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© 2005 Thomson
CChapter 21hapter 21
Consumption and Consumption and InvestmentInvestment
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Economic PrinciplesEconomic Principles
Keynes’s absolute income hypothesis
Duesenberry’s relative income hypothesis
Friedman’s permanent income hypothesis
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Economic PrinciplesEconomic Principles
Modigliani’s life-cycle hypothesis
The marginal propensity to consume
The marginal propensity to save
Autonomous investment
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Consumption Consumption
Spending?Spending?Consumption-spending and consumption-production decisions are made simultaneously and independently of each other.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Consumption Consumption
Spending?Spending?The result is that sometimes consumers don’t buy enough of everything produced and other times producers do not produce as much as people want to consume.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Consumption Consumption
Spending?Spending?Consumption function
• The relationship between consumption and income. It is written as C = f(Y), where C represents consumption and Y represents income.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Consumption Consumption
Spending?Spending?The single most important factor influencing a person’s consumption spending is his or her level of disposable income. The greater the disposable income, the greater the consumption spending.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Consumption Consumption
Spending?Spending?A number of hypotheses have been offered to explain how changes in an individual’s income, and, taken collectively, changes in national income affect individual and national consumption.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Keynes’s Absolute Keynes’s Absolute Income HypothesisIncome Hypothesis
Absolute income hypothesis
• As national income increases, consumption spending increases, but by diminishing amounts. That is, as national income increases, the marginal propensity to consume (MPC) decreases.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Keynes’s Absolute Keynes’s Absolute Income HypothesisIncome Hypothesis
Marginal propensity to consume (MPC)
• The ratio of the change in consumption spending to a given change in income.
• MPC = (change in C)/(change in Y).
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Keynes’s Absolute Keynes’s Absolute Income HypothesisIncome Hypothesis
Marginal propensity to consume (MPC)
• Consumption increases by diminishing amounts as the income level increases.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Keynes’s Absolute Keynes’s Absolute Income HypothesisIncome Hypothesis
Keynes believed that although people who earn high incomes spend more on consumption than people who earn less, they are less inclined to spend as much out of a given increase in income than those earning less.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Keynes’s Absolute Keynes’s Absolute Income HypothesisIncome Hypothesis
Keynes relied on the psychological law that the satisfaction of “immediate primary needs” is a stronger motive for consumption than “accumulation.”
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Keynes’s Absolute Keynes’s Absolute Income HypothesisIncome Hypothesis
For example, if a millionaire and a welfare recipient each received $500, the millionaire would likely just add the money to her savings account since her primary needs are already met.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Keynes’s Absolute Keynes’s Absolute Income HypothesisIncome Hypothesis
The welfare recipient, on the other hand, would likely immediately spend the money on food, clothing, and shelter.
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EXHIBIT 1 THE INDIVIDUAL’S MARGINAL PROPENSITY TO CONSUME
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Gottheil - Principles of Economics, 4e
Exhibit 1: The Exhibit 1: The Individual’s Marginal Individual’s Marginal
Propensity to ConsumePropensity to Consume1. What is the change in consumption as total income increases from $1,000 to $2,000 in Exhibit 1?• Consumption increases by $800 (from $1,400 to $2,200) as total income increases by $1,000.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 1: The Individual’s Exhibit 1: The Individual’s Marginal Propensity to Marginal Propensity to
ConsumeConsume2. What is the change in consumption as total income increases from $2,000 to $3,000?• Consumption increases by $700 (from $2,200 to $2,900) as total income increases by $1,000.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Keynes’s Absolute Keynes’s Absolute Income HypothesisIncome Hypothesis
To Keynes, national economies behave like individuals. He hypothesized that a nation’s MPC depends on its level of national income.
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EXHIBIT 2 THE NATION’S MARGINAL PROPENSITY TO CONSUME ($ BILLIONS)
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Gottheil - Principles of Economics, 4e
Exhibit 2: The Nation’s Exhibit 2: The Nation’s Marginal Propensity to Marginal Propensity to
ConsumeConsumeWhat happens to the national MPC as national income increases in Exhibit 2?• The national MPC increases, but by diminishing amounts.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Keynes’s Absolute Keynes’s Absolute Income HypothesisIncome Hypothesis
The pioneering work of Simon Kuznets showed that Keynes’s hypothesis was wrong. A nation’s MPC tends to remain fairly constant regardless of the absolute level of national income.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Duesenberry’s Duesenberry’s Relative Income Relative Income
HypothesisHypothesisRelative income hypothesis
• As national income increases, consumption spending increases as well, always by the same amount. That is, as national income increases, MPC remains constant.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Duesenberry’s Duesenberry’s Relative Income Relative Income
HypothesisHypothesisAccording to Duesenberry, consumption spending is rooted in status. High-income people not only consume more than others, but also set consumption standards for everyone else.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Duesenberry’s Duesenberry’s Relative Income Relative Income
HypothesisHypothesisAn individual’s MPC, then, remains the same, as long as the individual’s relative income position remains unchanged.
