2. Consumption (C) and
investment (I)
Since we are more concerned with two sector
model in our course, we will discuss about
consumption and investment.
In a two sector model, a simple but an
imaginary assumption of no government and
no foreign trade is made.
Here Yd =C+S or Yd =AD (aggregate demand)
This also implies that C+S=C+I
3. Consumption
Introducing you with: (Think yourself in advance)
What is consumption?
What is consumption function?
What are the determinants of consumption?
What is MPC?
What is APC?
4. Consumption
“Consumption is the sole end and purpose of all
production.” Adam Smith
Consumption is the act of spending income for
buying goods and services to satisfy wants.
Determinants of consumption are disposable income
(after tax income) of the consumers, their
accumulated wealth or assets, their expected future
income, the actual price level, the expected general
price level, rate of interest, thriftiness, their age, sex
and family size etc.
5. Consumption function
A relation between consumption and its
various determinants is called the
consumption function. The consumption
function taking all these determinants
into account can be written as:
C=f (Yd, W, Ye, P, Pe, r, s, DF…..)
6. Keynesian Consumption
function
Keynes, however, asserts that income alone is the
most important determinant of consumption.
Here, income refers to the disposable income. The
Keynesian consumption function, thus, can be written
as:
C=f (Yd), 1>f>0
Where,
C=Consumption demand
Yd = Disposable income= (Y-T)
Y=Personal income
T=Taxes (related to income)
7. Keynesian Consumption
function
The assumption of the Keynesian consumption
function is that consumption depends on
income, other things being equal. The higher the
income, higher is the consumption, ceteris paribus.
Keynes‟ psychological law of consumption (The
concept of the marginal propensity to consume).
Keynes argue that when the income
increases, consumption also increases but not to the
same extent as the increase in income.
8. Keynesian Psychological Law
“ The fundamental psychological law, upon which we
are entitled to depend with great confidence both a
priori from of our knowledge of human nature and
from the detailed facts of experience is that men are
disposed of, as a rule and on the average, to
increase their consumption as their income
increases, but not by as much as the increase in their
income.”
The idea is that when the income
increases, consumption also increases but less than
proportionately. Alternatively, marginal propensity to
consume (MPC) is positive but less than unity
(0<MPC<1).
9. Marginal Propensity to
Consume
Keynesian Psychological Law is also called the
MPC.
Given the consumption function: C= f
(Yd), the MPC is the ratio between change in
consumption expenditure and the change in
income level.
MPC=∆C = Change in consumption
∆Yd Change in disposable income
i.e. 0< =∆C <1
∆Yd
10. Marginal Propensity to
Consume
Suppose, initial income level is Rs. 1000 and
consumption demand is Rs. 800. When income level
increases to Rs. 1500, and consumption demand to
Rs. 1200, MPC will be:
=∆C/ ∆Yd =400/500=0.80
This implies that when income increases by Rs.
100, consumption demand increases by Rs 80. And
the difference Rs. 20 is the saving.
This means Yd = C+S
i.e. Disposable income=Consumption+Saving
11. Consumption function
Short run Keynesian consumption
function is often written as: C=Ca+bYd
Ca is autonomous consumption function.
This implies that Ca is not related to
income level (Yd) since a minimum level
of consumption is required just for
survival even if there is no income.
And “b” is MPC.
12. Average Propensity to
Consume
The fraction of total disposable income spent on
consumption demand is called the average
propensity to consume (APC).
APC= Consumption demand = C
Disposable income Yd
APC implies the average spending tendency of the
community or the people of a country.
Given the consumption function, C=Ca+bYd
APC=C/Yd=Ca+bYd/Yd
Or, APC = C + b
Yd
14. Main observations
When disposable income increases, consumption also
increases but not proportionately.
When disposable income increases, APC declines.
When disposable income increases, MPC remains
constant and APC>MPC.
At low level of income, there is dissaving and at
higher level of income there is saving.
At particular level of income (i.e. at Rs. 400, C=Yd
), saving is just zero. This point is called the break
even point.
16. Short run and long run
consumption
Disposable income (Yd )
C,S
CSR Consumption
in the short run
C=Ca+bYd
Ca
CLR: Consumption in
the long run C=bYd
17. Short run and long run
consumption
The short run consumption is non-
proportional in the sense that consumption is
partly autonomous and partly induced that is
related to the current disposable income.
