Consumption, Saving and Investment Function

1. Consumption and Consumption Function Referring the Keynesian theory of employment, increase in aggregate demand leads to increase in effective demand which increase employment level and output. The major components of aggregate demand are consumption and investment. So, Keynes has given importance to consumption which Increases in aggregate demand, effective demand, output level and employment level to get rid of the depression. Thus, consumption has greater role in macroeconomics. C↑ → AD↑ → ED↑ → N↑ → Y↑ → Living Standard↑ Consumption is defined as the amount spent by people for buying goods and services to satisfy wants. In macroeconomics, aggregate or total consumption is considered. Consumption function is the mathematical or quantitative relationship between consumption and determinants of consumption. The major determinants of consumption (C) are disposable income (Yd), accumulated wealth (W), future income or expected income (Ye), price level (P), interest rate (r), etc. C = f(C, Yd, W, Ye, P, r, … ) Out of these determinants, disposable income (Yd) is the most influencing determinant. Thus, in simply, consumption function is taken as quantitative relationship between consumption and disposable income which can be mathematically expressed as C = f(Yd) Consumption function can be expressed in linear form as C = a + bYd Where, C = consumption Yd = disposable income (Y – T) a = autonomous consumption bYd = induced consumption b = marginal propensity to consume or rate of change of consumption with respect to income 2. Psychological Law of Consumption This law was propounded by J.M. Keynes which basic about the consumption function and it is described as psychological law of consumption. This law explains the relationship between change in income and corresponding change in consumption. Statement When aggregate real income increases, aggregate consumption also increases, but not by as much as income increases. Aggregate consumption increases by smaller amount than aggregate income increases. Yd↑ → C↑ but Yd↑ > C↑ Or C = f(Yd); 1> >0 The reason is as the income increases, our wants get more and more satisfied. But, it does not mean that the consumption expenditure falls with the increase in income. In fact, consumption expenditure varies positively with income, but not in the same proportion in which income increases. Assumptions Keynes psychological law of consumption is based on the following assumption: a. Constant psychological and institutional factor Consumption depends on income alone and other psychological and institutional factors like fashion, taste and preference, habit, income distribution, price level, population, etc. do not change at least in the short period. b. Existence of normal circumstance The law is operative when there is normal condition in the economy. There is no war, no revolution, no high inflation, etc. c. Free Enterprise Economy This law is effective in a free enterprise economy where people are free to choose spending and saving out of their income. There is no government intervention. Explanation Numerical Illustration Income (Yd) Consumption (C) Savings (S) 0 40 -40 200 200 0 300 280 20 400 360 40 500 440 60 Graphical Illustration 3. Attributes of consumption function (APC and MPC) Average Propensity to Consume (APC): It is the outcome of aggregate consumption expenditure divided by aggregate income. It is also defined as the ratio of absolute consumption to absolute income. i.e. APC= C/Y Total income earned by any individual is either consumed or saved or both. If income is denoted by Y, consumption is denoted by C and saving is denoted by S, then or, or, 1 = APC + APS and 0 MPCrich) Generally, poor people are unable to satisfy even their basic needs. So, they tend to spend larger amount of their increased income on consumption. Difference between APC and MPC 1. APC is the ratio of absolute consumption to absolute income at particular point of time. MPC is the ration of change in consumption to change in income for a particular period of time. 2. For linear consumption function not passing through origin, • When income increases APC falls but MPC remains constant. • APC is always greater than MPC. APC at Y1 and Y2 income level are respectively C1Y1/OY1 and C2Y2/OY2 which are also the slopes of the lines OC1 and OC2. Slope of OC1 is greater than slope of OC2, i.e. APC at Y1 level of income is greater than at Y2 level of income. Also MPC is constant. Similarly, slope of OC1 and OC2 is greater than the slope of consumption line or b. 3. For linear consumption function passing through origin, APC = MPC = constant 4. Determinants of Consumption According to Keynes, there are two types of factors which determine the consumption function. They are subjective factor (or internal factor) and objective (external factor). Subjective factor is related to psychological behavior which changes the slope (or b), whereas objective factor causes shift in consumption function or change in slope (or a). Subjective Determinants Subjective determinants are related to human behavior and social system. Followings are the subjective determinants of consumption function. a. Security Motive: People save more for unforeseen and future needs. Programs such as old age allowance, unemployment allowance, medical insurance, etc. reduce saving pattern and increase consumption. b. Demonstration effect: People in lower and middle class income groups imitate the life style