6 : Income, Consumption, Savings, and Investment

Overview of Economic Development and Core Variables

Economic Development: Defined as an increase in the standard of living for a country's population coupled with a sustained growth rate.
Key Variables: The foundational study of income, consumption, savings, and investment, specifically through the lens of the classical system and Keynesian theory.

Income: Definition and Historical Context

Definition: Income refers to money that ’comes in’ or is earned during a specific period (weekly, monthly, or annually).
Sources: Income may be derived from multiple sources, including:
- Salaries
- Investments
- Interest
- Annuities
Etymology: The term originates from the Old English word incuman, which was a verb meaning ’to come in.’ It historically referred to money earned via labor or business dealings.
History of Income Tax:
- Britain (1404): The first attempt at an income tax; it was extremely unpopular and subsequently ended.
- United States (1913): The Federal Income Tax became law and remains in effect today.

Consumption and the Keynesian Hypothesis

The Main Hypothesis: Famed British economist John Maynard Keynes suggested that disposable income is the primary influence on real consumption.
Disposable Income: This is calculated by deducting tax liabilities from gross income.
Consumption Behavior: Keynes observed that as disposable income rises, people tend to enhance their level of consumption. However, the increase in income is typically greater than the increase in consumption.
Positive Correlation: There is a positive correlation between disposable income and consumption spending.
Effective vs. Desire to Consume: It is critical to distinguish between the propensity to consume (effective consumption) and the desire to consume; the former refers to actual economic action regardless of desire.
Fundamental Identity: Disposable income ( $Y$ ) is divided between consumption ( $C$ ) and savings ( $S$ ): $Y = C + S$

Savings: National and Individual Determinants

Definition: Savings refers to the excess of disposable income over consumption expenditure.
National Savings: The unconsumed portion of the entire nation’s income, aggregating all its members.
Total Domestic Savings: The summation of savings from three sectors:
1. The Government
2. The Business Sector
3. Households
Determinants of Savings:
- Income: The saving-income ratio holds a proportionate relationship with rising income. Individuals generally save the excess part of their income rather than the entire bulk.
- Distribution of Income: Inequality in income distribution often facilitates the saving process. Conversely, the "demonstration effect" (the desire to showcase a superior standard of living to neighbors) can lead to the purchase of expensive goods, which declines savings levels.
- Psychological/Subjective Factors: Savings are driven by the need to safeguard against future insecurity and uncertainty. Farsightedness motivates individuals to save to ensure a better future standard of living for themselves and their families.
- Financial Environment: The prevalence of financial instruments and the rate of interest significantly impact savings; a higher rate of interest generally motivates greater savings.

Investment and the Classical System

Investment Definition: The act of putting money into an asset with the goal of increasing its value over time. Goals include generating profit/income or reselling for a higher price.
Economic Indicators of Investment:
- Production of fresh capital goods (e.g., plants and equipment).
- Change in capital stocks or inventories in a business venture between two periods.
Savings and Investment Relation (Classical Theory):
- In the classical system, Savings ( $S$ ) and Investment ( $I$ ) are equated automatically through adjustments in the interest rate.
- Equilibrium Mechanism: If $S$ exceeds $I$ , the excess supply of funds drives down the interest rate. This reduction in interest rates discourages saving and encourages investment until equilibrium is restored.
- Constraint: This law holds true provided the entire amount of savings is reinvested into the economy.

Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS)

MPC Definition: The proportion of extra income that an individual spends rather than saves. It measures how buyings habits change relative to a change in disposable income.
The Formula: $MPC = \frac{\Delta C}{\Delta Y}$ Where:
- $\Delta C$ = Change in Consumption
- $\Delta Y$ = Change in Income
MPS Definition: The proportion of an additional unit of income that is saved.
Key Relationship: Every dollar of additional income must be either spent or saved: $MPC + MPS = 1$
MPC Values and Interpretations:
- MPC < 1: The individual saves a portion and spends a portion of their raise. This is the most common state.
- MPC = 1: The consumer spends 100% of the additional income. This may occur if prices rise at the same rate as the pay increase.
- MPC = 0: The consumer saves/invests the entirety of the additional income.
- MPC > 1: Rare. Indicates that the increase in spending exceeded the increase in income, often due to significant price increases in essential goods forcing higher expenditure.

The Keynesian Multiplier and Economic Policy

The Multiplier Effect: Refers to a chain reaction of consumption. An initial increase in income (via government stimulus or investment) leads to increased consumption, which generates additional production and income for others, continuing the cycle.
Policy Implications: Governments use MPC to predict economic growth from stimulus packages. The higher the MPC, the higher the multiplier effect and the greater the total impact on the economy.
Income Levels and MPC: MPC is not constant across a population:
- Low-Income Households: Typically have a high MPC because a higher percentage of income must be directed toward essential subsistence consumption.
- High-Income Households: Typically have a lower MPC because their basic needs and wants are satisfied, allowing for a higher percentage of savings.

Calculation Procedures

Select a Time Period: Use identical time frames for income and consumption data (e.g., one year).
Identify Change in Income ( $\Delta Y$ ): Subtract previous income from current income.
Determine Change in Spending ( $\Delta C$ ): Subtract previous expenses from current expenses.
Apply Formula: Divide $\Delta C$ by $\Delta Y$ .

Mathematical Examples and Case Studies

Generic Formula Example: If income increases by $\$5,000$ and spending increases by $\$4,500$ : $MPC = \frac{4,500}{5,000} = 0.9\, \text{(or 90\%)}$
Example 1: Income Growth Step-by-Step:
- Initial Income: $\$10,000$ ; Initial Spending: $\$8,000$
- New Income: $\$12,000$ ; New Spending: $\$9,000$
- $\Delta Y = \$12,000 - \$10,000 = \$2,000$
- $\Delta C = \$9,000 - \$8,000 = \$1,000$
- $MPC = \frac{1,000}{2,000} = 0.5$
- $MPS = 1 - 0.5 = 0.5$
- Interpretation: For every additional dollar, the person spends 50 cents and saves 50 cents.
Example 2: Mixed Ratios:
- $\Delta Y = \$30,000 - \$25,000 = \$5,000$
- $\Delta C = \$23,000 - \$20,000 = \$3,000$
- $MPC = \frac{3,000}{5,000} = 0.6$
- $MPS = 1 - 0.6 = 0.4$
Example 3: ABC Company Employee:
- Salary Increase: \65,000 \rightarrow \ $75,000$ ( $\Delta Y = \$10,000$ )
- Spending Increase: \60,000 \rightarrow \ $65,000$ ( $\Delta C = \$5,000$ )
- $MPC = \frac{5,000}{10,000} = 0.5$
Example 4: Bonus and Luxury Purchase:
- Bonus ( $\Delta Y$ ): $\$500$
- Spending on a suit ( $\Delta C$ ): $\$400$
- $MPC = \frac{400}{500} = 0.8$
- $MPS = \frac{100}{500} = 0.2$
Example 5: Janet's Commission:
- Commission ( $\Delta Y$ ): $\$2,000$
- Spending ( $\Delta C$ ): $\$500$
- $MPC = \frac{500}{2,000} = 0.25$

Questions & Discussion

Q1: Savings is a form of _______.
- Ans: Investment
Q2: Keynes hypothesis suggests that people tend to enhance their _____ along with an increase in their disposable income.
- Ans: Consumption level
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