Consumption & Invest

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Dr. M. Jahangir Alam ChowdhuryFinance and Banking, DU 4 -1- 1

Management of Financial Institutions

Chapter 22

Consumption and

Investment


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Nations that save and invest large fractions of their incomes tend to haverapid growth of output, income, and wages;

This pattern characterized the United states in the nineteenth century, andthe miracle economies of East Asia in the last three decades.

By contrast, nations which consume most of their incomes like many poorcountries in Africa and Latin America, invest little in new plant and equipmentand show low rates of growth and productivity and wages.

High consumption relative to income spells low investment and slow growth;high saving leads to high investment and rapid growth.

A. Consumption and Expenditure

Consumption is expenditures by households on final goods and services.

Saving is that part of personal disposable income that is not consumed.

Consumption is the largest single component of GDP, constituting 66percent of total spending over the last decade.


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Budgetary Expenditure Patterns

Poor families must spend their incomes largely on the necessities of life: foodand shelter.

As income increases, expenditure on many food items goes up.

The proportion of total spending devoted to food declines as incomeincreases.

Expenditure on clothing, recreation, and automobiles increases more thanproportionately to after-tax income, until high incomes are reached.

Spending on luxury items increases in greater proportion than income.

Finally, as we look across families, note that saving rises very rapidly asincome increases. Saving is the greatest luxury of all.


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CONSUMPTION, INCOME AND SAVING

More precisely personal saving is the part of disposable income that is not

consumed;Saving equals income minus consumption.

Economic studies have shown that income is the primary determinant ofconsumption and saving.

Rich people save more than poor people, both absolutely and as a percent ofincome.

The very poor are unable to save at all.

Instead as long as they can borrow or draw down their wealth, they tend todissave.

That is, they tend to spend more than they earn reducing their accumulatedsaving or going deeper in to debt.

Table 22-3


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THE CONSUMPTION FUNCTION

The consumption function function shows the relationship between the levelof consumption expenditures and the level of disposable personal income.

This concept introduced by Keynes, is based on the hypothesis that there is astable empirical relationship between consumption and income.

Figure 22-3

The relation between consumption and income shown in figure 22-3 is calledthe consumption function.

THE BREAK EVEN POINT

The break-even point where the representative household neither saves

nor dissaves but consumes all its income.The 450 line tells us immediately whether consumption spending is equal to,

greater than, or less than the level of disposable income.


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The break even point on the consumption schedule that intersects the 450line represents the level of disposable income at which households just break

even.This break even point is at B in Figure 22-3. Here, consumption expenditure

is exactly equal to disposable income - the household is neither a borrowernor a save.

The relationship between income and consumption can be seen by

examining the thin black line from E

to E in Figure 22-3.At an income of $28,000, the level of consumption is $27,240 (see Table 22-

3) and the level of savings is $760.

Net saving is measured by the vertical distance from the consumptionfunction up to the 450 line. The 450 line tells us that to the left of point B the

household is spending more than its income.The excess of consumption over income is dissaving and is measured by

the vertical distance between the consumption function and the 450 line.


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The Saving FunctionFigure 22-4

The saving function shows the relationship between the level of saving andincome.

It is the vertical distance between the 450 line and the consumption function.

The marginal propensity to consume is the extra amount the people consumewhen they receive an extra dollar of disposable income.

The Marginal Propensity to Consume

The marginal propensity to consume is the extra amount that peopleconsume when they receive an extra dollar of disposable income.

The word marginal is used throughout economics to mean extra or

additional. Propensity to consume designates the desired level ofconsumption.

The MPC is therefore the additional or extra consumption that results from anextra dollar of disposable income. (Figure 22-5)


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THE MAGRINAL PROPENSITY TO SAVE

Along with the marginal propensity to consume goes its mirror image, themarginal propensity to save or MPS.

The marginal propensity to save is defined as the fraction of an extra dollar ofdisposable income that goes to extra saving.

Thus if MPC is 0.85, then MPC must be 0.15.

MPC and MPS must always add up to exactly 1, no more and no lessEverywhere and always, MPS=1-MPC.

Consumption is a major component of aggregate spending.

When consumption changes sharply, the change is likely to affect output andemployment through its impact on aggregate demand.

Consumption behavior is crucial because what is not consumed that is,what is saved - is available to the nation for investment in new capital goods.

capital serves as a driving force behind long learn economic growth.


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Consumption and saving behavior are key to understanding economic growthand business cycles

Determinants of ConsumptionCurrent Disposable Income

Current level of disposable income is the central factor determining a nationsconsumption.

Permanent income and the Life Cycle Model of Consumption

The simplest theory of consumption uses only the current years income topredict consumption expenditures.

Consider the following examples, which suggest otherwise:

If bad weather destroys a crop, farmers will draw upon their previous saving.

Similarly, law-school students borrow for consumption purposes while inschool because they believe that their postgraduate incomes will be muchhigher than their meager student earning.

Given my current and future income, how much can I consume today withoutincurring excessive debts ?


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Careful studies show that consumers generally choose their consumptionlevels with an eye to both current income and long run income prospects.

In order to understand how consumption depends on long term incometrends economists have developed the permanent income theory and thelifecycle hypothesis3.

Permanent income is the trend level of income that is income after removingtemporary or transient influences due to the weather or windfall gains orlosses.

According to the permanent income the theory, consumption respondsprimarily to permanent income.

This approach implies that consumers do not respond equally to all incomeshocks. If a change in income appears permanent (such as being promotedto a secure and high paying job), people are likely to consume a large fractionof the in crease in income.

On the other hand, if the income change is clearly transitory (for example, if itarises from a one-time bonus or a good harvest), a significant fraction of theadditional income may be saved.


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The life cycle hypothesis assumes that people save in order to smooth theirconsumption over their life time.

One important objective is to have an adequate retirement income.Hence, people tend to save while working so as to build up a nest egg for

retirement and then spend out of their accumulated saving in their twilightyears.

Social security, which provides a generous income supplement for

retirement, will reduce saving by middle waged workers since they no longerneed to save as much for retirement.

WEALTH AND OTHER INFLUENCES:

Higher wealth leads to higher consumption is called the wealth effect.

Wealth usually changes slowly from year to year, when wealth grows ordeclines rapidly this can cause sharp movements in consumption.


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The National Consumption Function

The level of disposable income is the primary determinant of the level of nationalconsumption.

Alternative Measures of Savings

Saving looks different to the household than to the nation as a whole. This is so because savings is measured in the national income and product

accounts is not the same as that measured by accountants or in individualbalance sheets.

The national accounts measure of saving excludes capital gains (increases inasset values).

while balance sheet measures include capital gains.A rise in stock market valuations on existing assets may not reflect the

productivity or realwealth of the economy. Although people feel richer whenasset prices rise in a speculative bubble, the economy cannot produce more cars,computers, food, or housing.

Moreover if everyone decided to cash in their stocks they would find the priceswould fall and they could not convert their paper wealth in to consumption.

While consumers may feel richer because of the booming stock market, thenation is actually richer only when its productive tangible and intangible assetsincrease.


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