Download What Determines Consumption Spending?

Chapter 21
Consumption and
Investment
© 2002 South-Western
Economic Principles
•Keynes’s absolute income
hypothesis
•Duesenberry’s relative income
hypothesis
•Friedman’s permanent income
hypothesis
2
Economic Principles
•Modigliani’s life-cycle hypothesis
•The marginal propensity to
consume
•The marginal propensity to save
•Autonomous investment
3
What Determines
Consumption Spending?
Consumption-spending and
consumption-production decisions
are made simultaneously and
independently of each other.
4
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.
5
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.
6
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.
7
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.
8
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.
9
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).
10
Keynes’s Absolute Income
Hypothesis
Marginal propensity to consume
(MPC)
Consumption increases by
diminishing amounts as the
income level increases.
11
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.
12
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.”
13
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.
14
Keynes’s Absolute Income
Hypothesis
The welfare recipient, on the other
hand, would likely immediately
spend the money on food,
clothing, and shelter.
15
EXHIBIT 1
THE INDIVIDUAL’S MARGINAL PROPENSITY
TO CONSUME
16
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.
17
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 $1,000.
18
Keynes’s Absolute Income
Hypothesis
To Keynes, national economies
behave like individuals. He
hypothesized that a nation’s MPC
depends on its level of national
income.
19
EXHIBIT 2
THE NATION’S MARGINAL PROPENSITY TO
CONSUME ($ BILLIONS)
20
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.
21
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.
22
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.
23
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.
24
Duesenberry’s Relative
Income Hypothesis
An individual’s MPC, then,
remains the same, as long as the
individual’s relative income
position remains unchanged.
25
EXHIBIT 3
THE MARGINAL PROPENSITY TO
CONSUME REMAINS CONSTANT
26
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?
• Keynes’s consumption curve flattens near
the top, reflecting his belief that MPC
increases by diminishing amounts as
27
income increases.
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
28
increases.
Friedman’s Permanent
Income Hypothesis
Permanent income hypothesis
A person’s consumption spending
is related to his or her permanent
income.
29
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.
30
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.
31
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.
32
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.
33
What Determines
Consumption Spending?
Autonomous consumption
Consumption spending that is
independent of the level of income.
34
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.
35
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.
36
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.
37
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.
38
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.
39
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.
40
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.
41
EXHIBIT 4
SHIFTS IN THE CONSUMPTION CURVE
42
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.
43
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.
ii. False. Shifts in the consumption
curve are unrelated to changes in
national income.
44
The Consumption Equation
There are two key factors that
influence the character of our
consumption spending:
autonomous consumption and our
income level.
45
The Consumption Equation
Consumption induced by our level
of income is referred to as induced
consumption.
46
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.
47
What Determines the Level
of Saving?
People do two things with their
income. They either spend it on
consumption or they save it.
48
What Determines the Level
of Saving?
Saving
The part of national income not
spent on consumption.
S = Y – C.
49
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.
50
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).
51
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.
52
What Determines the Level
of Saving?
o
45 line
o
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.
53
EXHIBIT 5A THE SAVINGS CURVE
54
EXHIBIT 5B THE SAVINGS CURVE
55
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.
56
The Investment Function
Producers in the economy must
decide how much income to spend
on new investment.
57
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.
58
The Investment Function
Each producer makes investment
decisions independently of others.
59
The Investment Function
Intended investment
Investment spending that
producers intend to undertake.
These intended investments do not
always end up being realized.
60
What Determines
Investment?
The level of national income
doesn’t play the decisive role in
determining investment that it
plays in determining consumption
spending.
61
What Determines
Investment?
Autonomous investment
Investment that is independent of
the level of income.
62
EXHIBIT 6
THE INVESTMENT CURVE
63
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.
64
What Determines
Investment?
Four factors determine the size of
the economy’s autonomous
investment.
65
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.
66
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.
67
What Determines
Investment?
2. Interest rate.
There is an inverse relationship
between the rate of interest and the
quantity of investment spending.
68
EXHIBIT 7
THE EFFECT OF CHANGES IN THE RATE OF
INTEREST ON THE LEVEL OF INVESTMENT
69
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.
70
What Determines
Investment?
3. Expectations of future economic
growth. Investment spending
reflects how producers view the
future. Future expectations are
shaped by past performance.
71
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.
72
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.
73
What Determines
Investment?
The level of investment spending in
the US 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.
74
EXHIBIT 8
THE 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.
75
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.
76