MACROECONOMICS

Consumption and Investment

Kunal Dasgupta
CONSUMPTION

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Figure 1: Consumption as a share of GDP (2010)

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Figure 2: Drivers of GDP growth in India

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Private consumption expenditure has the following features:

• It accounts for a large share of GDP

• It is an important driver of GDP growth

Given the importance of consumption, we will look at different

theories of consumption, and try to understand the link
between consumption and income.

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In this topic, we shall discuss

• the Keynesian consumption function

• the Life-Cycle hypothesis
• the Inter-temporal model

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Keynesian consumption function
John Maynard Keynes made the following conjectures about
how individuals consume:

• The marginal propensity to consume, how much an

individual spends out of an extra rupee earned, is between
0 and 1.
• The average propensity to consume, the ratio of
consumption to income, declines with income.
• The primary determinant of consumption is income;
interest rate plays a minor role.

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The Keynesian Consumption function takes the following form:

C = α + βY,

where

• Y is disposable income.
• α is the “minimum” level of consumption.
∆C
• ∆Y = β, where 0 < β < 1.

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Evidence

Figure 3: Consumption and Disposable Income

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The data was supportive of the following hypotheses:

1. Individuals with higher disposable income have

• higher consumption (mpc > 0)
• higher savings (mpc < 1)
2. Income and consumption are highly, positively correlated.

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From individual to per capita

• Suppose there are N individuals with consumption-income

pair (C1 , Y1 ), (C2 , Y2 ), .......(CN , YN ).
• Then we have
N
X N
X
Ci = αN + β Yi ,
i=1 i=1

Dividing by N ,
C̄ = α + β Ȳ ,

where

C̄ → per capita consumption

Ȳ → per capita income

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Based on the empirical success of the Keynesian consumption
function, economists predicted that consumption should closely
follow income over time.

This prediction was not supported by the data.

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Evidence

Figure 4: Consumption in t and t − 1

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Putting together all the evidence, it seems that income

• is a good predictor of consumption across individuals .....

• ..... but not a good predictor of consumption over time.

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Life-Cycle hypothesis
Life Cycle hypothesis (LCH)

Individuals plan their consumption and savings behaviour over

long periods with the intention of allocating their consumption
in the best possible way over their entire lifetimes.

• Individuals are averse to too much variability in lifestyle –

they like to smooth consumption.
• In its simplest form, the theory predicts constant
consumption over the lifetime.

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• Tintin became a reporter today.
He is 20 years old.
• He plans to work until age 60 and
expects to die at age 80.
• He expects to earn 150 francs
every year he works (Y ).
• Spreading resources earned
during his service life (S) over the
remaining years of life (T ), Tintin
will spend
S×Y
C= .
T
or 100 francs every year.

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Tintin’s wealth (W) evolves in the following way:

• Is 0 at age 20.
• Is 0 at age 80.
• Is maximized at age 60.
• Until retirement, Wt = 50 × (t − 20) at age t.
• Since retirement, Wt = Wt−1 − 100.

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Figure 5: Lifetime consumption and saving

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Application 1: mpc and nature of income

Suppose annual income rises by ∆Y .

• If this increase is permanent,

• the increase in annual consumption will be
S × ∆Y
∆C = .
T
∆C S
• Therefore, mpc = ∆Y = T.
• If this increase is transitory,
• the increase in annual consumption will be
∆Y
∆C = .
T
∆C 1
• Therefore, mpc = ∆Y = T .

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Application 2: mpc and age distribution

Consider two individuals, 1 and 2, both of whom will retire at

age R and expect to die at age D. Suppose

• 1’s current age is A1 .

R−A1
• A’s mpc out of permanent income will be D−A1 .
• 2’s current age is A2 .
R−A2
• B’s mpc out of permanent income will be D−A2 .

If A1 < A2 , it can be shown that 1’s mpc is greater than 2’s

mpc.

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Deviations from LCH:

1. Borrowing constraints
2. Myopia
3. Precautionary savings
4. Bequest
• The theory assumes that when current desired consumption
is more than current income, an individual can borrow.
• But borrowing may not be an option for every individual
due to financial market frictions.

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Deviations from LCH:

1. Borrowing constraints
2. Myopia
3. Precautionary savings
4. Bequest
• The theory assumes that when current desired consumption
is more than current income, an individual can borrow.
• But borrowing may not be an option for every individual
due to financial market frictions.

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Deviations from LCH:

1. Borrowing constraints
2. Myopia
3. Precautionary savings
4. Bequest
• The theory assumes that individuals are able to correctly
value future consumption.
• But individuals could attach too much importance to the
present relative to the future.

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Deviations from LCH:

1. Borrowing constraints
2. Myopia
3. Precautionary savings
4. Bequest
• The theory assumes that individuals save/dis-save only to
smooth consumption over the lifetime.
• But individuals could also save for future contingencies such
as unexpected healthcare expense.

