CHAPTER 21 CONSUMPTION AND INVESTMENT

1. CHAPTER 21CONSUMPTION AND INVESTMENT The Absolute Income Hypothesis

2. Keynesian Consumption Function John M. Keynes: The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge and from detailed facts of experience, is that men are disposed, as a rule and on average, to increase in their consumption as their income increases, but not by as much as the increase in their income. C = a + bYD a>0 0<b<1 C = real consumption a = autonomous consumption YD = real disposable income b = marginal propensity to consume

3. Average Propensity To Consume Consumption, C 45° C = a + bYD APC = the ratio of consumption to disposable income C = a + bYD APC = C/YD = a + bYD YD = a/YD + b ΔC ΔYD a YD ° Disposable income, YD

4. Marginal Propensity To Consume MPC: the increase in consumption per unit increase in disposable income measured by parameter b in the consumption function measured by the slope of the consumption function MPC = ΔC / ΔYD MPC = b Compared to APC … APC = a/YD + b APC is greater than MPC by a/YD

5. APC > MPC Given a consumption function, C = 20 + 0.5YD whereby MPC = 0.5 (i) when YD begins at 100, C = 20 + 50 = 70 (ii) when YD increases by 100 to 200, C = 20 + 100 = 120 (ii) when YD increases further by 100 to 300, C = 20 + 150 = 170 APC in (i) = 70/100 = 0.7 APC in (ii) = 120/200 = 0.6 APC in (iii) = 170/300 = 0.57 As income increases, households consume a smaller fraction of income. APC > MPC but APC is declining

6. Average Propensity To Save APS = the ratio of saving to disposable income. C = a + bYD S = YD – [a + bYD] APC = C/YD APS = S/YD = a + bYD = YD – a – bYD YD YD = a/YD + b = 1 – a/YD – b = 1 – b – a/YD

7. Marginal Propensity To Save MPS: the increase in saving per unit increase in disposable income measured by the slope of the consumption function = 1-b MPS = ΔS / ΔYD MPS = 1 – b Compared to APS … APS = 1 – b – a/YD APS is smaller than MPS by a/YD Although the MPC and MPS measures the tendency of people to spend/save, the APC and APS helps measure the actual average consumption and savings done by households when YD changes.

8. APS < MPS Given a consumption function, C = 20 + 0.5YD whereby MPS = 0.5 when YD begins at 100, C = 20 + 50 = 70, S = 100 – 70 = 30 (ii) when YD increases by 100 to 200, C = 20 + 100 = 120, S = 200 – 120 = 80 when YD increases further by 100 to 300, C = 20 + 150 = 170, S = 300 – 170 = 130 APS in (i) = 30/100 = 0.3 APS in (ii) = 80/200 = 0.4 APS in (iii) = 130/300 = 0.43 As income increases, households save a larger fraction of income. APS < MPS but APS is increasing

9. APS versus MPS Consumption, C At YD°, consumption equals disposable income, C = YD. Below YD°: C > YD, S < 0 negative APC > 1, APS negative Above YD°: C < YD, S > 0 positive APC < 1, APS positive 45° C = a + bYD ΔC ΔYD a YD ° Disposable income, YD

10. Absolute Income Hypothesis (1936) Proposed by English economist John Maynard Keynes (1883-1946) as part of his work on the relationship between income and consumption, absolute income hypothesis was much refined during the 1960s and 1970s, notably by American economist James Tobin (1918-2002). Consumption is a non-linear function of income. As income rises, consumption will rise but not necessarily at the same rate. [http://www.economyprofessor.com/economictheories/absolute-income-hypothesis.php] C = a + bYD a>0 0<b<1 APC > MPC but APC is declining, APS < MPS but APS is rising.

11. The Stagnation Thesis This consumption function has the property that as income increases the APC falls. Income Consumption APC 10000 8207 0.821 11000 8987 0.817 12000 9767 0.814 This generated the concerns about the long run properties of the economy termed ‘the Stagnation Thesis’. As incomes rose savings would rise and investment would fail to respond. This ‘glut’ of savings would depress national income and employment and the economy would permanently stagnate. [http://www.economics.strath.ac.uk/julia/teaching/mf/L3_JS.pdf]

12. 1921-1941 Keynesian economists estimated C = 26.5 + 0.75YD Data also supports that: before the intersection between C and the 45° line = APC > 1 and APS is negative; after the intersection = APC < 1 and APS is positive. This shows that APC declines whereas APS increases; people tend to spend a smaller portion of income and save a larger portion of income as their income rises. Keynesians believe that the relationship between C and YD is not proportional due to the autonomous consumption, a. Hence the concern that as income rises and people save more than they spend, demand may fall and affect the economy, unless, balanced by growth in govt. spending (G) or investment (I).

13. Family Budget Consumption, C 45° C = a + bYD A family budget comparative study found that families with progressively higher incomes have: 0 < b < 1 and a declining APC. a Disposable income, YD

14. 1869 – 1938 Consumption, C 45° C = 0.9YD Simon Kuznets examined the real national income (Y) and the consumption-income ratio (C/Y). Result: long-run relationship between C and Y is proportional. MPC is relatively stable at an average of 0.9 APC = MPC because there is no autonomous consumption, a, that will affect APC. Disposable income, YD

15. Quarterly Data A study done by Gardner Ackley using quarterly data found that: out of 22 quarter-to-quarter changes in consumption and income, 5 changes in opposite direction 10 changes in the same direction 7 changes measures 0 < MPC < 1 Ackley’s conclusion: Short-run behaviour of consumption was not as mechanical as predicted by the absolute income hypothesis (C = a + bYD). There may be other variables that influences C in the short-run.

16. Conclusion The absolute income hypothesis states that as income rises, people tend to (by ratio to disposable income) spend less and save more due to the existing autonomous consumption, a, in the consumption function: C = a + bYD where a > 0 and 0 < b < 1 As APC declines and APS increases, economists worry of stagnation, in which, the fall in demand by households is not countered by a boost in government spending (G) and private investment (I). Empirical studies suggest that the absolute income hypothesis may hold in the short-run but not in the long-run, but there are also evidence that the non-proportional relationship is arguable even in the short-run.