Consumption & Investment

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Arthur Ray
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1 Business Environment.2 Week 3 Consumption & Investment 1

2 Objectives To understand the nature of the consumption and investment. To understand the factors affecting consumption. To understand the factors affecting investment. To understand and examine the relationship between income and consumption (the concept of consumption function).

3 Aggregate Demand Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus. 3

4 Components of Aggregate Demand The components of aggregate demand are: 1. consumer spending ( C ), 2. expenditure by firms on investment goods ( I ), 3. government demand for goods and services ( G ) and 4. net exports (exports minus imports: X M). Thus aggregate demand can be written as: AD = C + I + G + (X M) 4

5 Consumption & Investment What are the main factors influencing demand? Consumption and Investment 5

6 Consumption Consumption is treated as that part of income that was not saved. Since savings were assumed to depend upon the rate of interest, this made consumption also depend on the rate of interest. 6

7 Personal Disposable Income Keynes argued that consumption depended upon personal disposable income. The higher a person s income the more he or she would consume. 7

8 What is meant by Personal Disposable Income? The income available for households to spend: i.e. personal incomes after deducting taxes on incomes and adding benefits. 8

9 Consumption function Consumption function tells us, in short, how consumption expenditure increases as income increases. It indicates a functional relationship between two aggregates: 1. Total consumption 2. The gross national income The relationship between consumption and income is expressed by the consumption function: C = f(y) 9

10 The Consumption Function Keynes argued that 'the fundamental psychological law is that men are disposed, 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'. From this statement, a number of propositions can be derived. 1

11 The Consumption Function Consumption is a function of income { C = f (Y) } remember Y is the symbol in economics for income Consumption will increase by a fraction of increasing income { C = b (Y) } - b stands for some fraction i.e. 0.5 or 0.3 of Y The fraction of income not spent is assumed to be saved. { C + S = Y } - Consumption + Saving 11

12 The Consumption Function It is clear that at low levels of income, or no income at all, people still have to eat, clothe themselves and keep warm. This means that they will have to spend income they do not have. Thus they either spend their savings or rely on welfare support, or both. This aspect of general consumption is added into the consumption function by adding a positive constant. The consumption function: C = a + b (Y) 12

13 The consumption function in diagrammatic form In fig. the consumption function {C = a + b (Y)} starts at point a on the expenditure axis to show that even at zero income some level of expenditure is necessary. The line then rises constantly at the rate of b (Y) to indicate that at all levels of national income the fraction (b) will be spent on consumption. The 45 line (Y = E) is a line which joints all points where national income equals consumption expenditure. Thus at every point along this line Y = E. this line is useful because the consumption function can be compared with it. 13

14 The consumption function in diagrammatic form Fig

15 The consumption function in diagrammatic form Up to the level of national income OY consumption expenditure is greater than national income. After the OY level of national income consumption expenditure is less than national income, indicating that saving is taking place. Only at OY level of national income is consumption equal to national income. 15

16 The marginal propensity to consume The slope of consumption function is given by the marginal propensity to consume. This is the proportion of any increase in national income that goes on consumption. The formula is: MPC = Δ C/Δ Y 16

17 The marginal propensity to consume In table 3.1 for each RO.10 billion rise in national income there is an RO.8 billion rise in consumption. Thus the marginal propensity to consume is RO.8 billion/ro.10 billion = 8/10 or 4/5 or

18 The marginal propensity to consume (Table3.1) National Income Consumption (RO.)

19 The marginal propensity to save This is the proportion of any increase in national income that goes on saving. The formula is: MPS = Δ S/Δ Y Suppose, for each RO.10 billion rise in national income there is an RO.2 billion rise in saving. Thus the marginal propensity to save is RO.2 billion/ro.10 billion = 2/10 or 1/5 or

20 The average propensity to consume and save The average propensity to consume (APC) is calculated by dividing consumption expenditure by income. Whereas, the average propensity to save (APS) is calculated by dividing saving by income 20

21 The other determinants of consumption 1. Assets held. 2. Taxation. 3. Expectations of future prices and incomes. 4. The distribution of income. 5. Tastes and attitudes. 6. The age of durables. 21

22 Investment Investment is the second element of aggregate demand. Investment can best be thought of as expenditure on new capital equipment such as machinery. It is carried out by firms. Investment are expenditures on (production of) new plant, equipment, and structures (capital) in a given time period, plus changes in business inventories. 22

23 Determinants of Investment 1. Expectations. 2. Interest rates. 3. Technology and innovation. 23

24 1. Expectations Expectations play a critical role in investment decisions. Favorable expectations for future sales are a necessary condition for investment spending. 24

25 2. Interest rates Businesses typically borrow money to invest in new plants or equipment. The higher the interest rate, the costlier it is to invest and the lower the investment spending. "More investment occurs at lower rates". 25

26 3. Technology and innovation New technology changes the demand for investment goods. 26

Learning Objectives. 1. Describe how the government budget surplus is related to national income.

Learning Objectives. 1. Describe how the government budget surplus is related to national income. Learning Objectives 1of 28 1. Describe how the government budget surplus is related to national income. 2. Explain how net exports are related to national income. 3. Distinguish between the marginal propensity