4/11/2013
Consumption, Savings & Investment
EC 102. Basic Economics,
Agrarian Reform, and Taxation
Lecture 13
Consumption, Saving &
Investment
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Consumption, Savings & Investment
“The importance of Consumption, Saving &
Investment is that they are a source of rapid
economic growth.”

High Consumption, High Aggregate
Demand, Boosts Output

High Savings, High Investments, High
Aggregate Demand, Boost Output

High Investments, Increases
Productivity, Boosts Output
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• Consumption
- expenditures by households on final
goods & services
• Saving
- part of the disposable income that is not
consumed or expended
• Investment
- increase in the capital stock
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Consumption, Savings & Investment
• Relationship between Consumption (C),
Savings (S) & Investment (I):
•Budgetary Expenditure Pattern

Given a certain level of Income, an individual
consumes good & services for subsistence…

But as incomes increase, an individual’s
consumption may remain constant (i.e. food
consumption)…

The remainder of the income that is not used for
consumption is savings…

Thus, S = DI - C

Note: DI = Disposable Income
3 = Personal Income + Transfers - Taxes
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Consumption, Savings & Investment Consumption, Savings & Investment

• Relationship between Consumption (C), • Mathematical Relationship between Consumption
Savings (S) & Investment (I): (C), Savings (S) & Disposable Income (DI):

An individual’s savings goes to the financial system
S = DI – C
(through placements with banks)…
Marginal Propensity to Consume (mpc)

The savings are lent out to firms for their funding - extra amount consumed for every extra unit of
needs… income received

The borrowed funds are invested by the firms for mpc = (C2 - C1) ÷ (DI2 – DI1)
their businesses…
Marginal Propensity to Save (mps)

Thus, S = I - extra amount saved for every extra unit of
income received
mps = (S2 – S1) ÷ (DI2 – DI1)
mps = 1 – mpc
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Consumption, Savings & Investment Consumption, Savings & Investment

• Mathematical Relationship between Consumption • Determinants of Consumption & Savings
(C), Savings (S) & Disposable Income (DI): 1. Disposable Income
Marginal Marginal - High Disposable Income, High Consumption &
Disposable Consumption Propensity to
Savings (S)
Propensity Savings
Income (DI) (C) Consume to Save
(mpc) (mps)
2. Permanent Income Hypothesis
24,000 24,110 -110 - Consumption increases substantially, if income
0.89 0.11
change appears permanent.
25,000 25,000 0
0.85 0.15 - If an increase in income is temporary, increase in
26,000 25,850 150 consumption is less & substantial increase may
0.75 0.25
27,000 26,600
0.64
400
0.36
instead be in savings.)
28,000 27,240 760
3. Wealth
0.59 0.41 - High Wealth, High Consumption
29,000 27,830 1,170
0.53 0.47
- No need to save, so much of income is consumed
30,000 28,360 1,640 - Wealth involves a high lifestyle.

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Consumption, Savings & Investment
• Determinants of Consumption & Savings
4. Life-cycle Hypothesis
- Consumption is less and savings high (relative to
income) during mid-age or working age.

because the individual is preparing for
retirement where income is low (or none at all)
- Consumption is high and savings less during
retirement age.

because of health care needs, intention to live
a full life, etc… and low income (or none at all)
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The Multiplier Model
• Multiplier Model
“Each unit of money change in exogenous
(independent) expenditures leads to more
than a unit change in GDP or output.”
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Consumption, Savings & Investment
• Determinants of Investment
1. Revenues/Income
- more revenues/income, more investment
- note: there is a give & take relationship
2. Cost of borrowing money (for investment)
- interest rate
- high interest rate, low investments (because
borrowing money is expensive)
3. Expectations/Business Confidence
- positive economic expectations, more investments
- higher output due to increased productivity (from
high investments) has a ready market
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The Multiplier Model
Illustration:
1.Suppose that a firm decides to invest Php
100MM to build a factory.
2.Assume that the mpc of the economy is 2/3 or
0.66. (mpc=0.66)
3.The contractor of the factory receives the Php
100MM check from the firm.
4.The Php 100MM is thus earnings for the
contractor.
5.Since the mpc = 0.66 (for the economy), the
contractor thus spends Php66MM on goods
and services (e.g. purchase equipment).
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The Multiplier Model The Multiplier Model

Illustration: Mathematical Illustration:
6. The supplier of the equipment thus earns Php Php 100MM
1.
Php 66MM
66MM. 2.
Php 43.56MM
7. In turn, the supplier of the equipment spends 3.
Php 28.75MM
part of its earnings (Php 43.56MM). 4.
Php 18.97MM
5.
Php 12.52MM
8. Those who earn from the expenditure of the 6.
Php 8.26MM
supplier will in turn spend their earnings 7.
Php 5.45MM
subject to their mpc. 8.
Php 3.60MM
9.
Php 2.38MM
9. The cycle goes on until the full impact of the 10.
Php 1.57MM
initial exogenous expenditure is exhausted. 11.
Php 1.03MM
12.
Php 0.68MM
13.
Php 0.45MM
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The Multiplier Model The Multiplier Model

Mathematical Illustration: Formula:
Php 100MM Change in output = [1÷(1-mpc)] x change in exogenous
14.
Php 0.30MM expenditure
15.
Php 0.20MM Change in output = [1÷mps] x change in exogenous expenditure
16.
Php 0.13MM Note: mps = 1-mpc
17.
Php 0.08MM
18.
Php 0.06MM Proof:
19.
Php 0.04MM Exogenous expenditure: Php 100MM
20.
Php 0.02MM…..Php0.00MM mpc = 0.66
mps = 1-mpc= 0.34
Sum= 100+66+43.56+…..+0.02+…..+0.00MM≈ 294MM Change in output = (1÷0.34) x Php100MM
= 2.94 x Php100MM

Given mpc = 0.66 & a Php100MM change in exogenous Change in output = Php 294MM
expenditure (investment) will lead to Php294MM change in
output.
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The Multiplier Model The Multiplier Model

Note: Note:
The Multiplier Model (Effect) will hold only if…. The Multiplier Model will hold only if:
1. Wages & prices are fixed or constant. 4. The financial market does not react to changes or
- costs of production may increase and hold back output (if developments in the economy.
otherwise) - Changes in the financial market can also affect interest rates
2. There are resources still unemployed or unused. which, once again, can change the mps and the mpc.
- If all resources are used up, output may not be able to
increase due to lack of resources; or costs of production will Q: With all the assumptions above, is the Multiplier Model
increase and stifle output. applicable in the real world?
3. Monetary policy is not in effect.
- Monetary Policy can affect interest rates which has an
impact on consumption, savings and investment of consumers
and firms (note: interest rate = cost of borrowing money) and
in turn alter the mps and the mpc.

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The Multiplier Model

A: In the real world, it may be applicable but the full impact that
it predicts may not happen (i.e. at mpc = 0.66 the change in
output following a Php100MM exogenous expenditure may
not necessarily be fully equal to Php294MM, it could be
lower).
- It is highly unlikely that the government will not enact
Monetary Policy especially when the economy has a chance of
overheating because of continuous spending/consumption by
the economic agents.
- It is also high unlikely, in today’s world of advanced financial
markets that such market will be non-reactive to economic
developments.

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