Download Principles of Economics Third Edition by Fred Gottheil

Chapter 21
Consumption and
Investment
© 2005 Thomson
Economic Principles
Keynes’s absolute income
hypothesis
Duesenberry’s relative income
hypothesis
Friedman’s permanent income
hypothesis
Gottheil - Principles of Economics, 4e
© 2005 Thomson
2
Economic Principles
Modigliani’s life-cycle hypothesis
The marginal propensity to
consume
The marginal propensity to save
Autonomous investment
Gottheil - Principles of Economics, 4e
© 2005 Thomson
3
What Determines
Consumption Spending?
Consumption-spending and
consumption-production decisions
are made simultaneously and
independently of each other.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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).
Gottheil - Principles of Economics, 4e
© 2005 Thomson
10
Keynes’s Absolute Income
Hypothesis
Marginal propensity to consume
(MPC)
• Consumption increases by diminishing
amounts as the income level increases.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.”
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
14
Keynes’s Absolute Income
Hypothesis
The welfare recipient, on the other
hand, would likely immediately
spend the money on food,
clothing, and shelter.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
15
EXHIBIT 1
THE INDIVIDUAL’S MARGINAL PROPENSITY
TO CONSUME
16
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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 $1,000.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
18
Keynes’s Absolute Income
Hypothesis
To Keynes, national economies
behave like individuals. He
hypothesized that a nation’s MPC
depends on its level of national
income.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
19
EXHIBIT 2
THE NATION’S MARGINAL PROPENSITY TO
CONSUME ($ BILLIONS)
20
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
25
EXHIBIT 3
THE MARGINAL PROPENSITY TO
CONSUME REMAINS CONSTANT
26
© 2005 Thomson
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
income increases.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
27
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
28
Friedman’s Permanent Income
Hypothesis
Permanent income hypothesis
• A person’s consumption spending is
related to his or her permanent income.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
33
What Determines
Consumption Spending?
Autonomous consumption
• Consumption spending that is
independent of the level of income.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
41
EXHIBIT 4
SHIFTS IN THE CONSUMPTION CURVE
42
© 2005 Thomson
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
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
i. True
ii. False. Shifts in the consumption curve
are unrelated to changes in national
income.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
44
The Consumption Equation
There are two key factors that
influence the character of our
consumption spending:
autonomous consumption and our
income level.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
45
The Consumption Equation
Consumption induced by our level
of income is referred to as induced
consumption.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
47
What Determines the Level
of Saving?
People do two things with their
income. They either spend it on
consumption or they save it.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
48
What Determines the Level
of Saving?
Saving
• The part of national income not spent
on consumption.
• S = Y - C.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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).
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
52
What Determines the Level
of Saving?
o
Income curve or 45 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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
53
EXHIBIT 5A THE SAVINGS CURVE
Gottheil - Principles of Economics, 4e
© 2005 Thomson
54
EXHIBIT 5B THE SAVINGS CURVE
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
56
The Investment Function
Producers in the economy must
decide how much income to spend
on new investment.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
58
The Investment Function
Each producer makes investment
decisions independently of others.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
59
The Investment Function
Intended investment
• Investment spending that producers
intend to undertake. These intended
investments do not always end up being
realized.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
61
What Determines Investment?
Autonomous investment
• Investment that is independent of the
level of income.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
62
EXHIBIT 6
THE INVESTMENT CURVE
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
64
What Determines Investment?
Four factors determine the size of
the economy’s autonomous
investment.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
67
What Determines Investment?
2. Interest rate.
• There is an inverse relationship between
the rate of interest and the quantity of
investment spending.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
68
EXHIBIT 7
THE EFFECT OF CHANGES IN THE RATE OF
INTEREST ON THE LEVEL OF INVESTMENT
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
73
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
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.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
76