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Deviations from LCH:

1. Borrowing constraints
2. Myopia
3. Precautionary savings
4. Bequest
• The theory assumes that individuals only save for personal
consumption.
• But individuals could also save for consumption of future
generations.

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Inter-temporal model
• Until now, we had simply assumed that individuals would
want to smooth consumption.
• Next, we consider a model where an individual optimally
chooses current and future levels of consumption.
• The key feature of this model is that consumer choice must
satisfy an inter-temporal budget constraint.

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The basic two-period model

• (Y1 , Y2 ): income in periods 1 and 2.

• (C1 , C2 ): consumption in periods 1 and 2.
• r: interest rate.
• S = Y1 − C1 : saving in period 1

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• Period 2 budget constraint is:

C2 = Y2 + (1 + r)S
= Y2 + (1 + r)(Y1 − C1 ).

• Re-arranging terms

(1 + r)C1 + C2 = (1 + r)Y1 + Y2 .

• Dividing both sides by 1 + r, we have ......

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..... the inter-temporal budget constraint:
C2 Y2
C1 + = Y1 + .
| {z1 + r} | {z1 + r}
Present-value of consumption Present-value of income

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 The intertemporal budget constraint

C2
(1 + r )Y1 +Y 2

Consump =
Saving income in
both periods
Y2
Borrowing

C1
Y1
Y1 +Y 2 (1 + r )
CHAPTER 17 Consumption 14

Figure 6: Inter-temporal budget constraint

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 The intertemporal budget constraint

C2
The slope of
the budget
line equals 1
-(1+r ) (1+r )

Y2

C1
Y1

CHAPTER 17 Consumption 15

Figure 7: Inter-temporal budget constraint

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 Consumer preferences
Higher
C2
An indifference indifference
curve shows curves
all combinations represent
of C1 and C2 higher levels
that make the of happiness.
consumer
equally happy. IC2

IC1
C1

CHAPTER 17 Consumption 16

Figure 8: Consumer preference

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 Consumer preferences

C2 The slope of
Marginal rate of an indifference
substitution (MRS ): curve at any
the amount of C2 point equals
the consumer the MRS
would be willing to 1 at that point.
substitute for MRS
one unit of C1.

IC1
C1

CHAPTER 17 Consumption 17

Figure 9: Consumer preference

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 Optimization

C2
The optimal (C1,C2)
At the optimal point,
is where the
MRS = 1+r
budget line
just touches
the highest
indifference curve. O

C1

CHAPTER 17 Consumption 18

Figure 10: Consumption equilibrium

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 How C responds to changes in Y

C2 An increase
Results:
in Y1 or Y2
Provided they are
shifts the
both normal goods,
budget line
C1 and C2 both
outward.
increase,
…regardless of
whether the
income increase
occurs in period 1
or period 2. C1

CHAPTER 17 Consumption 19

Figure 11: Response of C to a change in Y

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 How C responds to changes in r
C2
As depicted here, An increase in r
pivots the budget
C1 falls and C2 rises.
line around the
However, it could point (Y1,Y2 ).
turn out differently… B

A
Y2

Y1 C1

CHAPTER 17 Consumption 21

Figure 12: Response of C to a change in r

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How C responds to r depends on two effects.

1. Income effect: If consumer is a saver, the rise in r makes

her better off, which tends to increase both C1 and C2 .
2. Substitution effect: The rise in r increases the
opportunity cost of current consumption, which tends to
reduce C1 and increase C2 .

Bottomline: If consumer is a saver, C2 always rises. What

happens to C1 depends on the relative size of the income and
substitution effects.

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• In the inter-temporal theory, the timing of income is
irrelevant: the consumer can borrow and lend across
periods.
• For example, if the consumer learns that her future income
will increase, she can increase current consumption by
borrowing in the current period.
• This prediction could change under credit constraints.

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 Constraints on borrowing

C2
The budget
line with no
borrowing
constraints

Y2

Y1 C1

CHAPTER 17 Consumption 24

Figure 13: Inter-temporal budget constraint

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 Constraints on borrowing

C2
The borrowing
constraint takes
the form: The budget
line with a
C1 £ Y1
borrowing
Y2 constraint

Y1 C1

CHAPTER 17 Consumption 25

Figure 14: Inter-temporal budget constraint

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 Consumer optimization when the
borrowing constraint is not binding
C2
The borrowing
constraint is not
binding if the
consumer’s
optimal C1
is less than Y1.

Y1 C1

CHAPTER 17 Consumption 26

Figure 15: Borrowing constraint does not bind

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 Consumer optimization when the
borrowing constraint is binding
C2
The optimal
choice is at
point D.
But since the
consumer
cannot borrow, E
the best he can D
do is point E.

Y1 C1

CHAPTER 17 Consumption 27

Figure 16: Borrowing constraint binds

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• In the above example, the consumer’s borrowing constraint
binds – her current consumption is sub-optimal.
• Accordingly, following an increase in future income, she is
not able to increase current consumption.
• Hence, her consumption behaves as in the Keynesian
theory even though she is rational and forward-looking.

