CONSUMPTION AND

INVESTMENT

FUNCTION

- A Group K Presentation

KEY CONCEPTS TO NOTE

CONSUMPTION

INVESTMENT

SAVINGS

DETERMINANTS OF THE

THREE

WHAT IS CONSUMPTION?

Consumption, in economics, is the use of goods

and services by households.

The purchase of goods and services by use of

households is called consumption expenditure.

Consumption differs from consumption expenditure

primarily because durable goods, such as

automobiles, generate an expenditure mainly in

the period when they are purchased, but they

generate “consumption services” (for example,

an automobile provides transportation services)

until they are replaced or scrapped.

TYPES OF CONSUMPTION

Direct or Final consumption:

when the goods satisfy human

wants directly and immediately.

E.g. taking of meals, use of

furniture etc.

Indirect or Productive

consumption when the goods

are not meant for final

consumption but for

producing other goods which

will satisfy human wants, e.g.

use of fertilizer in agriculture

etc

WHY IS CONSUMPTION IMPORTANT?

Consider this:

WANT

(DESIRE)

EFFORTSATISFACTION

More often than not, this satisfaction is derived from the act of

consumption.

From the large scale perspective, in a country, say India, the

consumption of any good can be directly related to the satisfaction

of wants.

This, in turn sets up demand. Demand induces supply and the cycle

goes on.

Household consumption decision is closely linked to saving decision.

(For given level of disposable income, deciding how much

to consume = deciding how much to save!)

THE CONSUMPTION FUNCTION

The consumption function, as the name suggests

has to be dependent on a certain variable.

From a macro economic point of view, this variable is

National Income.

So, national consumption depends on National

Income.

A general consumption function:

C = f(Y).

THE MATH

C = a + b*Y

a = ‘subsistence’ or minimal level of

Consumption

b=marginal propensity to consume

(MPC)

Y= income

And, C= total consumption expenditure

MPC

The proportion of an aggregate raise in pay that a

consumer spends on the consumption of goods and

services, as opposed to saving it.

Marginal Propensity to Consume is present in Keynes'

consumption theory and determines by what amount

consumption will change in response to a change in

income.

Suppose an employee receives a Rs.500/- bonus in addition

to the annual earnings. They now have Rs.500/- more in

income than they did before. If they decide to spend Rs.400/-

of this marginal increase in income and save the remaining

Rs.100/-, the marginal propensity to consume will be 0.8

(Rs.400/- divided by Rs.500/-).

So, MPC= ΔC/ΔY , where C and Y have their usual meanings.

MPS

The MPS is also known as the Marginal Propensity to

Save.

It is defined as:

1-MPC=MPS

In this graphical illustration of the consumption function,

a= 5,000

MPC= 3/4

SHIFTS IN THE CONSUMPTION CURVE

POSITIVE SHIFT:

• Increase in Real

Assets and money

holding

•Increase in

expectation of future

prices.

NEGATIVE SHIFT:

• Increase in interest

rates

• Increase in taxes

POSITIVE SHIFT NEGATIVE SHIFT

SOME EXAMPLES

a= 100, b= 0.8, Y= Rs. 400

Then, using the formula:

C= 100+ 0.8*400

= 100+320

= 420

a= 175, b=0.75

Now, the function becomes:

C= 175+ 0.75*Y

For a given value of income, we can calculate the consumption

expenditure.

In some cases, the function is represented as:

C= a+b(Y-T)

Here, T represents taxes that are subtracted from the

income.

THE INVESTMENT FUNCTION

WHAT IS INVESTMENT?

Investment is the expenditure on capital goods

made for the purpose of income regeneration.

In other words, an investment is the purchase of

goods that is not used today but is used in the future

to create wealth or income.

The building of a factory used to produce goods and

the investment one makes by going to college or

university are both examples of investments in the

economic sense.

INVESTMENT

AUTONOMOUS INDUCED

AUTONOMOUS INVESTMENT

Expenditure made that is independent of

economic growth. They are investments made

for the good of society and not for the goal of

making profits

For example: The Government invests on

infrastructure items, such as roads and highways,

and other investments that keep the economic

engine running.

It is shown that autonomous investment curve la is a horizontal straight line.

For example, when national income is 0Y1, the autonomous investment is

Rs. 10 billion. If national income increases to 0Y2, the autonomous

investment remains Rs. 10 billion and so on.

INDUCED INVESTMENT

Investment which changes with the changes in

the income level, is called as Induced

Investment.