The long run consumption fully depends on
income. The long run autonomous
consumption is zero and according to
Keynes, in the long run, we all die if fail to
generate our own income.
18. Saving Function
The part of the disposable income not spent on
consumption is called saving. In this case, saving is
the difference between disposable income and
consumption.
It is based on the premise that Yd=C+S
Then S=Yd-C
S=Yd- (Ca+bYd)
Or, S= -Ca+(1-b)Yd
Where, -Ca=Autonomous saving that is negative or that
is dissaving. A person must borrow in order to
survive.
1-b is marginal propensity to save as we know b is
marginal propensity to consume.
19. Saving Function
From the macroeconomic perspective, aggregate saving is
that part of real output that is produced but not sold to
consumers. Thus, aggregate saving is the sum total of the
private saving, and government saving.
Gross National Saving=Govt. saving+ private saving
Personal saving is the difference between personal
disposable income and the personal consumption
expenditure.
Private saving is the sum of personal saving and gross
business saving. Gross business saving is the profits
minus dividends paid to individuals plus depreciation.
Government saving is the difference between government
revenues and government expenditures.
20. Again to remind: types of
saving
private saving = (Y – T) – C
public saving = T – G
national saving, S
= private saving + public saving
= (Y –T ) – C + T – G
= Y – C – G
21. Marginal Propensity to save
MPS is the change in saving as a result of an
additional unit of disposable income.
MPS =∆S = Change in saving
∆Yd Change in disposable income
Since MPC+MPS=1, when MPC
increases, MPS decreases. This relationship
between MPC and MPS can also be shown
graphically by plotting MPS on the vertical
axis and MPC on the horizontal axis. First
think and draw yourself.
23. Average Propensity to save
APS is the ratio between total saving
and total disposable income.
APS =S = Saving
Yd Disposable income
APS increases when disposable income
increases and vice versa.
25. Determinants of consumption
and Saving
Since consumption is the counterpart
of saving, both are related to each
other.
Factors affecting the consumption
demand also affect saving.
Thus, determinants of consumption
and saving are interrelated and
presented in the next slide.
26. Determinants of consumption
and Saving
1. Change in disposable income affects
consumption and saving.
Once the Yd changes, both consumption
and saving change. A higher Yd increases
both C and S.
However, it also depends on the preference
of an individual.
Increase in Yd shifts the budget line
rightward indicating that more consumption
and more saving are possible.
27. Determinants of consumption
and Saving
2. Change in interest rate affects consumption
and saving.
Real interest rate is the difference between nominal
interest rate (i) and inflation rate (Π), i.e. r=i- Π.
There is a positive relationship between real
interest rate, r and saving, S. When r increases S
also increases since r is the reward for saving.
However, increase in r reduces consumption. Even
people who borrow and consume are discouraged
to consume more.
When there is more saving and less consumption
due to increase in r, it is called the substitution
effect of increased real interest rate.
28. Determinants of consumption
and Saving
2. Change in interest rate affects consumption
and saving.
But the increased interest rate will also raise the
future income relative to the current income. In
this case, consumption may increase with the
expectation of higher future income. This effect of
higher interest rate on consumption is called
income effect. This leads towards less saving at
higher interest rates.
However, the effect of higher interest rate on S and
C depends on the relative strength of substitution
effect and income effect.
29. Determinants of consumption
and Saving
2. Change in interest rate affects
consumption and saving.
For low income group, substitution effect
will outweigh the income effect- saving
increases with higher rate of interest.
For high income group who tend to save
relatively large parts of their income, the
income effect may outweigh the
substitution effect. At high interest rates
saving declines.
30. Determinants of consumption
and Saving
3. Change in price level and price expectations
affect consumption and saving:
The effect of price level change on C and S
depends on what happens to the real disposable
income when price level changes.
If current disposable income rises or falls
proportionately with the price level, real income
remains unchanged. In this case, the shares of
consumption and saving remain unchanged.
31. Determinants of consumption
and Saving
3. Change in price level and price
expectations affect consumption and
saving:
Real income= nominal income/price level
For example, real income at present is
current income/price level i.e. 2000/5=400
After price level and Yd change say by 20
% i.e. 2400/6=400
In both cases S and C remain unchanged
since there is no change in real income.
