1 Chapter 21 Consumption & Investment 4/13/2015 © ©1999 South-Western College Publishing

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Chapter 21Chapter 21Chapter 21Chapter 21Consumption & Consumption &

InvestmentInvestment

04/18/23

©©1999 South-Western College Publishing

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What is the What is the Consumption Function?Consumption Function?

What is the What is the Consumption Function?Consumption Function?The relationship between

consumption and income

C = F(Y)


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The Consumption FunctionThe Consumption Function

Real Disposable Income

Rea

l Con

sum

ptio

n

CC

Y


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What is Saving?What is Saving?What is Saving?What is Saving?That part of national

income not spent on consumption


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Income

C

45o

Saving

Consumption FunctionC

onsu

mpt

ion,

Sav

ing

5©©1999 South-Western College Publishing

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Y

C

45o

6

C, S

Y1 Y2Y3

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On the previous graph, At Y1, C=Y, so S=0At Y2, C<Y, positive savingsAt Y3, C>Y, negative savings

(dissaving

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What is the What is the Marginal Marginal Propensity to consume Propensity to consume

((MPC)?MPC)?

What is the What is the Marginal Marginal Propensity to consume Propensity to consume

((MPC)?MPC)?Change in consumption

brought about by a change in income (the slope of the consumption function)

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What is the Marginal What is the Marginal Propensity to Propensity to Save(MPS)?Save(MPS)?

What is the Marginal What is the Marginal Propensity to Propensity to Save(MPS)?Save(MPS)?

The change in saving induced by a change in income


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MPC = ΔC/ ΔYMPC = ΔC/ ΔY

MPS = ΔS/ ΔYMPS = ΔS/ ΔY

Example: Y = 500, C = 400, S = 100Example: Y = 500, C = 400, S = 100YY11 = 600, C = 600, C11 = 480, S = 480, S11 = 120 = 120ΔY= 100, ΔC = 80, ΔS=20ΔY= 100, ΔC = 80, ΔS=20

so MPC = 80/100 = .8so MPC = 80/100 = .8MPS = 20/100 = .2MPS = 20/100 = .2

MPC = ΔC/ ΔYMPC = ΔC/ ΔY

MPS = ΔS/ ΔYMPS = ΔS/ ΔY

Example: Y = 500, C = 400, S = 100Example: Y = 500, C = 400, S = 100YY11 = 600, C = 600, C11 = 480, S = 480, S11 = 120 = 120ΔY= 100, ΔC = 80, ΔS=20ΔY= 100, ΔC = 80, ΔS=20

so MPC = 80/100 = .8so MPC = 80/100 = .8MPS = 20/100 = .2MPS = 20/100 = .2

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Note that Note that MPC + MPSMPC + MPSmust equal 1must equal 1

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If household's income rises If household's income rises from $30,000 to $33,000 and from $30,000 to $33,000 and

consumption rises from consumption rises from $28,000 to $30,000, then$28,000 to $30,000, then

MPC = $2000 / $3,000 = .67 MPS = $1000 / $3,000 = .33


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What isWhat isAutonomous Consumption?Autonomous Consumption?

What isWhat isAutonomous Consumption?Autonomous Consumption?

Consumption spending that is independent of the level of income


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What is significant about What is significant about Autonomous Consumption?Autonomous Consumption?

What is significant about What is significant about Autonomous Consumption?Autonomous Consumption?

Even when income is zero, autonomous spending is positive


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The Consumption FunctionThe Consumption Function


Rea

l Con

sum

ptio

n

CC

Y a

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What is theWhat is theConsumption Equation?Consumption Equation?

What is theWhat is theConsumption Equation?Consumption Equation?

C = a + bY


Autonomous Consumption

MPC

Income

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Many theories of the Many theories of the consumption functionconsumption functionMany theories of the Many theories of the consumption functionconsumption function

Note that a straight line C function assumes a constant MPC

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Who wasWho wasJohn Maynard Keynes?John Maynard Keynes?

Who wasWho wasJohn Maynard Keynes?John Maynard Keynes?Economist who had a

book published in 1936 named “The General Theory of Employment, Interest and Money”


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What is Keynes’ Absolute What is Keynes’ Absolute Income Hypothesis?Income Hypothesis?

What is Keynes’ Absolute What is Keynes’ Absolute Income Hypothesis?Income Hypothesis?

As income increases, consumption spending increases, but by diminishing amounts


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According to the absolute According to the absolute income hypothesis, What income hypothesis, What happens to the MPC as happens to the MPC as

income increases?income increases?

According to the absolute According to the absolute income hypothesis, What income hypothesis, What happens to the MPC as happens to the MPC as

income increases?income increases?

