CONSUMPTION AND INVESTMENT

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1 291 Chapter 21 CONSUMPTION AND INVESTMENT Key Topics consumption the marginal propensity to consume saving the marginal propensity to save investment Goals uunderstand the determinants of consumption and saving introduce the marginal propensities to consume and save understand the primary determinant of investment We have found that GDP income fluctuates along the course of the business cycle. To reduce the fluctuations, we must find what determines the level of income. Once we understand what determines the level of income, we can use this knowledge to find ways to change income. We know that GDP is made up of consumption, investment, government expenditure, and net exports. Determining the size of each of these components of GDP is essential since we wish to know the size of GDP as well as to explain what causes GDP to change. If we know what makes each component the size it is, we will know the size of GDP. In addition, if we can explain why the components of GDP change, we can explain why GDP changes. The forces that establish the equilibrium level of income will be the subject of the next chapter. In this chapter we will discuss what determines two of the components of GDP, consumption and investment, and what causes them to change. We start with a simple economy consisting of only two sectors, consumers and business. The government sector will be postponed until Chapter 23. And since net exports are less than 5 percent of economic activity in the United States, we will simplify our model and ignore the influence of net exports on

2 292 Introductory Economics GDP. However, if we were to study Japan or Great Britain or any one of a number of countries, the foreign sector would be a much larger and more important part of their GDP. Foreign trade will be discussed in Chapters 30 and 31. In an economy without either a government or foreign sector, the level of income will be determined solely by the amount of consumption and investment. We will examine the sectors of the economy that perform these functions and see how consumption and investment affect the economic performance of the society. Consumption The largest part of GDP is consumer expenditure, or consumption, which is currently about 65 percent of GDP. Consumption (C) was defined in Chapter 18 as the yearly total of all purchases of goods and services by consumers. Consumption is more than consumption by an individual household; consumption is an aggregate, a macro concept. Macro is concerned with the total consumption of all consumers. What causes consumption to rise or fall? The main factor is income, real GDP. The direct relation between the level of income and the level of consumption is shown by the consumption function. John Maynard Keynes was one of the first to point out this consumption relation. Generally, we expect people to buy more goods and services as income rises. As income rises, so does consumption. As income falls, so does consumption. Income is an important determinant of the level of consumption. But beware of the fallacy of composition. We are not concluding that aggregate consumption goes up as aggregate income rises just because one person consumes more as income rises. We are concluding that the macroeconomic variable consumption is directly related to the macroeconomic variable income. This is a simple but rather important observation. The level of total income will determine the amount of total consumer spending. The Marginal Propensity to Consume Sometimes we wish to know more than just the existing level of consumer spending. We may want to know how consumers react when the income level changes. We have already indicated that as income goes up or down, consumption does also. But by how much does consumption change? The consumption function reveals how much consumption changes as income changes through a new concept, the marginal propensity to consume.

3 Chapter 21. Consumption and Investment 293 The marginal propensity to consume (MPC) is the amount consumption changes when income changes by one dollar. Remember that marginal means additional or extra. Propensity is the inclination or tendency. What is your propensity if someone were to punch you in the nose? Would you tend to turn the other cheek or punch back? What is the propensity of consumers to spend? What will consumers tend to do with an additional dollar of income? What part of that dollar would tend to go into extra consumption? The marginal propensity to consume provides the answer. MPC = marginal propensity to consume = change in consumption change in income C = Y The marginal propensity to consume is a marginal concept. It relates changes in consumption, ΔC, to changes in income, ΔY. For example, if consumers receive an extra dollar of income and spend 80 cents more, their marginal propensity to consume would be 80 percent, found by dividing.80 by 1. And if income falls by one dollar and consumers spend 80 cents less, the MPC is still.8, found by dividing the change in consumption,.80, by the change in income, 1. Table 21-1 Marginal Propensity to Consume (1) Income (Y) (2) Consumption (C) (3) MPC (ΔC/ΔY) $1,000 $ , , , , Columns 1 and 2 together show the consumption function. Column 3 shows the marginal propensity to consume.

