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Chapter 21

Consumption and
Investment
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Economic Principles
Keyness absolute income
hypothesis
Duesenberrys relative income
hypothesis
Friedmans permanent income
hypothesis
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Economic Principles
Modiglianis 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 dont 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 persons 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 individuals income,
and, taken collectively, changes in
national income affect individual
and national consumption.
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Keyness 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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Keyness 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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Keyness Absolute Income


Hypothesis
Marginal propensity to consume
(MPC)
Consumption increases by diminishing
amounts as the income level increases.

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Keyness 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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Keyness 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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Keyness 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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Keyness 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 INDIVIDUALS MARGINAL PROPENSITY


TO CONSUME

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Exhibit 1: The Individuals


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 Individuals


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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Keyness Absolute Income


Hypothesis
To Keynes, national economies
behave like individuals. He
hypothesized that a nations MPC
depends on its level of national
income.

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EXHIBIT 2

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THE NATIONS MARGINAL PROPENSITY TO


CONSUME ($ BILLIONS)

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Exhibit 2: The Nations


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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Keyness Absolute Income


Hypothesis
The pioneering work of Simon
Kuznets showed that Keyness
hypothesis was wrong. A nations
MPC tends to remain fairly
constant regardless of the absolute
level of national income.
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Duesenberrys 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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Duesenberrys 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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Duesenberrys Relative
Income Hypothesis
An individuals MPC, then,
remains the same, as long as the
individuals 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 Duesenberrys
consumption curve in Exhibit 3
compare to Keyness consumption
curve in Exhibit 2?

Keyness 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 Duesenberrys
consumption curve in Exhibit 3
compare to Keyness consumption
curve in Exhibit 2?
Duesenberrys consumption curve is a
straight line, reflecting his belief that
MPC increases by the same amount as
income increases.
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Friedmans Permanent
Income Hypothesis
Permanent income hypothesis
A persons consumption spending is
related to his or her permanent income.

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Friedmans 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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Friedmans Permanent
Income Hypothesis
Transitory income
The unexpected gain or loss of income
that a person experiences. It is the
difference between a persons regular and
actual income in any year.

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Friedmans Permanent
Income Hypothesis
According to Friedman, an
unexpected gain or loss in income
in one year does not influence an
individuals overall MPC from
year to year.

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Modiglianis Life-Cycle
Hypothesis
Life-cycle hypothesis
Typically, a persons 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
havent 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).

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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?
o

Income curve or 45 line


A line, drawn at a 45o 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 SAVINGS CURVE

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EXHIBIT 5B THE SAVINGS CURVE

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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.

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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

that producers intend to undertake. These intended investments

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What Determines
Investment?
The level of national income
doesnt 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 economys autonomous
investment.

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What Determines
Investment?
1. Technology level.

ologies is one of the mainsprings of investment. Technological

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What Determines
Investment?
2. Interest rate.

ent when they believe the rate of return generated by the investm

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What Determines
Investment?
2. Interest rate.

nverse relationship between the rate of interest and the quantity

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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.

ng reflects how producers view the future. Future expectations

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What Determines
Investment?
4. Rate of capacity utilization.

o operate at 100 percent capacity. Operating at less than 100 per

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What Determines
Investment?
4. Rate of capacity utilization.

end up choosing influences the economys level of production.

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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

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.

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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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