© 2005 Thomson C hapter 21 Consumption and Investment

© 2005 Thomson 2 Gottheil - Principles of Economics, 4e Economic Principles Keynes’s absolute income hypothesis Duesenberry’s relative income hypothesis Friedman’s permanent income hypothesis

© 2005 Thomson 3 Gottheil - Principles of Economics, 4e Economic Principles Modigliani’s life-cycle hypothesis The marginal propensity to consume The marginal propensity to save Autonomous investment

© 2005 Thomson 4 Gottheil - Principles of Economics, 4e What Determines Consumption Spending? Consumption-spending and consumption-production decisions are made simultaneously and independently of each other.

© 2005 Thomson 5 Gottheil - Principles of Economics, 4e What Determines Consumption Spending? The result is that sometimes consumers don’t buy enough of everything produced and other times producers do not produce as much as people want to consume.

© 2005 Thomson 6 Gottheil - Principles of Economics, 4e What Determines Consumption Spending? Consumption function The relationship between consumption and income. It is written as C = f(Y), where C represents consumption and Y represents income.

© 2005 Thomson 7 Gottheil - Principles of Economics, 4e What Determines Consumption Spending? The single most important factor influencing a person’s consumption spending is his or her level of disposable income. The greater the disposable income, the greater the consumption spending.

© 2005 Thomson 8 Gottheil - Principles of Economics, 4e What Determines Consumption Spending? A number of hypotheses have been offered to explain how changes in an individual’s income, and, taken collectively, changes in national income affect individual and national consumption.

© 2005 Thomson 9 Gottheil - Principles of Economics, 4e Keynes’s Absolute Income Hypothesis Absolute income hypothesis As national income increases, consumption spending increases, but by diminishing amounts. That is, as national income increases, the marginal propensity to consume (MPC) decreases.

© 2005 Thomson 10 Gottheil - Principles of Economics, 4e Keynes’s Absolute Income Hypothesis Marginal propensity to consume (MPC) The ratio of the change in consumption spending to a given change in income. MPC = (change in C)/(change in Y).

© 2005 Thomson 11 Gottheil - Principles of Economics, 4e Keynes’s Absolute Income Hypothesis Marginal propensity to consume (MPC) Consumption increases by diminishing amounts as the income level increases.

© 2005 Thomson 12 Gottheil - Principles of Economics, 4e Keynes’s Absolute Income Hypothesis Keynes believed that although people who earn high incomes spend more on consumption than people who earn less, they are less inclined to spend as much out of a given increase in income than those earning less.

© 2005 Thomson 13 Gottheil - Principles of Economics, 4e Keynes’s Absolute Income Hypothesis Keynes relied on the psychological law that the satisfaction of “immediate primary needs” is a stronger motive for consumption than “accumulation.”

© 2005 Thomson 14 Gottheil - Principles of Economics, 4e Keynes’s Absolute Income Hypothesis For example, if a millionaire and a welfare recipient each received $500, the millionaire would likely just add the money to her savings account since her primary needs are already met.

© 2005 Thomson 15 Gottheil - Principles of Economics, 4e Keynes’s Absolute Income Hypothesis The welfare recipient, on the other hand, would likely immediately spend the money on food, clothing, and shelter.

© 2005 Thomson 16 EXHIBIT 1THE INDIVIDUAL’S MARGINAL PROPENSITY TO CONSUME

© 2005 Thomson 17 Gottheil - Principles of Economics, 4e Exhibit 1: The Individual’s Marginal Propensity to Consume 1. What is the change in consumption as total income increases from $1,000 to $2,000 in Exhibit 1? Consumption increases by $800 (from $1,400 to $2,200) as total income increases by $1,000.

© 2005 Thomson 18 Gottheil - Principles of Economics, 4e Exhibit 1: The Individual’s Marginal Propensity to Consume 2. What is the change in consumption as total income increases from $2,000 to $3,000? Consumption increases by $700 (from $2,200 to $2,900) as total income increases by $1,000.

© 2005 Thomson 19 Gottheil - Principles of Economics, 4e Keynes’s Absolute Income Hypothesis To Keynes, national economies behave like individuals. He hypothesized that a nation’s MPC depends on its level of national income.

