Topic 3

Consumption and Investment

 Consumption and Investment
GDP = C + I + G + X
Changes on Consumption (and Savings) and
Investment are of central concern to
Macroeconomics
Consumption: component of aggregate demand
Savings: source of funds for investment
Investment
Component of aggregate demand
Adds to productive capacity and increases potential
output
Govt exp on Government borrowing
goods & services Government
Transfers
Taxes
Household savings

Consumer Households
spending
Wages etc

Market for goods Factor Financial

& services markets markets
Wages etc
GDP

I spending Firms
Barrowing & stocks issued
Exports
Rest of Foreign borrowing etc
World
Imports Foreign lending etc 3
 Aggregate Consumption
Aggregate consumption expenditure is the
sum total of individual households
consumption expenditure
 Households, typically
Use a part of their income for consumption
And save the other part

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 Firms
Investment expenditure:
Planned investment (mainly fixed investment
expenditure, i.e., expenditure on final investment
goods such as plant, machinery)
Unplanned inventory adjustment
Use retained earnings (business savings) and
loans and other sources to fund investment

6
 Consumption Expenditure

Depends on:
Current disposable income (DI)
Other factors:
Permanent income hypothesis
Life cycle hypothesis
Wealth effect

7
 Consumption Function
Relationship between C and DI, other
factors remaining constant

8
 Saving Function
(Saving is the residual after deduction C from DI)

10
 C(Y)
Deriving Savings function C3

C b

C2
C1 Savings at Y1 = OY1
C1Y1 = -a
a
45
0 Y2 Y3 Y Savings at Y2 = OY2
Y1Y
1
S
C2Y2 = 0
S(Y)
Y1 Y2 b
Savings at Y3 = OY3
0 a Y3 C3Y3 = + b
Y

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 Consumption Function
Movement along curve Shift of curve
C C

DI DI
 Marginal propensity to consume
MPC is the change in C when DI changes by a
unit
= C/ DI
MPC + MPS = 1
 Consumption function and Aggregate
Demand curve
Consumption function:
Relationship between income and consumption,
other factors including the price level remaining
the same
Aggregate demand curve:
Relationship between aggregate demand
(consumption) and the price level, other factors
including income remaining the same
Movement along the Consumption function =
Shift of the AD curve
 Meaning of Investment
Fixed investment (= expenditure on final
investment goods (durable goods like plant,
machinery, buildings)
+ Net change in inventories
Not financial investment:
Buying land, stocks etc
Unless otherwise mentioned, we refer to fixed
investment when discussing investment
 Planned Investment Expenditure
(= investment spending = investment demand)

Private Investment undertaken for profits

It is influenced by the Expected rate of return

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 Return on Investment
Rate of return =
(Expected Revenue from project Cost of project) x 100
Cost of project
 Expectations
Are subjective
Are often influenced by current and
recent rates of return
But can be highly volatile due to changes
in the business climate:
Political, ideological, psychological,
technological and other influences on
future expectations

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Expected Return on Investment (%)

A
30% PROJECTS in order of return
B
25% C

20%
D
15%
E
10%
F
5%

Investment spending
Expected Return on Investment (%) and rate of interest
Downward sloping INVESTMENT DEMAND
A derived from this curve
30% At 20% r/i: A + B + C
B At 10% r/i: A + B + C+ D + E
25% C At 5% r/i: A + B + C + D + E + F
20%
D
15%
E
10%
F
5%

10 20 30 40 50 60 70 80
Investment spending (Rs million)
Rate of interest (%)

A
30% INVEST DEMAND Curve
B
25% C

20%
D
15%
E
10%
F
5%

Investment spending
Rate of interest (%)

30%
INVESTMENT DEMAND Curve
25%

20%

15%

10%

5%

Investment spending
Rate of interest (%) INVEST DEMAND Curve

Rate of interest and Investment are

30%
inversely related,
25%
GIVEN particular expectations about future
and a particular Demand curve
20%

15%

10%

5%

Investment spending
Rate of interest (%) INVEST DEMAND Curve
When expectations about future change,
30% the Demand curve shifts; and the rate of
interest and investment may be positively
25% correlated
20%

15%

10%

5%

Investment spending
Rate of interest (%) INVEST DEMAND
If expectations about future worsen and
30% the Demand curve shifts to the left:
A fall in the rate of interest may be
25% associated with a fall in Investment
20%

15%

10%

5%

Investment spending
Rate of interest (%) INVEST DEMAND
If expectations about future improve and
30% the Demand curve shifts to the right:
Even a rise in the rate of interest may be
25% associated with a rise in Investment
20%

15%

10%

5%

Investment spending
 Increasing Investment
The dual role of
Rate of interest and
Expected return
In a depressed environment, a reduction of
rate of interest alone may not be sufficient
 RBI vs Government

What is controversy about the

interest rate movement?