Consumption and Investment

Unit 3
At the end of this unit, you should be able to:
•Define the term consumption, saving and investment
•Explain the absolute income hypothesis, recognising the
relationship between consumption and saving.
•Define the term marginal propensity to consume (and save) and
average propensity to consume (and save).
•Explain the main features of the permanent income, the life-cycle
and the relative income hypotheses as alternatives to the absolute
income hypothesis.
•Explain the accelerator theory of investment and discuss other
possible influences on aggregate investment.
 Consumption and Investment
• Consumption is the flow of households’ spending o goods and services
which yield utility in the current period.
• Saving is that part of disposable income which is not spent.
• In a closed economy
• Yd = C+S
• Investment is firms 'spending on goods which are not for current
consumption but which yield a flow of consumer goods and services in the
future.
• The different between consumption spending and total consumption
• Consumption spending is the actual amount spent on new consumer
goods in the current period.
• Total consumption is the using up of consumer goods (both those
purchased in the current period and those purchased in past periods
which are still providing services to the household)
 The absolute income hypothesis
The Absolute Income Hypothesis is theory of
consumption proposed by English economist John
Maynard Keynes
The absolute income hypothesis state that consumption
depends on current disposable income
• consumption and saving are both directly and linearly
related to current disposable income.
• Consumption and saving functions of the absolute
income hypothesis can be illustrated
either numerical, graphically or algebraically.
 The absolute income hypothesis
Numerical illustration of Consumption and
saving functions

Disposable Income (N$) Consumption (N$) Saving (N$)

250 210 40
200 170 30
150 130 20
100 90 10
50 50 0
0 10 -10
Do the graphical illustration from the table above
 The absolute income hypothesis
Average propensity consume is equal total
consumption divided by total disposable income
and it varies as disposable income varies.
C Consumption
APC at point A = 50/50 =1
200 APC at point B = 90/100 = 0.9
150
100 B
50 A

0 50 100 150 200 Disposable income

 The absolute income hypothesis
Algebraic illustration of consumption and saving
functions.
Yd=C+S
C=a+bYd
S=Yd-C
S=Yd-a-bYd
S=-a+Yd(1-b)
S=-a+(1-b)Yd
mpc + mps=1
b+(1-b) = 1 or mpc+mps =1
 The absolute income hypothesis
Let us use the previous table to construct consumption
function and saving function
Consumption function
C = a+bYd
b= dC/dYd = mpc
b= (170-210)/(200-250)
b= -40/-50 =0.8 = mpc
210 = a + 0.8(250)
210 = a + 200
210-200 = a
10 = a
Therefore consumption function is C = 10 +0.8Yd
 The absolute income hypothesis
Saving function
S = x + dYd
d= ds/dYd = mps
d= (30-40)/(200-250)
d =-10/-50
d =0.2 = mps
S=x+0.2(Yd)
40=x+0.2(250)
40=x+50
40-50=x =-10
Therefore saving function is S= -10+0.2Yd
 The absolute income hypothesis
The following points represent the major
characteristics of the absolute income
hypothesis:
1. Consumption and saving are stable functions of current
disposable income. The relationships are positive.
2. The relationships are linear but it is also possible for
consumption and saving lines to be curved in such a way
that the mpc falls as income rises and the mps rises as
income rises
3. The mpc lies between zero and one (0<mpc<1)
4. The apc falls as income rises and is greater than the mpc.
 Permanent Income Hypothesis
The permanent income hypothesis (PIH) is an economic theory about
consumption, first developed by Milton Friedman.

Permanent consumption (Cp) is proportional to permanent income

(Yp)
It state that a person's consumption in a year is determined not just by
their income in that year but also by their expected income in future
years.

Therefore consumption depends on permanent income, which is the present

value of expected flow of long term income.

In its simplest form, the hypothesis states that changes in

permanent income, rather than changes in temporary income, are
what drive the changes in a consumer's consumption patterns.

