CHAPTER 4

CONSUMPTION AND INVESTMENT

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 CONSUMPTION & SAVING
▪ Consumption (or, more precisely, personal
consumption expenditures) is expenditures by
households on final goods and services. Saving
is the part of personal disposable income that
is not consumed
▪ Consumption is the largest single component
of GDP, constituting 66 percent of total
spending over the last decade. What are the
major elements of consumption? Among the
most important categories are housing, motor
vehicles, food, and medical care.

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▪ The table in the next slide displays the major
elements, broken down into three categories of
durable goods, nondurable goods, and
services. The items themselves are familiar, but
their relative importance, particularly the
increasing importance of services, is worth a
moment’s study

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THE MAJOR COMPONENTS OF CONSUMPTION
Category of consumption

Durable goods
Motor vehicles & parts
Furniture & household equipment
Other
Nondurable goods
Food
Clothing & shoes
Energy goods
Other
Services
Housing
Household operation
Transportation
Medical care
Recreation
Other

Total personal consumption expenditures

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BUDGETARY EXPENDITURE PATTERNS

▪ Poor families must spend their incomes

largely on the on the necessities of life: food
and shelter. As income increases,
expenditure on many food items goes up.
People more and eat better. There are,
however, limits to the extra money people
will spend on food when their incomes rise.
Consequently, the proportion of total
spending devoted to food declines as
income rises.

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 CONSUMPTION, INCOME, & SAVING
▪ Income, consumption, and saving are all closely
linked. More precisely, personal saving is that
part of disposable income that is not consumed;
saving equals income consumption. To
understand the way consumption affects
national output, we need to introduce some new
tools. We need to understand how many extra
dollars of consumption & saving are induced by
each extra dollar of income. This relationship is
shown by:
1. The consumption function, relating to
consumption & income

2. Its twin, the saving function, relates saving &

income
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THE CONSUMPTION FUNCTION
▪ One of the most important relationships in
all macroeconomics is the consumption
function. The consumption function shows
the relationship between the level of
consumption expenditures and the level of
disposable personal income. This concept,
introduced by Keynes, is based on the
hypothesis that there is a stable empirical
relationship between consumption and
income

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A PLOT OF THE CONSUMPTION FUNCTION

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▪ The curve through A, B, C…G is the consumption
function. The horizontal axis depicts the level of
disposable income (DI). For each level of DI, the
consumption function shows the dollar level of
consumption (C) for the household. Note that
consumption rises with increases in DI. The 45
degrees line helps locate the break-even point
and helps our eye measure net saving
▪ The break-even point on the consumption
schedule that intersects the 45-degree line
represents the level of disposable income at
which households just break even

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THE SAVING FUNCTION
▪ The saving function shows the relationship
between the level of saving and income. This
is shown graphically in the next slide. Again,
we show disposable income on the horizontal
axis; but now saving, whether negative or
positive in amount, is on the vertical axis
▪ This saving schedule is derived by
subtracting consumption from income.
Graphically, the saving function is obtained
by subtracting vertically the consumption
function from the 45-degree line in the next
slide. Note that the break-even point B is at
the same $25,000 income level as in the
previous slide

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 THE SAVING FUNCTION IS THE MIRROR
IMAGE OF THE CONSUMPTION FUNCTION

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THE MARGINAL PROPENSITY TO CONSUME
▪ Modern macroeconomics attaches much
importance to the response of consumption
to changes in income. This concept is called
the marginal propensity to consume, or MPC
▪ The marginal propensity to consume is the
extra amount that people consume when
they receive an extra dollar of disposable
income

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 THE MARGINAL PROPENSITY TO SAVE

▪ Along with the marginal propensity to

consume goes its mirror image, the marginal
propensity to save is defined as the fraction
of an extra dollar of disposable income that
goes to extra saving
▪ MPC + MPS = 1, always and everywhere