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INVESTMENT

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Figure 17: Investment rate and GDP growth for India

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Figure 18: Investment and growth (2000 - 2013)

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Private investment expenditure has the following features:

• It is the most volatile component of GDP

• It is positively correlated with economic growth

Given the importance of private investment, we will look at

different types of investment and their corresponding
determinants.

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Keep in mind that

1. Investment refers to physical investment and not financial

investment. The latter is considered to be savings.
2. Investment is a flow variable (typically measured as
units/year). It adds to the stock of capital.

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In this topic, we shall discuss

• business fixed investment

• residential investment
• inventory investment

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Business fixed investment
Definition
Business fixed investment refers to private firms’ spending on
equipment and structure for use in production.

Observe that

• Includes the computer bought in the current period by the

accounts division of Tata Steel.
• Includes the truck leased by MacDonalds to transport food
to its restaurants.

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The Cost of Capital

Let the price of a unit of capital be denoted by PK . The cost of

capital has two components:

• Interest cost: r × PK , where r is the real interest rate.

• Depreciation cost: δ × PK , where δ is the rate of
depreciation.

The cost of a unit of capital is then

cK = PK (r + δ),

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Firm’s problem

A firm chooses its capital stock by looking at the rate of profit:

Profit rate = P.M PK − cK ,

where M PK is the marginal productivity of capital and P is the

price of the final product.

• If profit rate is positive, the firm gains by adding to the

existing capital stock.
• If profit rate is negative, the firm gains by reducing the
existing capital stock.

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Capital stock and Investment

Capital stock evolves in the following way:

Kt+1 = Kt + It − δKt ,

where Kt and It are capital stock and investment at time t

respectively.

• For capital stock to increase, investment must exceed the

replacement rate of capital (It > δKt ).
• It = 0 causes the capital stock to decline.

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Investment and real interest rate

An increase in the real interest rate

• reduces the profit rate

• reduces investment
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Investment and marginal product of capital

An increase in marginal product of capital

• increases the profit rate

• raises investment
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Investment and policies

Investment is affected by both monetary and fiscal policies.

• A loose monetary policy, by lowering the real interest rate,

reduces the cost of capital and increases investment.
• Tools such as corporate income tax or investment subsidy
tend to have large effects on investment as well.

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Example:

• High corporate income tax rates in the U.S. had a negative

effect on the return to capital.
• To reduce their tax burden, some U.S. firms transferred
profits to subsidiaries in tax havens.

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Application: Credit rationing

• Until now we have assumed that any investor can borrow

money at the prevailing risk-free nominal interest rate i.
But that may not always be so.
• Consider an investor who will repay a loan with probability
p < 1.
• If a lender charges an interest rate i∗ , then the expected
return on |1 is |p(1 + i∗ ).
• In equilibrium, we must have

p(1 + i∗ ) = 1 + i.
=⇒ i∗ > i.

• Investors considered risky have restricted access to the

credit market.
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Residential investment
Figure 19: Sector-wise employment in India (2016)

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Definition
Residential investment refers to the construction of
single-family and multi-family houses.

Observe that:

• Because of its long life, housing investment in any year is a

small fraction of the total stock of housing.
• Just as in business fixed investment, residential investment
depends on the rate of return from housing.

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The return from housing depends on

• Benefit
• The rent for a landlord or implicit value for owner
• Any capital gains
• Cost
• Mortgage interest rate
• Real estate taxes and depreciation

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House prices and risk

• The typical residential housing transaction is financed

largely with borrowed money.
• The use of such leverage to purchase an asset magnifies the
risk assumed by the buyer.
• If the value of the asset subsequently drops, the debt
incurred to buy the asset remains in place.

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House prices and finances

• When house prices are high, a typical owner spends a large

fraction of his/her income on mortgage payments.
• If the debt is very large relative to the owners income,
repayment can strain the owners finances.
• If savings are limited, any increase in mortgage rates can
force the owner to reduce other spending.

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Inventory investment
Definition
Inventory investment consists of raw materials, goods under
production and any change to the existing inventory of finished
goods.

Observe that:

• Firms have a desired ratio of inventories-to-sales, with this

ratio depending on the benefits and costs of holding
inventory.
• The cost of holding inventory takes two forms – (i)
depreciation cost and (ii) interest cost.

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Some benefits of holding inventory

1. Saving transaction cost

• There is typically a cost of placing orders that is
independent of the size of the order.
2. Production smoothing
• Production depends on efficient operation of supply chains
– a disruption in the supply chain can halt production.

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• BMW has an extremely complex
supply chain, with 12,000
suppliers in 70 countries.
• Despite this complexity, BMW
has adopted a just-in-time
inventory method.
• On average, a BMW assembly
line has just one and half hours of
inventory at any given point in
time.

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