynes central Keynes central idea?idea?
An economy can be in equilibrium at less than full employment.
How did this idea differ from How did this idea differ from the Classical School view?the Classical School view?How did this idea differ from How did this idea differ from the Classical School view?the Classical School view?
The Classical Economists believed that the economy is always tending toward a full employment equilibrium
Keynes’s View on Consumption:Keynes’s View on Consumption:
Consumers are guided by the “Fundamental Psychological Law”
In terms of consumption, we all strive to achieve a “comfort zonecomfort zone”. Once we achieve that or are closer to it we do not need to increase our consumption as much with our income as we had done at lower levels of income.
What is Keynes’ Absolute What is Keynes’ Absolute Income Hypothesis?Income Hypothesis?What is Keynes’ Absolute What is Keynes’ Absolute Income Hypothesis?Income Hypothesis?
As national income increases, consumption spending increases, but by diminishing amounts
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What is MPC?What is MPC?What is MPC?What is MPC?The ratio of the change in
consumption spending to a given change in income, that induces it.
Y
CMPC
Change in Consumption
Change in Income
If household's income rises from If household's income rises from $12,000 to $12,700 and $12,000 to $12,700 and consumption rises from $13,000 to consumption rises from $13,000 to $13,500, then$13,500, then
MPC = $500 / $700 = .71
According to the “According to the “Absolute Absolute Income HypothesisIncome Hypothesis”, What ”, What happens to the Marginal happens to the Marginal Propensity to Consume as income Propensity to Consume as income increases?increases?
According to the “According to the “Absolute Absolute Income HypothesisIncome Hypothesis”, What ”, What happens to the Marginal happens to the Marginal Propensity to Consume as income Propensity to Consume as income increases?increases?
MPC decreases as income increases and increases as income decreases
The Consumption FunctionThe Consumption Function
Real Disposable Income
Rea
l Con
sum
ptio
n
CC
Y
1000 4000
800
3200
Y
CMPC
80.3000
2400
An Individual’s Marginal Propensity to ConsumeAn Individual’s Marginal Propensity to Consume
TotalIncome
(Y)
Change inIncome
Consumption(C)
Change inConsumption
0 500
1000 1000 1400 900
2000 1000 2200 800
3000 1000 2900 700
4000 1000 3500 600
5000 1000 4000 500
An Individual’s Marginal Propensity to ConsumeAn Individual’s Marginal Propensity to Consume
TotalIncome
(Y)
Change inIncome
Consumption(C)
Change inConsumption
MPC
0 500
1000 1000 1400 900 0.90
2000 1000 2200 800 0.80
3000 1000 2900 700 0.70
4000 1000 3500 600 0.60
5000 1000 4000 500 0.50
The Individual’s Marginal Propensity to Consume
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The Nation’s Marginal Propensity to Consume
123
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Who was Simon Kuznets?Who was Simon Kuznets?Who was Simon Kuznets?Who was Simon Kuznets?
He is the author of “National Income and Its Composition”, ...... won Nobel Prize in Economics in 1971 for his pioneering analysis of national income data.
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What did Kuznets What did Kuznets conclude about MPC?conclude about MPC?What did Kuznets What did Kuznets conclude about MPC?conclude about MPC?
His empirical research led to the conclusion that MPC tends to remain fairly constant regardless of the absolute level of national income
The Marginal Propensity to Consume Remains Constant
Duesenberry’s Relative Income Duesenberry’s Relative Income Hypothesis:Hypothesis:Duesenberry’s Relative Income Duesenberry’s Relative Income Hypothesis:Hypothesis:
Because social status influences consumption spending, MPC remains constant as long as relative income remains unchanged.
Autonomous Consumption:Autonomous Consumption:Autonomous Consumption:Autonomous Consumption:
Consumption spending that is independent of the level of income
The Consumption FunctionThe Consumption Function
Real Disposable Income
Rea
l Con
sum
ptio
n C
0
500Autonomous Consumption
TheTheConsumption Equation?Consumption Equation?TheTheConsumption Equation?Consumption Equation?
C = a + bY
Autonomous Consumption
MPCIncome
Induced Consumption
Calculate C for each level of National Income (Y)Calculate C for each level of National Income (Y)
Y Ca MPC C
100 50 0.50
200 60 0.60
300 70 0.70
400 80 0.80
500 90 0.90
C = a + bY = 100 +.5 (100) = 100= 50 +
100
180
280
400
540
C = a + bY = 60 + .60 (200) = 180C = a + bY = 70 + . 70 (300) = 280C = a + bY = 80 + .80 (400) = 400C = a + bY = 90 + .90 (500) = 540
National Income
Con
sum
ptio
n
C0
C1
C2
Will a change in Income Will a change in Income cause a shift in C?cause a shift in C?Will a change in Income Will a change in Income cause a shift in C?cause a shift in C?
No! When income changes there is a movement along a stationary Consumption Curve
National Income
Con
sum
ptio
nConsumption
AB
0
What can cause a shift in the What can cause a shift in the Consumption Function? Consumption Function? What can cause a shift in the What can cause a shift in the Consumption Function? Consumption Function?
Real assets & money holdings Expectations of price changes Interest rates Taxation
A change in...A change in...
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What is Saving?What is Saving?What is Saving?What is Saving?That part of national
income not spent on consumption
If, Y = C + S
then, S = Y – C
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What is the Marginal What is the Marginal Propensity to Save (MPS)?Propensity to Save (MPS)?What is the Marginal What is the Marginal Propensity to Save (MPS)?Propensity to Save (MPS)?
The Ratio of the change in saving to the change in income, which induced it.
Y
SMPS
Lets assume that your income increases by $100. We observe that you increase your consumption by $80. What is your MPC?
Y
CMPC
Y
SMPS
80.100
80
20.100
20
MPC + MPS = 1
MPC = 1– MPS
MPS = 1 – MPC
At each Y level, calculate the MPC, MPS and the SAt each Y level, calculate the MPC, MPS and the S
Y C MPC MPS S
0 60
100 140
200 220
300 300
400 380
500 400
Y
CMPC
80.100
80
MPC + MPS = 1
. 80 . 20 – 40
. 80 . 20 – 20
. 80 . 20 0
. 80 . 20 20
. 80 . 20 100
Y = C + S
– 60
C
Y
Y
S
0
0 y*
y*
45o
$
$