Chapter Third

Consumption Saving and Investment

Consumption: consumption means an act of spending income for goods and

services to satisfy present desire of individual/ households. In other words, it refers
to that expenditure which is used to purchase goods and services for satisfaction.

Consumption function is written as

There are different factors that affect the consumption such as disposable income,
wealth, price level, expected future income etc. Out of these, income is the major
determinants. The functional/ mathematical relation between consumption and its
determinants is called consumption function.

C = f(yd)………………………(i)

Where; C = consumption and Yd = disposable income

Equation (i) indicates that other thing remaining the same, level of income
determine the level of consumption. There is direct relation between income and
consumption. It means when the income level increases the consumption level also
increases. An individual /households receive income from their labor and own
capital but they can’t get chance to spend all amount which they earned because
they have to pay direct tax to government. It means they can only spend disposable
income.

Consumption functions in linear form.

C = a + b(yd)…………………………(ii)

Where;

a = autonomous consumption

b = marginal propensity to consume (MPC) or slop of consumption curve or

rate of change in induce consumption with respect to change in income.

yd = disposable income
 Note: 0 < MPC < 1

Autonomous consumption = autonomous consumption is not related to

disposable income because minimum level of consumption must be required for
the survival. Even at zero income the consumption is necessary so it always remain
positive which depends on past saving or borrowing. In other words it is income
inelastic. (Not connected with present income)

Marginal propensity to consume: MPC is the incremental change in

consumption due to the incremental change in disposable income (induce
consumption). MPC is always in between of zero and one , because it is the ratio
of change in aggregate consumption to the change in level of income. It means it is
income elastic.

When the income increases consumption also increases but MPC decreases and
vice versa.

Psychological law of consumption:

The law of consumption is propounded by J.M Keynes, which is described as

psychological law of consumption or fundamental law of consumption. It explains
the relationship between change in income and corresponding change in
consumption. According to Keynes people have a tendency to spend more on
consumption when there income increases, but not as same level of income
because they save some part of their income for different purpose.

Three propositions of this law

 Aggregate consumption has a tendency to rise with the increase

aggregate income but in smaller ratio because when income increases,
our wants are satisfied side by side, so that the need to spend more on
consumer goods diminishes. But it doesn’t mean that consumption
expenditure fall with the increase in income.
 The increase in income will be divided in some ratio between
consumption and saving (Y= C+S). Saving means that money which
is left after consumption. The reason is that after consumption people
eager to save some for future.
 Both saving and consumption increases.
 Assumptions

 Habit of consumer regarding spending doesn’t change.

 Economic condition remain same I.e, no hyperinflation or war or
others abnormal condition.

Income saving
(mil) consumption
0 40 -40
100 100 0
200 160 40
300 220 80
 Free market economy i.e, no government intervention and people are
free to choose spending and saving.

The above table shows the Keynesian consumption function at where income and
consumption expenditure increases at constant rate i.e, by 100 million and 60 mil
respectively in each stage. This increased income is divided between consumption
and saving so saving also increases by 40 million in each stage.

This psychological law of consumption can be explained with the help of

following figure.

(Figure sketch and explain) yourself

Determinants of consumption function

Determinants mean influencing factors. These factors may have positive and
negative impact on consumption. It means consumption is dependent and
determinants are independent. Determinants broadly categories in two headings I,e.
objective/exogenous/ external factors and subjective/endogenous/internal.
External factors are related to economic environment and subjective factors are
related to socio-cultural environment and psychological factors.

Objective factors:

 Level of income: level of income of people is the most influencing factors of

consumption because when the level of income increases consumption
 expenditure also increases. Hence there is positive relationship between
income level and consumption expenditure.
 Price level: When the price level increases it reduce the purchasing power
and when price level decreases, it increases the purchasing power of
consumers. Increase purchasing power increases the consumption
expenditure and vice versa. Thus price level and consumption expenditure
has inverse relation.
 Fiscal policy: When the government changes the fiscal policy its impact falls
on consumption level of community. For example when government reduce
the tax the propensity to consume of community increases. The progressive
tax system increases the propensity to consume of people.
 Rate of interest: According to classical economists the consumption and rate
of interest has inverse relation because when the rate of interest increases
people desire to save more by reducing consumption and vice versa.
 Distribution of income: If there is large gap between rich and poor I,e. high
inequality then consumption is low ,because rich people have low propensity
to consume then poor. On the other side if government able to reduce
inequality then consumption level of society increases.

