Consumption and Investment Chapter 6 Consumption and Investment

What Determines Consumption Spending? Consumption-spending and consumption-production decisions are made simultaneously and independently of each other. Gottheil - Principles of Economics, 4e

What Determines Consumption Spending? The result is that sometimes consumers don’t buy enough of everything produced and other times producers do not produce as much as people want to consume. Gottheil - Principles of Economics, 4e

What Determines Consumption Spending? Consumption function The relationship between consumption and income. It is written as C = f(Y), where C represents consumption and Y represents income. Gottheil - Principles of Economics, 4e

What Determines Consumption Spending? The single most important factor influencing a person’s consumption spending is his or her level of disposable income. The greater the disposable income, the greater the consumption spending. Gottheil - Principles of Economics, 4e

Keynes’s Absolute Income Hypothesis Marginal propensity to consume (MPC) The ratio of the change in consumption spending to a given change in income. MPC = (change in C)/(change in Y). Gottheil - Principles of Economics, 4e

Keynes’s Absolute Income Hypothesis Keynes believed that although people who earn high incomes spend more on consumption than people who earn less, they are less inclined to spend as much out of a given increase in income than those earning less. Gottheil - Principles of Economics, 4e

Keynes’s Absolute Income Hypothesis For example, if a millionaire and a welfare recipient each received $500, the millionaire would likely just add the money to her savings account since her primary needs are already met. Gottheil - Principles of Economics, 4e

Keynes’s Absolute Income Hypothesis The welfare recipient, on the other hand, would likely immediately spend the money on food, clothing, and shelter. Gottheil - Principles of Economics, 4e

EXHIBIT 1 THE INDIVIDUAL’S MARGINAL PROPENSITY TO CONSUME

Exhibit 1: The Individual’s Marginal Propensity to Consume 1. What is the change in consumption as total income increases from $1,000 to $2,000 in Exhibit 1? Consumption increases by $800 (from $1,400 to $2,200) as total income increases by $1,000. Gottheil - Principles of Economics, 4e

Exhibit 1: The Individual’s Marginal Propensity to Consume 2. What is the change in consumption as total income increases from $2,000 to $3,000? Consumption increases by $700 (from $2,200 to $2,900) as total income increases by $1,000. Gottheil - Principles of Economics, 4e

EXHIBIT 2 THE NATION’S MARGINAL PROPENSITY TO CONSUME ($ BILLIONS)

Exhibit 2: The Nation’s Marginal Propensity to Consume What happens to the national MPC as national income increases in Exhibit 2? The national MPC increases, but by diminishing amounts. Gottheil - Principles of Economics, 4e

Keynes’s Absolute Income Hypothesis The pioneering work of Simon Kuznets showed that Keynes’s hypothesis was wrong. A nation’s MPC tends to remain fairly constant regardless of the absolute level of national income. Gottheil - Principles of Economics, 4e

Duesenberry’s Relative Income Hypothesis As national income increases, consumption spending increases as well, always by the same amount. That is, as national income increases, MPC remains constant. Gottheil - Principles of Economics, 4e

Duesenberry’s Relative Income Hypothesis According to Duesenberry, consumption spending is rooted in status. High-income people not only consume more than others, but also set consumption standards for everyone else. Gottheil - Principles of Economics, 4e

EXHIBIT 3 THE MARGINAL PROPENSITY TO CONSUME REMAINS CONSTANT

What Determines Consumption Spending? Autonomous consumption Consumption spending that is independent of the level of income. Gottheil - Principles of Economics, 4e

What Determines Consumption Spending? Some consumption spending is simply unavoidable. While individuals may spend less on food, clothing, and shelter when income falls, there are limits to how much one can cut and still survive. Gottheil - Principles of Economics, 4e

What Determines Consumption Spending? A change in national income induces a change in consumption. The change in consumption is considered movement along the consumption curve. Gottheil - Principles of Economics, 4e

What Determines Consumption Spending? The consumption curve can also shift. Shifts in the consumption curve are unrelated to national income. There are several factors that can shift the consumption curve. Gottheil - Principles of Economics, 4e