32. Determinants of consumption
and Saving
3. Change in price level and price expectations
affect consumption and saving:
However, this may not be valid in the case of
money illusion, a situation in which a person cares
more about the nominal income than the real
income. If a person increases his saving because of
the money illusion than the real consumption will
decline.
In the absence of money illusion, when real
disposable income decreases because of the
increase in price level, there will be an absolute
decrease in real consumption expenditure.
33. Determinants of consumption
and Saving
3. Change in price level and price expectations
affect consumption and saving:
Given the disposable income, expectation of a
higher price level in the future may cause increase
in consumption expenditure thereby reducing the
saving. Because higher price in the future period
will reduce the value of saving in real term (value
of money declines due to price rise).
If the expected price level declines, people
postpone consumption expenditure and increase
saving with the hope that they can take advantage
of higher purchasing power of money they
deposited.
34. Determinants of consumption
and Saving
4. Pattern of income distribution:
According to N. Kaldor, people with low income
level have higher MPC and hence lower MPS. On
the contrary, people with higher income level have
lower MPC and higher MPS.
This implies that MPS is higher for high income
group and lower for low income group. In other
words, low income group consumes whatever they
earned while high income group saves more when
income increases.
35. Determinants of consumption
and Saving
4. Pattern of income distribution:
However, still there are debates. A number of
hypothesis in discussion are :
Absolute income hypothesis (J. M. Keynes)
Relative income hypothesis (James Duesenberry)
Permanent Income hypothesis (M. Friedman)
Life-cycle hypothesis (F. Modigliani)
These are discussed in advanced level.
36. Determinants of consumption and
Saving
5. Real assets, financial assets and outstanding
debt affects consumption and saving:
Ceteris paribus, accumulation of wealth in terms of
real (houses, other consumer durables) and financial
(stocks, bonds, and other forms of deposit) assets
leads to increase consumption expenditure. Given the
size of real and financial assets, consumption
expenditure depends on the rate of interest (as a
return fro such assets) and the price level.
Any outstanding debt compels an individual to reduce
consumption expenditure thereby saving more. In the
case of no outstanding debt, this may be opposite.
37. Determinants of consumption and
Saving
6. Thriftiness, old age security and social safety net
also affect consumption and saving:
Attitudes toward thrift (desire to save more) also
influences the allocation of disposable income between
consumption and saving. If people are thriftier, they
keep aside increasing fraction of their disposable
income for future consumption by reducing current
consumption.
In a society with sufficient provision of old-age security
and social safety net, people will save less and
consume more. Converse will hold in the absence of
such program in the society.
38. Determinants of consumption and
Saving
7. Growth rate of population and its age
distribution affects the consumption-saving
pattern:
• Population growth rate and its age distribution affects
the consumption-saving pattern accordingly. If
population growth rate is quite high and exceeds that
of economic growth rate, disposable income per capita
declines. This reduction in income reduces per capita
consumption expenditure and so does saving.
• Another factor is the age structure. Big families spend
proportionately more from income than small families.
Young families busily acquire durables, while
established families tend to replace only worn out
durables. Thus, societies full of young or large families
39. Determinants of consumption and
Saving
8. Availability of credit and the state of
financial institutions also affects
consumption-saving pattern.
• Consumption expenditure for durable goods may
increase if credits are easily available. If getting
credit is relatively difficult, expenditures on
consumer durables decline.
• Saving habit of people also depends on the
institutional arrangement. For working people, the
provision of provident fund, life insurance and
arrangements of financial institutions also help to
save more for future use.
40. Aggregate expenditure
The desired expenditures, made up of desired
consumption, desired investment, desired
government purchases, and desired net
exports account for total desired expenditure.
The result is total desired expenditure on
domestically produced goods, and services
called desired aggregate expenditure, or
more simply aggregate expenditure (AE):
AE=C+I+G+NX
41. Aggregate expenditure
Desired expenditure need not equal actual
expenditure, either in total or in any
individual category.
National income accounts measure actual
expenditures in each of the four
expenditure categories. National income
theory deals with desired expenditures in
each of these four categories.
42. Equilibrium National Income
…is that level of national income where desired aggregate
expenditure equals actual national income.
