Set 4 - Consumption and Investment

Consumption Decisions Aggregate Consumption Investment Summary
Economics 2: Macroeconomics
Set 4: Consumption and Investment
Nordhaus and Samuelson, Economics 19e, Chapter 21
Dr. Christoph Bierbrauer

Professorship for Economics
Cologne Business School
Winter Term 2016/2017
1/ 40 Economics 2: Macroeconomics
created by: Christoph Bierbrauer
Review: Gross Domestic Product
The GDP is the sum of the euro values of consumption C

and gross investment I, government purchases of goods and
services G and net exports X at current prices within an
economy during a given year
Y = C +I+G+X (1)
The gross domestic product is a nominal variable
GDP Components: Germany
Source: Statistisches Bundesamt, annual, measured in Billion Euros
GDP Components: Germany, cont.
Component Share in % 2013 Standard deviation and variance

Consumption 57,4% σC = 1, 34% (σ2 = 0, 02%)
C
Government spending 19,5% σG = 1% (σ2 = 0, 01%)
G
Investment 16,75% σI = 2, 8% (σ2 = 0, 08%)
I
Net exports 6,3% σX = 2, 2% (σ2 = 0, 05%)
X
Source: Statistisches Bundesamt, annual, measured in %age
GDP Components
Consumption C and investment I are two major components

of GDP, obviously they are closely related
C∝I (2)
Consumption and savings add up to disposable income

DI ≡ C + S, everything that is not consumed, must be saved
and is therefore available for investment
Consumption and investment are key determinants of

aggregate demand and thus, govern the ups and downs of
the business cycle
Consumption, Income and Saving
The distribution of disposable income between

consumption and saving is an individual decision,
households take different decisions depending on their
• preferences
• nominal budget
Everything that is not consumed is saved; there is a

break-even point where disposable income is sufficient to
cover individual consumption needs, at this point, an
individual household neither saves nor dissaves
Expenditure Patterns
Observing the behavior of many households, we are able to

identify general, qualitative consumption patterns
German household income 2013
In Germany, surpassing a tier of approximately Euro 50,000 implies that

an individual is among the top 10% of the income distribution. Depending
on marital status and the eventual existence of progeny, the gross income
varies. However, a single with no children in that category receives a net
wage of about Euro 2,450. The definition of household income differs
from this level, as any type of income is included. About 20% of German
households have a disposable monthly income of Euro 5,000 and above
The typical German household in 2013 had 2.01 members. According to

the definition of the Statistische Bundesamt, its monthly net income is
defined as the gross household income (labor income, capital income,
received transfers and income from real estate) minus taxes and social
insurance payments
Source: Statistisches Bundesamt, insbesondere: Einkommens- und Verbrauchsstichprobe Aufwendungen privater

Haushalte fuer den Privaten Konsum vom 10. September 2015
Consumption spendings of the poor

About 15% of Germany’s population are considered being poor, implying
an income of 60% of the average or less. Destatis reports households
with a consumption spending of Euro 900 or less
Average German household
In 2013, the average German household spends Euro 2,448 per month on
consumption goods

Top 20% households

The top 20% of German households receive a monthly income of Euro
5,000 or more. The so-called super-rich households, starting with an
income of Euro 18,000 are as group too small as to observe their
consumption behavior

Expenditure Patterns, cont.

Predictable regularities in individual demand include the
following:
• The higher the individual income, the smaller the
fraction that is spend on food and housing/shelter
• An increase in income is accompanied by an
disproportional increase in spending on luxury goods
• There is a lower bound for consumption spending,
when the individual income is below that threshold,
households dissave
If all consumption desires are satisfied, an individual

household will start saving a fraction of his income:
Saving is the greatest luxury of all!

