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Chapter 21

Chapter 21. Consumption & Investment. GDP = C + I + G + ( X – M). GDP = C + I + G. GDP = C + I. What determines Consumption Spending?. Consumption is a function of income C = f(Y). John Maynard Keynes:. Author of “ The General Theory of Employment, Interest and Money ”.

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Chapter 21

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  1. Chapter 21 Consumption & Investment

  2. GDP = C + I + G + ( X – M) GDP = C + I + G GDP = C + I

  3. What determines Consumption Spending? Consumption is a function of income C = f(Y)

  4. John Maynard Keynes: Author of “The General Theory of Employment, Interest and Money”

  5. What was Keynes central idea? An economy can be in equilibrium at less than full employment.

  6. How did this idea differ from the Classical School view? The Classical Economists believed that the economy is always tending toward a full employment equilibrium

  7. Keynes’s View on Consumption: Consumers are guided by the “Fundamental Psychological Law” In terms of consumption, we all strive to achieve a “comfort zone”. Once we achieve that or are closer to it we do not need to increase our consumption as much with our income as we had done at lower levels of income.

  8. What is Keynes’ Absolute Income Hypothesis? As national income increases, consumption spending increases, but by diminishing amounts

  9. What is MPC? The ratio of the change inconsumption spendingto a given change inincome, that induces it. Change in Consumption Change in Income

  10. If household's income rises from $12,000 to $12,700 and consumption rises from $13,000 to $13,500, then MPC = $500 / $700 = .71

  11. According to the “Absolute Income Hypothesis”, What happens to the Marginal Propensity to Consume as income increases? MPC decreases as income increases and increases as income decreases

  12. The Consumption Function C 3200 DC RealConsumption 800 DY 4000 1000 Real Disposable Income

  13. An Individual’s Marginal Propensity to Consume

  14. An Individual’s Marginal Propensity to Consume

  15. The Individual’s Marginal Propensity to Consume 122

  16. The Nation’s Marginal Propensity to Consume 123

  17. Who was Simon Kuznets? He is the author of “National Income and Its Composition”, ...... won Nobel Prize in Economics in 1971 for his pioneering analysis of national income data.

  18. What did Kuznets conclude about MPC? His empirical research led to the conclusion that MPC tends to remain fairly constant regardless of the absolute level of national income

  19. The Marginal Propensity to Consume Remains Constant

  20. Duesenberry’s Relative Income Hypothesis: Because social status influences consumption spending, MPC remains constant as long as relative income remains unchanged.

  21. Autonomous Consumption: • Consumption spending that is independent of the level of income

  22. The Consumption Function C RealConsumption 500 Autonomous Consumption 0 Real Disposable Income

  23. The Consumption Equation? C = a + bY Income Autonomous Consumption MPC Induced Consumption

  24. Calculate C for each level of National Income (Y) 100 180 280 400 540 C = a + bY = 100 + = 50 + .5 (100) = 100 C = a + bY = 60 + .60 (200) = 180 C = a + bY = 70 + . 70 (300) = 280 C = a + bY = 80 + .80 (400) = 400 C = a + bY = 90 + .90 (500) = 540

  25. C2 C0 C1 Consumption National Income

  26. Will a change in Income cause a shift in C? No! When income changes there is a movement along a stationary Consumption Curve

  27. B Consumption A Consumption 0 National Income

  28. What can cause a shift in the Consumption Function? • Real assets & money holdings • Expectations of price changes • Interest rates • Taxation A change in...

  29. What is Saving? That part of national income not spent on consumption If, Y = C + S then, S = Y – C

  30. What is the Marginal Propensity to Save (MPS)? The Ratio of thechange in savingto thechange in income,which induced it.

  31. Lets assume that your income increases by $100. We observe that you increase your consumption by $80. What is your MPC? $60. 60 .60 40 .40

  32. MPC + MPS = 1 MPC = 1– MPS MPS = 1 – MPC

  33. At each Y level, calculate the MPC, MPS and the S – 60 . 80 . 20 – 40 . 80 . 20 – 20 . 80 . 20 0 . 80 . 20 20 . 80 . 20 100 MPC + MPS = 1 Y = C + S

  34. Isosceles $ in million 150 100 150 45o 100 45o 90o 0 100 150 Y in million $ 100

  35. C $ 45o 0 Y y* $ S 0 y* Y

  36. What determines Autonomous Investment? • Interest rate • Level of technology

  37. Apartment Bank 15% 9% Packaging 20% 11% Restaurant Coffee Shop Toy Store 12% 10% 8% 18%

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

  39. The Effect of Changes in the Rate of Interest on the Level of Investment 128

  40. C+Ii C,S C = a + by Ii 45o Y

  41. Why is investment volatile? Because factors that influence investment sometimes change in unison to create dramatic increases or decreases in investment

  42. Chapter 22: Equilibrium National Income: Keynesian Cross: Simplifying Assumptions: • There is no Government Sector. • There is no Foreign Sector. • There is no Depriciation.

  43. + Net Factor Payments from Abroad GDP = GNP GNP - Depreciation = NNP NNP – Indirect Business Taxes = NI GDP = NI

  44. From Producers’ Side: Y = C + Ii Y = C + Ii + G + (X-M) In other words, the producers decide how much of the total production would be investment goods and how much would be consumption good. Intended Consumption Y Y – Ii = Ci Intended Investment

  45. From Consumer’s Side: Y = C + S Consumers’ decide how much of Y (income) they want to consume and how much they want to save. Consumer’s consumption is determined by the consumption function. Which is,- C = a + bY

  46. From Consumer’s side, Y = C + S, where C = a + bY From Producer’s side, Y = Ci + Ii If, C = Ci then S = Ii The Economy will be inMacroequilibrium C = Ci Y = C + Ii C = Y - Ii

  47. Actual Investment (Ia):Investment spending that producers actually make --- that is, intended investment (Ii), plus unintended changes in inventories. Ia = Ii +  in Inventory

  48. C + Ii C C = a + bY a 0 Y Ii Ii 0 Y

  49. AE, C+Ii C,Ii,S C = a + by y1 c 45o y1 y* Y

  50. When, yi < y* Ci < C Ii > S Ia < Ii This signals the economy toExpand

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