Business Economics (ECO 341)Fall: 2012 Semester

Khurrum S. Mughal

1

YearPrice ofHot dogs

Quantity ofHot dogs

Price of Hamburgers

Quantity ofHamburgers

2001 $1 100 $2 50

2002 $2 150 $3 100

2003 $3 200 $4 150

Quiz

Consumption, Saving and Investment

Macroeconomics

Consumption

Savings

Investment

Multiplier Effect

Theme of Lecture

Importance of Consumptions, Savings and Investments for a country

The choice between Consumption and Investment defines the future direction of an economy

Personal Consumption Expenditure is on final goods and services by households

What is not consumed from the disposable income is saved.

Macroeconomics

Consumption and Saving Pattern for 2010-11, PBS

Major differences in Pakistan

◦ In Income Class

◦ Due to Provincial, hence cultural differences

◦ Urban or Rural Life style

Difference in Consumption Patterns

AssignmentGo to

http://www.pbs.gov.pk/content/pakistan-social-and-living-standards-measurement◦ Household economic Survey (HES)

Difference in Consumption Saving Patterns

Punjab Sindh KPK BalochistanTotal Urban Rural Total Urban Rural Total Urban Rural Total Urban Rural

Difference in Consumption Patterns

The Keynesian Theory of Consumption:

Current real disposable income is the most important determinant of consumption in the short run.

Disposable Income (Yd) = Gross Income - (Deductions from Direct Taxation + Benefits)

Consumption Function

Gross income (Y) can either be consumed (C), Saved (S), or given to the Government in taxes (T)

Y = C + S + T Yd = Yg – T

Consumption Function

Savings

45˚

Y

C

0

Consumption function C = f(Y)

Consumption

Y1 Y 2

CA

Consumption Function

The standard Keynesian consumption function:

C = a + c Yd where,Yd= Disposable incomeC= Consumer expenditurea = autonomous consumption. c = marginal propensity to

consume (mpc). Y

C

0

C = f(Y)

Savings

Consumption

45˚

Y1 Y 2

CA

Consumption Function

• If an individual's income fell to zero some of his existing spending could be sustained by using savings. This is known as DIS-SAVING.

The gradient of the consumption curve gives the marginal propensity to consume. As income rises, so does total consumer demand.

Break-even Point

Y

C

0

C = f(Y)

Savings

Consumption

45˚

Y1 Y 2

CA

Consumption Function

The nineteen century Prussian statistician Ernst Engel (1821–1896) noticed

as income increases, expenditures on many items go up, but there are limits to the extra money people will spend on food when their income rise.

Engel's Law: The proportion of total spending devoted to food declines as income increases.

Engel's Law

Nonlinear Consumption function

Y

C

C = f(Y)

CA

45°

E

YE

Current disposable income: it is the central factor determining a nation's consumption.◦Permanent-Income theory◦Life-Cycle Hypothesis

Wealth Effect

Expectations (interest rate, inflation, etc)

Determinants of Consumption

Consumption

Savings

Investment

Multiplier Effect

Theme of Lecture

Saving is that part of income that is not consumed. Saving equals income minus consumption: S = Y – C

Income is the sum of consumption and savings: Y = C + S

Savings

Like consumption, Saving is also a function of income: S = f(Y)

If autonomous consumption exists then autonomous saving exists as well and saving function is:

S = -CA + s.Y

Saving is a source for investment.

Savings Function

Like consumption, Saving is also a function of income: S = f(Y)

If autonomous consumption exists then autonomous saving exists as well and saving function is:

S = -CA + s.Y

Saving is a source for investment.

Savings Function

Y

C, S

0

C = f(Y)

45˚

Y E

CA

-CA

S = f(Y)

The saving function is the mirror image of the consumption function. It shows the relationship between the level of saving and income.

Savings Function

The marginal propensity to save

is defined as the fraction of an extra unit of income that goes to extra saving.

Y

SMPS

Savings

Calculating MPC & MPS

Income Category

DI ($) Consumption Exp

MPC Net Savings

MPS

A 24,000 24,200 ? ? ?

B 25,000 25,000 ? ? ?

C 26,000 25,800 ? ? ?

D 27,000 26,600 ? ? ?

E 28,000 27,400 ? ? ?

F 29,000 28,200 ? ? ?

G 30,000 29,000 ? ? ?

Calculating MPC & MPS

Income Category

DI ($) Consumption Exp

MPC Net Savings

MPS

A 24,000 24,200 -200

B 25,000 25,000 0.80 0 0.20

C 26,000 25,800 0.80 200 0.20

D 27,000 26,600 0.80 200 0.20

E 28,000 27,400 0.80 200 0.20

F 29,000 28,200 0.80 200 0.20

G 30,000 29,000 0.80 200 0.20

How much of every additional rupee in income is consumed? MPC

How much of every additional rupee in income is saved? MPS

MPC + MPS = 1 (IDENTITY)

Identity of Marginal Propensities

Consumption

Savings

Investment

Multiplier Effect

Theme of Lecture

Meaning of Investment in Economics

Investment plays two roles in macroeconomics:

◦ It can have a major impact on Aggregate Demand and affects business cycles

◦ It leads to capital accumulation

Focusing on Gross private Domestic Investment

Investment

Revenues: an investment should bring the firm additional revenue.

Costs: interest rates & taxes influences the costs of the investment.

Consumer demand: the bigger the increase in consumer demand, the more investment will be needed.

Expectation: business expectation about future state of economy.

Determinants of Investment

Investment spending

Interest rate i

D

D1

Higher Output

The Investment Demand Curve

Investment spending

Interest rate i

D1

D

Higher Taxes

The Investment Demand Curve

Investment spending

Interest rate i

D1

D

Pessimistic Expectation

The Investment Demand Curve

Consumption

Savings

Investment

Multiplier Effect

Theme of Lecture

The Keynesian investment multiplier

model shows that an increase in investment will increase output by a multiplied amount – by an amount greater than itself.

The multiplier is the number by which the change in investment must be multiplied in order to determine the resulting change in total output.

Investment Multiplier

Y

C, I

0

45˚

C +I1

C + I2

Y1

I2 = I

1 + ΔI

ΔY = k . ΔI

Y2

ΔY

ΔI

E1

E2

I

Yk

Investment Multiplier

When there is change in C , I , G or Xn either

increases or decreases, real GDP also increases/decreases.

Total increase in real GDP is larger than the initial increase in spending.

The MULTIPLIER is the amount by which a change in any component of spending is magnified or multiplied to determine the change that it generates in real GDP.

Multiplier

A change in spending ultimately changes output and income by more than the initial change in investment spending. This is called the multiplier effect.

The Multiplier Effect

The size of the multiplier k depends upon how large the MPC is.

MPSMPCYCCY

Y

I

Yk

1

1

1

1

1

Investment Multiplier

The Spending Multiplier can be calculated from the MPC or the MPS.

Multiplier = 1/1-MPC or 1/MPS

Multipliers are (+) when there is an increase in spending and (–) when there is a decrease in spending

You multiply the multiplier times the initial increase in spending to determine total effect on real GDP.

Investment Multiplier