Chapter 6 Consumption and Investment By Elvis Guzman

Chapter 6: Consumption and Investment By: Elvis Guzman “ 06” People make consumption-spending and consumption production decisions simultaneously and independently from each other.

Reason!!! This may explain why an economy slides into recession or rockets to prosperity

What Determines Consumption Spending How do people choose their level of consumption spending? ? It depends on the level of a person’s disposable income. The rich consume more than the poor because the rich have more money!! DUH!!!!

Consumption Function The relationship between consumption and income is the consumption function. C= f(Y) C represents consumption Y represents income

Keyne’s Absolute Income Hypothesis Keyne’s hypothesized that although people who earn high incomes spend more on consumption than the people who earn less, they are less inclined to spend as much “out of a given increase in income” than are those earning less. - 1936 Book: The General Theory of Employment, Interest, and Money

FOR EXAMPLE!!!! Jessica Alba’s consumption spending is greater than Megan’s. Yet, if both were given $1, 000, Jessica would likely spend less of the $1, 000 on consumption than Megan.

Absolute Income Hypothesis As national income increases consumption spending increases, but by diminishing amounts. That is, as national income increases, the MPC decreases.

FOR EXAMPLE!!!! A millionaire won’t run off to the store and spend a $500 gift card; he would probably save it. In Keyne’s view, the millionaire’s “margin of comfort” is already provided, and the “stronger motive” guiding his behavior, then, becomes “accumaltion”. A regular guy would spend it on immediate primary needs!!!!

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

THE INDIVIDUAL’S MARGINAL PROPENSITY TO CONSUME!!!!

THE NATION’S MARGINAL PROPENSITY TO CONSUME ($ BILLIONS)

THE MARGINAL PROPENSITY TO CONSUME REMAINS CONSTANT

MPC w. MPC is the SLOPE of the Consumption Curve w. MPC falls as the absolute level of income increases (according to Keynes)

Make Sense? w Keynes was WRONG. Five years later, Simon Kuznets published “National Income and Its Composition” which refuted Keynes’s theory. He found that a nation’s MPC tends to remain fairly constant regardless of the absolute level of national income.

Duesenberry’s Relative Income Hypothesis According to Duensberry, consumption spending is rooted in status. High income people not only consume more goods and services than others, but also set consumption standards for everybody else.

Relative Income Hypothesis (Duesenbery) As national income increases, consumption spending increases as well, but always by the same amount. That is as national income increases, MPC remains constant. - As long as a person’s relative income stays the same, their MPC remains constant

Permanent Income Hypothesis – Milton Friedman (Nobel Prize in 1976) Permanent income hypothesisa person’s consumption spending is related to his or her permanent income

Definitions!!!!! Permanent Income: The regular income a person expects to earn annually. It may differ by some unexpected gain or loss from the actual income earned. (Milton Friedman)

More Definitions (Still Friedman) 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. -Don’t change consumption habits based on unexpected changes in income - Can create negative savings when experience loss of income, but MPC remains constant, based on permanent income

Life-cycle Hypothesis (Franco Modigliani, MIT, Nobel Prize in 1985) 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.

Modigliani’s cont’d MPC for young adults is relatively high. They buy first homes, cars, stocks of household durables etc.

Modigliani’s cont’d When they become middle-aged, their consumption spending also increases. They tend to consume more because they earn more, but the ratio of changes in consumption to changes in income tends to fall. That is, their MPC falls!

Modigliani’s cont’d Nearing or end of retirement, their MPC tends to rise. They become more careful about their spending and their incomes fall.

Life-Cycle Hypothesis w Is consistent with constant MPC theory – as long as birth and death rates remain fairly constant, the percentage of the population in the three stages of life are fairly constant, resulting in a constant MPC.

MORE DEFINITIONS Autonomous consumption: Consumption spending that is independent of the level of income. -Consumption spending is simply unavoidable. The spending takes place regardless of level of income. - Therefore the consumption curve intersects the vertical axis at a point above the origin (the Y intercept)

Consumption Curve w. Just like demand and/or supply curve, a change in national income leads to movement along the consumption curve, not a shift.

What factors shift the consumption curve? Real assets and money holdings Expectations of price changes Credit and interest rates Taxation

Real Asset and Money Holdings w When people’s real asset and money holdings increase, their consumption increases as well w Imagine winning the lottery w Will shift the consumption curve up, NOT to the right like a demand or supply curve

Expectations of price changes w If consumers expect inflation, they spend their money NOW, knowing it will soon be worth less w Expected inflation = Increased Consumption Now

Credit and Interest Rates w If credit is more available or interest rates are lower, consumption will increase w Example: Buying a house, a car, a computer, etc.

