3.

THE THEORY OF THE NATIONAL INCOME

(1)
3.1. Consumption and savings

Consumption = it is the share of the available income used by the households

for goods and services.

The relationship between consumption and the income: → two theories:

1) The theory of the available current income – “the theory of the
prodigal son”; (J.M. Keynes)
2) The theory of the permanent income – the theory of the life cycle;
(M. Friedman, Modigliani)

1) The theory of the current income 2) The theory of the permanent

income
 Consumption is in a direct  Consumption depends on the income
relationship with the current the individuals anticipate they will get
income; all life;
 Keynes says individuals want to  When individuals decide to consume
satisfy the consumption needs first now they take into account both the
of all; only if the available income current income and the income they
is higher than the wanted anticipate to earn in the future;
consumption, the difference wil be  An individual will not react to the
saved; unexpected / accidental changes; he /
 Therefore, savings depend on she will react only to those which are
consumption and do not depend permanent;
directly on the interest rate;  if an individual anticipates that the
 Consumption is an expenditure income modification is accidental, he /
induced by the available income.. she will save the greatest part of that
modification or he / will borrow money
to pass its sudden decrease; on the
contrary, if the individual estimates
that the income modification is
permanent then he will spend more of
this income increase.
Permanent
income Income

Consumption

Borrow Savings

0 Time
Fig. 3.1. The theory of the permanent
1 income
 Consumption: influence factors:
1. wealth
2. anticipations regarding changes of the prices;
3. fiscality;
4. interest rate (creditors versus debtors) → an individual will spend less
of his income as the level of his debts is higher;
5. the wish for rewards, generosity, being irresponsible, setea de
satisfacţii, generozitatea, nechibzuinţa, ostentation, being prodigal.

The relationship consumption – savings – available income

- the current available income still stays the most important factor /
variable the consumption depends on;
-
C=C 0 +c '⋅Y d , where C – consumption, C0 – autonomous
ΔC
c '=
(independent) consumption; Yd – available income; ΔY d - the
marginal propensity to consume.
- We suppose that the available income is totally used for consumption
and savings →
S=Y d −C=Y d −(C 0 +c '⋅Y d )=−C0 +(1−c ' )⋅Y d =−C 0 +s '⋅Y d , where: S –
ΔS
s '=
avings; ΔY d - the marginal propensity to savings.

Consumption
C<Yd

C > Yd C=C 0 +c '⋅Y d

C0
45º
0 Income

Savings

S=−C0 +s '⋅Y d

Savings
2
0 Income
-C0 Diseconomies / Unsavings
Why individuals save money?
- Prudence: they want to keep some reserves for unexpected situations;
- Forecast / prediction: they want to assure a future income for
satisfying their / their family’s needs: retirement, taking care of some
dependent people etc;
- Wish for prosperity: to have a certain amount for some speculative
projects;
- independence;
- pride: they want to spend more in order to get a better standard of
living;
- shelfishness / greed: they want to leave their fortune to thenext
generations.

3.2. Investments

These are the part of GDP formed by: 1) gross fixed capital formation; 2) change
in the stocks of working capital; 3) expenditures for new houses.

Factors for investments::

D K1 = K0 + IN
IB
IN

K0 K1

- they decide to make an investment if they anticipate that the extra

production will get an income / a revenue higher than the investment
cost.

Factors which influence the decision to invest:

1) the investor’s expectations;
2) the investment cost;
3) the revenue of the investment.

1) The expectations: the anticipated / expected profit has to be proportional

to the risk assumed by the investor.

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 2) Cost and revenues: as we know, profit is maximum when Vmg = Cmg →
the marginal revenue of the capital is equal to the marginal cost of the
capital.

The marginal revenue of the capital = the extra revenue due to the capital
ΔY
WmgK=
stock increase; it is the value marginal revenue of the capital: ΔK .
The marginal cost of the capital = it is the cost of the last unit of the capital
they buy. The capital cost = the value of the capital + Opportunity cost + The
installation

CT =K + K⋅i=K (1+i ) → CmgK = 1 + i

Therefore, the maximum profit will be when WmgK = 1 + i

1+i1

1+i0
WmgK1

WmgK0

0 K1 K0 K2 K
Fig.3.3. The optimum level (stock) of the capital

We include in the installation costs: production loss because of the installation of

the new equipments, spending for employees’ trainings etc; these costs make
the new investment be more expensive than the previously installed

→ In order the investment to take place, the marginal product value has to be
higher than the capital marginal cost:
WmgK actualizat
q=
Raport Cost m arg inal al capitalului = Tobin coefficient.

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The present value of the marginal product = it is the present value of the
marginal productivity estimated to be obtained in future due to the present /
current investment.

The demand for investments:

1) Interest rate → the demand curve for investments is an indirect
relationship between investments and interest rates;
2) Technological change;
3) fiscality;
4) economic growth (the rate of GDP);
5) investors’ expectations.