Consumption and Saving in Germany
Source: Statistisches Bundesamt
In 2013, German consumers received a disposable income of Euro

1717, 41bn, 10% were saved and 90% spend for consumption purposes

Relation between Income and Consumption
When observing variations in disposable income and their

implied effect on aggregate demand, we are interested in
the effect that marginal changes in disposable income
have on consumption and saving:
The marginal propensity to consume
A marginal change is identical with the concept used in

microeconomics: How is one additional Euro of disposable
income distributed between consumption and saving?
This question is answered by one of the most important

relationships in macroeconomics, the consumption function

Consumption Function
The disposable income is the most important determinant

of consumption. The concept of the consumption function,
i.e. a stable empirical relationship between
consumption and disposable income, was introduced by
John Maynard Keynes
The consumption function

C(DI) (3)
describes the relationship between individual consumption

and disposable income

Example: Consumption, Income and Saving
In our example, households break even at a disposable

income of $25.000

Example: A Linear Consumption Function

Break-even Point
Disposable income equals consumption spending on the

45◦ −line, the break-even point corresponds to the
intersection of the consumption function and the 45◦ −line, if
the consumption function
• is above the 45◦ −line; households dissave
• is below the 45◦ −line; households save
As disposable income is the sum of saving and

consumption, we can construct the saving function by
calculating the vertical distance between the consumption
function and the 45◦ −line

Saving Function
Saving mirrors consumption decisions of individual

households

Marginal Propensity to Consume
The classical Keynesian consumption function (for the aggregate

or whole economy) is
C = A + MPC · Y (4)
where A is the autonomous consumption and MPC the marginal

propensity to consume
The marginal propensity to consume is the fraction of one

additional Euro of disposable income that is spend for
consumption. Obviously, the MPC corresponds to the slope of the
consumption function and can be calculated by ∂∂CY = MPC
Autonomous consumption mirrors the fact that in order to

survive, individuals need a minimum level of consumption goods

Slope of the Consumption Function
This example corresponds to a linear consumption function, the

MPC = 0.8 and constant

Linear Consumption Function for Germany
Source: Statistisches Bundesamt, annual data, 1970-2013

Aggregate Behavior
We are interested in the aggregate behavior of consumers in

order to determine aggregate consumption and saving:
• Short run: Variations in C , I affect the GDP, as these
contribute a major fraction to aggregate demand, private
consumption is one determinant of the business cycle
• Long run: Everything that is not consumed is available for
investment which determines the future capital stock. Thus,
current C , I has a huge impact on the future growth of an
economy
Understanding the behavior of C , I is crucial for understanding the

short run fluctuations of the business cycle as well as the long run
economic growth

A simple Keynesian Approach to Consumption
C = A + MPC · Y (5)
• Autonomous consumption provides for a lower bound

• Consumption is determined by current income

Permanent Income Hypothesis: Euler Equation
Ct = β(1 + rt )Et Ct+1 (6)
• Consumers decide on their current consumption level based on

their current and prospects for future income, i.e. their permanent
income (average lifetime income)
• By purchasing and selling financial assets, income can be shifted
between different periods, consumption is smoothed over time

Permanent Income Hypothesis
Other variables that affect consumption include:

• Wealth allows to smooth consumption over time
• Uncertainty about future income may effect current
consumption, e.g. by precautionary saving
• Household preferences determine consumption and
savings, alike
• Society and an existing social safety net such as,
unemployment benefits or public pension schemes,
increase permanent income

Consumption and Disposable Income: USA

Consumption and Disposable Income: Germany
Source: Statistisches Bundesamt, measured in billion Euros

Intertemporal Dimension of Investment
Y = C +I+G+X (7)
Investment is defined as the gross investment of private

enterprises, it
• constitutes a major fraction of aggregate demand and
tends being more volatile than C
• implies the formation of capital K and therefore
improves the future consumption possibilities of an
economy, if it exceeds the rate of capital
depreciation
Changes in gross investment I have short and long run effects!

Investment Decisions
Why does the business sector invest?
The crucial precondition is that expected revenues exceed

the costs of investment over the course of the
implementation of the investment project
Key determinants of investment decisions are:

• Costs of the investment project
• Revenues implied by additional production
• Expectations, i.e. gains and risks involved in the
investment project

Costs and Revenues
Revenues
Typically companies invest in order to increase their output.
The demand for their goods depends, at least to some
degree, on the state of the economy, i.e. the business cycle
Costs
In general, companies finance investment projects via
credits. Thus, the costs of an investment project depend
on the market interest rates.
In addition, taxes may play a role, i.e. off-setting the costs
of an investment project against tax liabilities

