Unit 5: Consumption and Investment

1. The Consumption Function

The consumption function describes the functional relationship between aggregate consumption expenditure and aggregate income in an economy. It illustrates how households allocate their income between consumption and savings.

1.1 Definition and Concept

In macroeconomics, specifically within the Keynesian framework, consumption () is primarily a function of disposable income (). As income increases, consumption increases, but typically at a slower rate than the increase in income.

1.2 The Linear Consumption Equation

The relationship is often expressed algebraically as:

Where:

• : Total Consumption.
• (Autonomous Consumption): The minimum level of consumption that exists even when income is zero (). This represents spending on basic survival needs (food, shelter) funded through past savings or borrowing.
• (Marginal Propensity to Consume - MPC): The slope of the consumption function. It represents the percentage of each additional dollar of income that is spent on consumption.
• : Disposable Income.

1.3 Key Concepts of Propensity to Consume

A. Average Propensity to Consume (APC)

APC refers to the ratio of total consumption to total income at a specific level of income.

• Trend: As income rises, APC generally falls because the proportion of income spent on consumption decreases while the proportion saved increases.

B. Marginal Propensity to Consume (MPC)

MPC refers to the ratio of the change in consumption to the change in income.

• Range: .
• Significance: It determines the size of the investment multiplier. If MPC is high, the multiplier effect on the economy is strong.

1.4 Keynes’ Fundamental Psychological Law of Consumption

John Maynard Keynes proposed three fundamental propositions regarding consumption behavior:

1. Positive Relationship: When aggregate income increases, consumption expenditure also increases.
2. Non-proportionality: Consumption increases by a smaller amount than the increase in income (). People save a portion of the increased income.
3. Stability: As income increases, the spending on consumption increases but not as rapidly as income, causing the savings gap to widen.

2. Determinants of Consumption

Factors affecting consumption are broadly classified into subjective and objective factors.

2.1 Subjective Factors (Psychological)

These are internal factors related to human behavior and social psychology. They are generally stable in the short run.

• Security (Precautionary Motive): Saving for unforeseen future contingencies (illness, unemployment).
• Foresight: Saving for anticipated future needs (education, retirement).
• Status/Pride: The desire to leave a bequest or fortune for heirs.
• Avarice: Pure miserliness; the enjoyment of hoarding money.

2.2 Objective Factors (Economic and External)

These factors can change rapidly and cause shifts in the consumption function.

1. Income Distribution:

   • If income is distributed unequally (concentrated among the rich), aggregate consumption tends to be lower. (The rich have a lower MPC).
   • If income is distributed more equally, aggregate consumption is higher (The poor have a higher MPC).

2. Fiscal Policy (Taxation):

   • Higher Taxes: Reduce disposable income, thereby reducing consumption.
   • Lower Taxes: Increase disposable income, thereby increasing consumption.

3. Changes in Expectations:

   • If consumers expect prices to rise in the future (inflation), they will consume more now.
   • If they expect a war or shortage, current consumption rises (panic buying).

4. The Rate of Interest:

   • Classical View: Higher interest rates encourage saving and reduce consumption.
   • Modern View: The effect is ambiguous but generally, higher rates make borrowing for consumption (credit cards, mortgages) more expensive, lowering consumption.

5. Windfall Gains/Losses:

   • Unexpected gains (stock market boom, lottery) shift the consumption function upward.
   • Unexpected losses (stock market crash) shift it downward (the "Wealth Effect").

6. Corporate Financial Policies:

   • If corporations retain profits (Dividend retention), shareholders have less disposable income, reducing consumption.
   • High dividend payouts increase shareholder income and consumption.

3. Investment and its Types

3.1 Definition

In economics, Investment refers to the addition to the stock of physical capital. It does not refer to buying shares or bonds (which is financial investment); rather, it refers to the creation of new productive assets.

Investment = Capital Formation

It includes:

• Construction of new buildings/factories.
• Purchase of new machinery and equipment.
• Increase in inventories (stocks of goods).

3.2 Types of Investment

A. Autonomous vs. Induced Investment

1. Autonomous Investment:

   • Investment that is independent of the level of income.
   • Driven by social needs, population growth, or new technology.
   • Usually undertaken by the Government (infrastructure, roads, defense).
   • Graph: A horizontal line parallel to the X-axis (Income).

2. Induced Investment:

   • Investment that is dependent on the level of income and profit.
   • Driven by profit motive. As income/demand increases, firms invest more to meet demand.
   • Usually undertaken by the Private Sector.
   • Graph: Upward sloping curve (Positive correlation with income).

B. Gross vs. Net Investment

1. Gross Investment: The total amount spent on new capital assets and replacement of old assets.
2. Net Investment: Gross Investment minus Depreciation (Capital Consumption Allowance). This represents the actual addition to the capital stock.
   

C. Planned (Ex-ante) vs. Actual (Ex-post) Investment

1. Ex-ante Investment: The investment planned by firms at the beginning of a period based on expectations.
2. Ex-post Investment: The actual investment realized at the end of the period (Planned Investment + Unplanned changes in inventory).

4. Factors Affecting Investment

According to Keynes, the volume of private investment depends primarily on two factors:

1. Marginal Efficiency of Capital (MEC)
2. Rate of Interest ()

4.1 Marginal Efficiency of Capital (MEC)

MEC is the expected rate of profitability of a new capital asset. It is the highest rate of return over cost expected from an additional unit of a capital asset.

MEC depends on two sub-factors:

1. Prospective Yield: The total net return (revenue minus variable costs) an entrepreneur expects to get from the asset over its lifetime.
2. Supply Price: The replacement cost or the cost of purchasing the new asset.

The Decision Rule:

• If MEC > Interest Rate (): The project is profitable. Invest.
• If MEC < Interest Rate (): The project is not profitable. Do not invest.
• Investment continues until MEC = .

4.2 The Rate of Interest ()

This is the cost of borrowing funds to invest. Even if a firm uses its own money, the interest rate represents the opportunity cost (the return they could have earned by lending the money instead of buying a machine).

• Inverse Relationship: There is an inverse relationship between the interest rate and the level of investment. As rises, investment falls.

4.3 Other Factors Influencing Investment

1. Technological Advancement:

   • New inventions and efficient technologies increase the productivity of capital (raising MEC), leading to higher investment.

2. Business Expectations (Keynes' "Animal Spirits"):

   • Optimism: If entrepreneurs expect an economic boom, they will invest even if interest rates are slightly high.
   • Pessimism: If a recession is feared, investment halts regardless of low interest rates.

3. Level of Income and Demand:

   • High consumer demand requires increased production capacity, triggering the Accelerator Effect (induced investment).

4. Government Policy:

   • Taxation: High corporate taxes reduce net profitability (MEC), discouraging investment. Tax incentives (e.g., investment tax credits) encourage it.
   • Monetary Policy: Central bank actions that lower interest rates stimulate investment.

5. Political Stability:

   • Stable governments and clear property rights laws encourage long-term capital investment. Political unrest freezes investment.

6. Liquid Assets:

   • Availability of internal funds (retained earnings) makes it easier for firms to invest without relying on external debt markets.