of or consumption pattern of higher class income group. It increases the consumption. c. Increasing Social Status: People are motivated to save more and accumulate large wealth which will increase their social status. This helps to reduce consumption. d. Financial Prudence: Business fir desires to save more (increase undistributed corporate profit) for the expansion and modernization of business. If the business firm keeps relatively larger amount of its profit for financial prudence and pay smaller amount of profit as dividends to the shareholders, this will generally reduce the propensity to consume of the society. Objective Determinants a. Income of the people: Income of the people is the most influencing factor for consumption and there is positive relationship between income and consumption. Similarly, past income also influences consumption. b. Income distribution: If there is a large disparity between rich and poor, the consumption is low, because, rich people have a low propensity to consume than poor people. Similarly, a community with a very equal distribution of income tends to have high propensity to consume and low propensity to save. c. Price Level: The price level affects the consumption level. When the price falls, this will induce people to consume more and propensity to consume of the society increases. d. Wage Level: Increased wage has direct effect in consumption which increases the propensity to consume in the economy. e. Interest rate: Rate of interest also affects the propensity to consume of the community. Higher rate of interest induces people to save more and reduces consumption. f. Fiscal Policy: When government reduces the tax, the propensity to consume of the community increases. The progressive tax system increases the propensity to consume of the people by altering the income distribution. 5. Measures to Raise Consumption Increase in consumption expenditure increases aggregate demand, then increases effective demand and employment level. Propensity to consume should be increases in any economy. Followings are the important measures to increase propensity to consume. a. Income redistribution: Redistribution of income in favor of poor tends to raise the propensity to consume, because MPC for poor people is high than rich people. The progressive tax should be levied on income, wealth, capital gains, etc. for the redistribution. b. Wage policy: When the wages of labors increase, they consume more goods and services as it leads to increase the propensity to consume. But, policy of high wage should be along with the increase in marginal productivity of labor, otherwise it reduces employment level. c. Social security: Social security like unemployment allowance, old age allowance, health facility, etc. remove the future uncertainty and tendency to save is reduced. It leads to increase propensity to consume. d. Credit facilities: When loans are easily and cheaply available to the people, they buy more goods and services as it increases propensity to consume. e. Advertisement: Consumers get information about the goods and services through the advertisement and attracts consumer which raises their propensity to consume. 6. Saving and Saving Function Saving is the excess of income over consumption expenditure. It is the part of income which is not spent on consumption. Saving depends on income and higher the income, higher will be the saving and vice-versa. Saving function is the quantitative relationship between saving and determinants of saving. Since, income is the most important determinant of saving, it is generally defined as the quantitative relationship between saving and income. S = f(Y) and Where, S = saving Y = income Saving function can also be derived as linear form with the help of linear consumption function. Y = C + S S = Y – C = Y – (a + bY) = –a + (1 – b)Y = –a + sY Where, S = saving Y = income s = (1 – b) = marginal propensity to saving –a = autonomous negative saving which implies until income is not more than a, which is autonomous consumption, there will be no saving. Thus, saving starts when Y > a. The income (Y – a) is partly consumed (=cY) and partly saved (=sY). Saving Schedule Y C S APC=C/Y APS=S/Y MPC=∆C/∆Y MPS=∆S/∆Y 0 50 –50 ∞ ----- ----- ----- 100 125 –25 1.25 –0.25 0.75 0.25 200 200 0 1.00 0.00 0.75 0.25 300 275 25 0.91 0.08 0.75 0.25 400 350 50 0.87 0.12 0.75 0.25 Saving Graph 7. Types of Saving There are four major types of savings: 1. Personal saving: The saving made by individuals and households is called personal saving. People sacrifice present consumption and save for or future purpose. 2. Corporate saving: The saving made by business firms is called corporate saving or business saving. When business firms earn corporate profit, they retain undistributed corporate profit for the expansion and development of the organization. 3. Government saving or public saving: The positive gap between government income and expenditure is government saving or public saving. If government income is greater than government expenditure, then only public saving occurs. 4. Forced saving or compulsory saving: If government compels individual and firms to investment in government securities, it is forced saving or compulsory saving. 