Consumption & Investment – Comprehensive Study Notes

Budgetary Expenditure Pattern

Core guiding questions
- How do individuals decide how much to consume?
- What causes them to raise or cut purchases of goods & services?
- Habit vs. impulse vs. income?
Single-most important influence: disposable (after-tax) income
- High-income households consume absolutely more than low-income households.

Consumption, Income & Saving: Core Definitions

Consumption (C): total household spending on goods & services.
Income (Y): earnings available to households (usually national income in macro models).
Saving (S): portion of income not consumed $S = Y - C$
- Negative saving → dissaving (spending more than current income, financed by drawing down wealth or borrowing).

The Consumption Function

Generic form: $C = f(Y)$
Linear form used in introductory macro: $C = a + bY$
- $a$ (autonomous consumption): spending that occurs even when $Y = 0$ .
- $b$ : slope of the function = MPC (marginal propensity to consume).
Two components of total consumption
- Autonomous consumption (independent of income)
- Induced consumption (the $bY$ term) – rises with income.

Marginal Propensities

Marginal Propensity to Consume (MPC)
- Formula: $MPC = \frac{\Delta C}{\Delta Y}$
- Measures the extra consumption generated by an extra dollar of income.
Marginal Propensity to Save (MPS)
- Formula: $MPS = \frac{\Delta S}{\Delta Y}$
- Relationship: $MPC + MPS = 1$ and $MPS = 1 - MPC$ .

Major Hypotheses Explaining Consumption Behaviour

Keynes’s Absolute Income Hypothesis
- As national income rises, consumption rises but by diminishing amounts.
- Hence MPC falls with higher income.
- Psychological justification: primary needs are met first; additional income increasingly directed to accumulation (saving).
- Illustrative example: millionaire vs. welfare recipient both get $\$500$ ; the millionaire mainly saves, the welfare recipient spends.
- Individual-level exhibit (A):
- Income levels $\$1{,}000 \to \$5{,}000$ , consumption increases from $\$1{,}400 \to \$4{,}000$ .
- Falling MPC sequence: $0.90, 0.80, 0.70, 0.60, 0.50$ .
Empirical Challenge
- Simon Kuznets found national MPC to be roughly constant, contradicting Keynes’s diminishing MPC claim.
Duesenberry’s Relative Income Hypothesis
- Consumption depends on one’s relative income/status, not absolute level.
- If relative position is unchanged, MPC remains constant even as absolute income grows.
- National MPC therefore flat; exhibit shows constant $MPC = 0.80$ at every $\$100$ increment of national income.
Friedman’s Permanent Income Hypothesis (PIH)
- Consumption linked to permanent income (long-run expected average income).
- Transitory income (unexpected gains/losses) affects current savings, not average MPC over time.
Modigliani’s Life-Cycle Hypothesis
- MPC varies over the life span: high in youth, lower in middle-age (peak earning), rises again near/at retirement as savings are drawn down.

National vs. Individual Consumption Exhibits (Key Figures)

NATIONAL exhibit under Keynesian view (before Kuznets):
- Income $\$100 \text{ to } \$500\ \text{billion}$ ; consumption rises from $\$60 \text{ to } \$410\ \text{billion}$ .
- MPC schedule: $0.90 \to 0.50$ (declining).
Under Duesenberry: identical income range; consumption rises by $\$80\ \text{billion}$ for each $\$100\ \text{billion}$ income gain; MPC fixed at $0.80$ .

Shifts vs. Movements Along the Consumption Curve

Movement along: caused solely by a change in income.
Shifts (autonomous changes) occur when income is unchanged but some other factor alters spending:
1. Real assets & money holdings (e.g.
  inheritance → upward shift).
2. Expectations of future prices (anticipated inflation → spend now).
3. Credit conditions & interest rates (easier credit/lower rates → higher durable-goods spending).
4. Taxation (higher income tax → downward shift due to lower disposable income).
Exhibit shows upward shift ( $C'$ ) and downward shift ( $C''$ ) relative to baseline C.
Important: shifts are not caused by income changes (True/False question in slides, answer = False).