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 BRIEF REVIEW OF DEFINITIONS
▪ 1. The consumption function relates the level
of consumption to the level of disposable
income
▪ 2. The saving function relates the saving to
disposable income. Because what is saved
equals what is not consumed, saving and
consumption schedules are mirror images
▪ 3. The marginal propensity to consume
(MPC) is the amount of extra consumption
generated by an extra dollar by the slope of
the consumption function
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 NATIONAL CONSUMPTION BEHAVIOR
▪ We begin by examining economic activity on
the individual level and then add up or
aggregate the totality of individuals to study the
way the overall economy operates
▪ Consumption behavior is crucial because what
is not consumed – that is, what is saved – is
available to the nation for investment in new
capital goods; capital serves as a driving force
behind long-term economic growth.
Consumption and saving behavior is key to
understanding economic and business cycles

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 DETERMINANTS OF CONSUMPTION

▪ We begin by analyzing the major forces that

affect consumer spending. What factors in a
nation’s life and livelihood set the pace of its
consumption outlays (expenses)?
▪ Current disposable income. Both observation
and statistical studies show that the current
level of disposable income is the central
factor determining a nation’s consumption

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▪ Permanent income and the life-cycle model of
consumption. The simplest theory of
consumption uses only the current year’s income
to predict consumption expenditures. Consider
the following examples, which suggest
otherwise:
If bad weather destroys a crop, farmers will
draw upon their previous savings. Similarly, law-
school students borrow for consumption
purposes while in school because they believe
that their postgraduate income will be much
higher than their meager student earnings

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▪ In both these circumstances, people are in effect
asking, “Given my current and future income,
how much can I consume today without incurring
excessive debts?
▪ Permanent income is the trend level of income –
that is, income after removing temporary or
transient influences due to the weather or
windfall gains or losses. According to the
permanent-income theory, consumption
responds primarily to permanent income. If a
change in income appears permanent (such as
being promoted to a secure and high-paying
job), people are likely to consume a large
fraction of the increase in income
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▪ The life-cycle hypothesis assumes that people
save in order to smooth their consumption over
their lifetime. One important objective is to
have an adequate retirement income. Hence,
people tend to save while working so as to
build up a nest egg for retirement ad then
spend out their accumulated savings in their
twilight years

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 WEALTH AND OTHER INFLUENCES

▪A further important determinant of the

amount of consumption is wealth. Consider
two consumers, both earning $50,000 per
year. One has $200,000 in the bank, while the
other has no savings at all. The first person
may consume part of wealth, while the
second has no wealth to draw. The fact that
higher wealth leads to higher consumption
is called the wealth effect

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 REASONS FOR THE SHARP DECLINE IN THE PERSONAL
SAVING RATE
▪ Social security system. Some economists argue that the social
security system has removed some of the need for private
savings. In earlier times, as the life cycle model of
consumption suggests, a household would save during
working years to build up a nest egg for retirement
Capital markets. Until recently, capital markets had numerous
imperfections. People found it hard to borrow funds for
worthwhile purposes, whether for buying a house, financing an
education, or starting a business. As capital markets
developed, often with the help of the government, new loan
instruments allowed people to borrow easily. One example is
the proliferation (increase) of credit cards, which encourage
people to borrow (even though the interest rates are quite
high)
▪ The rapid growth in wealth. Part of the decline in personal
savings in the 1990s was surely caused by the rapid increase in
personal wealth
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ALTERNATIVE MEASURES OF SAVING
▪ The national-accounts measure of saving is the
difference between disposable income
(excluding capital gains) and consumption. The
balance sheet measure of saving calculates the
change in the real net worth (that is, assets
fewer liabilities, corrected for inflation) from
one year to the next; this measure includes real
capital gains

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 B. INVESTMENT
▪ The second major component of private spending
is an investment. Investment plays two roles in
macroeconomics. First, because it is a large and
volatile (unstable) component of spending,
investment often leads to changes in aggregate
demand and affects the business cycle. In
addition, investment leads to capital accumulation.
Adding to the stock of buildings and equipment
increases the nation’s potential output and
promotes economic growth in the long run.
▪ Thus, investment plays a dual role, affecting short-
run output through its impact on aggregate
demand and influencing long-run output growth
through the impact of capital formation on
potential output ad aggregate supply
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 DETERMINANTS OF INVESTMENT
▪ Three elements essential to understanding
investment: revenues, costs, and expectations
▪ Revenues. An investment will bring the firm
additional revenue if it helps the firm sell more
products. This suggests that the overall level of
output (or GDP) will be an important
determinant of investment. When factories are
lying idle, firms have relatively little need for
new factories, so the investment is low. More
generally, investment depends upon the
revenues that will be generated by the state of
overall economic activity

