Download What Determines Consumption Spending?

Chapter 21
CONSUMPTION, INVESTMENT,
AND NATIONAL INCOME
© 2013 Cengage Learning
Gottheil — Principles of Economics, 7e
1
Economic Principles
Keynes’s absolute income hypothesis
Duesenberry’s relative income
hypothesis
Friedman’s permanent income
hypothesis
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Economic Principles
Modigliani’s life-cycle hypothesis
The marginal propensity to consume
The marginal propensity to save
Autonomous investment
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What Determines Consumption
Spending?
Consumption-spending and
consumption-production decisions
are made simultaneously and
independently of each other.
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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.
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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.
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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.
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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.
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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.
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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)
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Keynes’s Absolute Income
Hypothesis
Marginal propensity to consume (MPC)
• Consumption increases by diminishing
amounts as the income level increases.
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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.
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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.”
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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.
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Keynes’s Absolute Income
Hypothesis
The welfare recipient, on the other
hand, would likely immediately
spend the money on food, clothing,
and shelter.
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EXHIBIT 1
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THE INDIVIDUAL’S MARGINAL PROPENSITY
TO CONSUME
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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.
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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 $1,000.
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Keynes’s Absolute Income
Hypothesis
To Keynes, national economies behave
like individuals. He hypothesized that a
nation’s MPC depends on its level of
national income.
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EXHIBIT 2
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THE NATION’S MARGINAL PROPENSITY TO
CONSUME ($ billions)
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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.
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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.
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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.
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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.
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Duesenberry’s Relative Income
Hypothesis
An individual’s MPC, then, remains
the same, as long as the individual’s
relative income position remains
unchanged.
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EXHIBIT 3
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THE MARGINAL PROPENSITY TO
CONSUME REMAINS CONSTANT
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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.
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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.
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Friedman’s Permanent Income
Hypothesis
Permanent income hypothesis
• A person’s consumption spending is related
to his or her permanent income.
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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.
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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.
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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.
© 2013 Cengage Learning
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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.
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What Determines Consumption
Spending?
Autonomous consumption
• Consumption spending that is independent
of the level of income.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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EXHIBIT 4
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SHIFTS IN THE CONSUMPTION CURVE
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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
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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.
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The Consumption Equation
There are two key factors that
influence the character of our
consumption spending: autonomous
consumption and our income level.
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The Consumption Equation
Consumption induced by our level of
income is referred to as induced
consumption.
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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.
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What Determines the Level of
Saving?
People do two things with their
income. They either spend it on
consumption or they save it.
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What Determines the Level of
Saving?
Saving
• The part of national income not spent on
consumption.
•S=Y–C
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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.
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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).
© 2013 Cengage Learning
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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
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What Determines the Level of
Saving?
Income curve or 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.
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EXHIBIT 5A THE SAVING CURVE
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EXHIBIT 5B THE SAVING CURVE
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Exhibit 5: The Saving Curve
What is the saving when income is
$400 billion in Exhibit 5?
• S = Y – C or S = Y – (a + bY).
• Savings = $400 billion – [$60 billion + (0.8
× $400 billion)] = $20 billion
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The Investment Function
Producers in the economy must
decide how much income to spend on
new investment.
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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.
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The Investment Function
Each producer makes investment
decisions independently of others.
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The Investment Function
Intended investment
• Investment spending that producers intend to
undertake. These intended investments do
not always end up being realized.
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What Determines Investment?
The level of national income doesn’t
play the decisive role in determining
investment that it plays in determining
consumption spending.
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What Determines Investment?
Autonomous investment
• Investment that is independent of the level
of income.
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EXHIBIT 6
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THE INVESTMENT CURVE
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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.
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What Determines Investment?
Four factors determine the size of the
economy’s autonomous investment.
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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.
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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.
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What Determines Investment?
2. Interest rate.
• There is an inverse relationship between the
rate of interest and the quantity of investment
spending.
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EXHIBIT 7
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THE EFFECT OF CHANGES IN THE RATE OF
INTEREST ON THE LEVEL OF INVESTMENT
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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.
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What Determines Investment?
3. Expectations of future economic
growth
• Investment spending reflects how producers
view the future. Future expectations are shaped
by past performance.
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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.
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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.
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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.
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EXHIBIT 8
THE VOLATILITY OF INVESTMENT
Unlike consumption, which is fairly stable over time, investment is subject to erratic fluctuations even through
very short periods of time. The economic and technological factors that influence investment can sometimes
create the conditions for rapid expansion of investment and, just as quickly, reverse to cause investment to
fall just as rapidly, as we see in the annual rate of change in real investment spending over the years 1960 to
1995.
Source: Economic Report of the President 2006 (Washington, D.C.: United States Government Printing Office, 2006), p. 285.
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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.
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