Unit

Consumption, Saving and

Investment
Unit Objectives
After completing this unit, you will be able to:
‡ realize the relationship among consumption, saving, and investment;
‡ compute average and marginal propensity to consume and save; and
‡ appreciate the role of investment in economic growth.

Main Contents
8.1 CONSUMPTION
8.2 SAVING
8.3 RELATIONSHIP BETWEEN CONSUMPTION AND SAVING
8.4 INVESTMENT

 Unit Summary
 Review Exercise
Y
S
+
C
=
Y
d

(C = Yd)

C
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INTRODUCTION
The main purpose of every economic activity is consumption, whatever the type
of economy. Most people spend the major part of their income on the consumption
of goods and services. The balance of income which is not used for consumption
is saved.

At the national level, developing countries spend a higher proportion of their

income on consumption than do developed countries. Thus, developing countries
save a smaller proportion of their income. A nation that saves a relatively small
part of its income makes smaller investments and exhibits relatively lower rates
of growth in productivity. On the other hand, nations that save and invest large
parts of their income exhibit higher rates of growth in income and output.

From the above discussion, we can conclude that:

 Income, consumption, saving, and investment are closely interlinked.
 Consumption, saving, and investment are crucial factors in any country’s
economic performance (income, output, employment, etc.).
Earlier units briefly mentioned consumption and investment while discussing
concepts such as aggregate demand and gross domestic product. This unit
discusses consumption, saving, and investment in detail, emphasizing their roles
in the economic growth of a country.

8.1 CONSUMPTION
At the end of this section, you will be able to:
‡ define the concept of consumption; and
‡ asses the basic determiners of consumption.

Key Terms and Concepts

³ Income ³ Marginal propensity to consume
³ Consumption ³ Average propensity to save
³ Saving ³ Break-even point
³ Investment ³ Personal disposable income

Start-up Activity
List down material consumptions you made in the previous week. Then compare
your level of consumption with that of your friend. Are they similar or different? Why
do you think they are similar or different?

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As we know household consumption expenditure is one of the major components
of aggregate demand or aggregate expenditure in an economy. We also know
that households spend their income (apart from savings) on consumption of final
goods and services for the satisfaction of their basic wants. Consumption may
thus be defined as the expenditure by households on final goods and services.
The main elements of household consumption are expenditures on food, housing,
clothing, transportation, medical care, etc.

Does consumption depend upon income? Yes, consumption is a part of income

and directly depends upon income itself. However, we must note that consumption
is necessary for survival and thus takes place even if income is zero. In such a
case, households might be consuming from sources such as accumulated wealth,
borrowing, or begging (seeking charity). In this context, there are two categories
of consumption:
 Consumption when income is zero – i.e., when a minimum level of
consumption must be maintained for survival. This is called autonomous
consumption, and it is independent of income level.
 Consumption when income rises: With an increase in income, consumption
also increases, but usually less than the income increased. This part of
consumption, which varies with income, is called induced consumption.
Table 8.1 shows the relationship between increasing income and increasing
consumption.
Table 8.1: Relationship between income and consumption
Income Consumption expenditure
(in units of money) (in units of money)
0 100
200 200
400 300
600 400
800 500
1000 600

As shown in the schedule in Table 8.1, there is always a minimum level of

consumption expenditure, even if income is zero. This is why, at zero income
level, consumption expenditure is represented by a positive value 100 units
of money) rather than zero units. The table also shows that, with increases in
income, consumption expenditure also increases but at lesser rate.

Table 8.1 also clearly shows that the relationship between income and consumption
expenditure is always positive or direct.

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Determinants of Consumption Expenditure
The previous section discussed consumption expenditure at the individual
(household) level. Adding together individual consumption expenditures gives us
national consumption expenditure. As discussed earlier, consumption expenditure
as a macroeconomic variable (national consumption expenditure) is crucial to
any economy’s performance.

The major determinants of consumption expenditure at individual and national

levels are:
 Money Income: The relationship between money income and consumption
expenditure is positive and direct. The increase in income results in an
increase of consumption expenditure. This principle also acts inversely.
 Distribution of Income: Consumption expenditure per unit of income
is more for poor people than rich people. Unequal distribution of a
nation’s income reduces consumption expenditure, and equality in
distribution of income increases it.
 Level of Direct Taxes: A higher level of direct taxes leads to a lower level
of personal disposable income, and thus to a decrease in consumption
expenditure. This principle also acts inversely.
 Expectation of the Future: If prices are expected to rise in the future,
present consumption will be more. This principle also acts inversely.
 Rate of Interest: Increases in the rate of interest lead to a reduction of
consumption expenditure and an increase in saving. This principle also
acts inversely.
 Level of Wealth: A higher wealth level leads to higher consumption
expenditure. This principle also acts inversely.
Consumption Function
Consumption function is one of the most important tools in macroeconomics. It
shows the relationship between level of consumption and level of income. The
consumption function is also known as propensity to consume.