Desiredexpenditure
Actual National income
45 line or actual expenditure
AE or Desired expenditure line
E
43. Determination of equilibrium
income and output Y=AD, AD=C+I+G+NX
AD=Y
E1
E
AD
Y
AE1
AE2
Planned spending precisely matches production in the points E, and E1.
44. Determination of equilibrium
income and output
In the previous graph:
Increase in AE has shifted the equilibrium income
upward.
Given the intercept, a steeper aggregate demand
function-as would be implied by a higher marginal
propensity to consume-implies a higher level of
equilibrium income.
Similarly, for a given MPC, a higher level of
autonomous spending-a larger intercept- implies a
higher level of equilibrium income.
45. The Multiplier Model
• A question arises, by how much does a Rs 1 increase
in autonomous spending (aggregate expenditure) raise
the equilibrium level of income? In other words, we
want to know the magnitude of change in equilibrium
GDP as a result of the change in aggregate
expenditure.
• A simple answer may be, since in equilibrium, income
equals aggregate demand, it would seem that a $1
increase in autonomous demand or spending should
raise equilibrium income by Rs 1. But this is wrong.
• Suppose first that output increased by Rs 1 to match
the increased level of autonomous spending. This
increase in output and income would in turn give rise
to further induced spending as consumption rises
because the level of income has risen.
46. The Multiplier Model
• How much does a Rs 1 initial increase in income
would be spent on consumption? Out of this, a
fraction „b‟ is consumed. Assume that production
increases further to meet this induced
expenditure, i.e. output and income increases by
1+b.
• This will again create an excess demand because
the expansion in production and income by 1+b
will give rise to further induced spending. This
process goes on like this and is explained by the
multiplier model.
• Multiplier analysis is an important tool of income
expansion, and business cycle analysis.
47. The Multiplier Model
• The multiplier is the ratio of the change in GDP to the
change in expenditure.
• It is also defined as the ratio of the final change in
income to the initial change in autonomous
expenditure i.e. ∆Ā. ∆Ā stands for any increase in
autonomous expenditure, this could be an increase in
investment or in the autonomous component of the
consumption.
• Thus a multiplier can be written as K= ∆Y/ ∆Ā, where
K is multiplier, ∆Y is change in GDP, and ∆Ā is change
in autonomous expenditure.
• The dynamic multiplier process is shown in the
following table.
48. The Dynamic Multiplier process
Round Increase in
demand
this round
Increase in
production
in this
round
Total increase in
income (all
rounds)
1
2
3
4
….
∆Ā
b∆Ā
b2∆Ā
b3∆Ā
…..
∆Ā
b∆Ā
b2∆Ā
b3∆Ā
…..
∆Ā
(1+b) ∆Ā
(1+b+b2) ∆Ā
(1+b+b2+b3)∆Ā
1 ∆Ā
(1-b)
49. The Multiplier
The equation ∆AD= (1+b+b2+b3 ) ∆Ā, following
the rule of geometric series, simplifies to:
1 *∆Ā,
(1-b) .
The idea is that cumulative change in aggregate spending
is equal to a multiple of the increase in autonomous
spending. The multiple 1/(1-b) is called the multiplier.
The multiplier is the amount by which equilibrium output
changes when autonomous aggregate demand increases
by 1 unit.
50. The Multiplier
You should note that, 1-b is Marginal Propensity to Save
(MPS), thus multiplier in other words is the reciprocal of
MPS. That is,
K=1/(1-b).
It should also be understood that the multiplier effect
occurs when one person‟s spending becomes someone
else‟s income, and some of the second person‟s income is
subsequently spent, becoming the income of a third
person, and so on.
Discuss an example, where MPC is o.5 and autonomous
expenditure is Rs. 10,000, what is the final income?
51. The Effect of Multiplier
C+I+I'
O
C
C
Y
C+I
C
Y2Y1
0.5
45º
E1
E2
Y1 increased to Y2 because of the multiplier effect and a new equilibrium
is attained.
52. The Multiplier
The basic assumption of the above mentioned multiplier
principle for a two sector economy are:
there is no change in the marginal propensity of consume
during the adjustment process which remains more or less
constant,
there is no induced investment (i.e. accelerator is not
operating),
the new higher level of investment is maintained long enough
for the completion of the adjustment process,
the output of consumer goods is responsive to effective
demand for these goods,
there is complete absence of government activity like taxation
or expenditure,
there is no time lag between the receipt of income and its
expenditure, and
there is a closed economy.
