3.

CONSUMPTION, SAVINGS AND INVESTMENTS

Consumption Function
C =  + Y

The function shows that consumption is an increasing function of income.

However, the marginal increase in consumption will be less than the marginal increase in income.
That is   1 .
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 
 = 
 Y 
The Consumption function is composed of autonomous consumption ( ) and induced
consumption ( ( Y ) .
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.

Graphically, the consumption function is presented as follows:

Y
Average propensity to consume, (APC) is the proportion of disposable income that is spent on
consumption. It is given by C/Y.
Therefore: from the above consumption function,
C  + Y 
APC = = = + ,
Y Y Y
C dc
MPC =  = =
Y dy

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

Given the consumption function, we can derive the savings function.

Suppose C =  + Y, then

S = Y -  − Y  S = -  + Y − Y ,

Therefore, S = −  + (1 −  )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. It
is given by S/Y, which implies that as income increases, APS decreases and vise versa.

Mathematically, the relationship between MPC and MPS is given as;

MPS = I – MPC  MPS + MPC = 1

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 =  + Y.
In Keynesian theory, savings is a function of income while investment is a function of interest rate
(r). In the long run, it is assumed that consumption entirely depends on income because with time
as Y becomes very large α disappears.
Diagrammatically this is shown as follows:

C = f(Y)
C

0 Y

Long run consumption function

In classical economics, savings is a function of interest rate i.e. S = f (r). It is assumed that
depending on the interest rate in commercial banks, households decide how much to save, before
devoting the balance to consumption i.e. C = Y – S and S = f(r). Note that in this case S is an
increasing function of interest rate hence C is a decreasing function of interest rate (r).
Whereas classical theory emphasizes consumption as a function of interest rates, Keynes’
emphasis is on income as the main determinant of consumption. Therefore, the following
inferences can be drawn:
- Consumption is a stable function of real income
- Generally, consumption increases as income increases, but not as much as the increase
in income
- Short run marginal propensity to consume is less than the long run marginal propensity
to consume.
- In the long run, a greater proportion of income will be saved as real income increases
hence the APC falls with increase in income.

Theories of Consumption
1. Absolute Income Hypothesis

This hypothesis was postulated by Keynes.

According to this hypothesis, consumption is a function of current level of disposable personal
income.
Consumption is directly, but not proportionately related to current level of aggregate disposable
income both in the short run and long run. This implies that C/Y decreases as income increases.
Keynes bases this assumption (disproportionate consumption change) on the argument that
consumers’ reaction to income change is not instant, but gradual since change in income may not
be permanent.
Therefore, Ct =  + Y t + dCt-1.

This means that consumption over time (Ct) is not only dependent on income overtime (Yt), but
also previous level of consumption (dCt-1)

2. The Relative Income Hypothesis

This hypothesis was put forth by James Duesenberry in 1949.

It makes two assumptions:
- Consumption behavior of individuals is interdependent.
- Consumption relations are irreversible over time.

(i) Consumption behavior of individuals is interdependent.

This means that the ratio of income consumed depends on the individual’s absolute income as well
as their relative income, i.e. consumption will depend on the individual’s percentile position in the
total income distribution within a community. In any given year, an individual will consume small
percentage of his/her income if increase in his/her income is accompanied by improvement in
his/her percentile position and vice versa. If his/her percentile position remains unchanged over
time, the individual will consume the same percentage of his/her income despite changes in the
absolute income.

(ii) Consumption relations are irreversible over time.

This assumption makes the relative income hypothesis to be referred to as previous peak theory.
It means that 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.

C = f(Y) = Long run consumption function.

C0 & C1 = short run consumption functions.
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.

Ratchet effect makes the consumer to move back along the short run consumption function
following a decrease in Y. When income falls back to Y0 consumption expenditure moves along
the short run consumption function C1 to point F from point B. F is clearly higher than A.

3. 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.
According to this hypothesis, permanent consumption (CP) is proportional to permanent income
(YP), i.e. CP = f(YP).
The ratio of consumption (CP) to induced consumption (βYP) is constant at all levels of income.
Income consists of two components namely: permanent income (YP) and transitory income (YT).
Transitory income refers to temporary unexpected rise or fall in income. It is given by the
difference between measured income (Y) and permanent income (Yp), i.e. Y = YP + YT.