The consumption function indicates how consumption responds to different

levels of income. The functional relationship between consumption and income
is generally expressed as:

C = f (Yd) (8.1)
Where C = consumption expenditure, and
Yd = personal disposable income.

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C = a + bYd, where a is autonomous consumption, b is percentage
of income for consumption, and bYd is induced consumption.
Example: Consider a consumer with a consumption function given by
C = 110 + 0.75Yd, and disposable income of Birr 4,800. Calculate
the consumer’s:
a autonomous consumption
b induced consumption
c total consumption
d saving
Solution: Given: Consumption function C = 110 + 0.75Yd
Disposable income = 4,800
a Autonomous consumption is the level of consumption when income
is zero. Thus,
Autonomous consumption = 110 + 0.75 × 0 = 110
b Induced consumption is = Total consumption
– Autonomous consumption
Induced consumption = 0.75 × 4,800 = 3,600
c Total consumption = Autonomous consumption
+ Induced consumption
= 110 + 3,600 = 3,710
d Saving = Yd – C = 4,800 – 3,600 = 1,200
S = Yd – bYd
Note that propensity to consume does not mean desire to consume. It means the
actual consumption that takes place, or is expected to take place, out of varying
levels of income. A distinction may be made here between consumption and
consumption function. Consumption refers to the amount of income which is
spent upon the purchase of goods and services at a given level of income, but
consumption function refers to the whole of a schedule that shows consumption
expenditure at various levels of income.

Propensity to consume or consumption function demonstrates the fact that, as

income increases, consumption also increases but by less than the increase in
income. An important fact about the behavior of the consumption function is that
it is stable in the short run. Further, even when income is zero, consumption is
always positive (i.e., there is always some minimum level of consumption even
when income is zero). The following hypothetical schedule and corresponding
graph illustrate the concept of consumption function:
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Table 8.2: Hypothetical Consumption Function Schedule
Y
Level of National Income Consumption
(in million Birr) (Yd) (in million Birr) (C)

S
+
C
=
0 50

Y
d
C
50 75
(C = Yd)
100 100
150 125
200 150 C
250 175
300 200
Figure 8.1: Consumption function
curve
Consider the preceding Table 8.2 and Figure 8.1 for the hypothetical situation,
and note the following facts:
 Consumption increases with increase in income. When income level
is zero, the minimum level of consumption is Birr 50 million in our
hypothetical situation. When income is Birr 100 million, consumption
is also Birr 100 million. When income exceeds Birr 100 million,
consumption also increases, but it lags behind the increase in income.
 Consumption (i.e., autonomous consumption) can never be zero, even
if income is zero, because a minimum level of consumption must be
maintained for survival. That is why the consumption function curve
starts from point C and not from zero. In such a situation, the economy
draws on past savings in the absence of current income. In the figure,
OC is the minimum level of consumption.
 The 45° line Yd = C + S is called the expenditure equals income line.
Its significance is that each point on this line shows expenditure equal
to income. Comparing the consumption function curve with the 45° line
for any point tells us whether consumption is equal to, greater than or
less than income level.
The point at which the consumption function Note:
curve intersects the 45° line is known as the
break-even point. It indicates equality between The amount of dissaving
or positive saving is
consumption and income. Above the 45° line, measured by the vertical
consumption spending is more than income distance between the
(indicating dissaving), whereas below this line consumption curve and
consumption expenditure is less than income the 45° line.
(indicating positive saving).
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 Line CC represents the consumption function curve, which is also
simply called the consumption curve.
The relationships between consumption and income (propensity to consume)
are expressed in the following ways. The next sections describe their numerical
expressions.
i Average Propensity to Consume (APC)
ii Marginal Propensity to Consume (MPC)

I Average Propensity to Consume (APC)

APC is the ratio of total consumption expenditure (C) to total income (Yd) at a
given level of income in an economy. Symbolically,
C
APC = (8.2)
Yd
For example, if at a particular time, the income level in an economy is Birr 250
million, and consumption is Birr 175 million,
C 175
APC = = = 0.7 or 70%
Yd 250
This example indicates that 70% of income was spent by way of consumption
expenditure. But if aggregate income is very low — for example, Birr 50 million
– and if aggregate consumption is Birr 75 million, APC = 75/50 = 1.5.