Subjective factors:

 Security motive: If employers have to contribute more on social security

scheme like provident fund, health and other insurance then it reduce present
consumption of the people, because it reduce the disposable income of
people.
 Unexpected incidence: Everyone is worry about future therefore they want
to keep certain amount for unexpected future needs like illness, accidental
case, retirement life, education of children etc. It means people reduce
present consumption and save some amount for old age, insurance premium
and other security purposes. Hence these saving limit the consumption
expenditure.
 Demonstration effect: Demonstration effect is widely spread in every
society. A lower or middle class income groups always try to imitate the life
style of upper class people. This demonstration effect help to increase the
 consumption level of lower and middle class group when their income level
increases.
 Social status: People are motivated to save more by reducing consumption
expenditure at present and accumulate wealth. They think that more wealth
is the symbol of social status and high prestige.

Measures to raise the marginal propensity to consume

 Income redistribution (transferring purchasing power from higher income

group to the lower income group): Income redistribution in favor to poor is
one of the best methods for raising MPC, because rich people have higher
marginal propensity to save (MPS) and poor have higher MPC. This can be
done with the help of progressive tax system I.e, high tax to rich and low tax
to poor.
 Wage policy: When the wages of labor increases, they consume more goods
and services which lead to increases the MPC. But the policy of high wage
should be along with the increases in Marginal productivity of labor
(efficiency) otherwise it invite unemployment and has adverse effect on
MPC.
 Social security: A well advance system of social security system also
increases the MPC. The social security system like old age pension,
unemployment allowances, health facility from the side of government
reduce uncertainty of public which reduce the tendency to save and leads to
increase MPC.
 Credit facility: The easy and cheap credit facilities for the purchase of semi
durable and durable goods like television, mobile, motorbike etc. help to
increase the MPC. For this government (Central bank) should adopt
expansionary monetary policy.( easy installment loan).
 Advertisement: The proper development of advertisement industry can also
help to raise the MPC. The advertisement spread the information about the
goods and services even at backward areas. As a result it enhances the
demand of products.
 Saving

Definition, Saving function and Technical attributes of saving. (Dictation)

Determinants / influencing factors of saving:

 Level of income: Saving is strongly related with disposable income because
it has positive relationship with disposable income. It means higher the
disposable income higher will be the level of saving and vice versa.
According to Keynes, with the increase in income consumption increases in
slower and saving increases faster.
 Interest rate: According to classical economists saving and rate of interest
has positive relationship because when the rate of interest increases people
desire to save more by reducing present consumption with the view to earn
more by saving.
 Price level: When the price level increases (high inflation) people are
compel to spend more on daily consumable goods and can’t save. On the
other side if price level decreases people able to save more because they
spend less than previous time for same commodities.
 Facility to save: An individual and households can save more if there is
proper access of Financial institution everywhere. The development of such
institutions helps the people of the country to save income easily and
quickly. Only an advance financial system can able to increase the saving.
 Fiscal policy: The fiscal policy of government is another main determinant
of saving. If government imposes more tax on income then it reduces the
size of disposable income and its effect falls on saving. On the other side if
government reduce tax rate it helps to increase saving.

Other factors are: wage policy, social security, habit etc.

Paradox of thrift/saving is vice (badness) and virtue (good point)

The concept of paradox of thrift is introduced by J.M Keynes. The paradox of thrift
refers the situation in which increasing saving finally reduce the saving by
reducing aggregate consumption, demand, investment, production, employment
and income. It is a critical evaluation of classical thought about saving.
According to classical economists saving is a virtue so they encourage people to
save more and spend less. They said investment is determined by saving and both
saving and investment are the function of rate of interest.