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EXHIBIT 3 THE MARGINAL PROPENSITY TO CONSUME REMAINS CONSTANT
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Gottheil - Principles of Economics, 4e
Exhibit 3: The Marginal Exhibit 3: The Marginal Propensity to Consume Propensity to Consume
Remains ConstantRemains Constant
• Keynes’s consumption curve flattens near the top, reflecting his belief that MPC increases by diminishing amounts as income increases.
How does Duesenberry’s consumption curve in Exhibit 3 compare to Keynes’s consumption curve in Exhibit 2?
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 3: The Marginal Exhibit 3: The Marginal Propensity to Consume Propensity to Consume
Remains ConstantRemains ConstantHow does Duesenberry’s consumption curve in Exhibit 3 compare to Keynes’s consumption curve in Exhibit 2? • Duesenberry’s consumption curve is a straight line, reflecting his belief that MPC increases by the same amount as income increases.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Friedman’s Friedman’s Permanent Income Permanent Income
HypothesisHypothesisPermanent income hypothesis
• A person’s consumption spending is related to his or her permanent income.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Friedman’s Friedman’s Permanent Income Permanent Income
HypothesisHypothesisPermanent income
• Permanent income is the regular income a person expects to earn annually. It may differ by some unexpected gain or loss from the actual income earned.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Friedman’s Friedman’s Permanent Income Permanent Income
HypothesisHypothesisTransitory income
• The unexpected gain or loss of income that a person experiences. It is the difference between a person’s regular and actual income in any year.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Friedman’s Friedman’s Permanent Income Permanent Income
HypothesisHypothesisAccording to Friedman, an unexpected gain or loss in income in one year does not influence an individual’s overall MPC from year to year.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Modigliani’s Life-Modigliani’s Life-Cycle HypothesisCycle Hypothesis
Life-cycle hypothesis
• Typically, a person’s MPC is relatively high during young adulthood, decreases during the middle-age years, and increases when the person is near or in retirement.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Consumption Consumption
Spending?Spending?Autonomous consumption
• Consumption spending that is independent of the level of income.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Consumption Consumption
Spending?Spending?Some consumption spending is simply unavoidable. While individuals may spend less on food, clothing, and shelter when income falls, there are limits to how much one can cut and still survive.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Consumption Consumption
Spending?Spending?A change in national income induces a change in consumption. The change in consumption is considered movement along the consumption curve.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Consumption Consumption
Spending?Spending?The consumption curve can also shift. Shifts in the consumption curve are unrelated to national income. There are several factors that can shift the consumption curve.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Consumption Consumption
Spending?Spending?1. Real asset and money holdings.
• An increase or decrease in real assets or money holdings causes the consumption curve to shift. For example, a substantial inheritance of money or property would cause the curve to shift upward.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Consumption Consumption
Spending?Spending?2. Expectations of price changes.
• An expectation of inflation could cause an increase in the current level of consumption, even though incomes are not expected to change. The increase in consumption would shift the curve upward.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Consumption Consumption
Spending?Spending?3. Credit and interest rates.
• If credit is more easily available or if the credit terms are made more attractive, people are likely to increase their spending on durable goods, even if their incomes haven’t changed. The consumption curve would shift upward.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Consumption Consumption
Spending?Spending?4. Taxation.
• If government decided to increase the income tax, people would end up with a smaller pay check, even though their salaries remained unchanged. This would cause a decrease in consumption and a downward shift in the consumption curve.
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EXHIBIT 4 SHIFTS IN THE CONSUMPTION CURVE
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 4: Shifts in Exhibit 4: Shifts in the Consumption the Consumption
CurveCurve
i. True
ii. False
The consumption curve shifts depicted in Exhibit 4 can be attributed to increases and decreases in national income.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 4: Shifts in Exhibit 4: Shifts in the Consumption the Consumption
CurveCurveThe consumption curve shifts depicted in Exhibit 4 can be attributed to increases and decreases in national income.i. True
ii. False. Shifts in the consumption curve are unrelated to changes in national income.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
The Consumption The Consumption EquationEquation
There are two key factors that influence the character of our consumption spending: autonomous consumption and our income level.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
The Consumption The Consumption EquationEquation
Consumption induced by our level of income is referred to as induced consumption.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
The Consumption The Consumption EquationEquation
The consumption function takes the following form:
C = a + bY
Where a equals autonomous consumption spending, b equals MPC and Y equals level of national income.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines the Level of Saving?the Level of Saving?
