CEC 3102:Introduction to Macroeconomics

Lecture two: Consumption, Savings, and Investment

Abdiaziz Ahmed
Department of Economics and Development Studies
University of Nairobi
Email: [email protected]

Venue:LT 301
March 12th 2024

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Table of Contents

1 Content of Lecture two

Consumption Function
Savings Function
Income as a Determinant of Consumption
Theories of Consumption
Investment Demand Theory

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Consumption Function

The consumption function can be represented as:

C = α + βYd (1)

Where:
1 C is consumption,
2 Yd is disposable income,
3 α is the intercept (autonomous consumption), and
4 β is the slope (marginal propensity to consume).
The marginal increase in consumption resulting from an increase in income is called marginal propensity to consume
(MPC).
MPC is the change in consumption arising from a unit change in income and is represented by

∆C
β = (2)
∆Y

The Consumption function is composed of autonomous consumption α and induced consumption βY .

The autonomous part of consumption does not depend on disposable income. Thus it is the consumption when income
is zero.
There is consumption at zero income because consumption also depends on other factors e.g. transfer payments and
savings.

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Consumption Function Contd
Graphically, the consumption function is presented as follows:

Average propensity to consume, (APC) is the proportion of disposable income that is spent on consumption. It is given
C .
by Y
Therefore: from the above consumption function,

C α + βY α
APC = = = +β (3)
Y Y Y

∆C dC
MPC = β = = (4)
∆Y dY

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Savings Function
It describes the total amount of savings at each level of disposable personal income.
Savings is the difference between disposable income and consumption. Savings function is given by:

S =Y −C (5)

Given the consumption function, we can derive the savings function. Suppose C = α + βY , then

S = Y − α − βY ⇒ S = −α + Y − βY , (6)

Therefore, S = −α + (1 − β)Y is the savings function.

The savings function is upward sloping, implying that savings is an increasing function of income.
The slope of the savings function is the marginal propensity to save (MPS).
MPS is the change in savings resulting from a unit change in personal disposable income.
The average propensity to save (APS) is the proportion of disposable personal income that is saved.
Mathematically, the relationship between MPC and MPS is given as;

MPS = 1 − MPC ⇒ MPS + MPC = 1 (7)

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Numerical example

In an economy, the population spend 500 million dollars on absolute necessities needed to sustain themselves. The
current income is 2500 dollars and MPC is 0.5. What is the level of consumption? The consumption equation is given
by:
C = 500 + 0.5 × 2500 = 500 + 1250 = 1750 (8)

So consumption is 1750 dollars.

Using the data in the table below,calculate the APC and APS at each level of disposable income given.
Disposable Income Consumption Saving APC APS
$0 $2,000 — — —
$2,000 $3,600 $1,600 1.8 0.8
$4,000 $5,200 $1,200 1.30 0.3
$6,000 $6,800 $800 1.13 0.13
$8,000 $8,400 $400 1.05 0.05
$10,000 $10,000 0 1.00 0
$12,000 $11,600 $400 0.97 0.03

1 How can savings be negative? Explain. People are borrowing or reducing their savings to be able to consume
at the particular level of income.
2 Calculate the MPC and MPS at each level of disposable income.

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Exercise

Using the data in table below,calculate the MPC and MPS at each level of disposable income.(This is not a typical
consumption function.Its purpose is to provide practice in calculating MPC and MPS.)
Disposable Income Consumption Saving APC APS MPC MPS
$12,000 $12,100 $-100 — — — —

$13,000 $13,000 0 — — — —
$14,000 $13,800 200 — — — —
$15,000 $14,500 500 — — — —
$16,000 $15,100 900 — — — —
$17,000 $15,600 1,400 — — — —

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Income as a Determinant of Consumption

Income is the major determinant of consumption. Keynesian consumption theory suggests that consumption is linearly
dependent on income so that in the short run,
C = α + βY (9)

In the long run, it is assumed that consumption entirely depends on income because with time as Y becomes very large
disappears.
Diagrammatically this is shown as follows:

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Theories of Consumption
Absolute Income Hypothesis was postulated by Keynes.According to this hypothesis, consumption is a function of
current level of disposable income.
It is a relationship between real income and real consumption. Real consumption is a function of real disposable income.
When real disposable income rises, real consumption will also go up but not necessarily at the same rate.
This means that consumption over time (Ct ) is not only dependent on income overtime but also previous level of
consumption.
The Relative Income Hypothesis was put forth by James Duesenberry in 1949.
It assumes that consumption relations are irreversible over time.
Consumption behavior of individuals is interdependent.
That is, when income falls during cyclical downswing the resultant fall in consumption will be less than proportionate
because individuals base their consumption patterns on previous levels of income.
When income increases, consumption increases proportionately, but when income falls below the previous peak,
consumption does not fall proportionately.

If income increases from Y0 to Y1, the consumer moves along the long run consumption function to Y1 and consumes
at point B from point A.
The increase in income causes the short run consumption function to shift from C0 to C1. However, a decrease in
income does not lead to a downward shift of the short run consumption. This is called the Ratchet effect.

