Business Economics (ECO 341) Fall: 2012 Semester Khurrum S. Mughal 1

Quiz

Consumption, Saving and Investment Macroeconomics

Consumption Savings Investment Multiplier Effect Theme of Lecture

Importance of Consumptions, Savings and Investments for a country The choice between Consumption and Investment defines the future direction of an economy Personal Consumption Expenditure is on final goods and services by households What is not consumed from the disposable income is saved. Macroeconomics

Consumption and Saving Pattern for , PBS

Major differences in Pakistan ◦In Income Class ◦Due to Provincial, hence cultural differences ◦Urban or Rural Life style Difference in Consumption Patterns

Assignment Go to social-and-living-standards-measurementhttp:// social-and-living-standards-measurement ◦Household economic Survey (HES) Difference in Consumption Saving Patterns

Difference in Consumption Patterns

The Keynesian Theory of Consumption: Current real disposable income is the most important determinant of consumption in the short run. Disposable Income (Yd) = Gross Income - (Deductions from Direct Taxation + Benefits) Consumption Function

Gross income (Y) can either be consumed (C), Saved (S), or given to the Government in taxes (T) Y = C + S + T Yd = Yg – T Consumption Function

Savings 45˚ Y C 0 Consumption function C = f(Y) Consumption Y 1 Y 2 CACA Consumption Function

The standard Keynesian consumption function: C = a + c Yd where, Yd= Disposable income C= Consumer expenditure a = autonomous consumption. c = marginal propensity to consume (mpc). Y C 0 C = f(Y) Savings Consumption 45˚ Y 1 Y 2 CACA Consumption Function If an individual's income fell to zero some of his existing spending could be sustained by using savings. This is known as DIS-SAVING.

The gradient of the consumption curve gives the marginal propensity to consume. As income rises, so does total consumer demand. Break-even Point Y C 0 C = f(Y) Savings Consumption 45˚ Y 1 Y 2 CACA Consumption Function

The nineteen century Prussian statistician Ernst Engel (1821–1896) noticed as income increases, expenditures on many items go up, but there are limits to the extra money people will spend on food when their income rise. Engel's Law: The proportion of total spending devoted to food declines as income increases. Engel's Law

Nonlinear Consumption function Y C C = f(Y) CACA 45° E YEYE

Current disposable income: it is the central factor determining a nation's consumption. ◦Permanent-Income theory ◦Life-Cycle Hypothesis Wealth Effect Expectations (interest rate, inflation, etc) Determinants of Consumption

Consumption Savings Investment Multiplier Effect Theme of Lecture

Saving is that part of income that is not consumed. Saving equals income minus consumption: S = Y – C Income is the sum of consumption and savings: Y = C + S Savings

Like consumption, Saving is also a function of income: S = f(Y) If autonomous consumption exists then autonomous saving exists as well and saving function is: S = -C A + s.Y Saving is a source for investment. Savings Function

Like consumption, Saving is also a function of income: S = f(Y) If autonomous consumption exists then autonomous saving exists as well and saving function is: S = -C A + s.Y Saving is a source for investment. Savings Function

Y C, S 0 C = f(Y) 45˚ Y E CACA -CA-CA S = f(Y) The saving function is the mirror image of the consumption function. It shows the relationship between the level of saving and income. Savings Function

The marginal propensity to save is defined as the fraction of an extra unit of income that goes to extra saving. Savings

Calculating MPC & MPS Income Category DI ($)Consumptio n Exp MPCNet Savings MPS A24,00024,200??? B25,000 ??? C26,00025,800??? D27,00026,600??? E28,00027,400??? F29,00028,200??? G30,00029,000???

Calculating MPC & MPS Income Category DI ($)Consumptio n Exp MPCNet Savings MPS A24,00024, B25, C26,00025, D27,00026, E28,00027, F29,00028, G30,00029,

Identity of Marginal Propensities

Consumption Savings Investment Multiplier Effect Theme of Lecture

Meaning of Investment in Economics Investment plays two roles in macroeconomics: ◦It can have a major impact on Aggregate Demand and affects business cycles ◦It leads to capital accumulation Focusing on Gross private Domestic Investment Investment

Revenues: an investment should bring the firm additional revenue. Costs: interest rates & taxes influences the costs of the investment. Consumer demand: the bigger the increase in consumer demand, the more investment will be needed. Expectation: business expectation about future state of economy. Determinants of Investment

Investment spending Interest rate i D D1D1 Higher Output The Investment Demand Curve

Investment spending Interest rate i D1D1 D Higher Taxes The Investment Demand Curve

Investment spending Interest rate i D1D1 D Pessimistic Expectation The Investment Demand Curve

Consumption Savings Investment Multiplier Effect Theme of Lecture

The Keynesian investment multiplier model shows that an increase in investment will increase output by a multiplied amount – by an amount greater than itself. The multiplier is the number by which the change in investment must be multiplied in order to determine the resulting change in total output. Investment Multiplier

Y C, I 0 45 ˚ C +I 1 C + I 2 Y1Y1 I 2 = I 1 + ΔI ΔY = k. ΔI Y2Y2 ΔY ΔIΔI E1E1 E2E2 Investment Multiplier

When there is change in C, I, G or Xn either increases or decreases, real GDP also increases/decreases. Total increase in real GDP is larger than the initial increase in spending. The MULTIPLIER is the amount by which a change in any component of spending is magnified or multiplied to determine the change that it generates in real GDP. Multiplier

A change in spending ultimately changes output and income by more than the initial change in investment spending. This is called the multiplier effect. The Multiplier Effect

The size of the multiplier k depends upon how large the MPC is. Investment Multiplier

The Spending Multiplier can be calculated from the MPC or the MPS. Multiplier = 1 / 1-MPC or 1 / MPS Multipliers are (+) when there is an increase in spending and (–) when there is a decrease in spending You multiply the multiplier times the initial increase in spending to determine total effect on real GDP. Investment Multiplier