© 2005 Thomson 20 EXHIBIT 2THE NATION’S MARGINAL PROPENSITY TO CONSUME ($ BILLIONS)

© 2005 Thomson 21 Gottheil - Principles of Economics, 4e Exhibit 2: The Nation’s Marginal Propensity to Consume What happens to the national MPC as national income increases in Exhibit 2? The national MPC increases, but by diminishing amounts.

© 2005 Thomson 22 Gottheil - Principles of Economics, 4e Keynes’s Absolute Income Hypothesis The pioneering work of Simon Kuznets showed that Keynes’s hypothesis was wrong. A nation’s MPC tends to remain fairly constant regardless of the absolute level of national income.

© 2005 Thomson 23 Gottheil - Principles of Economics, 4e Duesenberry’s Relative Income Hypothesis Relative income hypothesis As national income increases, consumption spending increases as well, always by the same amount. That is, as national income increases, MPC remains constant.

© 2005 Thomson 24 Gottheil - Principles of Economics, 4e Duesenberry’s Relative Income Hypothesis According to Duesenberry, consumption spending is rooted in status. High-income people not only consume more than others, but also set consumption standards for everyone else.

© 2005 Thomson 25 Gottheil - Principles of Economics, 4e Duesenberry’s Relative Income Hypothesis An individual’s MPC, then, remains the same, as long as the individual’s relative income position remains unchanged.

© 2005 Thomson 26 EXHIBIT 3THE MARGINAL PROPENSITY TO CONSUME REMAINS CONSTANT

© 2005 Thomson 27 Gottheil - Principles of Economics, 4e Exhibit 3: The Marginal Propensity to Consume Remains Constant Keynes’s consumption curve flattens near the top, reflecting his belief that MPC increases by diminishing amounts as income increases. How does Duesenberry’s consumption curve in Exhibit 3 compare to Keynes’s consumption curve in Exhibit 2?

© 2005 Thomson 28 Gottheil - Principles of Economics, 4e Exhibit 3: The Marginal Propensity to Consume Remains Constant How does Duesenberry’s consumption curve in Exhibit 3 compare to Keynes’s consumption curve in Exhibit 2? Duesenberry’s consumption curve is a straight line, reflecting his belief that MPC increases by the same amount as income increases.

© 2005 Thomson 29 Gottheil - Principles of Economics, 4e Friedman’s Permanent Income Hypothesis Permanent income hypothesis A person’s consumption spending is related to his or her permanent income.

© 2005 Thomson 30 Gottheil - Principles of Economics, 4e Friedman’s Permanent Income Hypothesis Permanent income Permanent income is the regular income a person expects to earn annually. It may differ by some unexpected gain or loss from the actual income earned.

© 2005 Thomson 31 Gottheil - Principles of Economics, 4e Friedman’s Permanent Income Hypothesis Transitory income The unexpected gain or loss of income that a person experiences. It is the difference between a person’s regular and actual income in any year.

© 2005 Thomson 32 Gottheil - Principles of Economics, 4e Friedman’s Permanent Income Hypothesis According to Friedman, an unexpected gain or loss in income in one year does not influence an individual’s overall MPC from year to year.

© 2005 Thomson 33 Gottheil - Principles of Economics, 4e Modigliani’s Life-Cycle Hypothesis Life-cycle hypothesis Typically, a person’s MPC is relatively high during young adulthood, decreases during the middle-age years, and increases when the person is near or in retirement.

© 2005 Thomson 34 Gottheil - Principles of Economics, 4e What Determines Consumption Spending? Autonomous consumption Consumption spending that is independent of the level of income.

© 2005 Thomson 35 Gottheil - Principles of Economics, 4e What Determines Consumption Spending? Some consumption spending is simply unavoidable. While individuals may spend less on food, clothing, and shelter when income falls, there are limits to how much one can cut and still survive.

© 2005 Thomson 36 Gottheil - Principles of Economics, 4e What Determines Consumption Spending? A change in national income induces a change in consumption. The change in consumption is considered movement along the consumption curve.

© 2005 Thomson 37 Gottheil - Principles of Economics, 4e What Determines Consumption Spending? The consumption curve can also shift. Shifts in the consumption curve are unrelated to national income. There are several factors that can shift the consumption curve.

