Unit 3 Consumption and Investment Objectives Define the

Unit 3: Consumption and Investment Objectives: Define the term consumption, saving and investment. Explain the absolute income hypothesis, recognising the relationship between consumption and saving. Define the term marginal / 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 on goods and services. 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. What is Yd?

Consumption and Investment (Cont. ) 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 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 (Cont. ) 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 How can savings be negative?

The absolute income hypothesis (Cont. ) Algebraic illustration of consumption and saving functions. Yd=C+S C=a+b. Yd S=Yd-C S=Yd-a-b. Yd S=-a+Yd(1 -b) S=-a+(1 -b)Yd mpc + mps=1 b+(1 -b) = 1 What is a? What is b?

Average propensity to consume Average propensity consume is equal to total consumption divided by total disposable income and it varies as disposable income varies (C/Y). Consumption B A APC at point B= 90/100 = 0. 9 APC at point A = 50/50 = 1 Disposable income

Consumption function Let us use the previous table to construct consumption function and saving function Consumption function: C = a+b. Yd b= C/ Yd = MPC b= (170 -210)/(200 -250) -40/-50 = 0. 8 = MPC Solve for a: 210 = a + 0. 8(250) 210 = a + 200 210 -200 = a 10 = a Therefore consumption function is C = 10 +0. 8 Yd

Savings function Saving function S = c + d. Yd d= C/ Yd = MPS d= (30 -40)/(200 -250) d =-10/-50 =0. 2 = MPS S=c+0. 2(Yd) MPC + MPS = 1 40=c+0. 2(250) 40=c + 50 c = -10 Therefore saving function is S= -10+0. 2 Yd Why is c (-) ?

The absolute income hypothesis (Cont. ) The following points represent the major characteristics of the absolute income hypothesis: Consumption and saving are stable functions of current disposable income. The relationships are positive. 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) The MPC / MPS lies between zero and one (0<MPC<1) 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.

Permanent Income Hypothesis (Cont. ) 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 = k. Yp where k is constant and equal to the average and marginal propensities to consume.

Permanent Income Hypothesis (Cont. ) 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.

Permanent Income Hypothesis (Cont. ) 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 shares, and property). 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 (Cont. ) Transitory income is the difference 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 (for example: an unexpected increase in income resulting from winning a competition, 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.

Permanent Income Hypothesis (Cont. ) Permanent consumption ( Cp) can be thought of as the normal or planned level of spending out of permanent income and can differ from measured (C) by any unplanned, temporary increases or decreases in consumer spending, called transitory consumption (Ct). C = Cp +Ct

Permanent Income Hypothesis (Cont. ) 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 = Cp= k. Yp (k = marginal / average propensity to consume)

Permanent Income Hypothesis (Cont. ) Friedman’s consumption function Consumption C = k. Yp 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 (k). Wealth is also part of the permanent income.

The life-cycle hypothesis was developed by Ando and Modigliani in the 1950 s. The hypothesis claims that each individual household will make an estimate of its expected life-time income and will then devise a longterm consumption plan based on this estimate. o 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. o 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. o After retirement, this accumulated wealth is gradually depleted as once again dissaving occurs.

The life-cycle hypothesis (Cont. )

Relative income hypothesis Which theory makes for determining consumption is the strongest? Developed by James Duesenberry, the relative income hypothesis states that an individual’s attitude to consumption and saving is dictated more by his income in relation to others than by abstract standard of living; the percentage of income consumed by an individual depends on his percentile position within the income distribution. Secondly it hypothesises that the present consumption is not influenced merely by present levels of absolute and relative income, but also by levels of consumption attained in previous period. It is difficult for a family to reduce a level of consumption once attained.

Investment function The simple investment function relating investment to the real interest rate is: I = I (r) This function states that, an increase in the real interest rate results in a higher opportunity cost of investment (as opposed to maintaining liquid assets) / increases the cost of capital, and thus reduces investment.

The accelerator theory assumes that investments made by companies increase when either demand or income increases. The theory also suggests that when companies face an excess of demand, companies can meet the need in two ways: decrease demand by raising prices or increase investment to the level of demand. The accelerator theory suggests that companies typically choose to increase production, thereby increasing profits; this growth, in turn, attracts further investors that works to accelerate growth. Similar to Multiplier effect

The crowding out effect is an economic theory stipulating that rises in public sector spending (expansionary fiscal policy) drives down or even eliminates private sector spending. How? Increase in government borrowing = increase in the real interest rate = reduction in private sector investment Is this realistic? Why / why not? It depends on the stage of the economy (full employment)