Chapter 6

Personal disposable income Y=C+S Where,Y=disposable income

C=ConsumptionS=savings

Consumption brings benefits by way of satisfaction of human needs, while saving is needed for old age, rainy days and bequest.

Consumption expenditure is the most dominant component of aggregate demand.

It accounts for 2/3 of the GDP

Consumption (C)Definition: The value of all goods and services bought by

households. Includes:durable goods

last a long time ex: cars, home appliances

nondurable goods last a short time ex: food, clothingservices

work done for consumers ex: dry cleaning, air travel.

Consumption functionC= f (Y,Ys,Ymp,W,i,CA,CE,IWD,u)

C= ConsumptionY =Income of consumersYs = Consumers’ expectations about future incomeYmp = Consumers’ max. past incomeW=wealth i=interest rate CA=credit aviabilityCE= Consumers’ expectations about future priceIWD =Distribution of wealth and income F1, f2, f3, f4,f7 >0 > f5, f9 : f8, f6, f10

Graph 1: Disposable Income, Consumption, and Saving

The relationship between disposable income and consumption has been relatively constant and stable over timeSaving is the difference between disposable income and consumption

Graph 2: U.S. Consumption Depends on Disposable Income

The Consumption FunctionThe relationship between consumption and income,

other things constantConsumption is the dependent variable Disposable income is the independent variable.

Because consumption depends on income, it is a function of income

Graph 3: The Consumption Function

Both disposable income and consumption are measured in real terms, or in inflation-adjusted dollarsConsumption increases with disposable income, assuming other determinants of consumption remain constant

Nonincome Determinants

What are these factors that could cause the entire consumption function to shift?Net wealth and consumptionPrice levelInterest rateExpectations

Net Wealth

Net wealth is the value of all assets that households own minus any liabilities, or debts owed

A decrease in net wealth would make consumers less inclined to spend, more inclined to save

Increase in net wealth increases consumption

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Real disposable income

C"

C'

•Increase in net wealth shifts consumption function from C to C''•Decrease in net wealth shifts it from C to C'

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Shifts and Movements Along

Difference between a movement along the consumption function and a shift of the consumption function

Movement along the consumption function results from a change in income

Shift of the consumption function results from a change in one of the non income determinants of consumption

Price LevelWhen price level changes, real value of

rupees-denominated financial assets (bank accounts, cash) also changesIncrease in the price level reduces the purchasing

power of wealth held in fixed rupees assets – households consume less and save more

Decreases in the price level increase the purchasing power of wealth held in fixed assets – households consume more and save less

Interest Rate

InterestThe reward savers earn for deferring consumption The cost paid by borrowers for current spending

power

The higher the interest rate, the less is spent on items purchased on credit (households save more and borrow less) and the consumption function shifts downward

Conversely, a lower interest rate shifts the consumption function upward

Expectations

Changing expectations about price levels, interest rates, job security and other such factors influence consumer behavior

If expectations become more pessimistic, then consumption function shifts downward

If expectations become more optimistic, then consumption function shifts upward

InvestmentInvestment consists of spending on

New factories and new equipment New housing Net change in inventories

Firms invest in capital goods now in the expectation of a future return

Since return is in the future, investors must estimate how much a particular investment will yield in all years of its productive life

Determinates of investments function: I = f (Y,r,w,Q,FMP,F,T,BC,Y-1,K-1,u)

=> I = net investment Y = output (income) r = real interest rate w = real wage rate Q = Tobin’s Q FMP = fiscal (tax) and monetary (credit) policies F = financial constraints T = technology BC = business confidence Y-1 = output in the previous year

K-1 = stock of capital in the previous year u = ‘other’ factors

Demand for Investment

Firms buy new capital goods only if they expect this investment to yield a greater return than other possible uses of their funds

The expected rate of return equals the annual rupees earnings expected from the investment divided by the purchase price

Market interest rate is the opportunity cost of investing in capital

•Shows the inverse relationship between the quantity of investment demanded and the market interest rate, other things constant. •Sums the investment demanded by each firm at each interest rate. •At lower interest rates, more investment projects become profitable for individual firms, so total investment in the economy increases.

Planned Investment and Income

Investment depends more on interest rates and on business expectations than on the prevailing level of income

Thus, the investment decision is said to be “forward looking,” based more on expected profit than on current levels of income and output

Investment FunctionThe investment function isolates the

relationship between the level of income in the economy and planned investment – the amount firms would like to invest, other things constant

Two determinants of investment assumed to be constant areThe market interest rateBusiness expectations

Market Interest Rate

A decline in the rate of interest, other things remaining constant, will reduce the cost of borrowing and increase planned investment: investment function shifts upward

Conversely, when the interest rate increases, the planned investment function shifts downward

1.0

0 2.0 4.0 6.0 8.0 10.0 12.0 14.0

Real disposable income (millions of rupees)

I

1.1 I"

0.9 I'

The horizontal investment functions imply that planned investment does not vary with real disposable income, it is autonomous

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Investment Spendingand Interest Rates

The decision to invest is based on the principle of opportunity cost.

• The interest rate prevailing in the economy The interest rate prevailing in the economy provides a measure of the opportunity cost of provides a measure of the opportunity cost of investment.investment.

PRINCIPLEPRINCIPLE of Opportunity Costof Opportunity CostThe opportunity cost of something is what you The opportunity cost of something is what you sacrifice to get it.sacrifice to get it.

Investment Spendingand Interest Rates

A firm has a menu of investment projects it would like to undertake.

If the net return from an investment exceeds the opportunity cost of the funds, the investment should be undertaken.

As market interest rates rise, there will be fewer profitable investments.

Interest Rates and InvestmentThere is a negative

relationship between real investment spending and the real interest rate.

• As the real rate of interest As the real rate of interest rises, fewer investment rises, fewer investment projects will be profitable.projects will be profitable.

Interest Rates and InvestmentRemember, nominal rates of interest are not a good indicator of the true cost of investing.

The firm makes its investment decisions by comparing the expected real net return from investment to the real rate of interest.

Q-theory of InvestmentThe Q-theory of investment, developed by Nobel laureate James Tobin of Yale University, links investment spending to stock prices. It states that investment spending increases when stock prices are high. Then, the firm uses its proceeds from the sale of stock to undertake new investment.

YY

(Income)(Income)

CC

(Consumpti(Consumption)on)

SS

(Savings)(Savings)

APCAPC MPCMPC APSAPS MPSMPS

00 6060 -60-60 -- -- -- --

100100 150150 -50-50 1.51.5 0.900.90 -0.5-0.5 0.100.10

200200 220220 -20-20 1.11.1 0.700.70 -0.1-0.1 0.300.30

250250 250250 00 11 0.600.60 00 0.400.40

350350 300300 5050 0.890.89 0.500.50 0.110.11 0.500.50

450450 345345 105105 0.770.77 0.450.45 0.230.23 0.550.55