Expectations
The prospect for future revenues by increased production

possibilities because of investments are subject to various
risks:
• The future state of the economy
• Possible changes to tax legislation
• Preferences of consumers
• Competitiveness of the company’s products
Investors have to form expectations and weigh the costs of

the investment against uncertain future revenues

Investment Demand Curve
Production capital is used for many years (empirical

observations point to 30-40 years). Moreover, such projects
include the financing and repayment of credits which may
stretch over several periods of time
I(i) (8)
The interest rate is an important determinant of I which is a

crucial relationship in macroeconomics
The interest rate is the key instrument of monetary

policy, by setting the interest rate, the ECB is able to
systematically affect the level of investment

Example: Investment Demand Curve

A plot of the Investment Demand Curve
The downward-sloping demand for investment schedule

depicts the relationship between investment and the interest
rate

Shifts in Investment Demand

Shifts in Investment Demand, cont.
Investment is the most volatile component of aggregate

demand: In virtually any business cycle, changes in investment
have been a major driving force behind booms and busts
Political measures that shift investment demand:

• Changes in taxation
• Monetary policy measures that affect i
Other influences that shift investment demand:

• Expectations regarding future GDP
• Demand shocks, changes in preferences

Consumption and Saving
1. The consumption function relates the level of

consumption to the level of disposable income
2. The saving function relates saving to disposable
income
3. The marginal propensity to consume (MPC) is the
amount of extra consumption generated by one extra
Euro of disposable income - the MPC is the slope of the
consumption function

Consumption and Saving, cont.
4. The marginal propensity to save (MPS) is the extra

saving generated by one extra Euro of disposable
income, and, the slope of the saving function
5. Each extra Euro of disposable income that is not
consumed is necessarily saved MPS = 1 − MPC

Investment
The private sector invests in view of gaining profits, capital

goods last many years, investment decisions depend on
1. the level of output produced by new investment,
2. the interest rates and taxes that influence the costs of
the investment, and
3. business expectations towards the future state of the
economy


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Consumption Decisions Aggregate Consumption Investment Summary

Dr. Christoph Bierbrauer

Cologne Business School

Winter Term 2016/2017

Review: Gross Domestic Product

The GDP is the sum of the euro values of consumption C

The gross domestic product is a nominal variable

GDP Components: Germany

Source: Statistisches Bundesamt, annual, measured in Billion Euros

GDP Components: Germany, cont.

Component Share in % 2013 Standard deviation and variance

Source: Statistisches Bundesamt, annual, measured in %age

Consumption C and investment I are two major components

Consumption and savings add up to disposable income

Consumption and investment are key determinants of

Consumption, Income and Saving

The distribution of disposable income between

Everything that is not consumed is saved; there is a

Observing the behavior of many households, we are able to

German household income 2013

In Germany, surpassing a tier of approximately Euro 50,000 implies that

The typical German household in 2013 had 2.01 members. According to

Source: Statistisches Bundesamt, insbesondere: Einkommens- und Verbrauchsstichprobe Aufwendungen privater

Consumption spendings of the poor

Average German household

10/ 40 Economics 2: Macroeconomics

Top 20% households

11/ 40 Economics 2: Macroeconomics

Expenditure Patterns, cont.

If all consumption desires are satisﬁed, an individual

12/ 40 Economics 2: Macroeconomics

Consumption and Saving in Germany

Source: Statistisches Bundesamt

In 2013, German consumers received a disposable income of Euro

13/ 40 Economics 2: Macroeconomics

Relation between Income and Consumption

When observing variations in disposable income and their

The marginal propensity to consume

A marginal change is identical with the concept used in

This question is answered by one of the most important

14/ 40 Economics 2: Macroeconomics

The disposable income is the most important determinant

The consumption function

describes the relationship between individual consumption

15/ 40 Economics 2: Macroeconomics

Example: Consumption, Income and Saving

In our example, households break even at a disposable

16/ 40 Economics 2: Macroeconomics

Example: A Linear Consumption Function

17/ 40 Economics 2: Macroeconomics

Disposable income equals consumption spending on the

As disposable income is the sum of saving and

18/ 40 Economics 2: Macroeconomics

Saving mirrors consumption decisions of individual

19/ 40 Economics 2: Macroeconomics

Marginal Propensity to Consume

The classical Keynesian consumption function (for the aggregate

where A is the autonomous consumption and MPC the marginal

The marginal propensity to consume is the fraction of one

Autonomous consumption mirrors the fact that in order to

20/ 40 Economics 2: Macroeconomics

Slope of the Consumption Function