Thus the value of APC may be greater than 1, because when income is at a very
low level, consumption exceeds income to meet the very basic necessities. (Then
saving becomes negative).

Table 8.3 demonstrates the estimation of APC, using a hypothetical situation.

Table 8.3: Hypothetical estimation of APC

Consumption APC
Income (in million Birr) C
(in million Birr)
(Yd)  
(C)  Yd 
200 150 0.75
250 175 0.7
300 200 0.66

Observe that APC continues to decline as long as income increases.

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Y

Figure 8.2: Estimation of APC

In Figure 8.2, CC is the consumption curve. It shows that, at point A,
C AN 150
APC = = = = 0.75 , and that, at point B,
Yd ON 200
BM 200
APC = = = 0.66.
OM 300
Thus, as income increases, APC falls.

II Marginal Propensity to Consume (MPC)

The ratio of change in consumption (∆C) to change in income (∆Yd) is called
marginal propensity to consume. Literally, marginal means additional (or
incremental) and propensity to consume means desire (or urge) to consume. Thus
MPC is the ratio of additional consumption expenditure to additional income.
It indicates the proportion of the additional income that is spent on additional
consumption. Symbolically,
∆C
MPC = (8.3)
∆Yd
For example if a country’s national income increases from Birr 200 million to
Birr 250 million, and as a result consumption expenditure goes up from Birr 150
million to Birr 175 million, then
ΔC 25
MPC = = = 0.50
ΔYd 50
Note that, with an increase in income, consumption expenditure also increases

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(i.e., MPC > 0), but the entire increase in income is not spent on consumption
(i.e., MPC < 1).

The following table demonstrates MPC estimations, using a hypothetical situation.

Table 8.4: Hypothetical MPC estimation

MPC
Income (in Change Consumption Change in
million Birr) in Income (in million birr) Consumption  ∆C 
 
(Yd) (ΔYd) (C) (ΔC)  ∆Yd 
150 — 100 — —
250 100 150 50 0.5
350 100 175 25 0.25

Table 8.4 shows that, with increase in income, consumption also increases but
by less than the increase in income. In the hypothetical situation, when income
increased from Birr 150 million to 250 million, consumption increased from Birr
100 million to Birr 150 million. Therefore,
ΔC 50
MPC = = = 0.50
ΔYd 100

This indicates that people spent Y

50% of the increased income.

Also observe that MPC goes on
declining with increases in income.

Yd

Yd Yd1

Figure 8.3: Estimation of MPC

Figure 8.3 shows OYd as original income = Birr 150 million. It goes up to OYd . Thus
1
change in income is YYd = Birr 100 million. With this change, consumption level
1
changes from Birr 100 million to Birr 150 million — i.e., by QT = Birr 50 million.
At point Q,
ΔC 50
MPC = = = 0.50
ΔYd 100

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Properties of MPC
The following are the main properties of MPC.
 MPC is greater than zero but less than one This is because, with an
increase in income, consumption expenditure also increases. But the
entire increase in income is not spent — part of it is saved. Thus,
MPC > 0, but MPC < 1.
 MPC falls with increase in income As the community becomes richer,
it tends to consume a smaller percentage of each increment to its
aggregate income.
 MPC of the poor class is higher than those of other classes: In the case
of poor people, most of their basic needs remain unfulfilled. As a result,
an additional increment to income leads to greater consumption.
 MPC is stable in the short run: This is because it depends upon
psychological factors which do not change in the short run.

Activity 8.1
1 Suppose a given family has an income of Birr 10,000 and saves only Birr 500.
What is its average propensity to consume? Can you tell from this information
about the MPC of the family?
2 Assume for the above example that the income of the family rises to Birr 12,000
and, as a result, the family increases the amount that it saves to Birr 700. What is
the marginal propensity to consume?
3 Suppose that a given family spends Birr 2,000 at zero income and then, as its
income increases, it spends 80 per cent of it on consumption over and above
the Birr 2,000. What is the family’s total consumption spending when its income
is Birr 20,000?
4 Answer the following:
a Can the value of APC be greater than one? Give reasons for your answer.
b Can the value of MPC be greater than one? Give reasons for your answer.
c Copy and complete the following tabulation. Its values are in million Birr.