© 2005 Thomson 38 Gottheil - Principles of Economics, 4e What Determines Consumption Spending? 1. Real asset and money holdings. An increase or decrease in real assets or money holdings causes the consumption curve to shift. For example, a substantial inheritance of money or property would cause the curve to shift upward.

© 2005 Thomson 39 Gottheil - Principles of Economics, 4e What Determines Consumption Spending? 2. Expectations of price changes. An expectation of inflation could cause an increase in the current level of consumption, even though incomes are not expected to change. The increase in consumption would shift the curve upward.

© 2005 Thomson 40 Gottheil - Principles of Economics, 4e What Determines Consumption Spending? 3. Credit and interest rates. If credit is more easily available or if the credit terms are made more attractive, people are likely to increase their spending on durable goods, even if their incomes haven’t changed. The consumption curve would shift upward.

© 2005 Thomson 41 Gottheil - Principles of Economics, 4e What Determines Consumption Spending? 4. Taxation. If government decided to increase the income tax, people would end up with a smaller pay check, even though their salaries remained unchanged. This would cause a decrease in consumption and a downward shift in the consumption curve.

© 2005 Thomson 42 EXHIBIT 4SHIFTS IN THE CONSUMPTION CURVE

© 2005 Thomson 43 Gottheil - Principles of Economics, 4e Exhibit 4: Shifts in the Consumption Curve i. True ii. False The consumption curve shifts depicted in Exhibit 4 can be attributed to increases and decreases in national income.

© 2005 Thomson 44 Gottheil - Principles of Economics, 4e Exhibit 4: Shifts in the Consumption Curve The consumption curve shifts depicted in Exhibit 4 can be attributed to increases and decreases in national income. i. True ii. False. Shifts in the consumption curve are unrelated to changes in national income.

© 2005 Thomson 45 Gottheil - Principles of Economics, 4e The Consumption Equation There are two key factors that influence the character of our consumption spending: autonomous consumption and our income level.

© 2005 Thomson 46 Gottheil - Principles of Economics, 4e The Consumption Equation Consumption induced by our level of income is referred to as induced consumption.

© 2005 Thomson 47 Gottheil - Principles of Economics, 4e The Consumption Equation The consumption function takes the following form: C = a + bY Where a equals autonomous consumption spending, b equals MPC and Y equals level of national income.

© 2005 Thomson 48 Gottheil - Principles of Economics, 4e What Determines the Level of Saving? People do two things with their income. They either spend it on consumption or they save it.

© 2005 Thomson 49 Gottheil - Principles of Economics, 4e What Determines the Level of Saving? Saving The part of national income not spent on consumption. S = Y - C.

© 2005 Thomson 50 Gottheil - Principles of Economics, 4e What Determines the Level of Saving? Saving When C is greater than Y, saving is negative and is called dissaving. People can consume more than their income allows by running down their savings or other forms of accumulated wealth.

© 2005 Thomson 51 Gottheil - Principles of Economics, 4e What Determines the Level of Saving? Marginal propensity to save (MPS) The change in saving induced by a change in income. MPS = (change in S)/(change in Y).

© 2005 Thomson 52 Gottheil - Principles of Economics, 4e What Determines the Level of Saving? The marginal propensities to consume and to save add up to 100 percent. MPC + MPS = 1. MPS = 1 - MPC.

© 2005 Thomson 53 Gottheil - Principles of Economics, 4e What Determines the Level of Saving? Income curve or 45 o line A line, drawn at a 45° angle, showing all points at which the distance to the horizontal axis equals the distance to the vertical axis. The line is also called the income curve.

© 2005 Thomson 54 Gottheil - Principles of Economics, 4e EXHIBIT 5ATHE SAVINGS CURVE

© 2005 Thomson 55 Gottheil - Principles of Economics, 4e EXHIBIT 5BTHE SAVINGS CURVE

© 2005 Thomson 56 Gottheil - Principles of Economics, 4e Exhibit 5: The Saving Curve What is saving when income is $400 billion in Exhibit 5? S = Y – C or S = Y – (a + bY). Saving = $400 billion – [$60 billion + (0.8 × $400 billion)] = $20 billion.

© 2005 Thomson 57 Gottheil - Principles of Economics, 4e The Investment Function Producers in the economy must decide how much income to spend on new investment.