People do two things with their income. They either spend it on consumption or they save it.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines the Level of Saving?the Level of Saving?
Saving
• The part of national income not spent on consumption.
• S = Y - C.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines the Level of Saving?the Level of Saving?
Saving
• When C is greater than Y, saving is negative and is called dissaving. People can consume more than their income allows by running down their savings or other forms of accumulated wealth.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines the Level of Saving?the Level of Saving?
Marginal propensity to save (MPS)
• The change in saving induced by a change in income.
• MPS = (change in S)/(change in Y).
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines the Level of the Level of
Saving?Saving?The marginal propensities to consume and to save add up to 100 percent.• MPC + MPS = 1.
• MPS = 1 - MPC.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines the Level of Saving?the Level of Saving?
Income curve or 45o line
• A line, drawn at a 45° angle, showing all points at which the distance to the horizontal axis equals the distance to the vertical axis. The line is also called the income curve.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 5A THE SAVINGS CURVE
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Gottheil - Principles of Economics, 4e
EXHIBIT 5B THE SAVINGS CURVE
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 5: The Saving Exhibit 5: The Saving CurveCurve
What is saving when income is $400 billion in Exhibit 5?
• S = Y – C or S = Y – (a + bY).
• Saving = $400 billion – [$60 billion + (0.8 × $400 billion)] = $20 billion.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
The Investment The Investment FunctionFunction
Producers in the economy must decide how much income to spend on new investment.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
The Investment The Investment FunctionFunction
Producers may invest in replacing used up or obsolete machinery, expanding production, increasing raw material or finished goods inventories, and building new facilities for new products.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
The Investment The Investment FunctionFunction
Each producer makes investment decisions independently of others.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
The Investment The Investment FunctionFunction
Intended investment
• Investment spending that producers intend to undertake. These intended investments do not always end up being realized.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Investment?Investment?
The level of national income doesn’t play the decisive role in determining investment that it plays in determining consumption spending.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Investment?Investment?
Autonomous investment
• Investment that is independent of the level of income.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 6 THE INVESTMENT CURVE
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Gottheil - Principles of Economics, 4e
Exhibit 6: The Investment Exhibit 6: The Investment CurveCurve
How does the investment curve (I) in Exhibit 6 change as the level of national income changes?• The investment curve does not change. It remains at $75 billion at every level of national income.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Investment?Investment?
Four factors determine the size of the economy’s autonomous investment.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Investment?Investment?
1. Technology level.
• The introduction of new technologies is one of the mainsprings of investment. Technological leaps produce extensive networks of investment spending.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Investment?Investment?
2. Interest rate.
• Producers undertake investment when they believe the rate of return generated by the investment will exceed the interest rate, that is, the cost of borrowing investment funds.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Investment?Investment?
2. Interest rate.
• There is an inverse relationship between the rate of interest and the quantity of investment spending.
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Gottheil - Principles of Economics, 4e
EXHIBIT 7 THE EFFECT OF CHANGES IN THE RATE OF INTEREST ON THE LEVEL OF INVESTMENT
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 7: The Effect of Exhibit 7: The Effect of Changes in the Rate of Changes in the Rate of Interest on the Level of Interest on the Level of
InvestmentInvestmentWhy is the demand curve for investment in panel a of Exhibit 7 downward sloping?• The demand curve for investment is downward sloping because as the rate of interest decreases, the level of investment in the economy increases.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Investment?Investment?
3. Expectations of future economic growth.
• Investment spending reflects how producers view the future. Future expectations are shaped by past performance.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Investment?Investment?
4. Rate of capacity utilization.
• Producers seldom choose to operate at 100 percent capacity. Operating at less than 100 percent capacity gives them the ability to expand production on demand.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Investment?Investment?
4. Rate of capacity utilization.
• How much flexibility producers end up choosing influences the economy’s level of production. For producers who choose to operate close to full capacity, a moderate increase in sales may shift them quickly into investment spending.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
What Determines What Determines Investment?Investment?
The level of investment spending in the U.S. economy is volatile. Sometimes the factors that effect investment spending pull in opposite directions. Other times, they work in unison and lead to impressive economic growth.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
EXHIBIT 8 THE VOLATILITY OF INVESTMENT
Source: Economic Report of the President 1994 (Washington, D.C.: United States Government Printing Office, 1994), p. 270; and U.S. Department of Commerce, Survey of Current Business 76 (January/February 1996), Table 2.
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© 2005 Thomson
Gottheil - Principles of Economics, 4e
Exhibit 8: The Exhibit 8: The Volatility Volatility
of Investmentof InvestmentHow does the rate of investment spending in Exhibit 8 compare to the rate of consumption spending?• While the rate of consumption spending is fairly stable over time, the rate of investment spending is volatile.