Consumption, Savings And Investment

Consumption, Savings and Investment That part of the disposable income that is not consumed immediately is known as savings. Savings are the deferment of current consumption in favor of future consumption.

The Demand for Goods Consumption Consumption (C) (C) – The main determinant of consumption is disposable income (YD)

– The consumption function shows the relation between absolute disposable income (YD) and consumption (C), – C = C(YD) is a positive relationship meaning that increases in disposable income (YD) leads to increases in consumption (C)

Keynesian Consumption Function – C = C0 + C1YD – C1 = Marginal Propensity to Consume (MPC), is the change in consumption arising out of one unit change in income. – MPC = dC/dYD= C1

– In Keynesian theory MPC remains constant and lies between 0 & 1, – i.e. 0 < C1 < 1

Consumption (C) Average Propensity to Consume (APC) measures the average consumption expenditure per unit of income. Mathematically, APC = C/YD, – APC = C/YD =C0/YD, + C1 – Therefore, APC keeps declining as income rises. – C0 = C when YD is zero

Relationship between MPC and APC Since C = APC. YD MPC = dC/dYD = APC + YD . dAPC/dYD We know that dAPC/dYD <0 and YD>0 So MPC < APC, or APC exceeds MPC. With rise in income, APC will tend towards MPC Special Case: If APC is constant, then MPC = APC. In that case, consumption function passes through origin.

Consumption, c

Consumption and Disposable Income

Consumption function C = c0 + C1YD

Slope = MPC Slope=APC Disposable Income,YD

Savings Function – Income can either be spent for consumption or saved. Like consumption function, the savings function shows the relation between savings (S) and disposable income (YD)  S = S 0 + S 1Y D S1 = Marginal Propensity to Save (MPS), is the rate of change in savings arising out of one unit change in income. MPS = dS/dYD = S1

Savings Function (contd.) Average Propensity to Save (APS) measures the average savings consumption expenditure per unit of income. Mathematically, APS = S/YD = S0 /YD + S1 – Now, in 2-sector model Y=C+S Or S = Y – C S = Y – C0 + C1Y S = – C0 + (1 – C1)Y , comparing the earlier savings function we see that:

Savings Function (contd.) S0 = – C0 and S1 = (1 – C1) Or in other words, MPS = 1 – MPC. Since MPC is constant and lies between 0 & 1, MPS is also constant and lies between 0 & 1. 0 < S1 < 1 Again, since in 2-sector model Y=C+S Y/ Y =C/ Y +S/ Y 1 = APC + APS, or APS = 1-APC Given that APS = S/YD = S0 /YD + S1, as income rises, APS rises

Two Sector Keynesian Model Firms and Households Y=C+I Expenditure Approach Y = C + S Income Allocation At Equilibrium: C + I = Y = C + S Or in other words, the equilibrium condition can also be seen as equality between actual savings and actual investment; I = S

Equilibrium Income and Output Question: 1

Given C = 30+0.4Y and I =150, estimate what will be equilibrium level of income? What are C, S, APC, APS, MPC and MPS at equilibrium Y? Answer: Y = C+I = 30+0.4Y+150 Y-0.4Y = 30+150 Or, 0.6Y=180 So, Ye =180/0.6 = 300 MPC=0.4, So, MPS = 1-0.4= 0.6. APC = 30/Y + 0.4 = 30/300 + 0.4 = 0.5 APS = 1-0.5 = 0.5 Equilibrium C =30+0.4*300 = 150 Equilibrium savings = Ye-Ce= 300-150=150=I

Equilibrium Income with government Question 2: Let consumption depend on disposable income and consumption function is given by: C=50+0.75 (Y-T). Further assume that average tax rate is 20% and govt maintains a balanced budget (meaning that government expenditure, G is equal to taxes, T). If domestic private investment equals Rs.100 Crore, what is the equilibrium level of income, consumption, savings and taxes.

