Consumption

, Saving and
Investment
Dr. Shylajan, C.S

Topics of Discussion

Aggregate Demand (AD)

Components of AD
Consumption Demand
Consumption Function
What Determines Aggregate
Consumption Expenditure?
Consumption and Saving
Marginal Propensity to Consume
(MPC)
Marginal Propensity to Save

Aggregate Demand

Recall expenditure method of

estimating national output

Y= C + I + G + NX

Aggregate Demand

Where,
stands for actual GDP
or output and

C + I + G + NX

stands
for Aggregate Demand for
Four sector model

Aggregate Demand
has four components
Total spending on
1. Consumption goods and service (C)
by
the private sector
2. Investment goods and services (I)
by
the private sector

Aggregate Demand has

four components
3. C and I by the Government sector
(G)

4.

C and I by the External sector (X)

minus all imports

Why do we need to know

about Aggregate
Demand?

Let us assume that we are

investigating a economic slowdown
in large parts of East Asia.

In these economies, aggregate

demand is driven by the external
demand (demand for goods and
services originating from foreigners
(X)

Why do we need to know

about Aggregate
Demand?

So external sector demand (X)

growth is key to revival of the
East Asian economies.

In US economy - growth of
consumption demand (C )
Hence we have to stimulate C
part of AD

Consumption Demand
Y = C + I + G + NX
Aggregate expenditure on current
consumption of final goods and service
Examples?
Food, Fuel, clothing, education, medical
expenses etc

A Consumption
Function
for
a Household
The relationship
between consumption

and income is called the consumption

function.
The consumption
function for an
individual household
shows the level of
consumption at each
level of household
income.

Consumption
Function
Marginal Propensity to
Consume (MPC)

The change in
consumption expenditure
in response to a change
in disposable income.

Consumption
Function

Disposable income (Y) is divided between

consumption and saving.

Y=

C+S

=a+bY

=Y-C

Consumption
Function
C

=a+bY

The slope of the consumption function

(b) is called the marginal propensity
to consume (MPC)

0<b<1

Consumption
Function

C = 50 + 0.75 Y
If disposable income increases by Rs 100 and
Rs. 75 of this increase is spent on current
consumption, the MPC is 0.75

Balance is saved.

So Marginal Propensity to Save (MPS) is

MPC.
MPC + MPS = 1

1-

Consumption
Function

Consumption demand (c ) is the most

important component of aggregate demand
in India.

Private sector consumption expenditure in

India two thirds of GDP

On food (43 %), transport and

communication (13 %), rent, fuel, power etc
(11 %), medical care (7 %), clothing,
footwear (5 %) and others

Saving Function

Shows the relationship between the

level of saving and income.

Marginal Propensity to Save (MPS)

is the extra saving generated by an
extra amount of disposable income.

MPS = 1 - MPC

What determines Household

consumption expenditure?
Some Theories
1. Current Household
Disposable income
2. Relative Income Hypothesis
3. Households Permanent
Income
4. Household Wealth
5. Life-Cycle Model
Any other factors?

Keynesian Theory

Consumption is a function of
current income
Short run theory
Mpc is between 0 and 1
MPC declines as income increases

Permanent Income
Theory-Milton
Friedman
Not current income but permanent

income
PI is all the income anticipated in the
long run (labor income +Capital
Income).
The level of income that households
would receive when temporary or
transient influences such as the
whether, a short business cycle or a
windfall gain or loss- are removed.

INVESTMENT FUNCTION
Topics of Discussion
Investment

Function and AD
What is Investment Demand?
What determines Aggregate
Investment Spending?
The Investment Demand Curve
Shifts in Investment Demand
Curve

Investment Demand

Y = C + I + G + NX
Second major component
of Aggregate Demand

Investment Demand

Total Spending for

Purchase of new assets, which help

in the production of future goods
and services.

It is additions to the stock of

productive assets like capital goods

Investment spending
Examples:
Purchase

of new machinery,
expenditure on setting up a new
power plant etc
Capital goods which are used in
the production process
Additions to inventory

Investment Demand

Capital stock is the rupee value of

new plants, capital equipments,
machinery etc at a given point of
time.
Gross domestic invt 24% of GDP in
2000-01 and 39% in 2005-06
It is highly fluctuating in India

Investment and economic

growth correlated ?

What determines Aggregate

Investment Spending?
Policy-Induced

Factors and
(taxes, interest rates etc)
Sentiment

Driven Factors
(Expectations)

What determines Aggregate

Investment Spending?

I = f ( Y, r)

Benefits and Costs

Investment is undertaken for future

production.

Investments are planned on the basis of

expected rate of return on investment

What determines Aggregate

Investment Spending?

Expectations and Business Confidence

How are expectations formed?

If investors feel they can sell more at a

later date, they will invest in new capital
stock (expectations on economic recovery
in the future)

On Cost side, major determinants are

What determines Aggregate

Investment Spending?

Interest rate and

Tax policy

The lower the cost of borrowing of capital,

the larger would be the demand for
investment.

How can monetary and fiscal

authority influence domestic
investment spending?

What determines Aggregate

Investment Spending?

Reducing Interest rate, reducing corporate

income tax, increasing investment subsidy
etc
Investment also has two components:

Induced component (policy variable can

influence. Eg: income or interest rate) and
Autonomous component (independent of
income. It is subjective: business optimism)

The Investment
Demand Curve

Relationship between interest

rate and investment

Investment spending (X axis) and

Interest Rate (Y axis)

It is downward sloping. Why?

Shifts in the
Investment Demand
Curve
Factors other than interest rate also
affect investment spending.

What are they?

Current Investment slow down in

India.

What are the reasons?

Current Investment
slow down in India

Reasons?

Economic

growth?
Business Confidence?

Summary

Investment is the most volatile component

of AD

Investment fluctuations and business

cycles are highly correlated

Knowledge of consumption and

investment spending is important for the
study of equilibrium income determination,
impacts of fiscal and monetary policy etc.