National Income (Y) Consumption (C) APC MPC

0 30 ------- -------
100 100 ------- -------
200 170 ------- -------
300 240 ------- -------
400 310 ------- -------
500 380 ------- -------
600 450 ------- -------

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5 In your economics workgroup, discuss the relationship between income and
consumption.
6 In your economics workgroup, discuss and answer this question: How does
MPC affect the level of national income?

8.2 SAVING
At the end of this section, you will be able to:
‡ explain what saving is; and
‡ identify the determinant of saving.

Key Terms and Concepts

³ Average Propensity to save (APS)

Start-up Activity
Comment on the saving habits of your family members.

The part of income which is not spent on consumption is called savings. This
is because income is either consumed or saved. Thus, we may say ‘Savings is
an excess of income over consumption expenditure’. By deducting consumption
expenditure (C) from income (Yd), we get savings (S). Symbolically:

S = Yd – C (8.4)

Note the following points in the context of saving:

 Just like consumption, saving depends directly upon income.
 As income increases, savings also increase, but the rate of increase in
savings is more than the rate of increase in income. This means that as
income increases, the proportion of income saved increases (and the
proportion of income consumed decreases).
 At low income levels, savings is negative. In other words, when there
is no income or a very low level of income, consumption expenditure is
more than income, leading to negative saving (i.e., dissaving).

Determinants of Saving
The major determinants of saving at the individual and national levels are:
 Level of Income: As stated above, as income increases, saving also
increases. But the rate of increase in saving is higher than the rate
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of increase in income. This is because, with an increase in income,
consumption increases but by less than the increase in income.
 Distribution of Income: Saving increases when income inequality
increases. This is because the tendency to save is greater for rich people
than poor people.
 Expectation Future for the: If prices are expected to fall in the future,
present consumption is less, and hence saving is more. This principle
also acts inversely. Similarly, an expected future increase in income,
reduces present saving, and the inverse.
 Rate of Interest: A higher rate of interest induces greater saving. This
principle also acts inversely.
 Level of Wealth: A lower wealth level leads to a lower saving level.
This principle also acts inversely.
 Level of Direct Taxes: A higher level of direct taxes produces a lower
level of personal disposable income and hence reduced savings. This
principle also acts inversely.
 Individual Nature: Saving is directly related to the nature of the
individual. For example, a miser saves more than a spendthrift.

Saving Function
The functional relationship between saving and income is called saving function
(or propensity to save). The saving function is the proportion of income which is
saved. Thus saving (S) is a function (f) of income (Yd). Symbolically:

S = f (Yd) or S = Yd – C (8.5)
The saving function shows the tendency of households to save at given levels of
income. Thus the saving function is a corollary or reciprocal of the consumption
function.

The following hypothetical schedule and corresponding graph illustrate the

concept of the saving function.

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Table 8.5: Hypothetical Saving Function Schedule (in million Birr)

Income (Yd) Consumption (C) Savings (S)

0 50 –50
50 75 –25
100 100 0
150 125 25
200 150 50
250 175 75
300 200 100

Table 8.6 shows that saving (S) tends to increase with income (Yd). When income
is zero, saving is negative because consumption exceeds income. When income
in our hypothetical schedule increases beyond Birr 100 million, saving increases
faster than income. Figure 8.4 also shows that saving is negative until income
reaches Birr 100 million. After Birr 100 million, saving increases with every
increase in income.
Y

Figure 8.4: Hypothetical Saving function curve

Point B in Figure 8.4 represents the break-even point, because at this point
savings are zero — i.e., consumption is equal to income. The shaded area reflects
dissavings, which are equal to autonomous consumption.

Consumption and Saving Functions are Complementary

Since income is either consumed or saved, consumption + saving is always equal
to income. This indicates that the consumption and saving curves, which represent
the consumption and saving functions, are complementary. Thus, if we know
an income, we can derive the saving function directly from the consumption
function, as shown in Figure 8.5. Part A of the figure shows the consumption

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function, and Part B shows the saving function. Observe from the figure that the
saving function is the mirror image of the consumption function.

