Consumption, Savings and Investment Theory

Consumption Theory Definition: The purchase of goods and services by individuals or households which are produced by firms.

According to John Maynard Keynes, a person would increase his consumption as his income increases, but the expenditure will be less than the increase in income. (consumers will spend only a part of the increase in their income and save the rest).

Income = Consumption + Saving Y = C + S

Consumption Function Shows the relationship between the consumption level and the income level. General equation for a linear consumption function can be written as below: Where,C = consumption expenditurea = autonomous consumptionb = marginal propensity to consumeYd = disposable income C = a + bYd

Consumption Function, cont..Autonomous consumption: It does not depends on the income level whereby it is the part of consumption when the consumers income level is zero.Average propensity to consume (APC): defines the relationship between total income and total consumption. APC is defined as a fraction of the total income spent on consumption as a whole. APC = Total ConsumptionTotal Income

= C Y

Consumption Function, cont..Marginal Propensity to Consume (MPC): defines the relationship between a change in total income and a change in total consumption. MPC = Change in Total Consumption Change in Total Income

= C Y

Savings Theory Keynes argued that savings is divided into autonomous savings and induced savings. Autonomous saving: the part of savings that does not depend on the income level and occurs when there is autonomous consumption. So, the expenditure comes from savings which referred to as autonomous savings.

Savings Theory, cont.. Induced savings: Part of the income. The higher the income, the higher the amount of savings and vice versa.

Breakeven Income: The level at which households consume all their income. Thus, savings equals zero.

Savings Theory, cont.. Average Propensity to Save (APS): defines the relationship between total income and total savings. APS is defined as a fraction of total income that is saved. APS = Total saving = S Total Income Yd Marginal Propensity to save (MPS): defines the relationship between change in total income and change in total savings.MPS = S Yd

Savings Function Shows the relationship between savings and income level. Savings function can be derived from the consumption function and vice versa. General equation for a linear savings function can be written as follows:

where,S = savings-a = autonomous saving (does not depends on income level)1-b = marginal propensity to save (MPS) because MPC + MPS = 1Yd = disposable income

S = -a + (1 b)Yd

Consumption & Savings ScheduleCNational IncomeY = CC = 100 + 0.65YBreakevena = 100S-100S = -100 + 0.35YNational Income285.7285.7

Lets test your understandingDetermine the autonomous consumption and autonomous saving.Find the MPC and MPS. Write the consumption function and saving function.How much do households plan to save if income is RM1500 m?How much is the NI when households planned to save RM120 m?Find the value of B in the diagram above.Calculate the breakeven income level S-200YS = f (Y)12000160B2000

Investment Theory It refers to the spending on purchases and accumulation of capital goods such as buildings, equipment and additions to inventories.

The investment function refers to inducement to invest or investment demand.

Investment Theory, cont.. There are two types of investment: Autonomous Investment: fixed and independent of income. The amount of investment can be influenced by other factors such as interest rates, repayment rates, business expectations and technology developments. Ex: capital depreciation.InvestmentAutonomous InvestmentIncome

Induced Investment: Depends on the national income. As national income increases, induced investment will also increase since a higher national income attracts more investors to invest. Investment Theory, cont.. InvestmentIncomeInduced Investment

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