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▪ Costs. A second important determinant of the
level of investment is the costs of investing.
Because investment goods last many years,
reckoning (considering) the costs of the
investment is somewhat more complicated than
doing so for other commodities like coal or
wheat. For durable goods, the cost of capital
includes not only the price of the capital good
but also the interest rate that borrowers pay to
finance the capital as well as the taxes that
firms pay o their incomes

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▪ Expectations. The third element in the
determination of investment is profit
expectations and business confidence.
Investment is, above all, a gamble on the future,
a bet that the revenue from an investment will
exceed its costs. If businesses are concerned
that political conditions in Russia are unstable,
they will be reluctant to invest there.
Conversely, because businesses believe
(rightly or wrongly) that Internet commerce will
be an important feature of the distribution
network, they are investing heavily in that
sector

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 THE INVESTMENT DEMAND CURVE
▪ In analyzing the determinants of investment,
we focus particularly on the relationship
between interest rates and investment. This
linkage is crucial because interest rates
(influenced by central banks) are the major
instrument by which governments influence
investment. To show the relationship
between interest rates and investment,
economists use a schedule called the
investment demand curve

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 INVESTMENT DEPENDS
UPON INTEREST RATE

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INVESTMENT DEPENDS UPON INTEREST RATES

▪ The downward sloping demand-for-

investment schedule plots the amount that
businesses would invest at each interest rate.
Each step represents a lump of investment:
project A has such a high rate that it is off the
figure; the highest visible step is project B,
shown at the upper left. At each interest rate,
all investments that have positive net profit
will be undertaken

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 ON THE THEORY OF AGGREGATE DEMAND
▪ We have now completed our introduction to the
basic concepts of macroeconomics. We have
examined the determinants of consumption and
investment and seen how they can fluctuate from
year to year, sometimes quite sharply
▪ At this point, macroeconomics branches into one
of two major themes – business cycles ad
economic growth. In the chapters that follow, we
begin our survey of business cycles or the
behavior of the economy in the short run. This
approach, known as Keynesian economics, shows
how changes in investment, government spending
& taxation, foreign trade, and the money supply
can be transmitted to the rest of the economy
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 CHAPTER 5
BUSINESS CYCLES
AND THE THEORY
OF AGGREGATE DEMAND

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BUSINESS FLUCTUATIONS HAVE BEEN A
PERSISTENT FEATURE OF CAPITALISM

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 BUSINESS FLUCTUATIONS
▪A country may enjoy several years of
exhilarating economic expansion and
prosperity, as the United States did in the
1990s. This might be followed by a recession
or even a financial crisis or, on rare
occasions, a prolonged depression. Then
national output falls, profits and real incomes
decline, ad the unemployment rate jumps to
uncomfortably high levels as legions
(crowd) of workers lose their jobs

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▪ Eventually the bottom is reached, and
recovery begins. The recovery may be slow
or fast. It may be incomplete, or it may be so
strong as to lead to a new boom. Prosperity
may mean a log, sustained period of brisk
demand, plentiful jobs, and rising living
standards. Or it may be marked by a quick,
inflationary flaring up of prices and
speculation, to be followed by another
slump

▪ Upward and downward movements in

output, inflation, interest rates, and
employment form the business cycle that
characterizes all market economies
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 FEATURES OF THE BUSINESS CYCLE
▪ Business cycles are economy-wide
fluctuations in total national output, income,
and employment, usually lasting for a period
of 2 to 10 years, marked by widespread
expansion or contraction in most sectors of the
economy
▪ Typically, economists divide business cycles
into two main phases, recession, and
expansion. Peaks and troughs (channels)
market the turning points of the cycles

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▪ Recession is a recurring (reappearing) period
of decline in total output, income, ad
employment, usually lasting from 6 months to
a year and marked by widespread
contractions in many sectors of the economy
▪ Depression is a recession that is major in both
scale (size) and duration
▪ Although we call short-term fluctuations
“cycles”, the actual pattern is irregular. O two
business cycles are quite the same. No exact
formula, such as might apply to the revolutions
of planets or the swings of a pendulum, can be
used to predict the duration and timing of
business cycles