(Yd)

Figure 8.5: Consumption and saving functions

As in the case of the consumption function, the relationships between saving
and income (propensity to save) are expressed in the following ways. The next
sections present their numerical expressions.
i Average Propensity to Save (APS)
ii Marginal Propensity to Save (MPS)

I Average Propensity to Save (APS)

Average propensity to save is the ratio of total savings (S) to total income (Y). It
is the part of total income which is saved. Symbolically:
S
APS = (8.6)
Yd
For example, if income (Yd) is Birr 250 million and saving(s) is Birr 75 million,

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S 75
APS = = = 0.3 or 30% = 0.3 or 30%
Yd 250
Table 8.7 demonstrates APS estimations, using a hypothetical situation.
Table 8.6: Hypothetical APS estimation
APS
Income (in million Birr) Saving (in million Birr)  S 
(Yd) (S)  
 Yd 

200 50 0.25
250 75 0.3
300 100 0.33

Observe that APS continues to increase as long as income increases.

In Figure 8.6, SS is the saving curve. It shows that, at point A,

S 50
APS = = = 0.25
Yd 200
and that, at point B,
100
APS = = 0.33
300
Y

Figure 8.6: Estimation of APS

II Marginal Propensity to Save (MPS)

It is the ratio of the change in saving (ΔS) to the change in income (ΔYd).
Symbolically:

∆S
MPS = (8.7)
∆Yd

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For example, if a country’s national income increases from Birr 200 million to
Birr 250 million, and saving increases from Birr 50 million to Birr 75 million,
then
∆S 25
MPS = = = 0.50
∆Yd 50
Table 8.7 shows MPS estimation, using a hypothetical situation.
Table 8.7: Hypothetical MPS estimation

MPS
Income (in million Birr) Saving (in million Birr)  ∆S 
∆Yd ∆S
(Yd) (S)  
 ∆Yd 

150 – 50 – –
250 100 100 50 0.50
350 100 175 75 0.75

Table 8.7 shows that, when income increases, saving also increases. When income
increases in the hypothetical situation from Birr 150 million to Birr 250 million,
saving increases from Birr 50 million to Birr 100 million. Therefore,

∆S 50
MPS = = = 0.50
∆Yd 100

This indicates that people saved 50% of the increased income.

Observe that MPS continues to increase as long as income increases.

Y

Yd

Yd Yd1

Figure 8.7: Hypothetical Estimation of MPS

In Figure 8.7, when income is OYd = 150, saving is AYd = 50. When income
increases to OYd1 = 250, saving increases to BYd1 = 100. Thus ΔYd = 100 and
ΔS = 50. Therefore MPS at point B,
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ΔS BC 50
B= = = = 0.50
ΔYd AC 100

Properties of MPS
The main properties of MPS are:
 Value of MPS lies between 0 and 1. In other words, 0 < MPS < 1.
 MPS increases with increase in income.
 The MPS of the poor is lower than that of the rich.

8.3 RELATIONSHIP BETWEEN

CONSUMPTION AND SAVING
At the end of this section, you will be able to:
‡ show the relationship between consumption and saving.

Key Terms and Concepts

³ Saving function ³ Rate of interest

Start-up Activity
What is your personal opinion of this statement? “Many Ethiopian families do not
know how to balance their consumption and saving levels for their households.”?

As you already know, the consumption function and the saving function are
interrelated and counterparts of each other. Consumption and saving both depend
on income, and their sum total is equal to total income i.e., C + S = Yd. From this,
it also follows that the concepts of APC and MPC are respectively related to the
concepts of APS and MPS.
Relationship between APC and APS
We know Yd = C + S, dividing both sides by Yd, we get
Yd C S
= +
Yd Yd Yd
1 = APC + APS

or APC = 1 – APS, and APS = 1 – APC (8.8)

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We may conclude: the sum of APC and APS is always equal to unity (1). This is
because income is either consumed or saved.

Note that the value of APS is negative when consumption expenditure is greater
than income.

Relationship between MPC and MPS

We know Yd = C + S
⇒ ΔYd = ΔC + ΔS

Dividing both sides by ΔYd, we get

∆Yd ∆C ∆S
= +
∆Yd ∆Yd ∆Yd
∆C ∆S
1= +
∆Yd ∆Yd

1 = MPC + MPS

or MPC = 1 – MPS, ad MPS = 1 – MPC (8.9)

We may conclude: the sum of MPC and MPS is always equal to unity (1). The
following list shows this inter-relationship:
 APC + APS = 1
 APS = 1 – APC
 APC = 1 – APS
 MPC + MPS = 1
 MPS = 1 – MPC
 MPC = 1 – MPS

Activity 8.2
1 Can the value of APS be negative? If so, when? Give an example in support of
your answer.
2 What is the maximum possible value of MPS?
3 What is the value of MPC when MPS = 0?