© 2005 Thomson 58 Gottheil - Principles of Economics, 4e The Investment Function Producers may invest in replacing used up or obsolete machinery, expanding production, increasing raw material or finished goods inventories, and building new facilities for new products.

© 2005 Thomson 59 Gottheil - Principles of Economics, 4e The Investment Function Each producer makes investment decisions independently of others.

© 2005 Thomson 60 Gottheil - Principles of Economics, 4e The Investment Function Intended investment Investment spending that producers intend to undertake. These intended investments do not always end up being realized.

© 2005 Thomson 61 Gottheil - Principles of Economics, 4e What Determines Investment? The level of national income doesn’t play the decisive role in determining investment that it plays in determining consumption spending.

© 2005 Thomson 62 Gottheil - Principles of Economics, 4e What Determines Investment? Autonomous investment Investment that is independent of the level of income.

© 2005 Thomson 63 Gottheil - Principles of Economics, 4e EXHIBIT 6THE INVESTMENT CURVE

© 2005 Thomson 64 Gottheil - Principles of Economics, 4e Exhibit 6: The Investment Curve How does the investment curve (I) in Exhibit 6 change as the level of national income changes? The investment curve does not change. It remains at $75 billion at every level of national income.

© 2005 Thomson 65 Gottheil - Principles of Economics, 4e What Determines Investment? Four factors determine the size of the economy’s autonomous investment.

© 2005 Thomson 66 Gottheil - Principles of Economics, 4e What Determines Investment? 1. Technology level. The introduction of new technologies is one of the mainsprings of investment. Technological leaps produce extensive networks of investment spending.

© 2005 Thomson 67 Gottheil - Principles of Economics, 4e What Determines Investment? 2. Interest rate. Producers undertake investment when they believe the rate of return generated by the investment will exceed the interest rate, that is, the cost of borrowing investment funds.

© 2005 Thomson 68 Gottheil - Principles of Economics, 4e What Determines Investment? 2. Interest rate. There is an inverse relationship between the rate of interest and the quantity of investment spending.

© 2005 Thomson 69 Gottheil - Principles of Economics, 4e EXHIBIT 7THE EFFECT OF CHANGES IN THE RATE OF INTEREST ON THE LEVEL OF INVESTMENT

© 2005 Thomson 70 Gottheil - Principles of Economics, 4e Exhibit 7: The Effect of Changes in the Rate of Interest on the Level of Investment Why is the demand curve for investment in panel a of Exhibit 7 downward sloping? The demand curve for investment is downward sloping because as the rate of interest decreases, the level of investment in the economy increases.

© 2005 Thomson 71 Gottheil - Principles of Economics, 4e What Determines Investment? 3. Expectations of future economic growth. Investment spending reflects how producers view the future. Future expectations are shaped by past performance.

© 2005 Thomson 72 Gottheil - Principles of Economics, 4e What Determines Investment? 4. Rate of capacity utilization. Producers seldom choose to operate at 100 percent capacity. Operating at less than 100 percent capacity gives them the ability to expand production on demand.

© 2005 Thomson 73 Gottheil - Principles of Economics, 4e What Determines Investment? 4. Rate of capacity utilization. How much flexibility producers end up choosing influences the economy’s level of production. For producers who choose to operate close to full capacity, a moderate increase in sales may shift them quickly into investment spending.

© 2005 Thomson 74 Gottheil - Principles of Economics, 4e What Determines Investment? The level of investment spending in the U.S. economy is volatile. Sometimes the factors that effect investment spending pull in opposite directions. Other times, they work in unison and lead to impressive economic growth.

© 2005 Thomson 75 Gottheil - Principles of Economics, 4e EXHIBIT 8THE VOLATILITY OF INVESTMENT Source: Economic Report of the President 1994 (Washington, D.C.: United States Government Printing Office, 1994), p. 270; and U.S. Department of Commerce, Survey of Current Business 76 (January/February 1996), Table 2.

© 2005 Thomson 76 Gottheil - Principles of Economics, 4e Exhibit 8: The Volatility of Investment How does the rate of investment spending in Exhibit 8 compare to the rate of consumption spending? While the rate of consumption spending is fairly stable over time, the rate of investment spending is volatile.