53. Leakages and Injections in Multiplier
Leakages:
Households receive income in terms of factor payments. The
HHs income is divided into four components: consumption
demand (C), Taxes to the government (T), import expenditure
(M), and saving.
The total households income that is not used for consumption
demand is called the leakages or withdrawals.
Here leakages = net saving+ net taxes +import expenditure
Saving is the difference between Yd and consumption.
Generally, this is deposited at banks. Net saving is the
difference between savings deposited at banks and any
borrowing made there from.
Net taxes is the difference between government tax revenue
and any transfer payments made by the government.
Expenditure on imported goods is another form of leakages
from the circular flow of income.
54. Leakages and Injections in
Multiplier
Types of economic
model
Leakages (Withdrawals)
Two sector
Three sector
Four Sector
S, (Net savings)
S+T (Net savings, Net taxes)
S+T+M (Net savings, Net
taxes, Imports)
In addition, leakages can also result in from debt
conciliation, price inflation, hoarding, and purchase of
stocks and securities.
55. Leakages and Injections in Multiplier
Injections:
Injections are the sources of demand for
goods and services other than consumer
demand.
In two sector model, the sources of AD are C
and I. In three sector model, the sources of
AD are C+I+G. And in open economy, the
components of AD are C+I+G+X.
56. Leakages and Injections in
Multiplier
Types of Economic
models
Injections
Two sector
Three sector
Four sector
Investment (I)
Investment, government
spending (I+G)
Investment, government
spending, Exports (I+G+X)
57. Investment
Investment is the spending devoted to increasing or
maintaining the stock of capital. Investment demand
can be disaggregated into: business fixed
investment, residential investment, and inventory
investment.
Investment is a flow variable and its counterpart
stock variable is capital.
Capital
Produced, durable, used for further production
Examples: tangibles
(structures, equipment), intangibles
(software, patents)
Capital stock will increase if there is positive net
investment and vice versa.
58. Investment
Capital stock increases if gross
investment>depreciation
Capital stock deceases if gross investment<
depreciation.
Basic role of investment in macro
Important for short run because it is a volatile part of
aggregate demand
Recall decline of I in Great Depression
Important for long run because key determinant of
growth of potential output and major way that
governments affect economic growth.
59. Investment
Why does investment occur?
When there is a discrepancy between desired
stock of capital (K*) and actual stock of capital
(K).
Desired stock of capital refers to the expected
capital stock by the business community in
order to conduct their business. Actual capital
stock implies the existing stock of capital at
any point in time.
Investment occurs in order to bridge the gap
between the desired stock of capital and the
actual stock of capital.
60. Investment
Determinants of investment demand
Expectations: desired investment is primarily driven by
expectations of future profit and sales. Investment takes
place when expected return exceeds the expected cost of
capital. Expectations depend on several factors:
1. Degree of confidence in the future course of economic
events: Business cycle expectations are important in this
regard.
2. Government spending and tax policies: Favorable
expenditure and tax policy having lower rates and wider
base helps to increase the incentive to invest.
3. Behavior of input and output prices: Increase in input prices
without any rise on output prices may lower the
expectations. Increasing prices of output relative to the
input prices increase expectations. For example, if wage
rate is increasing without increase in the labor productivity.
61. Investment
Determinants of investment demand
Interest rates:
An increase in the real interest rate raises the cost of capital
and discourages investment demand. However, a decline in
the real interest rate reduces the cost of capital and
stimulates the investment demand. This implies that there
exists an inverse relationship between interest rate and the
investment demand. This is what suggested by the classical
view of the investment demand curve (function).
The Keynesian view, however, is different. According to
Keynes, role of expectations is important. Even if there is no
change in interest rate, investment demand can stimulate if
there are high expectations about the business. And even at
a lower level of interest rate if expectations worsen,
investment demand curve may shift to the left.
62. Investment
Determinants of investment demand
Change in the output level:
During recovery, investment rises very
rapidly. When economic growth rate slows
down, investment demand falls dramatically.
The idea is that there is a positive
relationship between investment demand
and the change in output level (national
income).