4 294 Introductory Economics Suppose that the data in Table 21-1 were true. The first two columns are the consumption function, income and consumption. The MPC can be easily calculated. The change in income is $100 as Y goes from 0 to 100 in column 1. The change in consumption in column 2 is $60 for this change in income. Thus the MPC is.60 in column 3. Consumption increases by 60 additional dollars, or 60 cents of each additional dollar is spent. As income increases from $100 to $200, consumption increases from $260 to $320, again a change of $60. Thus, the MPC of the second additional $100 is also.60. The MPC tells how many more dollars will be spent when income goes up by one dollar. Of the added dollar of income, what percentage will be spent for added consumption? The answer is called the marginal propensity to consume. What does the consumer do with the remaining income? The remaining income can be either saved or used to pay taxes. Saving is the subject of the next section. Saving In the model world we have discussed, there are only three ways that income may be used. Income may be used to buy goods, to save, or to pay taxes. We will postpone discussing taxes until government is included in this model in Chapter 23. The topic we wish to emphasize now is saving. Saving (S) is that part of income that is not spent for consumption or taxes. In our model, without government or taxes, all income is either spent or saved. Since income is either spent or saved, income equals consumption plus saving, Y = C + S. Therefore, if consumption changes with income, then saving must also change with income. When income goes up by one dollar, part of the dollar is consumed. Whatever part of the dollar that is not spent is added to saving. Thus we can expect the level of saving for all people to depend on the level of income for all people. As income goes up, so does the amount saved. You should recognize that if there is a consumption function, there must also be a saving function. The saving function shows that saving increases with the level of income. Recall that consumption also increases with the income level. Thus both the amount of consumption and the amount of saving increase as a society produces a higher level of income. With a higher income, a society can afford both to spend more and to save more than before. When income increases by one dollar, part of that dollar is consumed and the remaining part is saved. As income changes, so does saving. This change in saving has a name. The marginal propensity to save (MPS) is the change in saving when income changes by one dollar. The expression for the

5 Chapter 21. Consumption and Investment 295 MPS is similar to that of the MPC except that the emphasis is on the change in saving. MPS = marginal propensity to save = change in saving change in income S = Y When consumers receive an extra dollar of income, and 20 cents goes into additional saving, the MPS is.20/1 or.20. Recognize that the S in MPS stands for saving, not spending. The change in spending is represented by consumption, C, in the MPC. Since all income is either spent or saved, when income goes up by one dollar, part of the dollar is spent and the remaining part is saved. All changes in income must be completely accounted for by the change in consumption and the change in saving. This means that the sum of the MPC and the MPS must be 1 or 100 percent of the change in income. When income increases by one dollar, if the MPC were 80 percent, then the MPS must be 20 percent. Or if you prefer to think in decimals, the MPC is.80 and the MPS is.20. If the MPC is 50 percent, then so must be the MPS. If the MPC is 100 percent, meaning that all extra income is consumed, then the MPS is 0. The MPC + MPS = 100 percent. Thus MPC + MPS = 1.0 in decimal terms. You will find the saving function, income and saving, in the first two columns of Table From this you can calculate the MPS. As income in column 1 changes from $1,200 to $1,300, saving in column 2 changes from $280 to $320. This results in the.40 MPS in column 3. It should be clear that the MPS had to be.40 if the MPC were already.60 in Table The marginal propensities to consume and save explain how consumers react to a change in income. How will that extra income be divided into changes in consumption and changes in saving? These changes in consumption, and therefore saving, are significant because they affect the economic outcome of society. A thorough examination of Table 21-3 can clarify the concepts presented so far in this chapter. Both Tables 21-1 and 21-2 have been combined. Column 1 is the level of total income, the GDP of the economy. Column 2 is consumption. The first two columns together, income and consumption, are the consumption function. This shows that consumer spending always increases with the level of income. Notice that if income is zero, we expect that consumption will be positive. Even if there is no income, people will consume to live. This consumption will occur out of past saving or current borrowing. This is a

