Macroeconomics

Consumption, Savings and Investment

Consumption, Savings and Investment

▪ Consumption function
▪ Determinants of Consumption
▪ Savings
▪ Investment
▪ Determinants of Investment

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Autonomous consumption

▪ Autonomous consumption expenditure CA

occurs when income levels are zero. Such
consumption does not vary with changes in
income.
▪ If income levels are actually zero, this
consumption is financed by borrowing or using
up savings.

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Induced consumption

▪ Induced consumption CI describes consumption

expenditure by households on goods and services
which varies with income.
▪ Consumption is considered induced by income.

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Marginal Propensity to Consume

▪ The marginal propensity to consume (MPC) is

the extra amount that people consume when they
receive an extra unit of income.
MPC = ΔC / ΔY
MPC is the first derivation of consumption
function.
▪ Induced consumption can be described by
formula: CI = MPC . Y
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The Consumption Function

▪ The consumption function shows the relationship

between the level of consumption expenditure and
the level of income.
C = f (Y)

If autonomous and induced consumption is

identified then: C = CA + CI
C = CA + MPC . Y

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The Consumption Function

C
Savings
Consumption
function C = f(Y)

CA Consumption

45˚
0 Y1 Y 2 Y 6
The Consumption Function

▪ 45˚ line: at any point on the 45˚line consumption

exactly equals income and the households have
zero saving.
▪ MPC is the slope of the consumption function,
which measures the change in consumption per
unit change in income.

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 Determinants of Consumption
▪ Current disposable income: it is the central factor
determining a nation's consumption.
▪ Permanent income: it is the level of income that
households would receive when temporary
influences are removed.
▪ Wealth: it is the net value of tangible and financial
items owned by a nation or person at a point of time.
▪ Other (interest rate, inflation, expectations).

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Savings
▪ Saving is that part of income that is not
consumed. Saving equals income minus
consumption: S = Y – C
▪ Income is the sum of consumption and savings:
Y=C+S

▪ then C S and C S
+ =1 + =1
Y Y Y Y
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 Savings
▪ The marginal propensity to save

S
MPS =
Y
is defined as the fraction of an extra unit of
income that goes to extra saving.
▪ MPC + MPS = 1 because the part of each unit
of income that is not consumed is necessarily
saved.
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Saving Function

▪ Like consumption saving is also the function of

income: S = f(Y)
▪ If autonomous consumption exists then
autonomous saving exists as well and saving
function is: S = -CA + MPS.Y

▪ Saving is a source for investment.

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The Consumption and Saving Function
C, S
The saving
function is the
C = f(Y) mirror image of
the consumption
function. It shows
the relationship
between the level
CA S = f(Y) of saving and
income.
45˚
0
Y E Y 12
-CA
Investment

▪ Investment pays two roles in macroeconomics:

▪ It can have a major impact on AD (real output
and employment)
▪ It leads to capital accumulation (it increases
the nation's potential output and promotes
economic growth in the long run)

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Determinants of Investment
▪ Revenues: an investment should bring the firm
additional revenue.
▪ Costs: interest rate influences the costs of the
investment.
▪ Consumer demand: the bigger the increase in
consumer demand, the more investment will be
needed.
▪ Expectation: business expectation about future
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state of economy.
The Investment Demand Curve

Interest
rate i Higher Output

D1
D
Investment spending
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The Investment Demand Curve

Interest
rate i Higher Taxes

D
D1
Investment spending
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The Investment Demand Curve

Interest
rate i Pessimistic Expectation

D
D1
Investment spending
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The Simple Theory of Investment

▪ In the simple Keynesian model, investment is

independent of national income (autonomous
investment).
▪ The investment function will be a horizontal
straight line.

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The Investment Function

I In the short-run it
is reasonable to
assume that
investment is
I2 independent of
I2 national income.
I1
I1

0 Y 19
The expenditure components of GDP
▪ consumption, C
▪ investment, I
▪ government spending, G
▪ net exports, NX
An important identity:
Y = C + I + G + NX

value of total aggregate

output expenditure
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Consumption, C

▪ Disposable income is total income minus total taxes:

Y – T.
▪ Consumption function: C = C (Y – T )
Shows that (Y – T )  C
▪ Marginal propensity to consume (MPC) is the
change in C when disposable income increases by
one dollar.

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The consumption function
C

C (Y –T )

The slope of the

MPC
consumption function
1 is the MPC.

Y–T

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Investment (I)
▪ Spending on goods bought for future use
(i.e., capital goods)
▪ Includes:
▪ Business fixed investment
Spending on plant and equipment
▪ Residential fixed investment
Spending by consumers and landlords on housing
units
▪ Inventory investment
The change in the value of all firms’ inventories

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Investment, I
▪ The investment function is I = I (r)
where r denotes the real interest rate,
the nominal interest rate corrected for inflation.
▪ The real interest rate is
▪ the cost of borrowing
▪ the opportunity cost of using one’s own funds to
finance investment spending
So, r  I

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The investment function

r
Spending on
investment goods
depends negatively on
the real interest rate.

I (r )

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The market for goods & services
▪ Aggregate demand: C (Y −T ) + I (r ) + G

▪ Aggregate supply: Y = F (K , L )

▪ Equilibrium: Y = C (Y −T ) + I (r ) + G

The real interest rate adjusts

to equate demand with supply.

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The loanable funds market
▪ A simple supply–demand model of the financial
system.
▪ One asset: “loanable funds”
▪ demand for funds: investment
▪ supply of funds: saving
▪ “price” of funds: real interest rate

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Demand for funds: Investment
The demand for loanable funds…
▪ comes from investment:
Firms borrow to finance spending on plant &
equipment, new office buildings, etc. Consumers
borrow to buy new houses.
▪ depends negatively on r,
the “price” of loanable funds
(cost of borrowing).

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Loanable funds demand curve

r
The investment
curve is also the
demand curve for
loanable funds.

I (r )

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Supply of funds: Saving
▪ The supply of loanable funds comes from saving:
▪ Households use their saving to make bank deposits,
purchase bonds and other assets. These funds
become available to firms to borrow to finance
investment spending.
▪ The government may also contribute to saving
if it does not spend all the tax revenue it receives.

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Types of saving

private saving = (Y – T) – C
public saving = T – G
national saving, S
= private saving + public saving
= (Y –T ) – C + T – G
= Y – C – G

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Budget surpluses and deficits

▪ If T > G, budget surplus = (T – G)

= public saving.
▪ If T < G, budget deficit = (G – T)
and public saving is negative.
▪ If T = G, balanced budget, public saving = 0.
▪ The U.S. government finances its deficit by issuing
Treasury bonds–i.e., borrowing.

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The special role of r
r adjusts to equilibrate the goods market and the loanable
funds market simultaneously:
If L.F. market in equilibrium, then
Y–C–G =I
Add (C +G ) to both sides to get
Y = C + I + G (goods market eq’m)
Thus,
Eq’m in L.F.
market  Eq’m in goods
market

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