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Chapter 6Chapter 6Chapter 6Chapter 6

Consumption & Consumption & InvestmentInvestment

04/18/23

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GDP = C + I + G + ( X – M)GDP = C + I + G + ( X – M)

GDP = C + I + GGDP = C + I + G

GDP = C + IGDP = C + I

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What determines What determines Consumption Spending?Consumption Spending?What determines What determines Consumption Spending?Consumption Spending?

Consumption is a function of income

C = f(Y)

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John Maynard Keynes:John Maynard Keynes:John Maynard Keynes:John Maynard Keynes:

Author of “The General Theory of Employment, Interest and Money”

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What was What was Keynes central Keynes central idea?idea?

What was What was Keynes central Keynes central idea?idea?

An economy can be in equilibrium at less than full employment.

How did this idea differ from How did this idea differ from the Classical School view?the Classical School view?How did this idea differ from How did this idea differ from the Classical School view?the Classical School view?

The Classical Economists believed that the economy is always tending toward a full employment equilibrium

Keynes’s View on Consumption:Keynes’s View on Consumption:

Consumers are guided by the “Fundamental Psychological Law”

In terms of consumption, we all strive to achieve a “comfort zonecomfort zone”. Once we achieve that or are closer to it we do not need to increase our consumption as much with our income as we had done at lower levels of income.

What is Keynes’ Absolute What is Keynes’ Absolute Income Hypothesis?Income Hypothesis?What is Keynes’ Absolute What is Keynes’ Absolute Income Hypothesis?Income Hypothesis?

As national income increases, consumption spending increases, but by diminishing amounts

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What is MPC?What is MPC?What is MPC?What is MPC?The ratio of the change in

consumption spending to a given change in income, that induces it.

Y

CMPC

Change in Consumption

Change in Income

If household's income rises from If household's income rises from $12,000 to $12,700 and $12,000 to $12,700 and consumption rises from $13,000 to consumption rises from $13,000 to $13,500, then$13,500, then

MPC = $500 / $700 = .71

According to the “According to the “Absolute Absolute Income HypothesisIncome Hypothesis”, What ”, What happens to the Marginal happens to the Marginal Propensity to Consume as income Propensity to Consume as income increases?increases?

According to the “According to the “Absolute Absolute Income HypothesisIncome Hypothesis”, What ”, What happens to the Marginal happens to the Marginal Propensity to Consume as income Propensity to Consume as income increases?increases?

MPC decreases as income increases and increases as income decreases

The Consumption FunctionThe Consumption Function

Real Disposable Income

Rea

l Con

sum

ptio

n

CC

Y

1000 4000

800

3200

Y

CMPC

80.3000

2400

An Individual’s Marginal Propensity to ConsumeAn Individual’s Marginal Propensity to Consume

TotalIncome

(Y)

Change inIncome

Consumption(C)

Change inConsumption

0 500

1000 1000 1400 900

2000 1000 2200 800

3000 1000 2900 700

4000 1000 3500 600

5000 1000 4000 500

An Individual’s Marginal Propensity to ConsumeAn Individual’s Marginal Propensity to Consume

TotalIncome

(Y)

Change inIncome

Consumption(C)

Change inConsumption

MPC

0 500

1000 1000 1400 900 0.90

2000 1000 2200 800 0.80

3000 1000 2900 700 0.70

4000 1000 3500 600 0.60

5000 1000 4000 500 0.50

The Individual’s Marginal Propensity to Consume

122

The Nation’s Marginal Propensity to Consume

123

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Who was Simon Kuznets?Who was Simon Kuznets?Who was Simon Kuznets?Who was Simon Kuznets?

He is the author of “National Income and Its Composition”, ...... won Nobel Prize in Economics in 1971 for his pioneering analysis of national income data.

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What did Kuznets What did Kuznets conclude about MPC?conclude about MPC?What did Kuznets What did Kuznets conclude about MPC?conclude about MPC?

His empirical research led to the conclusion that MPC tends to remain fairly constant regardless of the absolute level of national income

The Marginal Propensity to Consume Remains Constant

Duesenberry’s Relative Income Duesenberry’s Relative Income Hypothesis:Hypothesis:Duesenberry’s Relative Income Duesenberry’s Relative Income Hypothesis:Hypothesis:

Because social status influences consumption spending, MPC remains constant as long as relative income remains unchanged.

Autonomous Consumption:Autonomous Consumption:Autonomous Consumption:Autonomous Consumption:

Consumption spending that is independent of the level of income

The Consumption FunctionThe Consumption Function

Real Disposable Income

Rea

l Con

sum

ptio

n C

0

500Autonomous Consumption

TheTheConsumption Equation?Consumption Equation?TheTheConsumption Equation?Consumption Equation?

C = a + bY

Autonomous Consumption

MPCIncome

Induced Consumption

Calculate C for each level of National Income (Y)Calculate C for each level of National Income (Y)

Y Ca MPC C

100 50 0.50

200 60 0.60

300 70 0.70

400 80 0.80

500 90 0.90

C = a + bY = 100 +.5 (100) = 100= 50 +

100

180

280

400

540

C = a + bY = 60 + .60 (200) = 180C = a + bY = 70 + . 70 (300) = 280C = a + bY = 80 + .80 (400) = 400C = a + bY = 90 + .90 (500) = 540

National Income

Con

sum

ptio

n

C0

C1

C2

Will a change in Income Will a change in Income cause a shift in C?cause a shift in C?Will a change in Income Will a change in Income cause a shift in C?cause a shift in C?

No! When income changes there is a movement along a stationary Consumption Curve

National Income

Con

sum

ptio

nConsumption

AB

0

What can cause a shift in the What can cause a shift in the Consumption Function? Consumption Function? What can cause a shift in the What can cause a shift in the Consumption Function? Consumption Function?

Real assets & money holdings Expectations of price changes Interest rates Taxation

A change in...A change in...

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What is Saving?What is Saving?What is Saving?What is Saving?That part of national

income not spent on consumption

If, Y = C + S

then, S = Y – C

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What is the Marginal What is the Marginal Propensity to Save (MPS)?Propensity to Save (MPS)?What is the Marginal What is the Marginal Propensity to Save (MPS)?Propensity to Save (MPS)?

The Ratio of the change in saving to the change in income, which induced it.

Y

SMPS

Lets assume that your income increases by $100. We observe that you increase your consumption by $80. What is your MPC?

Y

CMPC

Y

SMPS

80.100

80

20.100

20

MPC + MPS = 1

MPC = 1– MPS

MPS = 1 – MPC

At each Y level, calculate the MPC, MPS and the SAt each Y level, calculate the MPC, MPS and the S

Y C MPC MPS S

0 60

100 140

200 220

300 300

400 380

500 400

Y

CMPC

80.100

80

MPC + MPS = 1

. 80 . 20 – 40

. 80 . 20 – 20

. 80 . 20 0

. 80 . 20 20

. 80 . 20 100

Y = C + S

– 60

C

Y

Y

S

0

0 y*

y*

45o

$

$