Consumption, Saving and Investment

KEY TOPICS TO COVER

• Consumption and its Determinants
• Savings and its determinants
• The paradox of thrift and recession
• Investment and its determinants
• Accelerator theory
 LEARNING Objectives
• Explain the main determinants of
consumption (APC, MPC), Savings (APC,
MPS).
• Explain the main determinants of
investment including the Accelerator
Theory.
• Explain the Paradox of Thrift and
downward spiral into recession.
 CONSUMPTION:
Consumer Spending
INTRODUCTION
• Consumption is spending by households on
goods & services
• Consumption is the biggest single component of
aggregate demand, in 2012 it was 61% of GDP
• Many factors affect the ability of people to
spend and this has a large effect on the
economic cycle
 Disposable income and spending – the propensity to spend

• John Maynard Keynes was one of the major

figures who developed a theory of consumption
that depended mainly on disposable income.
Disposable income is income after direct taxes
and welfare benefits.
The Propensity to Consume
The rate at which consumers increase their
spending as income rises is called the marginal
propensity to consume.
• A simple rule to remember is that the marginal
propensity to consume added to the marginal
propensity to save must always equal 1.
• Generally, people on lower incomes tend to
have a higher propensity to spend. This
matters when the government announces
changes in taxation and the level of welfare
benefits.
• A fall in the marginal propensity to spend will
cause a lower level of consumption for a given
level of income.
Some Factors that Determine Consumer Spending

Need to
borrow
money to
finance
spending

WEALTH
EFFECT
 The Income- Consumption / Income -Saving Relationship

• Economists care about income/spending:

• relationship with each other
• relationship to overall health of the economy
• relationship to/ effects on economic growth,
inflation, recession, and business cycle
 The Consumption Schedule
• Reflects the relationship between direct
consumption (C) and disposable income (DI)
• Households increase their C as DI rises.
• Households spend a larger proportion, if their DI
is small.
• Break-even income is when C=DI , which also
means that households consume their entire
income, but not to the point where they go in
debt.
http://www.tutor2u.net/economics/blog/a2-macro-consumer-spending
 The Saving Schedule

• Savings = Disposable Income - Consumption

• Savings are essentially the portion of your
income you don't consume.
• Dissavings= consuming more than the available
income either by liquidating accumulated wealth
or borrowing money.
• If households consume a smaller and smaller
proportion of DI as DI increases, then they must
be saving a larger and larger proportion.
Average Propensity to Consume (APC):
• The proportion of total disposable income
spent or consumed
• APC = Consumption/Income
• the fraction of total income that is consumed
 APS
• Average Propensity to Save (APS): total
percentage of DI which is saved
• APS = Saving/income
• the proportion of total income that is saved

• APC+APS= 1
• Every leftover pound not spent is saved
 MPC and MPS

The MPC and MPS are the numerical values of the slopes of the consumption and
savings function, respectively.

• MPC (marginal propensity to consume) = change in

consumption/change in income.
• It is defined as the proportion of changes in income which is
consumed.
• MPS (marginal propensity to save) = change in
saving/change in income.
• the proportion of changes in income which is saved.
• MPC + MPS =1
• The sum of the MPC and the MPS for any change in DI
must always be 1 because every leftover pound not
spent is counted "saved".
 The Paradox of Thrift
• The paradox of thrift is an important idea from
Keynesian economics. Saving is regarded as positive
because it provides the funds to finance the capital
investment needed to promote long-term growth
• But if many people start saving more at the same
time, this causes a drop in consumer demand and
an even deeper recession
• What might be rational and virtuous for an
individual might be damaging for the economy as a
whole
https://www.youtube.com/watch?v=qrHyDztQlBY
 Paradox of Thrift
• The paradox of thrift helps to explain why a rise in
precautionary saving (i.e. people looking for
security) can lead to a fall in demand and incomes
and a reduction in output, income and wealth.
• In other words – negative multiplier and
accelerator effects can drag production and
employment in the economy to a low level where it
can remain for some time unless there is some
external stimulus to lift demand and output again
Non-Income determinants of consumption and saving

– Wealth = value of real assets (i.e. houses, land) and financial assets (i.e.
cash, savings, stocks, bonds)
• When wealth increases, households increase spending and reduce
savings
• Shifts Consumption schedule upward and savings schedule
downwards....Opposite occurs when wealth decreases
– Expectations about future prices and income
• Expectations of rising prices in the future will cause an increase in
consumption and decrease in saving in the present.
• Shifts Consumption schedule upward and Saving schedule
downward
• Opposite occurs, when there are expectations of a recession and
lower income in the future
 – Real Interest Rates
• When real interest rates fall, households borrow more, consume
more, and save less.
• When real interest rates climb, households borrow less, consume
less, and save more.
• These effects on consumption and saving are very modest. They
mainly shift products bought on credit.
– Household Debt
• When consumers as a group increase household debt, they can
increase current consumption at each level of DI.
• Household debt is a constant proportion in DI.
• Greater household debt means greater borrowing.
• Increased borrowing shifts the consumption schedule upward.
• Reduced borrowing shifts consumption schedule downward.
 Activity
worksheet

• Complete the first part – rest is homework

 Activity 2

• List and describe the factors which influence

the level of savings.
•  
•  
•  

•  Explain what is meant by the term dissaving.