Induced Investment is positively related to the income

level. That is, at high levels of income entrepreneurs are

induced to invest more and vice-versa. At a high level of

income, Consumption expenditure increases this leads to

an increase in investment of capital goods, in order to

produce more consumer goods.

It is shown that the investment curve is positively

sloped. It indicates that as the level of national income

rises from 0Y1 to 0Y2, the level of induced

investment also rises from 011 to 012

AN EXAMPLE

The owner of a pizza chain decides to purchase a new

Rs.10,000 pizza oven, paying for it by taking Rs.10,000

out of the savings account at the 87th National Bank.

This is an example of investment because the oven

purchased will further generate income for the owner.

0

500

1000

1500

2000

2500

3000

1 2 3 4 5 6 7 8 9 10

Inve

stm

en

t in

Rs.

Income Rs. Thousand

Investment Function

Induced Investment

Autonomous Investment

SAVINGS

Definition

Savings are the amount left over when the cost of a

person's consumer expenditure is subtracted from the

amount of disposable income that he or she earns in a

given period of time.

WHAT IS SAVINGS?

To economists, saving means not consuming

from a fixed amount of resources to enable

higher consumption in the future.

It is the decision to defer consumption and to

store this deferred consumption in some

form of asset.

SAVINGS

INCREASE

IN BANK

DEPOSITS

PURCHASE

OF

SECURITIES

INCREASED

CASH

HOLDINGS

The extent to which consumers save is

affected by their preference for the

future over present consumption,

expectations of future income and

rate of interest.

People save—accumulate assets—to finance their

retirement, and they dissave—spend their assets—during

retirement.

The more young savers there are relative to old

dissavers, the greater will be a nation’s saving rate.

The precautionary motive—that is, the motive to save in

order to be prepared for various future risks—is one of

the key reasons people save.

WHY DO PEOPLE SAVE?

By saving we can invest money to produce fixed capital,

which contributes to economic growth.

However, savings do not always correspond to increased

investment. If the money is not deposited into a

financial intermediary, it is not recycled in investment.

This can cause a shortfall of demand and recession

instead of economic growth.

CASE STUDY #1

We said that Savings affect the workings of an economy?

The question is How?

Germany, in common with the rest of continental Europe,

has been suffering from a lack of demand, caused in

part by the Germans' high propensity to save. Other

European members, subject to similar macro economic

constraints, have done far better.

This is has led to a total lack of consumer confidence on

the part of the Government.

SOME THEORIES

THEORIES OF CONSUMPTION

ABSOLUTE THEORY

OF CONSUMPTION

RELATIVE

CONSUMPTION

THEORY

LIFE CYCLE THEORY

ABSOLUTE THEORY OF

CONSUMPTION

The Absolute Income Hypothesis is theory of consumption

proposed by English economist John Keynes.

It is also known as the Absolute Income Hypothesis.

This theory states that real consumption is a function of real

disposable income, total income net of taxes. As income rises, the

theory asserts, consumption will also rise but not necessarily at the

same rate.

While this theory has success modeling consumption in the short

term, attempts to apply this model over a longer time frame have

proven less successful.

RELATIVE CONSUMPTION

THEORY

• This theory was developed by James Duesenberry.

• It states that an individual’s attitude to consumption

and saving is not solely dependent on income. Hence,

the percentage of income consumed by an individual

depends on his position in the income distribution

demographic.

THE LIFE CYCLE THEORY

This hypothesis addresses individual consumption

patterns

The life-cycle hypothesis implies that individuals both

plan their consumption and savings behaviour over the

long-term and intend to even out their consumption in

the best possible manner over their entire lifetimes

The key assumption is that all individuals choose to

maintain stable lifestyles. This implies that they usually

don't save up a lot in one period to spend furiously in

the next period, but keep their consumption levels

approximately the same in every period.

THE LIDUIDITY PREFERENCE

THEORY OF INVESTMENT

In the liquidity preference theory, Keynes said that people

value money for both "the transaction of current business

and its use as a store of wealth." Thus, they will sacrifice

the ability to earn interest on money that they want to

spend in the present, and that they want to have it on

hand as a precaution. On the other hand, when interest

rates increase, they become willing to hold less money

for these purposes in order to secure a profit.

Or, in other words:

The rate of interest is determined by the matching of demand and

supply of liquidity

• The Transaction Motive: people prefer to have liquidity to assure

basic transactions, for their income is not constantly available. The

amount of liquidity demanded is determined by the level of income: the

higher the income, the more money demanded for carrying out increased

spending.

