Consumption and Investment Unit 3

Consumption and InvestmentUnit 3 At the end of this unit, you should be able to: Define the term consumption, saving and investment Explain the absolute income hypothesis, recognising the relationship between consumption and saving. Define the term marginal propensity to consume (and save) and average propensity to consume (and save). Explain the main features of the permanent income, the life-cycle and the relative income hypotheses as alternatives to the absolute income hypothesis. Explain the accelerator theory of investment and discuss other possible influences on aggregate investment.

Consumption and Investment • Consumption is the flow of households’ spending o goods and services which yield utility in the current period. • Saving is that part of disposable income which is not spent. • In a closed economy • Yd = C+S • Investment is firms 'spending on goods which are not for current consumption but which yield a flow of consumer goods and services in the future. • The different between consumption spending and total consumption • Consumption spending is the actual amount spent on new consumer goods in the current period. • Total consumption is the using up of consumer goods (both those purchased in the current period and those purchased in past periods which are still providing services to the household)

The absolute income hypothesis The Absolute Income Hypothesis is theory of consumption proposed by English economist John Maynard Keynes The absolute income hypothesis state that consumption and saving are both directly and linearly related to current disposable income. Consumption and saving functions of the absolute income hypothesis can be illustrated either numerical, graphically or algebraically.

The absolute income hypothesis Numerical illustration of Consumption and saving functions Do the graphical illustration from the table above

The absolute income hypothesis Algebraic illustration of consumption and saving functions. Yd=C+S C=a+bYd S=Yd-C S=Yd-a-bYd S=-a+Yd(1-b) S=-a+(1-b)Yd mpc + mps=1 b+(1-b) = 1

The absolute income hypothesis Average propensity consume is equal total consumption divided by total disposable income and it varies as disposable income varies. Consumption APC at point A = 50/50 =1 200 APC at point B = 90/100 0.9 150 100 B 50 A 0 50 100 150 200 Disposable income

The absolute income hypothesis Let us use the previous table to construct consumption function and saving function Consumption function C = a+bYd b= dC/Yd = mpc b= (170-210)/(200-250) b= -40/-50 =0.8 = mpc 210 = a + 0.8(250) 210 = a + 200 210-200 = a 10 = a Therefore consumption function is C = 10 +0.8Yd

The absolute income hypothesis Saving function S = x + dYd d= ds/dYd = mps d= (30-40)/(200-250) d =-10/-50 d =0.2 = mps S=x+0.2(Yd) 40=x+0.2(250) 40=x=50 40-50=x =mps=-10 Therefore saving function is S= -10+0.2Yd

The absolute income hypothesis The following points represent the major characteristics of the absolute income hypothesis: 1. Consumption and saving are stable functions of current disposable income. The relationships are positive. 2. The relationships are linear but it is also possible for consumption and saving lines to be curved in such a way that the mpc falls as income rises and the mps rises as income rises 3. The mpc lies between zero and one (0<mpc<1) 4. The apc falls as income rises and is greater than the mpc.

Permanent Income Hypothesis The permanent income hypothesis (PIH) is an economic theory about consumption, first developed by Milton Friedman. Permanent consumption (Cp) is proportional to permanent income (Yp). It state that a person's consumption in a year is determined not just by their income in that year but also by their expected income in future years. In its simplest form, the hypothesis states that changes in permanent income, rather than changes in temporary income, are what drive the changes in a consumer's consumption patterns. Cp = kYp where k is constant and equal to the average and marginal propensities to consume.

Permanent Income Hypothesis Permanent income is the present value of the expected flow of income from the existing stock of both human and non-human wealth over a long period of time. Human wealth is the source of income received from the sale of labour service, while non-human wealth is the sources of all other income (that is, incomes received from ownership of all kinds of assets, like government bonds, company shares, and property). Current measured income (Y) for a household or for the economy as a whole could be greater or less than permanent income.

Permanent Income Hypothesis Transitory income is the different between current measured income and permanent income. In other word, transitory income can be thought of as a temporary, unexpected rise or fall in income (example , an unexpected increase in income resulting from a win at the races, or a temporary fall in income resulting from a short period of unemployment) Current measured income = Permanent income + Transitory Income Y = Yp + Yt The average transitory income level will be equal to zero, therefore the average permanent income would be equal be just equal to the average measured income.

Permanent Income Hypothesis Permanent consumption ( Cp) can be thought of as the normal or planned level of spending out of permanent income and can differ from measured ( C) by any unplanned , temporary increases or decreases in consumer spending, called transitory consumption. C = Cp +Ct Two assumptions about transitory consumption • Transitory consumption is not correlated with permanent consumption • Transitory consumption is not correlated with transitory income which means temporary increases in income do not cause temporary increases in consumption. On average transitory consumption is equal to zero, therefore measured consumption must be equal to permanent consumption. C = Cp=kYp

Permanent Income Hypothesis Friedman’s consumption function C C = kYp 0 Permanent income The relationship between consumption and permanent income is represented by a straight line through the origin with a slope equal to apc and mpc. Wealth also part of the permanent income.

The life-cycle hypothesis The life-cycle hypothesis developed by Ando and Modigliani in the 1950s. The hypothesis claims that each individual household will make an estimate of its expected life-time income and will then devise a long- term consumption plan based on this estimate. • Early years of income earning (say from age 18 to 30), households spend more than their current income. Availability of consumer credit facility can be the driving force. • Middle years of income earning (say, from age 30 to 60), household will spend less than its income, partly to repay earlier debts and partly to accumulate wealth for use in later years. • After retirement, this accumulated wealth is gradually depleted as once again dissaving occurs.

Consumption and Investment Unit 3