MPC decreases as income increases and increases as income decreases


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Who was Simon Kuznets?Who was Simon Kuznets?Who was Simon Kuznets?Who was Simon Kuznets?An economists who

published a book in 1941 named “National Income and Its Composition”


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What did Kuznets What did Kuznets say in his book?say in his book?

What did Kuznets What did Kuznets say in his book?say in his book?

MPC tends to remain fairly constant regardless of the absolute level of national income


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What is Duesenberry’s What is Duesenberry’s Relative Income Hypothesis?Relative Income Hypothesis?

What is Duesenberry’s What is Duesenberry’s Relative Income Hypothesis?Relative Income Hypothesis?People consume according to their

relative position in society, consistent with the idea that the MPC remains fairly constant as national income increases


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What is the Permanent What is the Permanent Income Hypothesis?Income Hypothesis?

What is the Permanent What is the Permanent Income Hypothesis?Income Hypothesis?

A person’s consumption spending is related to his or her permanent income


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What isWhat isPermanent Income?Permanent Income?

What isWhat isPermanent Income?Permanent Income?

The regular income a person expects to earn annually


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Who is Milton Friedman?Who is Milton Friedman?Who is Milton Friedman?Who is Milton Friedman?An economists who won

the Nobel Prize in Economics in 1976


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What is Friedman’s What is Friedman’s contribution to Income contribution to Income

Hypothesis?Hypothesis?

What is Friedman’s What is Friedman’s contribution to Income contribution to Income

Hypothesis?Hypothesis?People distinguish between

their regular income and income they expect to make or lose in any one year


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Who isWho isFranco Modigliani?Franco Modigliani?

Who isWho isFranco Modigliani?Franco Modigliani?

An economists who won the Nobel Prize in Economics in 1985


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What is Modigliani’s What is Modigliani’s Life Cycle Hypothesis?Life Cycle Hypothesis?What is Modigliani’s What is Modigliani’s

Life Cycle Hypothesis?Life Cycle Hypothesis?Typically, a person’s MPC

is relatively high during young adulthood, decreases during middle age, and then increases


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What can cause a shift in What can cause a shift in the Consumption Function?the Consumption Function?What can cause a shift in What can cause a shift in

the Consumption Function?the Consumption Function?• Real assets & money holdings• Expectations of price changes• Credit & interest rates• Taxation


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Rea

l Con

sum

ptio

n C1

C2


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For more information For more information on income data:on income data:

For more information For more information on income data:on income data:

http://www.census.gov/hhes/www/income.htmlhttp://www.bea.doc.gov/bea/dn/pitbl.htmhttp://www.bls.gov/eag.table.html


http://www.census.gov/hhes/www/income.html

http://www.census.gov/hhes/www/income.html

http://www.bea.doc.gov/bea/dn/pitbl.htm

http://www.bea.doc.gov/bea/dn/pitbl.htm

http://www.bls.gov/eag.table.html

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Will a change in Income Will a change in Income cause a shift in C?cause a shift in C?

Will a change in Income Will a change in Income cause a shift in C?cause a shift in C?

No! When income changes there is a movement along a stationary Consumption Function Curve


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Rea

l Con

sum

ptio

n

Consumption Income LineA

B


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What isWhat isIntended Investment?Intended Investment?

What isWhat isIntended Investment?Intended Investment?

Investment spending that producers intend to undertake, on plant, tools, construction, and inventory


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What isWhat isAutonomous Investment?Autonomous Investment?

What isWhat isAutonomous Investment?Autonomous Investment?

Investment that is independent of the level of income


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National Income

45o

Inv

estm

ent

37

I

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What determines What determines Autonomous Investment?Autonomous Investment?

What determines What determines Autonomous Investment?Autonomous Investment?• Level of technology• Interest rate• Expectations of growth• Rate of capacity utilization


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National Income

C

45oCon

sum

ptio

n, S

avin

g

39

(C+I)

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Why is Investment Volatile?Why is Investment Volatile?Why is Investment Volatile?Why is Investment Volatile?Because what can change

investors expectations is unpredictable sometime


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• What determines Consumption?• What is Keynes’ Absolute Income

Hypothesis?• What is MPC? • What happens to MPC as income in

creases?• What did Kuznets say in his book?• What is Duesenberry’s Relative

Income Hypothesis?

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• What is the Permanent Income Hypothesis?

• What is Friedman’s contribution to Income Hypothesis?

• What is Modigliani’s Life Cycle Hypothesis?

• What is Autonomous Consumption?• What is Saving?• What is the MPS?• What is Autonomous Investment?

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Documents

1 Chapter 21 Consumption & Investment 4/13/2015 © ©1999 South-Western College Publishing