What Determines Consumption Spending? 1. Real asset and money holdings. An increase or decrease in real assets or money holdings causes the consumption curve to shift. For example, a substantial inheritance of money or property would cause the curve to shift upward. Gottheil - Principles of Economics, 4e

What Determines Consumption Spending? 2. Expectations of price changes. An expectation of inflation could cause an increase in the current level of consumption, even though incomes are not expected to change. The increase in consumption would shift the curve upward. Gottheil - Principles of Economics, 4e

What Determines Consumption Spending? 3. Credit and interest rates. If credit is more easily available or if the credit terms are made more attractive, people are likely to increase their spending on durable goods, even if their incomes haven’t changed. The consumption curve would shift upward. Gottheil - Principles of Economics, 4e

What Determines Consumption Spending? 4. Taxation. If government decided to increase the income tax, people would end up with a smaller pay check, even though their salaries remained unchanged. This would cause a decrease in consumption and a downward shift in the consumption curve. Gottheil - Principles of Economics, 4e

What Determines Consumption Spending? 5. Expectations of future income. 6. Uncertainty about future income (or employment prospects) 7. Age distribution (baby boomers, Modigliani’s LCH) Gottheil - Principles of Economics, 4e

EXHIBIT 4 SHIFTS IN THE CONSUMPTION CURVE

The Consumption Equation There are two key factors that influence the character of our consumption spending: autonomous consumption and our income level. Gottheil - Principles of Economics, 4e

The Consumption Equation The consumption function takes the following form: C = a + bY Where a equals autonomous consumption spending, b equals MPC and Y equals level of national income. Gottheil - Principles of Economics, 4e

What Determines the Level of Saving? People do two things with their income. They either spend it on consumption or they save it. Gottheil - Principles of Economics, 4e

What Determines the Level of Saving? The part of national income not spent on consumption. S = Y - C. Gottheil - Principles of Economics, 4e

What Determines the Level of Saving? When C is greater than Y, saving is negative and is called dissaving. People can consume more than their income allows by running down their savings or other forms of accumulated wealth. Gottheil - Principles of Economics, 4e

What Determines the Level of Saving? Marginal propensity to save (MPS) The change in saving induced by a change in income. MPS = (change in S)/(change in Y). Gottheil - Principles of Economics, 4e

What Determines the Level of Saving? The marginal propensities to consume and to save add up to 100 percent. MPC + MPS = 1. MPS = 1 - MPC. Gottheil - Principles of Economics, 4e

What Determines the Level of Saving? Income curve or 45o line A line, drawn at a 45° angle, showing all points at which the distance to the horizontal axis equals the distance to the vertical axis. The line is also called the income curve. Gottheil - Principles of Economics, 4e

Gottheil - Principles of Economics, 4e EXHIBIT 5A THE SAVINGS CURVE Gottheil - Principles of Economics, 4e

Gottheil - Principles of Economics, 4e EXHIBIT 5B THE SAVINGS CURVE Gottheil - Principles of Economics, 4e

Exhibit 5: The Saving Curve What is saving when income is $400 billion in Exhibit 5? S = Y – C or S = Y – (a + bY). Saving = $400 billion – [$60 billion + (0.8 × $400 billion)] = $20 billion. Gottheil - Principles of Economics, 4e

Friedman’s Permanent Income Hypothesis A person’s consumption spending is related to his or her permanent income. Gottheil - Principles of Economics, 4e

Friedman’s Permanent Income Hypothesis Permanent income is the regular income a person expects to earn annually. It may differ by some unexpected gain or loss from the actual income earned. Gottheil - Principles of Economics, 4e

Friedman’s Permanent Income Hypothesis Transitory income The unexpected gain or loss of income that a person experiences. It is the difference between a person’s regular and actual income in any year. Gottheil - Principles of Economics, 4e

Friedman’s Permanent Income Hypothesis According to Friedman, an unexpected gain or loss in income in one year does not influence an individual’s overall MPC from year to year. Gottheil - Principles of Economics, 4e

Modigliani’s Life-Cycle Hypothesis Typically, a person’s MPC is relatively high during young adulthood, decreases during the middle-age years, and increases when the person is near or in retirement. Gottheil - Principles of Economics, 4e