Cp = kYp where k is constant and equal to the average and marginal

propensities to consume.
 Permanent Income Hypothesis
Permanent income is the present value of the expected flow of
income from the existing stock of both human and non-human
wealth over a long period of time.
Human wealth is the source of income received from the sale of
labour service, while non-human wealth is the sources of all
other income (that is, incomes received from ownership of all
kinds of assets, like government bonds, company stocks and
shares, and property).
Friedman points out that Current measured income (Y) for a
household or for the economy as a whole could be greater or
less than permanent income.
 Permanent Income Hypothesis
The difference between the two is called Transitory income
which is the different between current measured income and
permanent income. In other word, transitory income can be
thought of as a temporary, unexpected rise or fall in income
(example , an unexpected increase in income resulting from a
win at the races, or a temporary fall in income resulting from
a short period of unemployment)
Current measured income = Permanent income + Transitory Income
Y = Yp + Yt
The average transitory income level will be equal to zero,
therefore the average permanent income would be just equal to
the average measured income. (Yp =Y)
 Permanent Income Hypothesis
Permanent consumption ( Cp) can be thought of as the normal or
planned level of spending out of permanent income and can differ
from measured consumption ( C) by any unplanned , temporary increases or
decreases in consumer spending, called transitory consumption.
C = Cp +Ct
Two assumptions about transitory consumption
1. Transitory consumption is not correlated with permanent consumption
2. Transitory consumption is not correlated with transitory income which
means temporary increases in income do not cause temporary increases in
consumption.
On average transitory consumption is equal to zero, therefore measured
consumption must be equal to permanent consumption.
C = kYp
 Permanent Income Hypothesis
Friedman’s consumption function

C C = kYp

Slope = K = apc=mpc

0 Permanent income
The relationship between consumption and permanent income is
represented by a straight line through the origin with a slope equal to
apc and mpc. Wealth also part of the permanent income.
 The life-cycle hypothesis
The life-cycle hypothesis developed by Ando and
Modigliani in the 1950s.
The hypothesis claims that each individual household will make
an estimate of its expected life-time income and will then
devise a long-term consumption plan based on this estimate.
– Early years of income earning (say from age 18 to 30), households
spend more than their current income. Availability of consumer credit
facility can be the driving force.
– Middle years of income earning (say, from age 30 to 60), household
will spend less than its income, partly to repay earlier debts and partly
to accumulate wealth for use in later years.
– After retirement, this accumulated wealth is gradually depleted as
once again dissaving occurs.
• An individual household’s consumption will
not necessarily be constant throughout the
household’s life-time.
• Instead, in any given year, some households
will be spending more than their planned
average annual consumption and others will
be spending less.
• In aggregate, these differences will tend to
cancel each other out, so that aggregate long-
run consumption will tend to be proportional
to some measure of long-run income.
Y
Income curve Saving

Y Dissaving Dissaving

15 25 35 45 55 65 75
Lifetime
 Relative income hypothesis
• Proposed by J.S. Duesenberry in 1949, states
that:
• A household’s consumption depends not only
on its own income, but also on the income of
the other households which it observes.
• Households will spend more on consumption
if it lives in a neighbourhood in which its
income is relatively low than if it lives in a
neighbourhood in which its income is
relatively high.
 Investment
• Real investment – the addition to the stock of physical capital.
• New expenditure incurred on addition of capital goods such as
machines, buildings, equipment, tools etc
– All firms have to undertake investment expenditure (new plant,
machinery and other equipment must be replaced when wear out,
– Firms need to acquire additional capital if they are to grow and remain
technologically competitive.
– Also firms hold stocks of raw materials and semi-finished goods and
finished goods
• Firms hold stocks for three main reasons:
(a)Raw materials have to be held in sufficient quantities to allow
production process to take place smoothly
(b)Holding stock enable s firms to meet unexpected increase in demand
for final product,
(c)Raw materials may be bought and held in stocks if future rises in raw
materials are expected
• Investment always involve opportunity cost.
• If a firm borrows funds to finance an
investment, the opportunity cost is
represented by the interest rate that must be
paid on the borrowed funds.
• If new partners or shareholders are brought
in, the opportunity cost is the rate of return
that must be offered to make it worth their
while.
 Type of investment
1. Business investment – investment in
machinery, tools and equipment that business
use in further production of goods and services.
2. Residential investment – expenditure on
constructing or buying new houses or dwelling
apartments for purpose of living or renting out
to others
3. Inventory investment – inventory of raw
materials, semi-finished goods and final goods.
Autonomous investment and Induced
investment
• Autonomous investment – does not change with
the change in the income level and is therefore
independent of income.
• This investment take place in houses, roads,
public undertakings and other types of economic
infrastructure such as power, transport and
communication.
• Autonomous investment depends more on
population growth and technical progress than
on the level of income.
• Induced investment- depends more on
income than on the rate of interest.
• Increase in national income lead to increase in
induced investment.
Autonomous investment Induced investment