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4 Calculate MPS from the following data:
Income (Birr) Consumption expenditure (Birr)
1000 1500
2000 2000

5 If disposable income is Birr 1000, and consumption expenditure is Birr 700, what
is the average propensity to save? Can you use this information to calculate the
marginal propensity to save?
6 Calculate MPS from the following data:
Income (Birr) Saving (Birr)
100 60
200 100

7 In your economics work group, discuss the relationship between income and
saving. Create a diagram that interprets the result of your discussion.

8.4 INVESTMENT
At the end of this section, you will be able to:
‡ define investment;
‡ state the determinants of investment; and
‡ appreciate about the impact of investment on economic growth.

Key Terms and Concepts

³ Autonomous investment ³ Induced investment

Start-up Activity
What type of investment activities are occurring in your locality? Comment the overall
activities of such investments.

Meaning of Investment
In economics, the meaning of investment is quite different from its common use
by an ordinary person who speaks of ‘investing’ when he or she purchases a
piece of land, an old house, securities, debentures, etc. In economic analysis,
these transactions are simply the transfer of ownership rights from one person
to the other and, as such, result in no increase in income and employment. In
economics, investment means an addition, during a predefined ‘current period’,

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to national resources such as:
 existing stock of physical (or real) assets for example, the building of
new factories, new machines or equipment;
 existing stock of finished goods or raw materials.

Investment can be induced as well as autonomous.

Induced Investment
Induced investment is investment which is made with the motive of earning a
profit as in the private sector. Induced investment depends directly upon profit
expectations. It is income-elastic. If national income goes up, induced investment
also goes up – an increase in income induces investment. This occurs because
an increase in national income leads to an increase in the demand for goods
and services, which increases investor interest in meeting that demand, and
therefore leads to investment. Thus, we can say that induced investment takes
place when levels of income and demand in the economy go up. That is why the
induced investment curve, like the supply curve, is positively sloped, as shown in
Figure 8.8.
Y

Yd1 Yd2

Figure 8.8: Induced investment

Autonomous Investment
Autonomous investment refers to investment which is made irrespective of income
level. This approach is generally taken in the government sector. Autonomous
investment is income inelastic – it is not affected by changes in income level.
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The volume of autonomous investment is the same at all levels of income. That is
why the autonomous investment curve is a straight line, parallel to the X-axis, as
shown in Figure 8.9. Autonomous investment is generally affected by autonomous
factors (other than income) such as public utility works, construction of railways
and roads, changes in the nature of consumer demand, increase in population,
discovery of new resources, new technology, etc. For instance, government
investment in public utilities like the construction of railways, roads, post and
telegraph, electricity, etc., is normally autonomous investment.

Autonomous factors
Figure 8.9: Autonomous factors
Remark: Any investment made for the purpose of compensating for depreciation
caused by production in a current year is not real investment. Rather, it is what is
sometimes known as replacement investment.

Determinants of Investment
The basic motive for any private sector entrepreneur to invest is to earn profits
(which, as you know, is the excess of revenue over production cost). Thus
expectation of profit is the main determinant of the level of investment in an
economy. Here is more information about this factor and about related factors
and determinants of investment.
 Profit Expectation: Business investment depends upon the expectations
of the business firms involved. If the business people feel confident that
opportunities for making profits in the future exist, they will be prepared

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to undertake investment expenditure. On the other hand, if they do not
expect to make profits, they will not invest.
^ Rate of Interest: After business expectation of profit opportunities
is taken into account, investment depends upon the rate of interest,
on the one hand, and upon the expected rate of return on capital.
This expected rate of return is called marginal efficiency of capital
or marginal efficiency of investment.
^ If investment is to be profitable, then the expected rate of profit
cannot be less than the current rate of interest in the market. For
instance, if an entrepreneur finds out that funds for a project must
be borrowed at a 15% interest rate, then the proposed investment
would be undertaken only if the project’s expected rate of profit
were more than 15%. We thus see that investment depends upon the
marginal efficiency of investment, on the one hand, and upon the
rate of interest, on the other.
 Corporate Tax: Taxes are imposed by governments on corporations. A
corporation uses part of its revenues to pay these taxes. The higher the
tax rate is, the more that paying taxes reduces revenues and, in turn,
reduces profits. Therefore, we can say that a decrease in the rate of
corporate tax induces investment. This principle also acts inversely.
 Level of National Income: If national income goes up, induced
investment also goes up. The reason is that an increase in national
income leads to an increase in the demand for goods and services
and in investors’ interest in supplying them, which leads to increased
investment. Therefore, we can say that a higher level of national output
induces investment. This principle also acts inversely.

