Consumption & Investment Chapter 21 Consumption & Investment 4/10/2017 ©1999 South-Western College Publishing

What is the Consumption Function? The relationship between consumption and income C = F(Y) ©1999 South-Western College Publishing

The Consumption Function D C Real Consumption D Y Real Disposable Income ©1999 South-Western College Publishing

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

C Income Consumption Function Consumption, Saving Saving 45o 5 ©1999 South-Western College Publishing 5

C, S C 45o Y Y3 Y1 Y2 6

On the previous graph, At Y1, C=Y, so S=0 At Y2, C<Y, positive savings At Y3, C>Y, negative savings (dissaving

What is the Marginal Propensity to consume (MPC)? Change in consumption brought about by a change in income (the slope of the consumption function)

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

MPC = ΔC/ ΔY MPS = ΔS/ ΔY Example: Y = 500, C = 400, S = 100 Y1 = 600, C1 = 480, S1 = 120 ΔY= 100, ΔC = 80, ΔS=20 so MPC = 80/100 = .8 MPS = 20/100 = .2

Note that MPC + MPS must equal 1

If household's income rises from $30,000 to $33,000 and consumption rises from $28,000 to $30,000, then MPC = $2000 / $3,000 = .67 MPS = $1000 / $3,000 = .33 ©1999 South-Western College Publishing

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

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

The Consumption Function Real Consumption D C a D Y Real Disposable Income

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

Many theories of the consumption function Note that a straight line C function assumes a constant MPC

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

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

MPC decreases as income increases and increases as income decreases According to the absolute income hypothesis, What happens to the MPC as income increases? MPC decreases as income increases and increases as income decreases ©1999 South-Western College Publishing

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

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

What is Duesenberry’s Relative Income Hypothesis? People consume according to their relative position in society, consistent with the idea that the MPC remains fairly constant as national income increases ©1999 South-Western College Publishing

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

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

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

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

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

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

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

C1 C2 Real Consumption Real Disposable Income ©1999 South-Western College Publishing

For more information on income data: http://www.census.gov/hhes/www/income.html http://www.bea.doc.gov/bea/dn/pitbl.htm http://www.bls.gov/eag.table.html ©1999 South-Western College Publishing

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

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

What is Intended Investment? Investment spending that producers intend to undertake, on plant, tools, construction, and inventory ©1999 South-Western College Publishing

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

Investment I 45o National Income 3737

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

(C+I) Consumption, Saving C 45o National Income 3939

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

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

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

END ©1999 South-Western College Publishing