8. Determinants of Saving a. Income: There is positive relationship between income and saving. When income increases, saving also increases and vice-versa. With the increase of income, consumption increases slower and saving increases faster according to Keynes. b. Interest rate: Interest is the reward for saving. When interest rate increases one can earn more by saving more. So, if rate of interest increases, people save more and if rate of interest decreases, people spend more. c. Price level: If price level increases in the society, people have to spend more income for consumption and they can not save more. On the other hand, if price level decreases, people can save more. It is because, they spend less than before for the same commodity. d. Fiscal policy: If taxes are imposed on necessary commodities, people can not save more. Similarly, if taxes are reduced on the basic goods it leads to increase the level of saving. e. Distribution of income: If income distribution is more equal, the level of saving will be low and if it is more unequal the level of saving will be high. Paradox of Thrift The term "Paradox of Thrift" refers to the situation where increase in savings ultimately reduces to productive capacity, employment and saving itself. J.M. Keynes introduced the concept of paradox of thrift while discussing the great depression of the 1930s. Thriftiness means the tendency of saving more. The classical economists regarded the saving as a great social virtue. According to them, investment is determined by the saving. They thought that individual savings would create national saving and this saving would be converted into national investment. Therefore, saving is virtue or good for the economy. J.M. Keynes does not accept the concept of savings described by the classical economists. Keynes said that saving, which is good or bed depends upon its use. Savings in the forms of hoarding would decrease the consumption of the society. From individual point of view, saving may be virtue but from economy point of view, saving is social vice or evil. Keynes said that savings reduce the expenditure. But in society, the expenditure of one person is the income of other person. So, saving in the form of hoardings decreases the consumption. This would lead to the situation of decrease in effective demand. As a result of this, there will be over-production, unemployment and economic crisis in the economy. It reduces the profit and the investors will be discouraged for investment ie. Investment will also decrease. Ultimately, it reduces the national income and saving. Therefore, low investment reduces the income. When income is low, the amount of saving will also low. Thus, the process of reduction in savings due to an increase in savings in the beginning is called Paradox of Thrift. Graphically, 4. Investment Function Meaning of Capital and Investment The term capital and investment are the two different concepts. Capital is a stock concept and it refers to the accumulation of capital assets over a period of time. The term capital means stock of productive assets including business fixed investment in machinery and equipment; residential land and buildings; and inventories. Investment is a flow concept and it is addition to the stock of capital at t period of time. Thus, capital at time t is the accumulated investment until this time and is given as: Kt = and It = Kt – Kt-1 Where, Kt = Capital at time period t It = Investment at time period t Investment is the addition to the nation’s capital stock in one year which generates income, employment and output. Purchase of existing shares, bonds, debentures, properties, etc. are merely transfer of ownership of assets from one person to another person. These purchases do not increase the nation’s physical stock of capital thus are not considered as investment. It may be an investment from one’s point of view but not from nation’s point of view. Types of Investment Generally investment can be classified into two types. They are autonomous and induced investment. 1. Autonomous Investment: Autonomous investment refers to the investment which does not depend upon changes in the income level. This investment generally takes place in houses, roads, public undertakings and economic infrastructure such as water supply, electricity, transport and communication. Most of the autonomous investment is undertaken by the government. Autonomous investment can be explained graphically as follows: 2. Induced Investment: Induced investment is that investment which is affected by the changes in the level of income. Induced investment depends upon the level of income. Higher the level of income, higher will be the induced investment. The induced investment is income elastic. In general, induced investment is made by the private sector with profit motive. Graphically this investment is explained as follows: There are other types of investment also which are as: Gross and Net Investment: Gross investment means aggregate investment. It includes net investment as well as depreciation. It refers to total expenditure on capital goods in the given period of time. Net investment is the difference between gross investment and depreciation. So, net investment occurs due to increase in capital stock. The relationship between gross investment and net investment is expressed as GI = NI + Depression Private and Public Investment: The investment which is made by private sector or individual with main objective of maximizing profit or direct benefit is private investment. In other hand, public investment means the investment which is made by public or government sectors to increase public utilities. To fulfill the demand of social overheads, public investment plays the