Consumption, Saving and InvestmentDr. Shylajan, C.S

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Topics of DiscussionAggregate Demand (AD)Components of ADConsumption DemandConsumption FunctionWhat Determines Aggregate Consumption Expenditure?Consumption and SavingMarginal Propensity to Consume (MPC)Marginal Propensity to Save

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Aggregate Demand

Recall expenditure method of estimating national output

Y= C + I + G + NX

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Aggregate DemandWhere, Y stands for actual GDP or output and

C + I + G + NX stands for Aggregate Demand for Four sector model

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Aggregate Demand has four componentsTotal spending on

1. Consumption goods and service (C) by the private sector

2. Investment goods and services (I) by the private sector

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Aggregate Demand has four components

3. C and I by the Government sector (G)

4. C and I by the External sector (X) minus all imports

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Why do we need to know about Aggregate Demand?

Let us assume that we are investigating a economic slowdown in large parts of East Asia.

In these economies, aggregate demand is driven by the external demand (demand for goods and services originating from foreigners (X)

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Why do we need to know about Aggregate Demand?

So external sector demand (X) growth is key to revival of the East Asian economies.

In US economy - growth of consumption demand (C )Hence we have to stimulate C part of AD

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Consumption Demand

Y = C + I + G + NX

Aggregate expenditure on current consumption of final goods and serviceExamples?

Food, Fuel, clothing, education, medical expenses etc

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A Consumption Functionfor a HouseholdThe relationship between consumption and income is called the consumption function.

The consumption function for an individual household shows the level of consumption at each level of household income.

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Consumption Function Marginal Propensity to Consume (MPC)

The change in consumption expenditure in response to a change in disposable income.

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Consumption FunctionDisposable income (Y) is divided between consumption and saving. Y= C + S

C = a + b Y

S = Y - C

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Consumption FunctionC = a + b Y

The slope of the consumption function (b) is called the marginal propensity to consume (MPC) 0 < b < 1

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Consumption Function

C = 50 + 0.75 YIf disposable income increases by Rs 100 and Rs. 75 of this increase is spent on current consumption, the MPC is 0.75

Balance is saved.

So Marginal Propensity to Save (MPS) is 1- MPC.MPC + MPS = 1

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Consumption FunctionConsumption demand (c ) is the most important component of aggregate demand in India.

Private sector consumption expenditure in India two thirds of GDP

On food (43 %), transport and communication (13 %), rent, fuel, power etc (11 %), medical care (7 %), clothing, footwear (5 %) and others

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Saving FunctionShows the relationship between the level of saving and income.

Marginal Propensity to Save (MPS) is the extra saving generated by an extra amount of disposable income.

MPS = 1 - MPC

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What determines Household consumption expenditure? Some TheoriesCurrent Household Disposable incomeRelative Income HypothesisHouseholds Permanent IncomeHousehold WealthLife-Cycle ModelAny other factors?

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Keynesian TheoryConsumption is a function of current incomeShort run theoryMpc is between 0 and 1MPC declines as income increases

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Permanent Income Theory-Milton FriedmanNot current income but permanent incomePI is all the income anticipated in the long run (labor income +Capital Income).The level of income that households would receive when temporary or transient influences such as the whether, a short business cycle or a windfall gain or loss- are removed.

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INVESTMENT FUNCTIONTopics of DiscussionInvestment Function and ADWhat is Investment Demand?What determines Aggregate Investment Spending?The Investment Demand CurveShifts in Investment Demand Curve

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Investment DemandY = C + I + G + NX

Second major component of Aggregate Demand

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Investment DemandTotal Spending for

Purchase of new assets, which help in the production of future goods and services.

It is additions to the stock of productive assets like capital goods

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Investment spendingExamples:

Purchase of new machinery, expenditure on setting up a new power plant etcCapital goods which are used in the production processAdditions to inventory

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Investment DemandCapital stock is the rupee value of new plants, capital equipments, machinery etc at a given point of time.Gross domestic invt 24% of GDP in 2000-01 and 39% in 2005-06It is highly fluctuating in IndiaInvestment and economic growth correlated ?

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What determines Aggregate Investment Spending?

Policy-Induced Factors and

(taxes, interest rates etc)

Sentiment Driven Factors

(Expectations)

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What determines Aggregate Investment Spending?I = f ( Y, r)

Benefits and Costs

Investment is undertaken for future production.

Investments are planned on the basis of expected rate of return on investment

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What determines Aggregate Investment Spending?Expectations and Business Confidence

How are expectations formed?

If investors feel they can sell more at a later date, they will invest in new capital stock (expectations on economic recovery in the future)

On Cost side, major determinants are

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What determines Aggregate Investment Spending?Interest rate and Tax policy

The lower the cost of borrowing of capital, the larger would be the demand for investment.

How can monetary and fiscal authority influence domestic investment spending?

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What determines Aggregate Investment Spending?Reducing Interest rate, reducing corporate income tax, increasing investment subsidy etcInvestment also has two components:

Induced component (policy variable can influence. Eg: income or interest rate) and

Autonomous component (independent of income. It is subjective: business optimism)

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The Investment Demand CurveRelationship between interest rate and investment

Investment spending (X axis) and Interest Rate (Y axis)

It is downward sloping. Why?

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Shifts in the Investment Demand CurveFactors other than interest rate also affect investment spending.

What are they?

Current Investment slow down in India.

What are the reasons?

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Current Investment slow down in IndiaReasons? Economic growth?Business Confidence?

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SummaryInvestment is the most volatile component of AD

Investment fluctuations and business cycles are highly correlated

Knowledge of consumption and investment spending is important for the study of equilibrium income determination, impacts of fiscal and monetary policy etc.

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