Note that YT can be positive, negative or zero, and that the sum of transitory incomes for a group
of persons is equal to zero, i.e. ΣYT = 0.

Like measured income, measured consumption (C) has two parts, permanent consumption (CP)
which is the normal or planned level of spending and it is a function of permanent income, and
transitory consumption (CT) which is unplanned, temporary and is a function of transitory income.
Thus
C = CP + CT.
Since ΣYT = 0, then ΣCT = 0.
Therefore, we can write basic consumption function as a specific function in permanent income
given by
C = kYP,
Where k is the marginal propensity to consume

4. 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. Therefore, consumption is assumed to be a function of
lifetime income.

Graphically this is shown as follows:

C,S,Y

C
S>0,
Net saver S<0, Net dis-saver

S<0, Net borrower

0 Time (Years)
Where C = Consumption
Y = Income
S = Savings

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. This is why there is non-proportionality in income
and consumption relationship in the short run. In the long run however, consumption and income
relationship will be proportional.
Other Determinants of Consumption
1. Rate of Interest: According to classical economists, individuals will save more and
spend less as interest rate increases
2. Relative Prices: This influences consumption behaviour with consumers shifting to relatively
cheaper goods.
3. 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.
4. 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.
5. Money stock (Liquid assets): The higher the stock of liquid assets the higher the marginal
propensity to consume.
6. Availability of consumer credit: Readily available and/or cheap consumer credit leads to
consumers borrowing for consumption purposes. This pushes up the aggregate consumption
function.
7. 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.
8. Money Illusion: Consumption will go up when consumers suffer from money illusion. Money
illusion occurs when consumers fail to realize the price increase accompanying the increase in
their nominal income, thereby behaving as though their real income has increased when it has
not. Money illusion is also called Pigou or real cash balance effect.
9. 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.
10. Composition of Population: Population composition in terms of age, sex and class determines
consumption.

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

Types of Investment
1. Autonomous Investment (I0): This is investment that does not depend on the level of income.
It is determined by exogenous functions e.g. inventories, population growth, wealth changes,
research, etc.

2. Induced Investment: This is investment that depends on income or profit. It is influenced by

the factors, which affect income and profit e.g. prices, wages, interest, etc.
Induced investment is a function of income and is given by the equation
I = I0 +  Y,
Where  Y = Induced Investment
 = Marginal propensity to invest (MPI)
I0 = Autonomous Investment
MPI is the change in investment due to a unit change in income i.e. ΔI/ΔY, while API
is the ratio of investment to income i.e. I/Y.
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 is where capital stock accumulated due to
unexpected fall in demand.

5. Private Investment
 - It is investment made by private investors in an economy. It is normally made in
response to profit expectations. It depends on the interest rate and the marginal
efficiency of capital. It increases as the interest rate falls. It also increases as the
marginal efficiency of capital (MEC) increases.

6. Public Investment
- It is investment made by the government and other public enterprises.

Determinants of Investment
1. Interest rate (i): Investment is inversely related to interest rate.
2. 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.
3. Expected future income flows;- if the investor expects high profits, then investment will be
undertaken and vise versa
4. 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
5. Degree of certainty: An investor considers the risks and uncertainties involved in a particular
investment. if they are high he may not invest
6. 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.
7. 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
8. Business expectations; if businessmen are optimistic and confident regarding future returns
from capital goods they invest more.
9. Consumer demand; If the current demand for consumer goods is increasing rapidly, more
investments will be made
10. Liquid assets; If investors posses large liquid assets then their inducements to invest is high
11. Invention and innovation: If investments and technological improvements lead to more
efficient methods of production, which reduce costs, the marginal efficiency of new capital
assets will rise, hence firms will invest more.
12. New products; if sale prospects of the new product is high and the expected revenue more than
costs, investment will be encouraged
13. Population growth; this implies that there is a growing market (demand) for goods and services
that must be met by increased production hence investment will increase to provide the capital
goods required to increase production..
14. Government policy: Government can encourage investment through reduction in taxes and
provision of social amenities for those investing in particular sectors.
15. Political climate and stability; if there is political instability in the economy, investment will
adversely be affected.