Role of Investment in Economic Growth

Economic growth refers to an increase in the total output of a nation over time.
Investment plays a crucial role in the economic growth of a nation. Nations that
invest a large part of their income tend to have rapid output growth. As you
know, investment in an economy can be in the private sector and in the public
(government) sector. The roles of these two types of investment in economic
growth are discussed below.
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Role of Private Investment in Economic Growth
Investment made by the private sector in the form of new machinery and
equipment, the building of new factories, increases in inventories, etc., increases
the productive capacity of the economy and hence increases output and income.
Note that, whenever investment is increased in a country, income and output
increase many times more than the increase in investment. Therefore, we can
say that an increase in the level of investment brings rapid economic growth to
a country.

Role of Public Investment in Economic Growth

Public investment plays an active role in promoting economic growth, especially
in developing countries.

 Public investment promotes economic growth directly by developing

social overhead and infrastructure, by establishing capital-good
industries, basic and key industries, etc.
 Public investment can stimulate economic growth indirectly by
providing education, training, and research facilities. Public
investment in education and training and in public health and social
security schemes increases peoples’ efficiency and skills, and thereby
contributes to economic growth.
 Public investment reduces disparities in income and wealth as well as
regional disparities. Thus public investment promotes the achievement
of economic growth with social justice.

Activity 8.3
In your economics work group, discuss and answer this question: How does induced
investment depend upon the market rate of interest? Create a graphic presentation
of the results of your discussion.

Practical Work
1 Answer each of these questions and then consider the solutions.
a If APS is 0.6, how much is APC?
Solution: APC = 1 – APS = 1 – 0.6 = 0.4

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b If APC is 0.7, how much is APS?
Solution: APC + APS = 1, therefore APS = 1 – 0.7 = 0.3
c If MPC is 0.75, what is MPS?
Solution: MPS = 1 – MPC = 1 – 0.75 = 0.25
d If APC is 0.75, how much is APS?
Solution: APS = 1 – APC = 1 – 0.75 = 0.25
e If MPS = 1, how much is MPC?
Solution: MPC = 1 – MPS = 1 – 1 = 0
f From the following income consumption schedule, calculate:
i saving
ii average propensity to consume
iii marginal propensity to consume

Income 0 100 200 300 400

Consumption 60 110 150 180 200

Solution:
APC MPC
Consumption Saving (S) C  ∆C 
Income (Yd)    
(C) (Y d− C)  Yd   ∆Yd 

0 60 –60 ∞ —
100 110 –10 1.10 0.50
200 150 50 0.75 0.40
300 180 120 0.60 0.30
400 200 200 0.50 0.20

2 From the following information, find out:

i average propensity to save
ii marginal propensity to save

Income 100 200 300

Saving 20 80 150

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Solution:

APS MPS
Income Savings  S   ∆S 
(Yd) (S)    
 Yd   ∆Yd 

100 20 0.20 —
200 80 0.40 0.60
300 150 0.50 0.70

3 If disposable income is Birr 1,000 and consumption expenditure is Birr

750, what is APS?

Solution:

S 250 (1,000 − 750) 1

APS = = = = 0.25 or 25%
Yd 1,000 4

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Unit Review
UNIT SUMMARY
‡ Consumption refers to the amount of income which is spent by
households to purchase final goods and services.
 Autonomous consumption is consumption when income is zero.
 Induced consumption is consumption which varies with income.
Determinants of induced consumption are:
^ Money income ^ Expectations of the
^ Distribution of income future price
^ Level of direct taxes ^ Rate of interest
^ Level of wealth
‡ Consumption function shows the relationship between consumption
level and income level C = f (Yd) C = a + b Yd
‡ The break-even point is the point in income level at which consumption
expenditure is exactly equal to income and there is no saving.
‡ Average propensity to consume (APC) is the ratio between total
consumption and total income.
C
APC =
Yd
‡ Marginal propensity to consume (MPC) is the ratio of change in
consumption to change in income.
∆C
MPC =
∆Yd
‡ Savings is that part of income which is not spent on consumption S = Yd – C.
Determinants of savings are:
 Level of income  Rate of interest
 Distribution of income  Level of wealth
 Future expectations of  Level of direct taxes
price  Individual nature
‡ The saving function shows the relationship between saving level
and income level S = f(Y). Consumption and saving functions are
complementary.
‡ Average propensity to save (APS) is the ratio between total saving and
total income.