Saving Function & 45° Line

From $S = Y - C$ and $C = a + bY$ we derive $S = -a + (1 - b)Y$ .
Income/45° line: all points where $Y = C + S$ ; equally distant from both axes; used to juxtapose C and S schedules.
Exhibit data (MPC $= 0.80$ , MPS $=0.20$ ):
- At $Y = \$300\ \text{billion}$ , $C = \$300\ \text{billion}$ , $S = 0$ (“break-even” point).
- At $Y = \$400\ \text{billion}$ , $S = \$20\ \text{billion}$ (slide calculation shown).

The Investment Function

Producers undertake intended (planned) investment; not always equal to actual realised investment due to inventory surprises.
Autonomous investment (I): treated as independent of current income in simple Keynesian models → depicted as a horizontal line at e.g.
$I = \$75\ \text{billion}$ for all income levels.
Exhibit: changing national income from $\$100$ to $\$500\ \text{billion}$ leaves $I$ unchanged.

Determinants of Autonomous Investment

Technology level
- New technology prompts complementary capital outlays (e.g.
  adopting robotics triggers spending on robots, software, training).
Interest rate
- Investment demand curve slopes downward: lower market rate ⇒ more projects show rate-of-return > cost of funds.
Expectations of future economic growth
- Optimism → larger investment budgets; pessimism → scaled-back plans.
Rate of capacity utilisation
- Operating near capacity means even small sales increases require new plant & equipment; excess slack postpones investment.

Exhibit on interest: Panel (a) shows inverse relation between rate (%) and level of $I$ ; Panel (b) reiterates horizontal $I$ schedule once rate is fixed.

Volatility of Investment vs. Stability of Consumption

Historical data (U.S. Economic Report of the President 1994, Survey of Current Business 1996) show:
- Consumption growth path is comparatively smooth.
- Investment series is highly cyclical and erratic, amplifying booms & busts.
Key exam takeaway: macro fluctuations often trace back to swings in investment rather than in consumption.

Quick-Reference Equations & Identities

Consumption function: $C = a + bY$ .
Saving function: $S = -a + (1 - b)Y$ .
MPC: $\frac{\Delta C}{\Delta Y}$ .
MPS: $\frac{\Delta S}{\Delta Y}$ .
Relationship: $MPC + MPS = 1$ .

Practical / Policy Implications

Fiscal policy multipliers depend critically on MPC (larger MPC ⇒ larger spending multiplier $= \frac{1}{1 - MPC}$ , though full multiplier model not detailed in transcript).
Tax changes work partly via disposable-income effect on household consumption.
Stabilisation policies must account for investment volatility and the comparative rigidity of consumption patterns.

Ethical & Sociological Aspects Raised

Status consumption (Duesenberry) suggests inequality can fuel consumption cascades and social pressure to spend.
Life-cycle insight points to policy relevance of retirement planning & pension design.
Permanent-income framing highlights importance of credible, stable income expectations (e.g.
job security, economic policy consistency).

Worked Numerical Examples (Exhibit Recaps)

Change in C when Y rises $\$1{,}000 \to \$2{,}000$ (Keynes table): $\Delta C = \$800$ ; $MPC = 0.80$ .
Change in C when Y rises $\$2{,}000 \to \$3{,}000$ : $\Delta C = \$700$ ; $MPC = 0.70$ (diminishing).
Saving at $Y = \$400\ \text{billion}$ with $a = \$60\ \text{billion}$ and $b = 0.8$ : $S = 400 - [60 + 0.8\times400] = \$20\ \text{billion}$ .
Horizontal investment curve example: regardless of whether $Y = \$100$ or $\$500\ \text{billion}$ , $I = \$75\ \text{billion}$ .

Connections to Broader Macroeconomic Framework

Consumption & investment are two core components of aggregate expenditure $AE = C + I + G + (X - M)$ ; transcript zooms in on C & I.
The size of MPC feeds directly into the Keynesian multiplier (promised in unit outline).
Saving behaviour sets the pool of loanable funds, influencing interest rates which in turn feedback into investment decisions.