Taxation w. If the government raises taxes, disposable income will decrease, consumption will decrease w. The opposite is also true

SHIFTS IN THE CONSUMPTION CURVE

The consumption Equation Adding autonomous consumption to consumption spending induced by income generates a specific form of the consumption function. C = a + b. Y

BY THE WAY w A = autonomous consumption spending w B = marginal propensity to consume w Y = level of national income

What determines the level of saving? Saving- that part of national income not spent on consumption. S=Y–C Savings = Income - Consumption

Marginal Propensity to Save MPS- the change in saving induced by a change in income!!! MPS = Change in S Change in Y The marginal propensity to consume and save add up to 100% (or 1)

FORMULAS MPC + MPS = 1 OR MPS = 1 - MPC

Savings w Savings can actually be negative (also called dissaving) w They can consume more than their income via running down accumulated wealth

THE SAVINGS CURVE

Income Curve 45 degree line –a line drawn at a 45 degree angle, showing all points at which the distance to the horizontal axis equals the distance to the vertical axis.

THE SAVINGS CURVE

The Investment Function w At the same time that consumers are deciding how much of their income to spend on consumption and how much to save, producers in the economy are deciding how much to spend on new investment w Intended investment – Investment spending that producers intend to undertake. Intended investment doesn’t always end up realized w Level of investment doesn’t have to do with National Income level – more to do with phase of business cycle

Determinants of Investment Autonomous investment: Investment that is independent of the level of income. - There are four determinants of autonomous investment: level of technology, rate of interest, expectations of future economic growth, and the rate of capacity utilization

Determinants of Autonomous Investment Level of technology • The introduction of new technologies is one of the mainsprings of investment. • Technological leaps produce extensive networks of investment spending. • Example: The railroads

Rate of interest 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. - The lower the interest rate, the more investment is a good option

Expectations of future economic growth. Investment spending reflects how producers view the future. Future expectations are shaped by past performance. - It’s not the level of national income, but the projected changes to income that influences producers

The rate of capacity utilization - Producers don’t usually choose to operate at 100% capacity utilization because it reduces their ability to expand production on demand, they usually choose a rate to have some short-run flexibility. - 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.

THE INVESTMENT CURVE

THE VOLATILITY OF INVESTMENT

What is the consumption function? ? w 1. The consumption function expresses the relationship between consumption spending in the economy (C) and the economy’s level of income (Y). It is written as C = f(Y). As income increases, so does consumption spending

Question # 2 How does Keyne’s comment: “ The satisfaction of the immediate primary needs of a manand his family is usually a stronger motive than the motives toward accumalation” relate to his absolute income hypothesis? .

Answer w 2. Keynes believed that although rich people spend more on consumption than poor people, they are inclined to spend less out of a given increase in income than do the poor. If a rich family and a poor one each receive an additional $1, 000 of income, the rich family will spend less (and save more) of that extra income than would the poor family. Keynes explains that the poor family will use the income to satisfy “immediate primary needs. ” By “primary” he means essential needs, such as food and basic clothing. By “immediate” he means they need them now. What about the rich family? Because these immediate primary needs are already satisfied, the family would be more inclined to save more, satisfying “the motives toward accumulation. ”

Questions #3 Accepting the absolute income hypothesis, would you expect the MPC in the U. S. economy in 1995 to be higher , lower, or about the same as the MPC in the Haitian 1995 economy? Why? How wouldit compare to the MPC in the U. S. economy in 1925.

Answer w 3. Under the absolute income hypothesis, the MPC would be lower in the United States because the United States is a much richer country than Haiti. Similarly, the United States in 1995 was much richer than the United States in 1925, and so the 1995 MPC should be lower.

Question #4 Accepting the relative income hypothesis would you expect the MPC in the U. S. economy in 1995 to be higher, lower, or the same as the MPC in the U. S. economy in 1925? Why?

Answer w 4. According to the relative income hypothesis, the MPC is constant at all levels of income so that the U. S. MPC in 1995 would be the same as its 1925 MPC.

Question #5 Give an example of transitory income. What effect does this income have on marginal propensity to consume?

Answer w 5. Transitory income refers to any unexpected gain or loss of income, such as an inheritance or an unexpected loss of a job and income. People’s consumption depends on their permanent income, not transitory income. If an unexpected income gain occurs, it typically ends up as increased saving, and if an unexpected income loss occurs, it typically results in decreased saving.

What is autonomous consumption? ? ? ? w 6. Autonomous consumption is that part of consumption spending that is independent of income. Put differently, it is the amount of consumption spending that would occur even if income were zero.

Question Why would a change in asset or money holdings shift the consumption curve?

Answer w 7. The consumption function shows the relationship between consumption spending and income. For example, at an income level of $10, 000, consumption spending might be $8, 000, assuming nothing else in the economy changes to affect people’s consumption behavior. What might such a change be? Suppose a person’s real assets or money holdings increase. There is now more savings in the bank (an inheritance, perhaps) or more furniture in the house, or more kitchen appliances, or more house, or more cars, and so on. The need to save as much as you did out of your income now weakens. You are now more likely to spend more out of a given income (no matter what the income level may be) than you did before. Graphically, the consumption function shifts upward.