6 296 Introductory Economics (1) Income (Y) Table 21-2 Marginal Propensity to Save (2) Saving (S) (3) MPS (ΔS/ΔY) $1,000 $ , , , , Columns 1 and 2 together show the saving function. Column 3 shows the marginal propensity to save. (1) Income (Y) (2) Consumption (C) Table 21-3 MPS and MPC (3) Saving (S) (4) MPC (ΔC/ΔY) (5) MPS (ΔS/ΔY) $1,300 $200 $ , , , , Here Tables 21-1 and 21-2 are combined. Note that columns 4 and 5 total to 100 percent. Also note that Y = C + S, column 2 plus column 3 equals column 1.

7 Chapter 21. Consumption and Investment 297 form of dissaving so current saving will be negative. When we know both the income level and the level of consumption, we can find the level of saving. Saving, column 3, is the difference between columns 1 and 2. Notice also that columns 2 and 3 added together give column 1. This is because consumption and saving together account for all of the income. The income and saving columns, 1 and 3, are the saving function. Observe that at a higher level of income, society can afford to consume more, yet have more left over than before so it can save even more too. Column 4 in Table 21-3 is the marginal propensity to consume. Column 5 is the marginal propensity to save. The MPC and MPS, added together at each level of income, account for 100 percent of the change in income. Investment While investment is the smallest domestic component of GDP, about 15 percent, it is also the most variable. This variation is caused by a complex interaction of economic factors, and is a major cause of the fluctuation in the business cycle. Investment is the purchase of capital goods by business. Business is the only sector of the economy that invests in the economic sense. When consumers invest, there is a transfer of assets from one individual to another. When you buy a share of stock on the stock market, the ownership of the stock is transferred to you and your money to the previous owner of the stock. This transfer has no impact on the economy. Business investment, however, does have a significant economic impact. When business purchases capital goods beyond replacing worn-out capital goods, the production capabilities of the society have increased. This is shown by the production possibilities curve (Chapter 3) with a movement of the curve to the right, representing economic growth. Our references to investment will always mean the purchase of new capital goods by business. What causes investment to change? The primary determinant of investment is the interest rate, although there are also several other factors that are important in determining the size of investment. These are business profits, the level of income, and expectations about future economic conditions. But we will focus on how changes in the interest rate affect investment, or investment demand. The amount of capital purchased by business varies inversely with the interest rate. Firms usually must borrow to obtain money for investment. So the interest rate, the rate of interest on the borrowed money, will affect the decision of the firm to invest. The higher the interest rate, the less likely the firm is to borrow.

8 298 Introductory Economics Since the firm pays back the loan from the money generated by the capital, a higher interest rate will require that the capital improvement generate more money than if the interest rate were smaller. If the capital improvement cannot generate the higher interest payments, the project should not be undertaken. Would your firm borrow money at 12 percent for an investment project that promises a return of 8 percent? Of course not! A project that has a return of 8 percent would be acceptable at a 6 percent or 7 percent interest rate, but not at an interest rate of 9 percent. As the interest rate goes up, fewer and fewer investment projects will have a return high enough to be profitable. Thus the higher the interest rate, the smaller the amount of investment. Even if the firm has the money on hand and does not have to borrow, the firm may not invest in a capital improvement project. Any investment would have to return more than the firm could earn in interest from an alternative use of the money. One alternative for the firm may be the purchase of bonds. The return on the investment project would have to be greater than the opportunity cost of the money. If your firm has a choice between an investment project that returns 10 percent and a government bond paying 12.5 percent, the firm would be foolish to use its money for the investment project. The higher the interest rate, the less likely the firm can find capital improvement projects paying a rate of return higher than the interest rate it receives by other uses of its money. So again, the higher the interest rate, the smaller the amount of investment the firm will undertake. Interest rate Investment Demand Investment Figure 21-1 Investment Demand The downward-sloping investment demand curve shows an inverse relation between the interest rate and the amount invested.

