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Chapter 21

Chapter 21. Consumption and Investment. Economic Principles. Keynes’s absolute income hypothesis Duesenberry’s relative income hypothesis Friedman’s permanent income hypothesis. Economic Principles. Modigliani’s life-cycle hypothesis The marginal propensity to consume

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Chapter 21

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  1. Chapter 21 Consumption and Investment Gottheil — Principles of Economics, 6e

  2. Economic Principles • Keynes’s absolute income hypothesis • Duesenberry’s relative income hypothesis • Friedman’s permanent income hypothesis Gottheil — Principles of Economics, 6e

  3. Economic Principles • Modigliani’s life-cycle hypothesis • The marginal propensity to consume • The marginal propensity to save • Autonomous investment Gottheil — Principles of Economics, 6e

  4. What Determines Consumption Spending? Consumption-spending and consumption-production decisions are made simultaneously and independently of each other. Gottheil — Principles of Economics, 6e

  5. What Determines Consumption Spending? The result is that sometimes consumers don’t buy enough of everything produced and other times producers do not produce as much as people want to consume. Gottheil — Principles of Economics, 6e

  6. What Determines Consumption Spending? Consumption function • The relationship between consumption and income. It is written as C = f(Y), where C represents consumption and Y represents income. Gottheil — Principles of Economics, 6e

  7. What Determines Consumption Spending? The single most important factor influencing a person’s consumption spending is his or her level of disposable income. The greater the disposable income, the greater the consumption spending. Gottheil — Principles of Economics, 6e

  8. What Determines Consumption Spending? A number of hypotheses have been offered to explain how changes in an individual’s income, and, taken collectively, changes in national income affect individual and national consumption. Gottheil — Principles of Economics, 6e

  9. Keynes’s Absolute Income Hypothesis Absolute income hypothesis • As national income increases, consumption spending increases, but by diminishing amounts. That is, as national income increases, the marginal propensity to consume (MPC) decreases. Gottheil — Principles of Economics, 6e

  10. Keynes’s Absolute Income Hypothesis Marginal propensity to consume (MPC) • The ratio of the change in consumption spending to a given change in income. • MPC = (Change in C)/(Change in Y) Gottheil — Principles of Economics, 6e

  11. Keynes’s Absolute Income Hypothesis Marginal propensity to consume (MPC) • Consumption increases by diminishing amounts as the income level increases. Gottheil — Principles of Economics, 6e

  12. Keynes’s Absolute Income Hypothesis Keynes believed that although people who earn high incomes spend more on consumption than people who earn less, they are less inclined to spend as much out of a given increase in income than those earning less. Gottheil — Principles of Economics, 6e

  13. Keynes’s Absolute Income Hypothesis Keynes relied on the psychological law that the satisfaction of “immediate primary needs” is a stronger motive for consumption than “accumulation.” Gottheil — Principles of Economics, 6e

  14. Keynes’s Absolute Income Hypothesis For example, if a millionaire and a welfare recipient each received $500, the millionaire would likely just add the money to her savings account since her primary needs are already met. Gottheil — Principles of Economics, 6e

  15. Keynes’s Absolute Income Hypothesis The welfare recipient, on the other hand, would likely immediately spend the money on food, clothing, and shelter. Gottheil — Principles of Economics, 6e

  16. EXHIBIT 1 THE INDIVIDUAL’S MARGINAL PROPENSITY TO CONSUME Gottheil — Principles of Economics, 6e

  17. Exhibit 1: The Individual’s Marginal Propensity to Consume 1. What is the change in consumption as total income increases from $1,000 to $2,000 in Exhibit 1? • Consumption increases by $800 (from $1,400 to $2,200) as total income increases by $1,000. Gottheil — Principles of Economics, 6e

  18. Exhibit 1: The Individual’s Marginal Propensity to Consume 2. What is the change in consumption as total income increases from $2,000 to $3,000? • Consumption increases by $700 (from $2,200 to $2,900) as total income increases by $1,000. Gottheil — Principles of Economics, 6e

  19. Keynes’s Absolute Income Hypothesis To Keynes, national economies behave like individuals. He hypothesized that a nation’s MPC depends on its level of national income. Gottheil — Principles of Economics, 6e

  20. EXHIBIT 2 THE NATION’S MARGINAL PROPENSITY TO CONSUME ($ billions) Gottheil — Principles of Economics, 6e

  21. Exhibit 2: The Nation’s Marginal Propensity to Consume What happens to the national MPC as national income increases in Exhibit 2? • The national MPC increases, but by diminishing amounts. Gottheil — Principles of Economics, 6e

  22. Keynes’s Absolute Income Hypothesis The pioneering work of Simon Kuznets showed that Keynes’s hypothesis was wrong. A nation’s MPC tends to remain fairly constant regardless of the absolute level of national income. Gottheil — Principles of Economics, 6e

  23. Duesenberry’s Relative Income Hypothesis Relative income hypothesis • As national income increases, consumption spending increases as well, always by the same amount. That is, as national income increases, MPC remains constant. Gottheil — Principles of Economics, 6e

  24. Duesenberry’s Relative Income Hypothesis According to Duesenberry, consumption spending is rooted in status. High-income people not only consume more than others, but also set consumption standards for everyone else. Gottheil — Principles of Economics, 6e

  25. Duesenberry’s Relative Income Hypothesis An individual’s MPC, then, remains the same, as long as the individual’s relative income position remains unchanged. Gottheil — Principles of Economics, 6e