S
APS =
Yd

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‡ Marginal propensity to save (MPS) is the ratio between change in
saving and change in income.
∆S
MPS =
∆Yd
‡ MPS value lies between 0 and 1. APC + APS = 1. MPC + MPS = 1.
‡ Investment means the expenditure by people or business firms on the
purchase or production of new capital goods such as machinery,
factories, tools, houses, etc., which leads to the addition to the stock
of capital in the economy. Investment also includes additions to the
inventories of consumer goods and raw materials.
‡ Induced investment is investment made with the motive of earning
profits.
‡ Autonomous investment is investment which is made irrespective of
income level.
‡ Determinants of investment are:
 Profit expectations  Corporate tax
 Rate of interest  Level of national income.

REVIEW EXERCISE FOR UNIT 8

I Write detailed answers to the following.
1 Explain the concept of consumption function, using an example and a
diagram.
2 Explain the concept of saving function, using an example and a diagram.
3 Explain the concepts of consumption function and saving function, using
examples and diagrams.
4 Explain the relationship between marginal propensity to consume and
marginal propensity to save.
5 Explain the relationship between average propensity to consume and
average propensity to save.
6 Describe briefly the major factors that affect consumption expenditure.
7 Describe briefly the determinants of saving.
8 Consumption function and saving function are complementary to each
other. Explain this fact, using a diagram.
9 Create a schedule and curve to explain propensity to save.
10 Explain clearly the concept of investment as used in macroeconomics.

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11 What do you mean by private investment and public investment?
12 Explain the concept of induced investment and autonomous investment.
13 “Autonomous investment is income-inelastic”. Explain this statement,
using an example.
14 Describe the main determinants of investment.
15 Explain the role of investment in economic growth.
II Distinguish between the following:
16 Private investment and public investment
17 Induced investment and autonomous investment
18 Average propensity to consume and marginal propensity to consume
19 Average propensity to save and marginal propensity to save
20 Marginal propensity to consume and marginal propensity to save
III For each of the following statements, indicate whether it is
‘True’ or ‘False’.
21 The relationship between disposable income and consumption is known as
propensity to consume.
22 Investment is the part of income which is used for the creation of new
capital assets.
23 Demand for investment continues increasing as rate of interest increases.
24 At the break-even point, consumption is more than income.
25 The value of APC can be greater than 1.
26 MPC increases with increase in income.
27 As income increases, saving also increases.
28 The tendency to save is less for rich people than for poor people.
29 A lower level of wealth leads to a lower level of saving.
30 A higher level of direct taxes leads to increased saving.
IV For each of the following, four choices are given, but only one
out of them is correct. Choose the correct one.
31 At the break-even point:
A disposable income is equal to consumption
B income is less than consumption
C income is more than consumption
D none of the above.
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32 Important considerations for making investments are:
A safety of funds
B rate of interest
C return on investment
D all of the above
33 The consumption function is a relationship between:
A level of consumption and investment
B level of income and consumption
C level of income and saving
D level of consumption and saving
34 The saving function is a relationship between:
A level of saving and investment
B level of saving and consumption
C level of saving and income
D none of the above
35 Autonomous investment is:
A income-inelastic
B income-elastic
C dependent upon rate of interest
D dependent upon rate of corporate tax

V Match the following:

Column A Column B
36 APC S
A
37 APS Yd
38 MPC ∆S
B
39 MPS ∆Yd
C
C
Yd
∆C
D
∆Yd

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VI Write very short answers to the following.
40 Can consumption be greater than income?
41 What type of relationship is found between consumption and income?
42 What is the relationship between MPC and MPS?
43 What is the relationship between APC and APS?
44 What is the value of MPS when MPC = 0?
45 How much is MPS in an economy in which MPC = 0.6?
46 How much is MPC in an economy in which MPS = 0.2?
47 If APC = 0.65, how much is APS?
48 If APS = 0.26, how much is APC?
49 If disposable income is Birr 1200, and consumption expenditure is Birr
800, what is APS?
50 If disposable income is Birr 2000, and saving is Birr 500, what is APC?
51 Mention two factors that determine the level of investment in an economy.
52 Mention two factors that determine the level of saving in an economy.
53 Consumption at zero level of income is known by what name?
54 What is the impact of an increase in the rate of corporate tax on the level of
investment in an economy?
55 If the consumption function of a given individual is given as
C = 44 + 0.86Yd, and the individual’s disposable income for a specific
period was Birr 3600, then calculate the:
a autonomous consumption
b induced consumption
c total consumption
d saving
e APC and APS

Unit Review