Chapter 21

CONSUMPTION AND INVESTMENT

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Consumption is one of the major components of output

Y+Tr -T = YD = C + S
Consumption (C), or more precisely, personal consumption
expenditures, is the expenditures by households on final goods and
services. Saving (S) is part of personal disposable income (YD) that
is not consumed. Disposable income, on the other hand, is the share
of total income (Y) and transfers (Tr) less taxes (T). Consumption
and saving are thus determined by disposable income.

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 Exercise. Consider the following household behavior
In thousand PHP A B C D E
Disposable income (YD) 24 25 26 27 28
Consumption (C) 24.2 25 25.8 26.6 27.4
Saving (S) -0.2 0 0.2 0.4 0.6

Consumption and saving both increase with disposable income.

The break-even point at point B where the household neither
saves nor dissaves (saving is zero), but consumes all of its income.

C, S

CONSUMPTION FUNCTION
Illustrates the relationship between
consumption and disposable income

CB
saving Function
Illustrates the relationship between
saving and disposable income

SB A B C D E
YD
YD 24 25 26 27 28
C 24.2 25 25.8 26.6 27.4
S -0.2 0 0.2 0.4 0.6

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C, S
BREAK-EVEN LINE
At any point on the 45⁰line, YD is equal to C, thus S = 0. When
consumption is above this, the household is dissaving.

CONSUMPTION FUNCTION
Illustrates the relationship between
consumption and disposable income

CB
saving Function
Illustrates the relationship between
saving and disposable income

45 SB
YD

Graphically, the vertical distance between the break-even line and

consumption function is saving.

The tendency to consume are given by the household’s

marginal propensities

C = cYD + C0
The Marginal Propensity to Consume (c) is the additional amount of
consumption generated by an additional peso of disposable income.
Autonomous consumption (C0) is the level of consumption when
disposable income is zero.

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The tendency to save are given by the household’s
marginal propensities

S = sYD + S0
The Marginal Propensity to Save (s) is the additional amount of savings
generated by an additional peso of disposable income. Autonomous
saving (S0) is the level of savings when disposable income is zero.

Changes in consumption and saving given changes in

income is measured by their marginal propensities

Marginal propensity Marginal propensity

To consume,(MPC) to save,(MPS)
Additional amount of consumption Additional amount of saving
generated by an additional peso of generated by an additional peso of
disposable income. disposable income.
MPC = ∆C/∆YD MPS = ∆S/∆YD

MPC and MPS are the slopes of the consumption and saving
function, respectively.

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 Exercise. Consider the following household behavior
In thousand PHP A B C D E
Disposable income (YD) 24 25 26 27 28
Consumption (C) 24.2 25 25.8 26.6 27.4
Saving (S) -0.2 0 0.2 0.4 0.6
MPC 0.8 0.8 0.8 0.8
MPS 0.2 0.2 0.2 0.2

A peso increase in disposable income increases consumption by

80 cents, and increases saving by 20 cents.

C, S
BREAK-EVEN LINE
At any point on the 45⁰line, YD is equal to C, thus S = 0. When
consumption is above this, the household is dissaving.

CONSUMPTION FUNCTION
Illustrates the relationship between
consumption and disposable income
0.8
CB
saving Function
Illustrates the relationship between
saving and disposable income

45 SB 0.2
YD

The marginal propensities equal to one, MPC + MPS = 1, since

any peso not consumed is saved.

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Consumption and saving behavior are key to
understanding short-run and long-run growth

Business cycle Economic growth

Consumption is a major component
of aggregate demand. It is key to
understanding fluctuations in output,
employment, and prices.
What is not consumed today is
available for investment for capital
goods in the future. Capital is the
driving force behind long-term
economic growth.

Investment is another key expenditure component that

affects output

Business cycle Economic growth

A large and volatile component of Investment leads to capital
spending, investment affects the accumulation. It adds to the stock of
business cycle. buildings and equipment, increases
the nation’s potential output, and
promotes economic growth.

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Business buy capital goods expecting to earn profits
Major types of gross private domestic investment are buildings of
residential structures, software, and additions to inventory. Private
domestic investment is primarily influenced by revenues, costs (such
as taxes and interest rate), and business expectations (because
investment is a gamble on the future).

READING ASSIGNMENT: Determinants of Investment [SN], pages 420-421.

The profitability of an investment depends on interest rate

Investors raise the funds for buying capital goods by borrowing.
Interest rate (r) is the price for borrowing money for a period of
time. Influenced by the Central Bank, interest rates are the major
instrument by which governments influence investment. The investment
demand schedule relates the level of investment spending to the
interest rate.

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 Exercise. Consider the following firm
Project A B C D E F G
Investment (I) 1 4 10 10 5 15 10
Revenues per
thousand 1 500 220 160 130 110 90 60
Cost per ‘000 at
10% interest rate 100 100 100 100 100 100 100
Profit at10%
interest rate 1 400 120 60 30 10 -10 -40
Cost per ‘000 at
5% interest rate 50 50 50 50 50 50 50
Profit at 5%
interest rate 1 450 170 110 80 60 40 10

Investment demand is inversely related to interest rate

r

Investment demand curve

Illustrates the downward relationship between investment
and interest rate. At a lower cost of borrowing, more business
projects are profitable

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Factors related to business expectations can shift
investment demand

Output taxes Animal spirits

Continuous GDP growth signal Business taxation depresses Business optimism (e.g., phases
optimism among investors, investment of business euphoria) increases
increasing investment investment