  26. EXHIBIT 3 THE MARGINAL PROPENSITY TO CONSUME REMAINS CONSTANT Gottheil — Principles of Economics, 6e

  27. Exhibit 3: The Marginal Propensity to Consume Remains Constant How does Duesenberry’s consumption curve in Exhibit 3 compare to Keynes’s consumption curve in Exhibit 2? • Keynes’s consumption curve flattens near the top, reflecting his belief that MPC increases by diminishing amounts as income increases. Gottheil — Principles of Economics, 6e

  28. Exhibit 3: The Marginal Propensity to Consume Remains Constant How does Duesenberry’s consumption curve in Exhibit 3 compare to Keynes’s consumption curve in Exhibit 2? • Duesenberry’s consumption curve is a straight line, reflecting his belief that MPC increases by the same amount as income increases. Gottheil — Principles of Economics, 6e

  29. Friedman’s Permanent Income Hypothesis Permanent income hypothesis • A person’s consumption spending is related to his or her permanent income. Gottheil — Principles of Economics, 6e

  30. Friedman’s Permanent Income Hypothesis Permanent income • Permanent income is the regular income a person expects to earn annually. It may differ by some unexpected gain or loss from the actual income earned. Gottheil — Principles of Economics, 6e

  31. Friedman’s Permanent Income Hypothesis Transitory income • The unexpected gain or loss of income that a person experiences. It is the difference between a person’s regular and actual income in any year. Gottheil — Principles of Economics, 6e

  32. Friedman’s Permanent Income Hypothesis According to Friedman, an unexpected gain or loss in income in one year does not influence an individual’s overall MPC from year to year. Gottheil — Principles of Economics, 6e

  33. Modigliani’s Life-Cycle Hypothesis Life-cycle hypothesis • Typically, a person’s MPC is relatively high during young adulthood, decreases during the middle-age years, and increases when the person is near or in retirement. Gottheil — Principles of Economics, 6e

  34. What Determines Consumption Spending? Autonomous consumption • Consumption spending that is independent of the level of income. Gottheil — Principles of Economics, 6e

  35. What Determines Consumption Spending? Some consumption spending is simply unavoidable. While individuals may spend less on food, clothing, and shelter when income falls, there are limits to how much one can cut and still survive. Gottheil — Principles of Economics, 6e

  36. What Determines Consumption Spending? A change in national income induces a change in consumption. The change in consumption is considered movement along the consumption curve. Gottheil — Principles of Economics, 6e

  37. What Determines Consumption Spending? The consumption curve can also shift. Shifts in the consumption curve are unrelated to national income. There are several factors that can shift the consumption curve. Gottheil — Principles of Economics, 6e

  38. What Determines Consumption Spending? 1. Real asset and money holdings • An increase or decrease in real assets or money holdings causes the consumption curve to shift. For example, a substantial inheritance of money or property would cause the curve to shift upward. Gottheil — Principles of Economics, 6e

  39. What Determines Consumption Spending? 2. Expectations of price changes • An expectation of inflation could cause an increase in the current level of consumption, even though incomes are not expected to change. The increase in consumption would shift the curve upward. Gottheil — Principles of Economics, 6e

  40. What Determines Consumption Spending? 3. Credit and interest rates • If credit is more easily available or if the credit terms are made more attractive, people are likely to increase their spending on durable goods, even if their incomes haven’t changed. The consumption curve would shift upward. Gottheil — Principles of Economics, 6e

  41. What Determines Consumption Spending? 4. Taxation • If government decided to increase the income tax, people would end up with a smaller pay check, even though their salaries remained unchanged. This would cause a decrease in consumption and a downward shift in the consumption curve. Gottheil — Principles of Economics, 6e

  42. EXHIBIT 4 SHIFTS IN THE CONSUMPTION CURVE Gottheil — Principles of Economics, 6e

  43. Exhibit 4: Shifts in the Consumption Curve The consumption curve shifts depicted in Exhibit 4 can be attributed to increases and decreases in national income. i. True ii. False Gottheil — Principles of Economics, 6e

  44. Exhibit 4: Shifts in the Consumption Curve The consumption curve shifts depicted in Exhibit 4 can be attributed to increases and decreases in national income. i. True ii. False. Shifts in the consumption curve are unrelated to changes in national income. Gottheil — Principles of Economics, 6e

  45. The Consumption Equation There are two key factors that influence the character of our consumption spending: autonomous consumption and our income level. Gottheil — Principles of Economics, 6e

  46. The Consumption Equation Consumption induced by our level of income is referred to as induced consumption. Gottheil — Principles of Economics, 6e

  47. The Consumption Equation The consumption function takes the following form: C = a + bY Where a equals autonomous consumption spending, b equals MPC, and Y equals level of national income. Gottheil — Principles of Economics, 6e

  48. What Determines the Level of Saving? People do two things with their income. They either spend it on consumption or they save it. Gottheil — Principles of Economics, 6e

  49. What Determines the Level of Saving? Saving • The part of national income not spent on consumption. • S = Y – C Gottheil — Principles of Economics, 6e

  50. What Determines the Level of Saving? Saving • When C is greater than Y, saving is negative and is called dissaving. People can consume more than their income allows by running down their savings or other forms of accumulated wealth. Gottheil — Principles of Economics, 6e

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