1. C hapter 21 Consumption and Investment © 2002 South-Western

2. 2 Economic Principles Keynes’s absolute income hypothesis Duesenberry’s relative income hypothesis Friedman’s permanent income hypothesis

3. 3 Economic Principles Modigliani’s life-cycle hypothesis The marginal propensity to consume The marginal propensity to save Autonomous investment

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

5. 5 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.

6. 6 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.

7. 7 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.

8. 8 What Determines Consumption Spending? A number of hypotheses have been offered to explain how changes in an individual’s income, and, taken collectively, changes in national income affect individual and national consumption.

9. 9 Keynes’s Absolute Income Hypothesis Absolute income hypothesis As national income increases, consumption spending increases, but by diminishing amounts. That is, as national income increases, the marginal propensity to consume (MPC) decreases.

10. 10 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).

11. 11 Keynes’s Absolute Income Hypothesis Marginal propensity to consume (MPC) Consumption increases by diminishing amounts as the income level increases.

12. 12 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.

13. 13 Keynes’s Absolute Income Hypothesis Keynes relied on the psychological law that the satisfaction of “immediate primary needs” is a stronger motive for consumption than “accumulation.”

14. 14 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.

15. 15 Keynes’s Absolute Income Hypothesis The welfare recipient, on the other hand, would likely immediately spend the money on food, clothing, and shelter.

16. 16 EXHIBIT 1THE INDIVIDUAL’S MARGINAL PROPENSITY TO CONSUME

17. 17 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.

18. 18 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.

19. 19 Keynes’s Absolute Income Hypothesis To Keynes, national economies behave like individuals. He hypothesized that a nation’s MPC depends on its level of national income.

20. 20 EXHIBIT 2THE NATION’S MARGINAL PROPENSITY TO CONSUME ($ BILLIONS)

21. 21 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.

22. 22 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.

23. 23 Duesenberry’s Relative Income Hypothesis 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.

24. 24 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.

25. 25 Duesenberry’s Relative Income Hypothesis An individual’s MPC, then, remains the same, as long as the individual’s relative income position remains unchanged.

26. 26 EXHIBIT 3THE MARGINAL PROPENSITY TO CONSUME REMAINS CONSTANT

27. 27 Exhibit 3: The Marginal Propensity to Consume Remains Constant How does Duesenberry’s consumption curve in Exhibit 3 compare to Keynes’s consumption curve in Exhibit 2? Keynes’s consumption curve flattens near the top, reflecting his belief that MPC increases by diminishing amounts as income increases.

28. 28 Exhibit 3: The Marginal Propensity to Consume Remains Constant How does Duesenberry’s consumption curve in Exhibit 3 compare to Keynes’s consumption curve in Exhibit 2? Duesenberry’s consumption curve is a straight line, reflecting his belief that MPC increases by the same amount as income increases.

29. 29 Friedman’s Permanent Income Hypothesis Permanent income hypothesis A person’s consumption spending is related to his or her permanent income.

30. 30 Friedman’s Permanent Income Hypothesis Permanent income 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.

31. 31 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.

32. 32 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.

33. 33 Modigliani’s Life-Cycle Hypothesis 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.

34. 34 What Determines Consumption Spending? Autonomous consumption Consumption spending that is independent of the level of income.

35. 35 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.

36. 36 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.

37. 37 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.

38. 38 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.

39. 39 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.

40. 40 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.

41. 41 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.

42. 42 EXHIBIT 4SHIFTS IN THE CONSUMPTION CURVE

43. 43 Exhibit 4: Shifts in the Consumption Curve The consumption curve shifts depicted in Exhibit 4 can be attributed to increases and decreases in national income. i. True. ii. False.

44. 44 Exhibit 4: Shifts in the Consumption Curve The consumption curve shifts depicted in Exhibit 4 can be attributed to increases and decreases in national income. ii. False. Shifts in the consumption curve are unrelated to changes in national income.

45. 45 The Consumption Equation There are two key factors that influence the character of our consumption spending: autonomous consumption and our income level.

46. 46 The Consumption Equation Consumption induced by our level of income is referred to as induced consumption.

47. 47 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.

48. 48 What Determines the Level of Saving? People do two things with their income. They either spend it on consumption or they save it.

49. 49 What Determines the Level of Saving? Saving The part of national income not spent on consumption. S = Y – C.

50. 50 What Determines the Level of Saving? 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.

51. 51 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).

52. 52 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.

53. 53 What Determines the Level of Saving? 45 o line A line, drawn at a 45 o 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.

54. 54 EXHIBIT 5ATHE SAVINGS CURVE

55. 55 EXHIBIT 5BTHE SAVINGS CURVE

56. 56 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.

57. 57 The Investment Function Producers in the economy must decide how much income to spend on new investment.

58. 58 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.

59. 59 The Investment Function Each producer makes investment decisions independently of others.

60. 60 The Investment Function Intended investment Investment spending that producers intend to undertake. These intended investments do not always end up being realized.

61. 61 What Determines Investment? The level of national income doesn’t play the decisive role in determining investment that it plays in determining consumption spending.

62. 62 What Determines Investment? Autonomous investment Investment that is independent of the level of income.

63. 63 EXHIBIT 6THE INVESTMENT CURVE

64. 64 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.

65. 65 What Determines Investment? Four factors determine the size of the economy’s autonomous investment.

66. 66 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.

67. 67 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.

68. 68 What Determines Investment? 2. Interest rate. There is an inverse relationship between the rate of interest and the quantity of investment spending.

69. 69 EXHIBIT 7THE EFFECT OF CHANGES IN THE RATE OF INTEREST ON THE LEVEL OF INVESTMENT

70. 70 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? The demand curve for investment is downward sloping because as the rate of interest decreases, the level of investment in the economy increases.

71. 71 What Determines Investment? 3. Expectations of future economic growth. Investment spending reflects how producers view the future. Future expectations are shaped by past performance.

72. 72 What Determines Investment? 4. 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.

73. 73 What Determines Investment? 4. 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.

74. 74 What Determines Investment? The level of investment spending in the US 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.

75. 75 EXHIBIT 8THE 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.

76. 76 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.