Unit IV

CONSUMPTION
AND SAVING
Four Components of AD

I. CONSUMPTION
- expenditure by consumers on final G&S
Key concept: disposable income
- amount of income consumers actually take home after all
taxes have been paid, transfers have been received, depreciation
charges & retained earnings have been subtracted
- either consumed or saved
DI = consumption + saving (two choices)

Saving - that part of disposable income not spent on current

consumption
Two Ways of Describing the Consumption-Income Relationship:

1. Ratio of total consumption to total disposable income

2. Relationship of changes in consumption to changes in disposable
income
I.
Average Propensity to Consume (APC)
- Total consumption in a given period divided by total disposable
income
 total consumption C
APC = -------------------- ---
total disposable incomeYd

P6.490B
Ex. APC = ---------- = .98
P6,638
Interpretation: 2 cents of every DI was saved
Ex. APC= 1.001
Interpretation: for every P1,000 DI, consumers spend
P1,001
? - where does the excess come from
Marginal Propensity to Consume (MPC)
- the fraction of each additional (marginal) dollar of disposable
income spent on consumption
change in consumption C
MPC = ------------------------- ----
change in DI YD
P.80
MPC = ----- = 0.8
P1.0
MPC – 0.8; MPS – 0.98
Interpretation: consumers responded to an increase in income
differently than the average imply

Marginal Propensity to Save

- the fraction of each additional dollar of DI that is saved
change in saving
MPS = ------------------
change in DI
MPS = 1- MPC (every additional $-spent/saved)
Average Propensity to Save
= saving
-------------------
total disposable income

The CONSUMPTION FUNCTION

 the relationship between consumer spending and the various factors
determining it
Importance:
1. understand the short-term (business cycle) fluctuations
2. examine long-run issues such as the level of interest rates and the
size of the capital stock (the amount of buildings, machinery, and
other reproducible assets useful in producing goods and services)
Non-Income Determinants of Consumption:
1. Expectation
expectations about the level and riskiness of future income or wealth,
interest rates, age, education, and family size.
Anticipation of a pay raise, tax refund, cash gift: spend more before it is
received; consumption function rise even if actual DI has not
Anticipation of being laid off: tend to save more & spend less
2. Wealth
Stock market rises: stockholders save less & spend more of current
income
Increase: inheritance, value of property, treasure, stocks - increases
consumption & saving function even with the same income level
3. Credit
Availability of credit: allows spending more
Need to pay past debts: limit consumption
low levels of debt: consume more and save less
4. Taxes
Tax cuts: stimulated more aggregate demand
Increased tax: DI & spending decline

5. Price level
Rising PL – reduce real value of money
Two Kinds of Consumer Spending: (KeyNes)

1. Spending not influenced by current income (autonomous

consumption:
depends on Non-Income Determinants of Consumption:
expectations, wealth, credit, taxes, price levels
Total C=autonomous C + income-dependent consumption

2. Spending determined by current income

Consumption Function
- a mathematical relationship indicating the rate of desired consumer
spending at various income levels
C = a + bYD
Where C= current consumption
a= autonomous consumption
b= marginal propensity to consume
YD = disposable income

Dissaving - consumption expenditure in excess of disposable income; a

negative saving flow

Note: consumption spending continues to rise with income

 Consumption Function
The Keynesian Consumption function expresses the level of
consumer spending depending on three factors.

Yd = disposable income
a = consumption which is independent of Y; consumption when
income is zero (e.g. even with no income, you may borrow to be
able to buy food)
b = marginal propensity to consume (the % of extra income that is
spent). Also known as induced consumption.
MPC is the ratio of change in consumption to change in Yd.
MPC is the slope of the consumption function
 Consumption Function

Consumption is a function of disposable income.