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Theories of Consumption Contd
Permanent Income Hypothesis It was put forward by Friedman in 1957.
It states that consumption depends on permanent income. Permanent income is defined as the present value of the
expected flow of long-term income.
Put differently, this theory states that people will spend money at a level consistent with their expected long term
average income.
The level of expected long term income then becomes thought of as the level of ”permanent” income that can be safely
spent.
A worker will save only if his or her current income is higher than the anticipated level of permanent income, in order to
guard against future declines in income.
Life Cycle Income Hypothesis This hypothesis was formulated by Modigliani, Ando and Brumberg. It is therefore also
called the MBA hypothesis.
It states that consumption is a function of the expected stream of disposable income over a long period of time and the
present value of wealth.
Individuals are assumed to spread out the present value of all future income streams on consumption through-out their
lifetime.
Graphically this is shown as follows:

When, C > Y , the individual is borrowing to consume and build up human capital;
Y > C , the individual is paying loans and saving for future consumption, investment and for bequests; and when
C > Y , the individual is consuming out of savings, pension and social security fund.
According to the life cycle income hypothesis, the average propensity to consume (APC) is high in the early and late
years of an individual’s life.

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Other Determinants of Consumption

Rate of Interest: According to classical economists, individuals will save more and spend less as interest rate increases.
Relative Prices: This influences consumption behaviour with consumers shifting to relatively cheaper goods.
Capital gains: Capital gains: According to Keynes, windfall gains/losses will influence consumption.Keynes argued that
consumption of wealth owners can be influenced by sudden changes in the money value of their wealth. Sudden changes
are common where the stock exchange market is composed of speculators.
Wealth: High stocks of wealth lead to low marginal value of wealth and hence less desire to accumulate more. As a
result, this leads to increased consumption.
Attitudes and Expectations of Consumers: Both change in consumer attitudes and expectations affect their
consumption behaviour. If for instance, consumers expect a price increase of a certain good, they may increase their
current purchase of the same good.
Distribution of Income: Redistribution of income may cause a shift in the aggregate consumption function, or lead to
both a shift to a change in the slope of the function. It therefore affects the level of aggregate consumption, if the
recipients have different marginal propensity to consume and average propensity to consume.
Composition of Population: Population composition in terms of age, sex and class determines consumption.

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Investment Demand Theory
Investment refers to the addition of capital stock in an economy. Therefore, it is given by the value of that part of aggregate
output for any given year that takes the form of:
Construction of new structures
Changes in business inventories
New capital investment
It is investment made by the government and other public enterprises.
Types of investment
1 Autonomous Investment (I0 ): Investment not dependent on income level, determined by exogenous factors like
inventories, population growth, wealth changes, research, etc.
2 Induced Investment: Depends on income or profit, influenced by factors affecting income and profit (e.g., prices, wages,
interest). Given by:
I = I0 + λY ,

Where
λY = Induced Investment

λ = Marginal propensity to invest (MPI)

I0 = Autonomous Investment

3 Gross and Net Investment: Gross investment is the total increase in capital stock in a year. Net investment is the net
addition to capital stock in an economy after deducting capital consumption allowance from gross investment.
4 Intended and Unintended Investment: Intended (voluntary/planned) investment refers to deliberate accumulation of
capital stock aimed at achieving a specific objective. Unintended (involuntary/unplanned) investment occurs due to
unexpected fall in demand.

5 Private and Public Investment:

Private Investment: Made by private investors, responding to profit expectations, dependent on interest rate
and marginal efficiency of capital (MEC).
Public Investment: Made by the government and public enterprises.

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Determinants of Investment

Interest rate (i): Investment is inversely related to interest rate.

Internal rate of Return (IRR): It is the rate of interest that equates the present value of benefits from a project to the
present value of its costs. A decision to invest is based on the comparison between IRR and i. If IRR > i, investment is
made IRR < i, no investment IRR = i, other factors are considered in deciding whether or not to invest.
Expected future income flows;- if the investor expects high profits, then investment will be undertaken and vise versa
Initial cost of the capital good and its useful life: - if the capital good is affordable then it will be purchased and vise
versa. An investor will purchase a good that is likely to last longer.
Degree of certainty: An investor considers the risks and uncertainties involved in a particular investment. if they are
high he may not invest.
Existing stock of capital: If the existing capital is large potential investors may be discouraged. Similarly if there is
excess or idle capacity in existing capital stock, investment may be discouraged.
Level of income; a rise in the level of income in the economy due to rise in money wages and other factors prices raises
the demand for goods and services and this in turn will induce an increase in investment
Business expectations; if businessmen are optimistic and confident regarding future returns from capital goods they
invest more.
Consumer demand; If the current demand for consumer goods is increasing rapidly, more investments will be made.
Liquid assets; If investors posses large liquid assets then their inducements to invest is high.

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