Theory of Income, Consumption, Savings, and Investments

Overview of Economic Development and Variables

  • Economic Development: Refers to an increase in the standard of living for a country's population, coupled with a sustained growth rate.

  • Key Variables: The study of economic development involves understanding the concepts of income, consumption, savings, and investment, as well as the relationships between these variables within the classical and Keynesian systems.

Concept of Income

  • Definition: Income refers to money that "comes in" or is earned by an individual or entity. It is the money made within a specific time period, such as weekly, monthly, or annually.

  • Sources of Income:

    • Salary or wages from labor.

    • Returns on investments.

    • Interest earned.

    • Annuities.

    • Business dealings.

  • Historical and Etymological Context:

    • The word originates from the Old English verb incuman, meaning "to come in."

    • 1404: The first attempt at an income tax occurred in Britain. It was eventually ended due to extreme unpopularity.

    • 1913: The Federal Income Tax became law in the United States and remains in effect today.

Concept of Consumption

  • Definition: Consumption is the level of real spending on goods and services, primarily influenced by disposable income.

  • Keynesian Hypothesis on Consumption:

    • Disposable Income: This is arrived at by deducting tax liabilities from gross income.

    • Keynes suggested that people tend to enhance their consumption level as their disposable income rises.

    • The Disparity: While consumption increases with income, the increase in disposable income is typically greater than the increase in consumption.

  • Correlation: There is a positive correlation between income and consumption.

  • Propensity vs. Desire: It is imperative to note that the "propensity to consume" is not the same as the "desire to consume." Propensity to consume refers specifically to "effective consumption."

Income, Consumption, and Savings Relationship

  • Fundamental Identity: The relationship between these variables is expressed by the formula:     Y=C+SY = C + S

    • Where YY stands for disposable income.

    • Where CC stands for consumption.

    • Where SS stands for savings.

  • Example of Allocation:

    • If income increases by 11 unit and the marginal propensity to consume increases by 0.80.8 units, the remaining 0.20.2 units are allocated to savings.

Concept of Savings

  • Definition: Savings refers to the excess of disposable income over consumption expenditure.

  • National Savings: This is the unconsumed portion of the entire nation's income, comprising the savings of all its members.

  • Total Domestic Savings: Defined as the summation of savings from:

    • The government sector.

    • The business sector.

    • Households.

  • Determinants of Savings:

    • Income: The saving-income ratio holds a proportionate relation with the rise in income. People generally save the excess part of their income rather than the entire amount.

    • Distribution of Income: The savings process is aided by inequality of income distribution.

    • Social Comparison: The desire to showcase a superior standard of living (compared to neighbors) often leads to the purchase of expensive goods, which declines the level of savings.

    • Psychological/Subjective Factors: Savings serve as a safeguard against future insecurity and uncertainty. Farsightedness drives people to save to ensure a better standard of living for themselves and their loved ones.

    • Financial Instruments and Interest Rates: The prevalence of financial instruments and higher interest rates motivates greater savings.

Concept of Investment

  • Definition: The act of putting money into an asset with the goal of increasing the value of that money over time to generate profit, income, or for resale at a higher price.

  • Types of Investment Activity:

    • Change in capital stocks or inventories pertaining to a business venture between two different periods.

    • Production of fresh capital goods, such as plants and equipment.

Savings and Investment in the Classical System

  • Automatic Equilibrium: In the classical theory, Savings (SS) is automatically equated with Investment (II) through adjustments in the interest rate.

  • Market Mechanism:

    • If S > I (excess supply of funds), the rate of interest will fall.

    • The lower interest rate reduces the incentive to save and increases the incentive for investment to restore equilibrium.

  • Caveat: This market law holds true only when the entire amount of savings is reinvested.

Marginal Propensity to Consume (MPC)

  • Definition: The proportion of extra (marginal) income that an individual spends on consumption rather than saving.

  • Origin: Formally introduced by John Maynard Keynes in his 1936 book, The General Theory of Employment, Interest, and Money.

  • Context: Observations made during the Great Depression of the 1930s suggested that individuals increase consumption as income increases, but not at the same rate.

  • Mathematical Formula:     MPC=ΔCΔYMPC = \frac{\Delta C}{\Delta Y}

    • ΔC\Delta C = Change in consumption.

    • ΔY\Delta Y = Change in income.

  • Key Takeaways:

    • Keynesian Multiplier: MPC helps predict economic growth resulting from government stimulus.

    • Multiplier Effect: A chain reaction of consumption by various entities caused by an initial income increase.