C = b + cYd

where: C = consumption level

b = minimum consumption
Yd = disposable income
c = marginal propensity to consume
MPC(c) = Change in Consumption
Change in Yd
 Consumption Function
MPC = ∆C/∆Yd

MPS = ∆S/∆Yd

APC = C/Yd

APS = S/Yd
Consumption Function
Consumption Function

• The graph suggests consumption

is primarily determined by the
level of disposable income (Yd.).
• Higher Yd, leads to a higher
consumer spending.
Eq. 1
MPC = change in MPC/ change in Yd = cd = 400/500= .80 meaning:
fraction of an extra $1 of disposable personal income that people spend
on consumption. Thus, if a person with an MPC of 0.8 received an extra
$1,000 of disposable personal income, that person’s consumption would
rise by $0.80 for each extra $1 of disposable personal income, or $800.
Eq.2
C=b + c(Yd) = $300B + .8(500) = $700B
Eq. 3
Personal saving = disposable personal income – consumption
= 500 – 700
= -$200
Eq.4
MPS = ∆S/∆Yd
= 100/ 500 = .20

Eq. 5
MPC + MPS = 1
.80 + .20 = 1
 Consumption Function

National Income (Yn) = C + I + G

Households receive income from their labor

and ownership of capital
Income after payment of all taxes:
Disposable Income (Yd) = Y – T
 Savings Function
S = -b + sYd

Y=C+S

∆Y = ∆C + ∆S (if divide both sides by ∆Y)

1 = ∆C + ∆S
∆Y ∆Y

1 = MPC + MPS
 Consumption Function

Yd C S I C+ I

4001000 -600 500 1500

8001200 -400 500 1700

1600 1600 0 5002100

2000 1800 200500 2300

2600 2100 500500 2600

3200 2400 800500 2900

 Consumption Function
Consumption is a function of disposable
income.

C = b + cYd
1000= b + c (400)

MPC(c)=1200-1000/800-400=0.50

1000=b+.5(400)
1000=b +200
1000-200=b
b =800 min consumption
C=800 +0 .50Yd
 Savings Function
Savings is a function of disposable income.

S = -b + sYd
-600= b + s (400)

MPS(s)=-400-(-600)/800-400=.5
-600= b+.5(400)
-600= b +200
-600-200 =b
b=-800
S=-800 + .5Yd
 Consumption Function
Yd C S APC APS I C+I
300 640 -340 2.13 -1.13 200 840
1200 1360 -160 1.13 -0.13 1560
2000 2000 0 1.00 0 2200
2500 2400 100 0.96 0.04 2600
4000 3600 400 0.90 0.10 3800
5000 4400 600 0.88 0.12 4600
 Consumption Function
Consumption is a function of disposable income.
C = b + cYd
640= b + c (300)

MPC(C) = 1360-640/1200-300= 0.80

4400 =b+0.80(5000)
4400 =b + 4000
4400 – 4000 = b
b = 400
C = 400 + 0.80Yd
 Saving Function
Saving is a function of disposable income.
S = -b + sYd
-340= b + s (300)

MPS(s)=-160-(-340)/1200-300= 0.20
-340 = b+0.20(300)
-340 = b + 60
-340 - 60=b
b=-400
S=-400+ 0.20Yd
 Income Equilibrium
Yd = C
Yd = 400+0.80Yd
Yd - 0.80Yd = 400
0.20Yd = 400
Yd=400/0.20
Yd=2000
C=400+0.80(2000)
C=400+1600
C=2000
Yd=2,000; C=2,000

Hence, this is the 1st Income Equilibrium when Yd =C

 Income Equilibrium
Yd = C+I
Yd =400+0.80Yd+200
Yd- 0.80Yd =600
0.20Yd =600
Yd =600/0.20
Yd =3000
C+I =400+0.80(3000) +200
C+I =600+2400
C+I =3000
Yd=3,000; C+I = 3,000
Hence, this is the 2nd Income Equilibrium when
Yd =C+I
II. Expenditure: INVESTMENT
The Interest Rate — Investment Relationship

expenditures on (production of) new plant, equipment and

structures (capital) in a given time period plus changes in business
inventories

1. Expectations on rate of return

 favorable expectations of future sales are a necessary condition for
investment spending
 expected rate of return is greater than the real interest rate, the
investment is possible
2. Interest Rates [deposit versus loan rates]
 investment spending is lower when interest rates are high, more
investments at lower rates
 the real interest rate determines the level of investment