According to Keynes, the demand for liquidity is

a result of three motives:

• The Precautionary Motive: people prefer to have liquidity in the

case of social unexpected problems that need unusual costs. The

amount of money demanded for this purpose increases as income

increases.

• Speculative Motive: People retain liquidity to speculate that bond

prices will fall. When the interest rate decreases people demand more

money to hold until the interest rate increases, which would drive

down the price of an existing bond to keep its yield in line with the

interest rate. Thus, the lower the interest rate, the more money

demanded (and vice versa).

NET PRESENT VALUE (NPV)

The difference between the present value of cash inflows

and the present value of cash outflows. NPV is used in

capital budgeting to analyze the profitability of an

investment or project.

If the present values of all future cash inflows is greater than the

present value off all future cash outflows, NPV is positive.

If the opposite is true, then the NPV is negative.

RATE OF DISCOUNT: An approach to choosing the discount

rate factor is to decide the rate which the capital needed

for the project could return if invested in an alternative

venture. If, for example, the capital required for Project A

can earn 5% elsewhere, use this discount rate in the NPV

calculation to allow a direct comparison to be made

between Project A.

INVESTMENT

INTIAL

INVESTMENT

FUTURE CASH

INFLOW

RATE OF

DISCOUNT

FACTORS DETERMINING

CONSUMPTION

SUBJECTIVE FACTORS OBJECTIVE FACTORS

1. Human nature 1. Level of income

2. Distribution of wealth

3. Expectations in change in price

4. Change in rat of interest

5. Changes in Fiscal Policy

6. Availability of goods

7. Attitude towards saving

FACTORS

DETERMINING

INVESTMENT

The two primary factors that influence economic

investment are:

Income: An increase in income encourages higher

investment from both firms and individual

consumers.

Interest Rates: However, a high interest rate can

discourage investment because high interest rates

make it more expensive to borrow money. To

encourage investment, interest rates need to be

lower.

Because all investments come with a certain amount

of risk, the interest rate represents an

opportunity cost. Even when a firm uses its own

funds on an investment, there is an opportunity

cost of using the funds for investment, instead of

lending out the money for interest. The level of

risk can be seen to a certain extent when

analyzing the income and interest rates, which

allows the risks to be managed

INVESTMENT AND INCOME

INVESTMENT AND INTEREST RATE

DETERMINANTS OF

SAVINGS

There are a number of determinants of saving. These

determinants are the major forces that shape the economic

scenario of a country. At the same time, determinants of saving

are also responsible for the development or downfall of the

investment sector of a country.

The major determinants are:

• Income level

• Production level

• Consumerism

• The price difference between the domestic goods and the

foreign goods also influences the savings rate

Some financial decisions of the public sector also play

an important role as the determinants of savings.

The percentages of children and old people are

also among the determinants of savings. This

section of a country's population is not expected

to generate income. Because of this, the portion is

dependent on the remaining part of the population

for maintaining their livelihood. All these factors

cause the saving capacity of the workforce to

come down to a certain level.

CASE STUDY #2

A COMPARATIVE STUDY IN

CONSUMPTION FUNCTION IN

IRAN AND INDIA

ABSTRACT

India and Iran are two of the oldest countries in Asia

and both are the transition countries in the world.

Both countries have had several Five-Year Plans to

increasing the real per capita income, growth rate of

GDP etc.

Both countries demonstrate similar problems like high

unemployment rate (especially for educated people),

poverty, high growth rate of population etc.

THE MAIN OBJECTIVE

The main objectives in this study are estimation of

Marginal Propensity to Consume (MPC) out of income

and wealth for both countries and then compare them

based on economics aspects. Another objective is to

show that which one of them is potentially going to

increase saving and Investment in the future.

INDIA IRAN

GROWTH RATE

(%)

8% 3.9%

GDP

(BILLION $)

2908 410

PER CAPITA GDP

GROWTH

(%)

3.7 2.6

INDIA IRAN

MPC OUT OF

WEALTH

0.221 0.189

MPC OUT OF

INCOME

0.672 0.541

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

MPC out of wealth MPC out of income

India

Iran

CONCLUSION

This study has demonstrated the Marginal Propensity to Consume

of India is higher than that of Iran.

It has also revealed that not only MPC out of Income of India is

higher than Iran’s but also MPC out of wealth of India is more than

Iran’s.

This means that higher the MPC, greater the spending and

lesser the saving.

Hence, greater the demand!

That’s all folks!