Unit 3: Consumption and Investment - PowerPoint Presentation

Slide1

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.

Slide2

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+SInvestment 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

?

Slide3

Consumption and Investment (Cont.)

The different between

consumption spending

and total consumptionConsumption 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)

Slide4

The absolute income hypothesis

The

Absolute Income Hypothesis

is theory of consumption proposed by English economist John Maynard KeynesThe 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.

Slide5

The absolute income hypothesis (Cont.)

Numerical illustration of Consumption and

saving functions

Disposable Income (N$)Consumption (N$)Saving (N$)25021040

200

170

30

150

130

20

100

901050500010-10

How can savings be negative?

Slide6

The absolute income hypothesis (Cont.)

Algebraic illustration of consumption and saving functions.

Yd=C+S

C=a+bYdS=Yd-CS=Yd-a-bYd

S=-

a+Yd

(1-b)

S=-a+(1-b)Yd

mpc

+ mps=1

b+(1-b) = 1

What is a? What is b?

Slide7

Average propensity to consume

A

verage propensity consume

is equal to total consumption divided by total disposable income and it varies as disposable income varies (C/Y).

Consumption

Disposable

income

A

B

APC at point A = 50/50 = 1

APC at point B= 90/100 = 0.9

Slide8

Consumption function

Let us use the previous table to construct consumption

function and saving function

Consumption function: C = a+bYdb= 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 +0.8Yd

Slide9

Savings function

Saving function

S = c +

dYdd= C/  Yd

= MPS

d= (30-40)/(200-250)

d =-10/-50 =

0.2 = MPS

S=c+0.2(

Yd

)

40=c+0.2(250)

40=c + 50

c = -10

Therefore saving function is

S= -10+0.2Yd

Why is c (-) ?

MPC + MPS = 1

Slide10

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.

Slide11

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.

Slide12

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 =

kYp where k is constant and equal to the average and marginal propensities to consume.

Slide13

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.

Slide14

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.

Slide15

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.

Slide16

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

Slide17

Permanent Income Hypothesis (Cont.)

Two assumptions about transitory consumption:

Transitory consumption is not correlated with permanent consumption.

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

=

kYp

(k = marginal / average propensity to consume)

Slide18

Permanent Income Hypothesis (Cont.)

Friedman’s consumption function

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.

Permanent income

Consumption

C =

kYp

Slide19

The life-cycle hypothesis

The life-cycle hypothesis was 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.

Slide20

The life-cycle hypothesis (Cont.)

Slide21

Relative income hypothesis

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.

Which theory makes for determining consumption is the strongest?

Slide22

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.

Slide23

The accelerator theory

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

Slide24

The crowding out 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)