Equilibrium Income with government Solution: T = 0.2 * Y= govt expenditure (G) as govt maintains a balanced budget. C=50+0.75(Y-T)=50+0.75(Y-0.2Y) =50+0.6Y Y=C+S+T=50+0.6Y+100+ 0.2Y as S=I=100. Or, Y= 150+0.8Y Or, Y-0.8Y = 150. OR, Y=150/0.2=750. T=0.2*750=150 =G C=50+0.75 (750-150) = 500 S=Y-C-T=750-500-150=100 Check: Y=C+S+T=500+100+150=750 Y=C+I+G=500+100+150=750.

Alternative theories of Consumption •Relative Income Hypothesis of Duesenberry •Lifecycle Hypothesis of Ando-Modigliani •Permanent Income Hypothesis of Friedman

Relative Income Hypothesis Duesenberry’s theorem “Consumption of a family depends not only on its absolute income, but also on consumption pattern of neighbours, relatives. That is, everybody tries to keep up with the consumption pattern of the people they know. As a result, the same family might end up consuming a higher fraction of their income in a rich neighourhood. This is known as “Keeping up with the Joneses”.

Relative Income Hypothesis • Consumption is a function of relative income, rather than absolute income • Relative income depends upon the relative position of the individual in the income distribution • Absolute Income increases over time but relative income remains the same • As relative income remains constant, the consumption behaviour would remain stable • IMPLICATION: Therefore APC is constant in the Long run

Two Effects on Consumption • Demonstration Effect – APC does not fall as income rises; High propensity to consume for lower income groups. • Ratchet Effect- People can refrain from consuming more when their income rises, however they cannot reduce their consumption level immediately attained at the previous period with the fall in income in the current period. This explains short run fluctuations

Life Cycle Hypothesis • Consumption at a particular period is not a function of the current income but the function of the whole lifetime expected income • The entire income-earning period of an individual can be grouped into three periods  Early period when Income Consumption  Period after Retirement when Income
Diagram showing lifecycle Income Savings

Dissaving

15

25

Dissaving

Lifetime

65

75

• Suppose a consumer who expects to live another T years, has wealth of W and expects to earn income Y until she retires R years from now. • The consumer’s lifetime resources then consist of initial wealth, W + income earned till retirement, RY. And she can divide her lifetime resources among her T remaining years of life. • It is assumed that she wants to maintain her consumption all through her remaining years of life.

• Therefore, the consumer divides this W+RY equally over T years and each year consumes: • C = (W+RY)/T • Or C = (1/T)W+(R/T) Y; Or C = a W+b Y • If every individual plans consumption like this, then aggregate consumption function will also behave in a similar manner. Implication: APC = C/Y = a W/Y +b • IMPLICATION: In the long-run, wealth and income grow together, resulting in constant W/Y. Hence, APC in the long run is constant.

Life Cycle Hypothesis (concluded) • Short run non-proportionality is exhibited between Labour income as wealth is constant at a time point and assuming expected income to be proportional to labour income • Long run stability as wealth changes over time in the same proportion as labour income, due to the fact that wealth is accumulated from labour income

Permanent Income Hypothesis Proposed by Milton Friedman and his argument was that long term consumption is a function of long term expected income – Permanent Income. That is that income which is likely to persist. Y = Yp + Yt where Yp = permanent income Yt = transitory income Transitory income is the part of income that people do not expect to persist.

Permanent Income Hypothesis • According to this hypothesis, consumers spend their permanent income, but they save rather than consume most of their transitory income. • Therefore, Permanent Consumption is proportional to Permanent Income • Cp = kYp • IMPLICATION: According to this theory, • APC = Cp /Y = kYp/Y

Permanent Income Hypothesis • That is, APC depends on the ratio of permanent income to current income. When current income rises above permanent income, APC falls temporarily. • Friedman argued that year to year variation in income is more on account of changes in temporary income. • However, over long periods of time, variation in income comes from the permanent income. Therefore, in the long run, APC is constant.