The Investment demand Curve

The inverse relationship between the real rate of interest and the level
of investment is illustrated in the Investment Demand Curve
shown below.
 Investment Value
 Both firms and households purchase investment
goods”
Firms  to add to capital stock and to replace existing
capital as it wears out
Households  buy new houses

 When interest rate increases, fewer investment

projects are profitable
 Investment Function
Quantity of investment goods demanded
depends on the real interest rate because
the interest rate is the cost of borrowing.
 Equilibrium in the Financial Markets
Rewrite national income accounts:
Y =C+I+G
I =Y–C–G
National savings
S=I
National savings : Output that remains after the
demands of consumers and government have
been satisfied.
Investment as a Function of National Income

 shows the relationship between real GDP and

investment levels
 decision is based on expected rates of return, and
the interest rate of borrowing for the investment
expenditure
 The slope of the investment function is zero
Factors that Shift the Investment Demand Curve [non-interest
factors]
1. Business Taxes – depends on the tax structure imposed
2. Technology and Innovation
- demand for investment goods increases in an industry where
there is technological advances than in industries with
fixed technology regardless of the level of the real
interest rate
3. Stock of Capital Goods on Hand
— with excess capital - less likely to invest in additional
capital
- a business that is operating at or beyond capacity – more
likely
at any given level of the real interest rate
 Investment Multiplier
INVESTMENT MULTIPLIER

-an income injection into the circular flow could generate

a much greater increase in income

investment multiplier = change in income / change in

investment

Investment Multiplier (K)

Using MPC: K = 1/1-MPC

Using MPS: K = 1/MPS

EX. A state government has invested P500M to construct a public
highway. They will have to hire engineers, suppliers and laborers. Such
investment will lead to employment opportunities for many people.
Result - they will receive income from which they will consume, which
would distribute the money among more people.

Suppliers’ MPC - 0.5 - meaning?

Investment multiplier of the above:

Investment multiplier = (1) / (1-MPC) = 1 / (1 – 0.5) = 2

Meaning: ?
Laborers have an MPS - 0.2 – meaning?
Investment multiplier = 1 / MPS = 1 / 0.2 = 5
Meaning: ?
 result: initial investment of P500M will generate the following
income:

Change in income / 500M = 1 / 0.2

Change in income = 500M / 0.2
= Rs.2500 crore

As shown by this calculation, an initial investment of Rs.500 crore

will generate an income of Rs.2,500 crore.
If Consumption Function is given by: C = 30 + 0.4 Y, then
determine: (i) Savings; (ii) MPC; (iii) MPS; (iv) Break-even level
of Income; (v) Saving Function
Y=C
S= s + (1-b)Y where s=autonomous savings, (1-b)= marginal
propensity to save, and Y= income.
The consumption function is C= 30+0.4Y where Y is the income
at different level in the economy.
Income = consumption + savings
=> Savings = Income - consumption
=> S = Y- C
Y=C
=> Y= 30 +0.4 Y
=> Y- 0.4 Y=30
=> 0.6 Y = 30
=> Y= 30/0.6 = 50

=> S = Y- C
=> S = Y - ( 30 + 0.4Y)
=> S = Y- 30 - 0.4Y
=> S = - 30 + Y ( 1 - 0.4)
=> S = -30 + 0.6Y
Therefore, the saving function is S= -30 + 0.6Y where
autonomous savings= -30 crores, MPS= 0.6 and Y is income at all
levels.
IV. NET EXPORT SPENDING

- gross exports depend on the spending behavior of foreign

consumers and businesses
Ex. Asian currency crisis of 1997-1999
US exports fell sharply
Asian students applying for US-produced educational services

- decline in export spending represented a leftward shift of AD

when consumer spending slips or stock market dips, import spending
declines with the rest of consumption