Consumption, Savings and

Investment
That part of the disposable income that is
not consumed immediately is known as
savings. Savings are the deferment of
current consumption in favor of future
consumption.
 The Demand for Goods
Consumption
Consumption (C)(C)
– The main determinant of consumption is
disposable income (YD)
– The consumption function shows the relation
between absolute disposable income (YD) and
consumption (C),
– C = C(YD) is a positive relationship meaning
that increases in disposable income (YD)
leads to increases in consumption (C)
Keynesian Consumption Function
– C = C0 + C1YD
– C1 = Marginal Propensity to Consume
(MPC), is the change in consumption
arising out of one unit change in income.
– MPC = dC/dYD= C1
– In Keynesian theory MPC remains
constant and lies between 0 & 1,
– i.e. 0 < C1 < 1
 Consumption (C)
Average Propensity to Consume (APC)
measures the average consumption
expenditure per unit of income.
Mathematically, APC = C/YD,
– APC = C/YD =C0/YD, + C1
– Therefore, APC keeps declining as
income rises.
– C0 = C when YD is zero
Relationship between MPC and APC
Since C = APC. YD
MPC = dC/dYD = APC + YD . dAPC/dYD
We know that dAPC/dYD <0 and YD>0
So MPC < APC, or APC exceeds MPC.
With rise in income, APC will tend towards
MPC
Special Case: If APC is constant, then MPC
= APC. In that case, consumption function
passes through origin.
Consumption and Disposable
Income
Consumption, c

Consumption
function
C = c0 + C1YD

Slope = MPC

Slope=APC
Disposable Income,YD
 Savings Function
– Income can either be spent for
consumption or saved. Like consumption
function, the savings function shows the
relation between savings (S) and
disposable income (YD)
 S = S 0 + S 1Y D
S1 = Marginal Propensity to Save (MPS),
is the rate of change in savings arising
out of one unit change in income.
MPS = dS/dYD = S1
 Savings Function (contd.)
Average Propensity to Save (APS)
measures the average savings
consumption expenditure per unit of
income.
Mathematically, APS = S/YD = S0 /YD + S1
– Now, in 2-sector model Y=C+S
Or S = Y – C
S = Y – C0 + C1Y
S = – C0 + (1 – C1)Y , comparing the
earlier savings function we see that:
 Savings Function (contd.)
S0 = – C0 and
S1 = (1 – C1)
Or in other words, MPS = 1 – MPC.
Since MPC is constant and lies between 0
& 1, MPS is also constant and lies
between 0 & 1. 0 < S1 < 1
Again, since in 2-sector model Y=C+S Y/
Y =C/ Y +S/ Y
1 = APC + APS, or APS = 1-APC
Given that APS = S/YD = S0 /YD + S1, as
income rises, APS rises
Two Sector Keynesian Model
Firms and Households
Y=C+I Expenditure Approach
Y = C + S Income Allocation

At Equilibrium: C + I = Y = C + S
Or in other words, the equilibrium
condition can also be seen as
equality between actual savings and
actual investment; I = S
 Equilibrium Income and Output
Question: 1
Given C = 30+0.4Y and I =150, estimate
what will be equilibrium level of income? What
are C, S, APC, APS, MPC and MPS at
equilibrium Y?

Answer:

Y = C+I = 30+0.4Y+150
Y-0.4Y = 30+150
Or, 0.6Y=180 So, Ye =180/0.6 = 300
MPC=0.4, So, MPS = 1-0.4= 0.6.
APC = 30/Y + 0.4 = 30/300 + 0.4 = 0.5
APS = 1-0.5 = 0.5
Equilibrium C =30+0.4*300 = 150
Equilibrium savings = Ye-Ce= 300-150=150=I
Equilibrium Income with government
Question 2: Let consumption depend on
disposable income and consumption
function is given by: C=50+0.75 (Y-T).
Further assume that average tax rate is
20% and govt maintains a balanced
budget (meaning that government
expenditure, G is equal to taxes, T). If
domestic private investment equals
Rs.100 Crore, what is the equilibrium
level of income, consumption, savings
and taxes.
Equilibrium Income with government
Solution: T = 0.2 * Y= govt expenditure (G) as govt
maintains a balanced budget.
C=50+0.75(Y-T)=50+0.75(Y-0.2Y)
=50+0.6Y
Y=C+S+T=50+0.6Y+100+ 0.2Y
as S=I=100.
Or, Y= 150+0.8Y
Or, Y-0.8Y = 150. OR, Y=150/0.2=750.
T=0.2*750=150 =G
C=50+0.75 (750-150) = 500
S=Y-C-T=750-500-150=100
Check: Y=C+S+T=500+100+150=750
Y=C+I+G=500+100+150=750.
 Alternative theories of
Consumption
•Relative Income Hypothesis of
Duesenberry
•Lifecycle Hypothesis of Ando-Modigliani
•Permanent Income Hypothesis of
Friedman
 Relative Income Hypothesis
Duesenberry’s theorem “Consumption of a
family depends not only on its absolute
income, but also on consumption pattern
of neighbours, relatives. That is,
everybody tries to keep up with the
consumption pattern of the people they
know. As a result, the same family might
end up consuming a higher fraction of
their income in a rich neighourhood. This
is known as “Keeping up with the
Joneses”.
 Relative Income Hypothesis
• Consumption is a function of relative income,
rather than absolute income
• Relative income depends upon the relative
position of the individual in the income
distribution
• Absolute Income increases over time but
relative income remains the same
• As relative income remains constant, the
consumption behaviour would remain stable
• IMPLICATION: Therefore APC is constant in
the Long run
 Two Effects on Consumption
• Demonstration Effect – APC does not fall as
income rises; High propensity to consume for
lower income groups.
• Ratchet Effect- People can refrain from
consuming more when their income rises,
however they cannot reduce their
consumption level immediately attained at the
previous period with the fall in income in the
current period. This explains short run
fluctuations
 Life Cycle Hypothesis
• Consumption at a particular period is not a
function of the current income but the
function of the whole lifetime expected
income
• The entire income-earning period of an
individual can be grouped into three periods
 Early period when Income<Consumption
 Middle period till your retirement when
Income> Consumption
 Period after Retirement when
Income<Consumption
 Diagram showing lifecycle

Income

Savings

Dissaving
Dissaving

15 25 Lifetime 65 75
• Suppose a consumer who expects to live
another T years, has wealth of W and
expects to earn income Y until she retires R
years from now.
• The consumer’s lifetime resources then
consist of initial wealth, W + income earned
till retirement, RY. And she can divide her
lifetime resources among her T remaining
years of life.
• It is assumed that she wants to maintain her
consumption all through her remaining years
of life.
• Therefore, the consumer divides this W+RY
equally over T years and each year
consumes:
• C = (W+RY)/T
• Or C = (1/T)W+(R/T) Y; Or C = a W+b Y
• If every individual plans consumption like this,
then aggregate consumption function will also
behave in a similar manner.
Implication: APC = C/Y = a W/Y +b
• IMPLICATION: In the long-run, wealth and
income grow together, resulting in constant
W/Y. Hence, APC in the long run is constant.
 Life Cycle Hypothesis (concluded)

• Short run non-proportionality is exhibited

between Labour income as wealth is constant
at a time point and assuming expected
income to be proportional to labour income
• Long run stability as wealth changes over
time in the same proportion as labour
income, due to the fact that wealth is
accumulated from labour income
 Permanent Income Hypothesis
Proposed by Milton Friedman and his
argument was that long term consumption is
a function of long term expected income –
Permanent Income. That is that income
which is likely to persist.
Y = Yp + Yt
where Yp = permanent income
Yt = transitory income
Transitory income is the part of income that
people do not expect to persist.
 Permanent Income Hypothesis
• According to this hypothesis, consumers
spend their permanent income, but they
save rather than consume most of their
transitory income.
• Therefore, Permanent Consumption is
proportional to Permanent Income
• Cp = kYp
• IMPLICATION: According to this theory,
• APC = Cp /Y = kYp/Y
 Permanent Income Hypothesis
• That is, APC depends on the ratio of
permanent income to current income.
When current income rises above
permanent income, APC falls temporarily.
• Friedman argued that year to year
variation in income is more on account of
changes in temporary income.
• However, over long periods of time,
variation in income comes from the
permanent income. Therefore, in the long
run, APC is constant.