crucial role. This type of investment has indirect benefits, because it stressed public benefits than that of profit maximizing. Investment in construction of roads, bridges, hospitals, educational institutions etc. is the example of public investment. Ex-ante and Ex-post Investment: The estimated or planned investment is called ex-ante investment. The actual investment or the realized investment is called ex-post investment. These are also known as estimated and actual investment. Marginal Efficiency of Capital (MEC) The concept of marginal efficiency of capital was developed by Keynes in 1936. It is the important determinant of autonomous investment. The marginal efficiency of capital is the highest rate of return expected from an additional unit of capital asset over its cost. Example – If supply price of capital assets or the amount of money that any entrepreneur invests on capital goods such as machine is Rs 40000 and its annual yields is Rs 4000, then MEC becomes Thus, MEC is the percentage of profit expected from given investment. Kurihara defines MEC is the ration between the prospective yield of additional capital assets and its supply price. Keynes defines MEC is the rate of return from the employment of a marginal or additional unit of a capital asset over cost or supply price of the assets. MEC is equal to the discount rate when present value of expected returns from capital asset during its life is just equal to its supply price. The MEC measurement includes prospective yields or the income expected from the capital and supply price or the cost of capital assets. It is given by the equation as Where, SP = supply price; Q1, Q2, Q3, … are the series of prospective annual returns; and r = discount rate or MEC Example 1: Supply price of capital asset is Rs 2000 and its life span is two years. The expected yields for first year and second year are respectively Rs 1100 and 1210. MEC can be calculated as: Or, Or, 2000 (1+r)2 – 1100 (1+r) – 1210 =0 Or, (1+r)= = MEC This result implies if the expected future returns are discounted at 10%, sum of the discounted future returns will be equal to the supply price. In the example, present values of first year’s return is 1000 and second year’s return is 1000 and sum of these values is 2000 which is equal to the supply price. In general, MEC refers to the discount rate at which the expected returns of capital in different times are discounted so that sum of discounted values is equal to supply price of that capital. Once MEC is estimated, investment decision can be taken by comparing MEC with the market rate of interest (i). The general investment decision rules are: • If MEC > I then the investment project is acceptable. • If MEC = I then the project is acceptable on nonprofit consideration. • If MEC < I then the project is rejected. Classical economists considered that investment mainly depends upon interest rate. Keynes emphasized MEC. Since, interest rate in a country generally remains stable, changes in MEC mainly determines changes in investment. So, MEC is assumed to be more important determinant of investment. In fact, MEC represents the return part and interest rate represents the expense part of the investment. Thus, investment decision depends upon both the determinants interest rate and MEC. Determinants of Investment Induced investment is influenced by endogenous factors and autonomous investment is influenced by exogenous factors. Thus, gross investment in the economy is the sum of induced investment and autonomous investment. Keynes argues investment rate in the economy is mainly influenced by the two factors – marginal efficiency of capital and rate of interest. Besides, there are other determinants of investment. Followings are the major determinants of investment: 1. Cost of Capital Assets: The cost of capital assets is also called the supply price of the capital. The supply price of capital is the original cost of the capital asset. Higher is the supply price of capital, lower is the inducement to investment and vice-versa. 2. Marginal Efficiency of Capital: Marginal efficiency of capital means the productivity or the efficiency of capital. In general, MEC shows the possible income from the additional capital investment. Any entrepreneur, before investment, compares the prospective yield from the investment and the interest for the investment loan taken. If the rate of return from the investment is more than the rate of interest for the capital, then he will invest, otherwise not. According to the Keynes, MEC is the most important factor of investment capital. 3. Rate of Interest: The current market rate of interest influences the inducement or motive to investment because, an investor always compares between MEC and current market rate of interest while making investment. 4. Income Level: If the level of income increases, it leads to increase the demand for consumption of goods through increasing purchasing power and finally induces to increase investment. 5. Propensity to Consume: The demand for capital good is high where the propensity to consume is high. The increased demand for capital good leads to an increase in investment demand. 6. Growth of Population: The growth of population causes increase in demand for good which finally increases the investment level. 7. Technological Progress: If there is improvement in the technique of production, it reduces the supply price or cost of capital and increases MEC which finally induces for more investment.