9 Chapter 21. Consumption and Investment 299 If we think of this relationship between investment and the interest rate as investment demand, we see that investment demand follows the law of demand. This inverse relation is shown in Figure As the price of investment the interest rate rises, the quantity demanded of investment falls. Because we do not yet have a way in our model to determine the interest rate, we will not immediately use this inverse relationship between the interest rate and the level of investment. When the model is expanded in Chapter 28 to include the interest rate, the relationship between the interest rate and the level of investment can then be applied. For now, recognize that investment does not change with the level of income, as does consumption, but with the interest rate. We will be considering impacts of a change in income in the next chapter; hence investment will remain constant, unaffected by income. Summary We have looked at two sectors of the economy, the consumer and business. We have developed a simple model of how two components of GDP, consumption and investment, are determined. The primary determinant of consumption is income. When we understand consumption, we also understand saving. The concepts of the marginal propensity to consume and the marginal propensity to save were also discussed. These marginal concepts are important and will have a major role in Chapter 23. Investment is the purchase of capital goods by business. We have established that investment spending varies inversely with the interest rate. Investment is for now assumed to be constant since it does not vary with the level of income. We are now prepared to find what determines the equilibrium level of income and what can be done to alter it. Key Concepts consumption function marginal propensity to consume saving saving function marginal propensity to save dissaving investment Discussion Questions 1. What is the consumption function? The saving function?

10 300 Introductory Economics 2. Use the following data to find the MPC and MPS as well as saving. Income Consumption Saving MPC MPS $100 $120 $ Explain why MPC + MPS = 1. Why Y = C + S. 4. Who invests? What is investment? 5. If buying bonds is not investment, then what is it? 6. Why does investment depend on the interest rate? Is this true when the firm does not have to borrow to invest? Self-Review Fill in the blanks consumption consumption income rises falls, direct marginal propensity to consume consumption, income saving, saving directly, income marginal propensity to save, 1 100, income change investment interest rate interest rate increases decreases The largest component of GDP is CONSUMPTIO. The CONSUMPTIO function states that consumption is related to the level of INCOME. As income rises, consumption RISESX. As income falls, consumption FALLSX. This is a DIRECT relation. The amount that consumption changes when income changes by one dollar is the MARGINALPROPENSITYTOCONSUM. The MPC is found by dividing the change in CONSUMPTION by the change in INCOME. The part of income that is not spent for consumption or taxes is SAVING. The SAVING function states that saving is DIRECTLY related to the level of INCOME. The change in saving when income changes by one dollar is the MARGINALPROPENSITYTOSAVE. The sum of the MPC and the MPS is 1XXX or 100X% of the change in INCOME. The marginal propensities show what happens to a CHANGE in income. The purchase of capital goods by business is INVESTMENT. The primary determinant of investment is the INTERESTRATE. Investment spending varies inversely with the INTERESTRATE. At lower rates of interest, investment INCREASES. At higher rates of interest, investment DECREASES.

11 Chapter 21. Consumption and Investment 301 Multiple choice 1. The consumption function directly relates consumption to the level of: a. taxes. b. income. c. wages. d. prices. 2. If the marginal propensity to consume were 60 percent, how much would be saved of an additional dollar of income? a. $1. b. $.60. c. $.40. d. impossible to say. 3. If $75 of an extra $100 is consumed, the marginal propensity to consume is: a. 25 percent. b. 50 percent. c. 75 percent. d. 100 percent. 4. As interest rates increase: a. consumption increases. b. investment increases. c. investment decreases. d. saving decreases. 5. The marginal propensity to save is: a. the change in saving when income changes by $1. b. the saving divided by income. c. the portion of income going to saving. d. saving plus investment. Answers: 1.b, 2.c, 3.c, 4.c, 5.a.

Chapter 12 Consumption, Real GDP, and the Multiplier

Chapter 12 Consumption, Real GDP, and the Multiplier Learning Objectives After you have studied this chapter, you should be able to 1. define saving, savings, consumption, dissaving, autonomous consumption,