The Investment Function Producers in the economy must decide how much income to spend on new investment. Gottheil - Principles of Economics, 4e

The Investment Function Producers may invest in replacing used up or obsolete machinery, expanding production, increasing raw material or finished goods inventories, and building new facilities for new products. Gottheil - Principles of Economics, 4e

The Investment Function Each producer makes investment decisions independently of others. Gottheil - Principles of Economics, 4e

The Investment Function Intended investment Investment spending that producers intend to undertake. These intended investments do not always end up being realized. Gottheil - Principles of Economics, 4e

What Determines Investment? The level of national income doesn’t play the decisive role in determining investment that it plays in determining consumption spending. Gottheil - Principles of Economics, 4e

What Determines Investment? Autonomous investment Investment that is independent of the level of income. Gottheil - Principles of Economics, 4e

Gottheil - Principles of Economics, 4e EXHIBIT 6 THE INVESTMENT CURVE Gottheil - Principles of Economics, 4e

Exhibit 6: The Investment Curve How does the investment curve (I) in Exhibit 6 change as the level of national income changes? The investment curve does not change. It remains at $75 billion at every level of national income. Gottheil - Principles of Economics, 4e

What Determines Investment? Four factors determine the size of the economy’s autonomous investment. Gottheil - Principles of Economics, 4e

What Determines Investment? 1. Technology level. The introduction of new technologies is one of the mainsprings of investment. Technological leaps produce extensive networks of investment spending. Gottheil - Principles of Economics, 4e

What Determines Investment? 2. Interest rate. Producers undertake investment when they believe the rate of return generated by the investment will exceed the interest rate, that is, the cost of borrowing investment funds. Gottheil - Principles of Economics, 4e

What Determines Investment? 2. Interest rate. There is an inverse relationship between the rate of interest and the quantity of investment spending. Gottheil - Principles of Economics, 4e

Gottheil - Principles of Economics, 4e EXHIBIT 7 THE EFFECT OF CHANGES IN THE RATE OF INTEREST ON THE LEVEL OF INVESTMENT Gottheil - Principles of Economics, 4e

Gottheil - Principles of Economics, 4e Exhibit 7: The Effect of Changes in the Rate of Interest on the Level of Investment Why is the demand curve for investment in panel a of Exhibit 7 downward sloping? Why do firms spend less on investment when interest rate increases? Fewer projects are now profitable (rate of return on investment vs. cost of borrowing to invest) Gottheil - Principles of Economics, 4e

What Determines Investment? 3. Expectations of future economic growth. Investment spending reflects how producers view the future. Future expectations are shaped by past performance. Gottheil - Principles of Economics, 4e

What Determines Investment? 4. Uncertainty about future economic growth (or GDP). Firms’ confidence Gottheil - Principles of Economics, 4e

What Determines Investment? 5. Rate of capacity utilization. Producers seldom choose to operate at 100 percent capacity. Operating at less than 100 percent capacity gives them the ability to expand production on demand. Gottheil - Principles of Economics, 4e

What Determines Investment? 5. Rate of capacity utilization. How much flexibility producers end up choosing influences the economy’s level of production. For producers who choose to operate close to full capacity, a moderate increase in sales may shift them quickly into investment spending. Gottheil - Principles of Economics, 4e

What Determines Investment? 6. Corporate tax rates. 7. Prices of capital goods ……… Gottheil - Principles of Economics, 4e

What Determines Investment? The level of investment spending in the U.S. economy is volatile. Sometimes the factors that effect investment spending pull in opposite directions. Other times, they work in unison and lead to impressive economic growth. Gottheil - Principles of Economics, 4e

Gottheil - Principles of Economics, 4e EXHIBIT 8 THE VOLATILITY OF INVESTMENT Source: Economic Report of the President 1994 (Washington, D.C.: United States Government Printing Office, 1994), p. 270; and U.S. Department of Commerce, Survey of Current Business 76 (January/February 1996), Table 2. Gottheil - Principles of Economics, 4e

Exhibit 8: The Volatility of Investment How does the rate of investment spending in Exhibit 8 compare to the rate of consumption spending? While the rate of consumption spending is fairly stable over time, the rate of investment spending is volatile. Gottheil - Principles of Economics, 4e