1 © ©1999 South-Western College Publishing PowerPoint Slides prepared by Ken Long Principles of Economics 2nd edition by Fred M Gottheil

2 Chapter 21 Consumption & Investment 7/15/2016 © ©1999 South-Western College Publishing

3 This chapter discusses principles associated with The Case for Income InequalityAutonomous Investment © ©1999 South-Western College Publishing The Marginal Propensity to Save The Marginal Propensity to Consume Modigliani’s Life-Cycle Hypothesis Friedman’s Permanent Income Hypothesis Duesenberry’s Relative Income Hypothesis Keynes’ Absolute Income Hypothesis

4 What determines Consumption Spending? Consumption is a relationship between consumption and income C = F(Y) © ©1999 South-Western College Publishing

5 Who was John Maynard Keynes? Economist who had a book published in 1936 named “The General Theory of Employment, Interest and Money” © ©1999 South-Western College Publishing

6 What did Keynes say in his book? The economy could tend toward a less than full employment equilibrium © ©1999 South-Western College Publishing

7 Why was this thought different? The Classical Economists believed that the economy is always tending toward a full employment equilibrium © ©1999 South-Western College Publishing

8 Who is correct, Keynes or the Classical Economists? Keynes is correct in the short run, the Classical Economists are correct in the long run © ©1999 South-Western College Publishing

9 What is Keynes’ Absolute Income Hypothesis? As national income increases, consumption spending increases, but by diminishing amounts © ©1999 South-Western College Publishing

10 What happens to the Marginal Propensity to Consume as income increases? MPC decreases as income increases and increases as income decreases © ©1999 South-Western College Publishing

11 For more information on income data: income.html bl.htm © ©1999 South-Western College Publishing

12 What is MPC? Change in consumption brought about by a change in income © ©1999 South-Western College Publishing

13 MPC =  C  DI © ©1999 South-Western College Publishing

14 If household's income rises from $12,000 to $12,700 and consumption rises from $13,000 to $13,500, then MPC = $500 / $700 =.71 © ©1999 South-Western College Publishing

15 The Consumption Function Real Disposable Income Real Consumption C CC   DI © ©1999 South-Western College Publishing

16 Who was Simon Kuznets? An economists who published a book in 1941 named “National Income and Its Composition” © ©1999 South-Western College Publishing

17 What did Kuznets say in his book? MPC tends to remain fairly constant regardless of the absolute level of national income © ©1999 South-Western College Publishing

18 What is Duesenberry’s Relative Income Hypothesis? As national income increases, consumption spending increases as well, always by the same amount © ©1999 South-Western College Publishing

19 What is Permanent Income? The regular income a person expects to earn annually © ©1999 South-Western College Publishing

20 What is the Permanent Income Hypothesis? A person’s consumption spending is related to his or her permanent income © ©1999 South-Western College Publishing

21 Who is Milton Friedman? An economists who won the Nobel Prize in Economics in 1976 © ©1999 South-Western College Publishing

22 What is Friedman’s contribution to Income Hypothesis? People distinguish between their regular income and income they expect to make or lose in any one year © ©1999 South-Western College Publishing

23 Who is Franco Modigliani? An economists who won the Nobel Prize in Economics in 1985 © ©1999 South-Western College Publishing

24 What is Modigliani’s Life Cycle Hypothesis? Typically, a person’s MPC is relatively high during young adulthood, decreases during middle age, and then increases © ©1999 South-Western College Publishing

25 What is Autonomous Consumption? Consumption spending that is independent of the level of income © ©1999 South-Western College Publishing

26 What is significant about Autonomous Consumption? Even when income is zero, autonomous spending is positive © ©1999 South-Western College Publishing

27 What can cause a shift in the Consumption Function? Real assets & money holdings Expectations of price changes Credit & interest rates Taxation © ©1999 South-Western College Publishing

28 Real Disposable Income Real Consumption C1C1 C2C2 © ©1999 South-Western College Publishing

29 Will a change in Income cause a shift in C? No! When income changes there is a movement along a stationary Consumption Function Curve © ©1999 South-Western College Publishing

30 Real Disposable Income Real Consumption Consumption Income Line A B © ©1999 South-Western College Publishing

31 What is the Consumption Equation? C = a + bY © ©1999 South-Western College Publishing Autonomous Consumption MPC Income

32 What is Saving? That part of national income not spent on consumption © ©1999 South-Western College Publishing

33 What is the Marginal Propensity to Save? The change in saving induced by a change in income © ©1999 South-Western College Publishing

34 MPS =  S  DI © ©1999 South-Western College Publishing

35 MPC + MPS … must equal one whole © ©1999 South-Western College Publishing

36 National Income C 45 o Saving Consumption Function Equilibrium Consumption, Saving 36 © ©1999 South-Western College Publishing

37 What is Intended Investment? Investment spending that producers intend to undertake © ©1999 South-Western College Publishing

38 What is Autonomous Investment? Investment that is independent of the level of income © ©1999 South-Western College Publishing

39 What determines Autonomous Investment? Level of technology Interest rate Expectations of growth Rate of capacity utilization © ©1999 South-Western College Publishing

40 National Income C 45 o Consumption, Saving 40 (C+I)

41 What determines the level of Investment? The rate of interest and expectations © ©1999 South-Western College Publishing

42 Why is Investment Volatile? Because what can change investors expectations is unpredictable sometime © ©1999 South-Western College Publishing

43 What determines Consumption? What is Keynes’ Absolute Income Hypothesis?What is Keynes’ Absolute Income Hypothesis? What is MPC? What happens to MPC as income increases?What happens to MPC as income increases? What did Kuznets say in his book? What is Duesenberry’s Relative Income Hypothesis?What is Duesenberry’s Relative Income Hypothesis?

44 What is the Permanent Income Hypothesis?What is the Permanent Income Hypothesis? What is Friedman’s contribution to Income Hypothesis?What is Friedman’s contribution to Income Hypothesis? What is Modigliani’s Life Cycle Hypothesis?What is Modigliani’s Life Cycle Hypothesis? What is Autonomous Consumption? What is Saving? What is the MPS? What is Autonomous Investment?

45 ENDEND © ©1999 South-Western College Publishing