S=F( r)

Here, S= saving and r = rate of interest

I=( r ).

Here, I = investment and r = rate of interest

They advocate that when individual starts to save this saving create national saving
and national saving converted into national investment. It means increased saving
increases the investment and then income. Therefore saving is beneficial to all the
individual and society. Hence saving is virtue for both.

But in the theory of paradox of thrift, economists advocate inverse situation at

where increase in saving ultimately reduce saving itself. Keynes mentions that the
consumption expenditure of one person is the income of another person. Therefore,
if people start to save this would reduce effective demand i.e, decrease
consumption. As a result, there will be overproduction of goods and services,
unemployment and economic crisis appear in the economy. This economic crisis
reduces investment as well as income and finally saving. Hence the process of
increasing saving reduces the saving is called paradox of thrift.

Figure yourself

Investment

In normal language investment refers to the expenditure made by people on

various activities but in economics investment refers only real investment which
helps to create or add capital stock/goods as well as generate employment and
income over a certain period in national economy. The creation of capital stock
means construction of new factories, building road as well as purchase of new
equipment etc. (physical stock of capital). Hence purchase of existing share and
securities are comes under financial investment not in real investment. On the other
side if a person/organization use the saving in new company for its establishment
and expansion then it becomes real investment.

Real investment = Productive capacity

Keynes: Investment means real investment I,e. an addition to physical stock of

capital.

Michael Parkin: Investment is the purchase of new plant, equipment, building and
additions to inventories.

Investment function: Investment function is related to private induces

investment. Investment function refers to the technical relationship between
investment and its determinants. There are two different views on investment
functions

Classical views: According to classical economists investment has negative

functional relation with rate of interest. It means higher the rate of interest, lower
the investment and vice versa.

I=f(r)

I = Investment and r = Rate of interest

Keynesian views: According to Keynes investment depends upon rate of interest,

marginal efficiency of capital (MEC), and income level. Keynes says investment
and rate of interest has negative relation with each other but investment has
positive relation with MEC and level of income.

I = f (r, MEC, Y)

r = rate of interest

MEC = marginal efficiency of capital

Y = level of income

Types of Investment

 Autonomous investment: Autonomous investment is independent with level

of income, means it doesn’t depend upon changes in the level of income. In
 other words it is income inelastic in nature. Generally this type of
investment is undertaken by government. The investment by government in
social overheads/ infrastructure like road construction, hospital, collages;
drinking water, dam etc. are the autonomous investment. It is mainly
influence/ determined by growth of population, research and invention.
 Induced investment: Induce investment is income elastic because it varies
with the changes in level of income. It increases as income increases and
decreases as income decreases. It is always guided by profit motive so this
type of investment comes from private sector. Generally, it is influence by
the MEC, demand, wages, price level, rate of interest etc.
 Public/government investment: The investment which is made by
government and government related state and local authorities is called
public investment. The main motto of public investment is to provide social
welfare or net social gain like road, education, health etc. Hence it is
autonomous in nature. It is influence by social and political factors.
 Private investment: Private investment is made by private entrepreneurs with
the major objectives of profit. It is highly influence by marginal efficiency of
capital (MEC) and rate of interest. The entrepreneurs take such projects
which give quick result and have short gestation period.
 Gross investment: Gross investment means aggregate investment which
includes net investment as well as depreciation. In other words the total
amount of expenditure which is used in capital assets is called Gross
investment.
 Net investment: When depreciation is deducted in gross investment then it
refers net investment.
 Planned / intended investment: If investment is made intentionally to
achieve pre- determined goal then it is called planned investment. Every
investment which is made by government on the basis of the policy of
National Planning Commission (NPC) is planned investment.
 Unplanned/ unintended investment: If investment is made due to sudden
changes or unexpected changes in economy then it is called unplanned
investment. For example immediate investment after earthquake.
 Actual investment: It is the sum of planned and unplanned investment.

MEC, MEI and Acceleration given in class (observe your note)