This relationship is also explained by the
accelerator theory.
63. Investment
Determinants of investment demand
Level of income (output):
Profit is the pivot around which investment
revolves. And profit depends upon the level
of income. Therefore, it is argued that,
investment could be the function of income:
I=I (Y)
1>I(Y)>0, when income level increases,
investment also increases but less than the
increase in income level.
64. Investment
Determinants of investment demand
Marginal Efficiency of Capital (MEC):
According to Keynes, MEC is the major determinant
of investment. Keynes says, “MEC as being equal to
that rate of discount which would make the present
value of the series of annuities given by the returns
expected from the capital asset during its life just
equal to its supply price.”
The idea is MEC is that rate of discount which
would make the present value of the expected net
returns from the capital goods just equal to its
supply price (considering the supply price as
constant over the years).
65. Investment
Determinants of investment demand
Marginal Efficiency of Capital (MEC):
MEC of capital is also called the Internal Rate of Return.
Cost=R1/(1+r)+R2/ (1+r)2+Rn/(1+r)n
Where, Cost is the supply price of investment, R1 is the
expected return from investment in year 1 and so on, r is
the MEC, and n is the number of periods.
If we sum the right side of the equation, we will get the
present value (PV) of all future returns.
If cost<PV of future returns, investment is made.
If cost>PV of future returns, investment is not made.
If MEC is higher than market rate of interest, investment is
profitable. If MEC is lower than market rate of
interest, investment is unprofitable.
67. Investment
MEC schedule:
If the market rate of interest is 10%, projects
A,B, and C could be undertaken depending
upon the availability of the fund. Project D can
not be undertaken since its MEC is less than the
market rate of interest.
This is also shown in the graph in the next slide.
69. Investment
Investment function:
The aggregate investment function can be expressed
as: I= I (Y, r). This implies that I changes either due to
the change in Y or due to the change in r.
The classical case: Investment is the function of the
interest rate. I=I (r). When r increases, I declines and
vice versa.
The Keynesian case: Investment demand is better
explained by the expected reruns from the investment
projects under consideration. As already discussed in
the MEC section, investment decision is based on: the
expected flow of income from the investment
projects, the purchase price of the capital good, and the
market rate of interest.
70. Investment
- Accelerator Theory
Accelerator theory: Oldest and simplest
theory, states that investment is a function of change
in output. Investment demand is proportional to the
change in output. The term accelerator refers that a
relatively modest rise in national income can cause
much larger increase in investment demand.
- Here, the idea is there is a target capital-output
ratio, K* = v Y. Where, K* is desired capital stock, v
is capital output ratio and Y is output.
71. Investment
- Accelerator Theory
- I* = ΔK* + δK = v Δ Y + δK.
- Where, I* is desired investment, K is capital
stock, ΔY is the acceleration of production, and δ =
depreciation rate.
- The actual investment might differ from the
desired, but this is a simple and useful model. It
shows why there is a close relationship between
investment and output change.
- This model is little used now because it assumes a
fixed v. Modern I theory assumes v depends upon
financial conditions.
72. Investment
- Accelerator Theory
• Denoting current change in output by ∆Yt, and
change in output in the past year by ∆Yt-1 the
accelerator theory asserts that:
• Investment will increase when the growth of national
income/output is rising. If ∆Yt> ∆Yt-1 , investment
increases.
• Investment will be constant even if national income
is growing, when the increase in income this year is
the same as last year, i.e. ∆Yt= ∆Yt-1, investment
remains the same.
• If the growth rate of income/output is slowing down,
investment will fall even if national income is still
growing, i.e. if ∆Yt< ∆Yt-1 , investment declines.
73. Investment
- Summary of investment theory
1. The major components of investment are
residential, business plant and
equipment, software, and inventories.
2. These are among the most volatile components of
output in the short run.
3. In equilibrium, demand for capital determined where
the rental cost of capital equals the marginal
productivity of capital.
74. Investment
- Summary of investment theory
4. The major theories are the accelerator theory, the
neoclassical theory, and the Q theory. We have not
discussed the latter two. These apply differently in
different sectors.
5. Economic policy affects investment through both
monetary and fiscal policy:
• monetary policy through r
• fiscal policy through things like depreciation policy
and investment tax credits.