 Investment

 Definition:
 The addition to the capital stock of the
economy

 Capital is defined as goods used to make

and produce other goods and services
 Types of Capital

 Physical capital – factories, buildings,

machinery etc

 Human capital – investment in

education and training to improve the
skill level of workers.
 Marginal Efficiency of Capital Theory
• Making profits is the main reason why firms invest
• The rate of return on an investment project is also
known as the MARGINAL EFFICIENCY OF CAPITAL
(MEC)
• The amount of planned investment will be
determined by the rate of interest
• The MEC theory therefore means that the amount of
planned investment will rise if the rate of interest
falls.
The Planned Investment Schedule
Factors which shift the planned investment
schedule

 Cost of Capital goods – if the price of

capital goods rises then the expected
rate of return on investment projects will
fall if firms cannot pass on the increase
in higher prices. So increase in the cost
of capital will ________ overall planned
investment. The PI curve will shift _____.
Factors which shift the planned investment
schedule

 Technological change – makes capital

more productive raising the rate of
return. Hence introducing new
technology will ______ the level of
planned investment at any given interest
rate.
 Expectations – positive or negative views
of the future influence planned
investment
 Accelerator Theory

 This theory suggests that the level of

planned investment varies with the rate
of change in income or output.
 In this example investment takes place
when there is a change in real spending.
No change in spending then no change
in investment.
 Example:
 A firm producing toys needs 1 machine to produce
£1m of output per year

No of
Annual machines
year output £
investment in
machines
required

1 10 10 0
2 10 10 0
3 12 12 2
4 15 15 3
5 15 15 0
• The simple accelerator model suggests that a fall in the growth rate can
lead to lower investment.
• Therefore, accelerator effect can explain how an economic slowdown
leads to a recession.

Formula for Accelerator Effect

• K = f(Y) K = Capital Stock

Y= National Output
f = relationship between capital and output.

Example of Accelerator Effect

• Assume f=2. If Y increases by £15bn. Then investment will need to be
£30bn (15*2).
• If in the next year Y increases by £5bn. Then investment will be only
£10bn.
• This suggests there will be a fall in the level of net investment.
Therefore a fall in the growth rate in the economy, can lead to lower
investment and further downward pressure on economy.
Are Multiplier effect and Accelerator effect the same concept?
 Accelerator Effect and Multiplier Effect

Accelerator Effect and Multiplier Effect

• There is some relationship between the two.
But, it is important to understand they are
different concepts. 
INVESTMENT
 Multiplier-Accelerator-and-Keynesian-
Economics
• Video

http://www.tutor2u.net/economics/reference/
multiplier-accelerator-and-keynesian-
economics-revision-presentation
 KEYNSIAN ECONOMICS:
DEMAND MANAGEMENTAND
THE CIRCULAR FLOW

Paradox of Thrift
• Keynes said that a free market economy
can suffer from recession if for some
reason incomes of households fall.
• This will happen if leakages become
larger than injections. This could be for a
number of reasons.
• Keynes focused on the example of an
increase in savings by households. He
pointed out that although saving is usually
seen as a sensible action to ensure
households have money for any
unexpected spending needs in the future,
it can have unfortunate macroeconomic
consequences.
• With more saving there is less demand
and consumption (spending on goods and
services) which would lead to a continuous
fall in National Income and rising
unemployment.
• Keynes called this effect the “Paradox of
thrift” (paradox means “an opinion or
statement that expresses the opposite of
what most people believe to be true” and
thrift means “saving”.

• This idea can also be shown through the

circular flow of income:
• Keynes said that in order for the economy to
experience economic growth, injections should
be greater than leakages.

• This could happen by increasing any of the

injections or reducing any of the leakages,
though he suggested the easiest and most direct
way was for governments to increase
government spending (G). This needed to be
extra spending in the economy, not just a
redirection of tax revenues. Therefore,
governments had to borrow money, known as
“deficit spending”.

• How much should they spend? This depends on

the size of what Keynes called the “Multiplier”.
• http://www.youtube.com/watch?
v=ZRvaxUNDTKY&feature=player_embed
ded
 Recap
• Explain the main determinants of
consumption (APC, MPC), Savings (APC,
MPS).
• Explain the main determinants of
investment including the Accelerator
Theory.
• Explain the Paradox of Thrift and
downward spiral into recession.
 Exam Questions:

a) Explain the factors influencing the level of investment in an

economy [10]
 MEC THEORY
 Business Confidence
 Change in Technology
 Fiscal Policy (lower corporate tax, expected profits)
 Interest Rates (Monetary Policy)
 Spare Capacity
a) Discuss the extent to which national income is determined by private

investment [20].

 Explain the multiplier process, include graph.

 Private investment = job = job creation, consumption rise = AD shift to right.

Other factors that influence national income includes

(i) Political Stability (wars and unrest)

(ii) Natural resources eg Oil, Land, Minerals (gold, diamond etc)

(iii) Size (quantity) & quality of labour force

(iv) Supply shocks (+ve or –ve)