Id

Ia I’a
Id

0 National income
National income
Investment and the rate of interest
• Classical economists viewed the rate of
interest as the main determinant of
investment.
• Consider the microeconomic analysis of a
single profit-maximising firm deciding whether
or not to undertake an investment,
• When a firm buys a new machine, it expects
the yield of the investment to exceed cost.
• One way of comparing the expected yield of
an investment to its cost is to calculate the
present value of the investment and to
compare that with the present cost. If present
value > present cost, the investment is
regarded as profitable.
• Example I: suppose a machine which has a
known life of only two years is expected to
yield $242 each year. The machine present
cost is $400 and a rate of interest is 10%. Is
the investment profitable?
Calculating the rate of return
• Example IV
• Reconsider the profitability in example III, when
the rate of interest is 15%
• As calculated in example III, the rate of return
from the investment is = 12.5%
• Rate of return 12.5% < Interest rate, 15%, the
investment is unprofitable at high interest rate.
– Marginal efficiency of investment (MEI)- the rate of
discount which would equate the present value of
expected stream of future income from an
investment project to the initial outlay. In other
words, it is the expected rate of return from an
additional dollar of planned investment
• A fall in the market rate of interest should
make profitable some investments in the
economy which were previously unprofitable,
so that aggregate investment should increase.
• Similarly, a rise in the market interest rate of
interest rate should make unprofitable some
investments which where previously
profitable, so that aggregate investment
should fall.
• Therefore aggregate investment is inversely
related to the rate of interest
 I

0 Investment
 The accelerator theory
• The view that the level of current net investment
depends on past changes in national income.
• According to the accelerator theory, the level of
current net investment depends on past income,
this can be expressed as follows:
• It = v(Yt- Yt-1),
• Where It = net investment Yt = current national
income, Yt-1 =national income in the previous
period and v = constant known as accelerator
coefficient.
• V is also the marginal capital-output ratio
• Gross investment is equal to net investment plus
any replacement investment which takes place
because of depreciation, written as follows:
• GIt = v(Yt – Yt-1)+Rt
• Where GIt =current gross investment and Rt =
replacement investment.
• Replacement investment – the investment
necessary to replace obsolete and worn-out
equipment
• In order for accelerator theory to be valid, firm
must demand additional capital to meet any
increases in demand for their product
• Calculated example:
• income in the t period = 1050, and in t-1=1000
and v=0.5, what is our investment (I) according to
accelerator theory?
• Answer: It = 0.5(1050-1000)
• It =0.5 (50) = $25
• Use the same example where our replacement
investment equal $10
• GIt = 0.5(1050-1000)+10
= $25 + $10 =$30
 Criticism of accelerator theory
1. It assumes that firms faced with increased
demand for their product will immediately
attempt to increase their capital stock. This
imply that there is no excess capacity ( that all
existing machines must be fully employed and
there must be no possibility of overtime work or
shift work).
2. It fails to take into account business
expectations. If businesses regard the increase
in demand as temporary, they may not respond
to it at all.
 Profit as determinant of investment
• It is argued that higher levels of profit in the
economy will lead to higher level of aggregate
investment. This is because higher profits level
will increase the availability of funds for
investment.
• Higher profits may also boost business
confidence and so raise the expected future
income from planned investment project.
 The ‘crowding out’ effect
• Finance required by the government to pay
for growth of public spending has the effect of
raising taxes on incomes and profits, and
pushing up interest rate.
• This squeezes the profitability of private firms
and raises their investment costs
• The argument leads to the conclusion that
excessive growth in public spending ‘crowds
out’ private investment spending.
Overall view of investment
Time Period Demand Desired Net Depreciatio Gross
stock investment n (no of investment
(no. of machine (No. of
machine machine
0 5000 100 0 0 0
1 6000 120 20 10 30
2 10000 200 80 10 90
3 12000 240 40 10 50
4 12000 240 0 10 10
5 10000 200 -40 10 -30