    • Scale:

      • An MPC=1MPC = 1 means the person spent all additional income.

      • An MPC=0MPC = 0 means the person spent none of the extra income (it was entirely invested/saved).

Marginal Propensity to Save (MPS)

  • Definition: Measures the proportion of an additional unit of income that is saved.

  • Formula:     MPS=ΔSΔYMPS = \frac{\Delta S}{\Delta Y}

  • Relationship to MPC:     MPC+MPS=1MPC + MPS = 1

    • This identity indicates that any additional unit of income must be either spent or saved.

    • MPS=1−MPCMPS = 1 - MPC

Mathematical Examples of MPC and MPS

  • Example 1:

    • Initial Income: $10,000\$10,000 | New Income: $12,000\$12,000

    • Initial Spending: $8,000\$8,000 | New Spending: $9,000\$9,000

    • ΔY=12,000−10,000=2,000\Delta Y = 12,000 - 10,000 = 2,000

    • ΔC=9,000−8,000=1,000\Delta C = 9,000 - 8,000 = 1,000

    • MPC=1,0002,000=0.5MPC = \frac{1,000}{2,000} = 0.5

    • MPS=1−0.5=0.5MPS = 1 - 0.5 = 0.5

    • Interpretation: For every additional dollar, the person spends 5050 cents and saves 5050 cents.

  • Example 2:

    • Income rise: $25,000\$25,000 to $30,000\$30,000 (ΔY=$5,000\Delta Y = \$5,000)

    • Consumption rise: $20,000\$20,000 to $23,000\$23,000 (ΔC=$3,000\Delta C = \$3,000)

    • MPC=3,0005,000=0.6MPC = \frac{3,000}{5,000} = 0.6

    • MPS=1−0.6=0.4MPS = 1 - 0.6 = 0.4

    • Interpretation: The person spends 6060 cents and saves 4040 cents of every new dollar.

  • Example 3 (Salary Raise):

    • Salary increase: $65,000\$65,000 to $75,000\$75,000 (ΔY=$10,000\Delta Y = \$10,000)

    • Spending increase: $60,000\$60,000 to $65,000\$65,000 (ΔC=$5,000\Delta C = \$5,000)

    • MPC=5,00010,000=0.5MPC = \frac{5,000}{10,000} = 0.5 or 50%50\%

  • Example 4 (Bonus/Suit Scenario):

    • Bonus: $500\$500 (ΔY\Delta Y

    • Spending on suit: $400\$400 (ΔC\Delta C

    • MPC=400500=0.8MPC = \frac{400}{500} = 0.8

    • MPS=100500=0.2MPS = \frac{100}{500} = 0.2

  • Example 5 (Commission):

    • Janet earns a $2,000\$2,000 commission. She saves $1,500\$1,500 and spends $500\$500.

    • MPC=5002,000=0.25MPC = \frac{500}{2,000} = 0.25

Economic Policy and the MPC

  • Income Level Variance:

    • High Income: Typically has a lower MPC. As income increases, more wants/needs are satisfied, leading to higher proportional savings.

    • Low Income: Typically has a higher MPC. Most or all income must be devoted to subsistence consumption (daily living expenses).

  • Keynesian Multiplier Theory:

    • An increase in government spending or investment increases consumer income.

    • Knowing the MPC allows economists to calculate how much an increase in production will affect overall spending.

    • This additional spending generates more production in a continuous cycle.

    • The higher the MPC, the higher the multiplier, and the greater the total impact on the economy from an initial increase in income.

Theoretical Interpretations of MPC Values

  • MPC Menos than 1 (MPC < 1): Indicates that individuals spend a portion of new income and save the rest. This characterizes most normal economic behavior.

  • MPC Equal to 1 (MPC=1MPC = 1): Consumers spend the exact amount of extra money they earn. This happens if a bonus is spent in its entirety or if price inflation matches pay increases perfectly.

  • MPC More than 1 (MPC > 1): A rare occurrence where spending increases by more than the increase in income. This typically indicates a sharp rise in the price of essential goods forcing consumers to spend more than their marginal gains.

Questions & Discussion

  • Q: Savings is a form of ______.

    • Ans: Investment.

  • Q: Keynes hypothesis suggests that people tend to enhance their _____ along with an increase in their disposable income.

    • Ans: Consumption level.

  • Analysis Question: If a person receives a bonus of $1,000\$1,000 and spends $100\$100 while saving $900\$900, what is the MPC?

    • Ans: MPC=1001,000=0.1MPC = \frac{100}{1,000} = 0.1.