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The following are a few of the customary
characteristics of a recession:
▪ a. consumer purchases decline sharply,
while business inventories of automobiles
and other durable goods increase
unexpectedly.
▪ b. As businesses react by curbing (limiting)
production, real GDP falls.
▪ c. Shortly afterward, business investment in
plant and equipment also falls sharply

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▪ d. The demand for labor falls (layoffs and
higher unemployment)
▪ e. Demand for crude (basic) materials
declines, and their prices tumble. Wages
and prices of services are unlikely to
decline, but they tend to rise less rapidly
in economic downturns
▪ f. Business profits fall sharply in
recessions. Common-stock prices usually
fall, the demand for credit falls, and
interest rates generally also fall

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 BUSINESS-CYCLE THEORIES
▪ Exogenous vs. internal cycles. Over the years
macroeconomics has been vigorous (strong) debates
about the sources of business cycles. Why do
employment and output change directions so
suddenly? Why should market economies blow hot and
cold?
▪ The exogenous theories find the sources of the
business cycle in the fluctuations of factors outside the
economic system – in wars, revolutions, and elections;
in oil prices, gold discoveries, and migrations; in
discoveries of new lands & resources; in scientific
breakthroughs and technological innovations; even in
sunspots, climate change, or the weather

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▪ An example of an exogenous cycle was the
discovery of the New World. When
explorers began to return to Europe with
their treasures, this led to an increase in
the amount of monetary silver and gold,
increasing prices and leading to economic
expansion. Here we saw an exogenous
event – the discovery of America –
producing an economic expansion

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▪ By contrast, the internal theories look for
mechanisms within the economic system itself that
give rise to self-generating business cycles. In this
approach, every expansion breeds recession and
contraction, ad every contraction breeds revival ad
expansion – in a quest-regular, repeating chain.
▪ One important case is the multiplier-accelerator
theory. According to the accelerator principle, rapid
output growth stimulates investment. High investment
in turn stimulates more output growth, and the
process continues until the capacity of the economy
is reached, at which point the economic growth rate
slows. The slower growth in turn reduces investment
spending ad inventory accumulation, which tends to
send the economy into a recession
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 DEMAND-INDUCED CYCLES
▪ One important source of business fluctuations
is shocked to aggregate demand
▪ Business-cycle fluctuations in output,
employment, and prices are often caused by
shifts in aggregate demand.
▪ These occur as consumers, businesses, or
governments change total spending relative to
the economy’s productive capacity.
▪ When these shifts in aggregate demand led to
sharp business downturns, the economy suffers
recessions or even depressions. A sharp upturn
in economic activity can lead to inflation
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ECONOMIC MODELING & FORECASTING
▪ In an early are, economists tried to peer into the
future by looking are easily available data on
items like money, boxcar loadings, and steel
production. For example, a drop in steel
production was a sign that businesses would
soon slow down
▪ For amore detailed look into the future,
economists turn to computerized econometric
forecasting models. An econometric model is a
set of equations, representing the behavior of the
economy, that has been estimated using
historical data
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 B. FOUNDATIONS OF AGGREGATE DEMAND
▪ The time has come to explore in depth the
foundations of aggregate demand.
▪ What are the major components of aggregate
demand?
▪ How do they interact with aggregate supply to
determine output & prices?
▪ We now look at aggregate demand in more detail
in order to get a better understanding of the
forces which drive the economy. In the next
chapter, we derive the simplest model of
aggregate demand – the multiplier model
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▪ Aggregate demand (AD) is the total or
aggregate quantity of output that is willingly
bought at a given level of prices, other things
held constant. AD is the desired spending in
all product sectors: consumption, private
domestic investment, government purchases
of goods and services, and net exports. It has
four components:
▪ 1. Consumption. As we saw in the last chapter,
consumption (C) is primarily determined by
disposable income, which is personal income
less taxes. Other factors affecting consumption
are long-term trends in income, household
wealth, and the aggregate price level

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▪ Investment. Investment (I) spending includes
purchases of buildings, software, and
equipment and the accumulation of
inventories. Our analysis in chapter 22
showed that the major determinants of
investment are the level of output, the cost of
capital (as determined by tax policies along
with interest rates and other financial
conditions), and expectations about the
future. The major channel by which economic
policy can affect investment in monetary
policy