Question & Answer What factor explains movements along the consumption curve? ? ? w 8. One factor explains movements along the consumption function: changes in income.

Why is MPC+MPS always equal to one? ? w 9. From the household’s perspective, there are only two possible uses of income: People can either spend it on consumption or save it. Each extra dollar of income is divided between the percent of that income spent on consumption (measuring MPC) and the percent of that income that ends up as saving (measuring MPS). One hundred percent of that, then, must equal the percent represented by the sum of MPC and MPS. In equation form, MPC + MPS = 1.

Question #10 What is dissaving? Describe a situation that would create dissaving in an economy.

Answer w 10. Dissaving (or negative saving) occurs when people’s consumption exceeds their income. Imagine how you would behave if your job was cut back to half time so that the income you earn is now insufficient to cover your basic consumption. (There a lot of things you could do without, but not everything. ) What would you do? First among alternatives would be to dip into whatever savings you have to make up the difference between income and consumption. That’s dissaving.

What factors determine autonomous investment? w 11. Autonomous investment is independent of the level of income. The factors that influence the size of autonomous investment are (1) the interest rate, (2) expectations of future economic growth, (3) the level of technology, and (4) the rateof capacity utilization. Investment will be greater the lower the interest rate, the more attractive the prospects for future economic growth, the higher the rate of capacity utilization, and the higher the rate of technological change.

Question Draw a graph depicting consumption for an economy through the range Y= $100 billion to Y= $ 500 when autonomous consumption is $100 billion and MPC= 0. 6

Answer National Income Consumption 0 100 160 200 220 300 280 400 340 500 400

Question #1 Calculate the marginal propensity to consume, the marginal propensity to save, and the level in the accompanying table.

Answer 1) Y C MPS Saving $0 $50 0. 50 –$50 100 0. 50 0 200 150 0. 50 50 300 200 0. 50 100 400 250 0. 50 150 500 300 0. 50 200

Question #2 Calculate the consumption for each level of national income, given the accompanying levels of autonomous consumption, Ca and marginal propensities to consume.

2) Y Ca MPC C 100 50 0. 50 100 200 60 0. 60 180 300 70 0. 70 280 400 80 0. 80 400 500 90 0. 90 540

Question #3 Calculate the level of autonomous investment, I, for each level of national income.

3) Y C I 100 50 60 200 100 60 300 150 60 400 200 60 500 250 60

Question #4 Accepting Milton Friedman’s permanent income hypothesis, calculate the marginal propensities to consume (MPCs) for each of the four scenarios.

4) Permanent Income Transitory Income Total Income Consumption MPC $ 8, 000 $ 2, 000 $10, 000 $ 6, 400 0. 80 14, 000 6, 000 20, 000 7, 000 0. 50 25, 000 30, 000 19, 500 0. 78 30, 000 10, 000 40, 000 21, 000 0. 70

Question #5 For each of the three income levels shown, provide appropriate data to satisfy or be consistent with the absolute and relative income hypothesis.

5) Consumption Absolute Income Hypothesis MPC Relative Income Hypothesis Absolute Income Hypothesis Relative Income Hypothesis $ 800 0. 90 0. 80 Income $1, 000 $ 900 2, 000 1, 700 1, 600 0. 80 3, 000 2, 400 0. 70 0. 80

Question #6 For each of the three income levels shown, provide appropriate data to satisfy or be consistent with the absolute and relative income hypothesis.

QUESTION #6 Saving Absolute Income Hypothesis Relative Income Hypothesis MPS Absolute Income Hypothesis Relative Income Hypothesis Incom e $4, 000 $ 400 $ 800 0. 90 0. 80 5, 000 600 1, 000 0. 80 6, 000 900 1, 200 0. 70 0. 80

Question #7 Calculate the 2000 and 2001 MPCs for each of the countries.

7) Question 7 DY 2000 DC 2001 MP C DY France 1, 000 francs 6, 000 francs 1, 000 francs Italy 1, 000 lire 7, 000 lire 1, 000 lire Britain 1, 000 pounds 7, 500 pounds 1, 000 pounds Ireland 1, 000 punts 8, 000 punts 1, 000 punts MPC

Question #8 Calculate the 2000 and 2001 MPCs for each of the countries when national income falls by 1, 000.

QUESTION 2000 DY France #8) DC – 1, 000 francs 2001 MP C DY – 1, 000 francs – 6, 000 francs Italy – 1, 000 lire – 7, 000 lire – 1, 000 lire Britain – 1, 000 pounds – 7, 500 pounds – 1, 000 pounds Ireland – 1, 000 punts – 8, 000 punts – 1, 000 punts MP C

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