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▪ 3. Government purchases. The third
component of aggregate demand is
government purchases of goods and
services (G): purchases of goods like tanks
or road-building equipment as well as the
services of judges and public-school
teachers. Unlike private consumption and
investment, this component of aggregate
demand is determined directly by the
government’s spending decisions; when the
Pentagon buys a new fighter aircraft, this
output directly adds to the GDP
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▪ 4. Net exports. A final component of aggregate
demand is net exports (X), which equal the
value of exports minus the value of imports.
Imports are determined by domestic income
and output, by the ratio of domestic to foreign
prices, and by the foreign exchange rate of the
dollar. Exports (which are imports of other
countries) are the mirror of image of imports,
determined by foreign income ad outputs, by
relative prices, and by foreign exchange rates.
Net exports, then, will be determined by
domestic and foreign incomes, relative prices,
and exchange rates

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COMPONENTS OF AGGREGATE DEMAND

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▪ Aggregate demand (AD) consists of four
components – consumption (C), domestic
private investment (I), government spending
on goods & services (G), and net exports.
▪ Aggregate demand shifts when there are
changes in macroeconomic policies (such as
monetary-policy changes or changes in
government expenditures or tax rates) or
when exogenous events change spending (as
would be the case with changes in foreign
output, affecting X, or in business confidence,
affecting I)
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MANY FACTORS CAN INCREASE AGGREGATE DEMAND AND SHIFT
OUT THE AD CURVE

Policy Variables
Variable Impact on Aggregate demand

Monetary policy Increase in money supply lowers interest rates

and relaxes credit conditions, inducing high levels of
investment and consumption of durable goods.
In an open economy, monetary policy affects the
exchange rate and net exports
Fiscal policy Increase in government purchases of goods and
services direct increases spending; tax reductions
or increases in transfers raise disposable income
and induce higher consumption. Tax incentives
like an investment tax credit can induce higher
spending in a particular sector

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MANY FACTORS CAN INCREASE AGGREGATE DEMAND AND SHIFT
OUT THE AD CURVE
Policy Variables Impact on Aggregate demand
Monetary policy • Increase in money supply lowers interest rates and
relaxes credit conditions,
• Inducing high level of investment and consumption
of durable goods.
• In an open economy, monetary policy affects the
exchange rate and net exports

Fiscal policy • Increase in government purchases of goods and

services direct increases spending;
• Tax reductions or increases in transfers raise
disposable income and induce higher consumption.
• Tax incentives like an investment tax credit can
induce higher spending in a particular sector

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MANY FACTORS CAN INCREASE AGGREGATE DEMAND AND SHIFT OUT THE AD CURVE

Exogenous variables Impact on Aggregate demand

Foreign output exports • Output growth abroad leads to an increase in net
exports
Asset values • Rise in stock market increases household wealth
and thereby increases consumption;
• also, this leads to lower cost of capital and
increases business investment

Advances in technology • Technological advances can open up new

opportunities for business investment.
• Important examples have been the railroad, the
automobile, and the computers
Others • Political events, free-trade agreements, and the end
of the cold war promote business and consumer
confidence and increase spending on investment
and consumer durables

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RELATIVE IMPORTANCE OF FACTORS INFLUENCING DEMAND
▪ Some economists concentrate primarily on
monetary forces in analyzing movements in
aggregate demand, especially stressing the role
of the money supply.
▪ According to these economists, who are often
called monetarists, the supply of money is the
primary determinant of the total dollar value of
spending
▪ Other economists focus on exogenous factors
instead. For example, some have argued that
technological progress is one of the key
determinants of booms and busts
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▪ Economists looking at the 1990s have
concluded that the fundamental
technological changes in computer
hardware, software, and communications
have triggered rapid declines in prices in
that sector and in the economy; have led
to a significant increase in the overall
potential growth of the economy; and
have produced a remarkable increase in
investment

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 IS THE BUSINESS CYCLE AVOIDABLE?
▪ Recessions are now generally considered to
be fundamentally preventable, like airplane
crashes and hurricanes.
▪ But we have not banished air crashes from the
land, and it is not clear that we have the
wisdom or the ability to eliminate recessions.
▪ The danger has not disappeared. The forces
that produce recurrent recessions are still in
the wings, merely waiting for their cue

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