The Production Possibilities Frontier
Adapted from Time and Money:
The Macroeconomics of Capital Structure
by Roger W. Garrison
London: Routledge, 2001
The Consumption-Investment Tradeoff
And the Essence of Economic Growth
2009
45o
INCOME
EXPENDITURES
EXPENDITURES
C+I
C = a + bY
45o
Yeq
INCOME
Equilibrium in the simple Keynesian
framework means only that income
equals expenditure. The economy
may be in recession or experiencing
inflation.
EXPENDITURES
C = a + bY
YeqY
=Y
eqfe
INCOME
Equilibrium in the simple Keynesian
framework means only that income
equals expenditure. The economy
may be in recession or experiencing
inflation.
CONSUMPTION
C+I
INVESTMENT
We assume, though, that
this economy is enjoying
full employment without
inflation—if only by good
luck.
The Production Possibilities Frontier
(PPF) depicts these alternatives during
a given time period, typically one year.
CONSUMPTION
In any economy, some resources are
devoted to producing consumables, the
remaining resources being available for
maintaining and expanding the
economy’s productive capacity.
INVESTMENT
The Production Possibilities Frontier
The tradeoff between CONSUMPTION (in the present) and INVESTMENT
(for the future) should be an integral part of our macroeconomic thinking.
Under favorable conditions, a fully employed market economy allocates
resources to both uses, making the most of the trade-off.
A “fully employed market economy” allows for a so-called “natural rate of
unemployment,” which is about five or six percent. That is, frictional and
structural unemployment are characteristic of even a healthy economy.
CONSUMPTION
If resources were characterized by
perfect homogeneity, such that each unit
of input is equally suitable for producing
either kind of output (consumption goods
or investment goods), then the PPF
would be linear. But raw materials and
capital equipment are heterogeneous.
Riverboats and river barges are not
readily substitutable one for the other.
A PPF with
heterogeneous
homogeneous
inputs
INVESTMENT
The heterogeneity of equipment and materials implies a convex PPF.
As the tradeoff is made away from consumption and toward more
investment, the scope for still more investment diminishes.
Microeconomists would describe this feature of the PPF in terms of
a diminishing marginal rate of substitution.
Typically, the investment needed just
to replace worn out or obsolete
capital is substantial but something
less than gross investment.
The extent to which gross investment
exceeds the “replacement” magnitude
constitutes net investment and allows
for the expansion of the economy.
CONSUMPTION
“Investment” in this construction
represents gross investment, which
includes replacement capital.
INVESTMENT
Replacement
Capital
Net Investment
Gross
Investment
Positive net investment means that the economy is growing. The PPF
shifts outward from year to year, permitting increasing levels of both
consumption and investment.
This outward shifting of the PPF represents sustainable economic growth.
Four periods of growth are shown—with
consumption, as well as investment,
increasing in each period.
The actual rate of expansion of the PPF
depends upon many factors. For instance,
with economic expansion, more resources
are needed for capital replacement. And
the desired trade-off between consuming
and investing can itself change as the
economy generates more wealth.
CONSUMPTION
Watch the economy grow.
YEAR 4
0
1
2
3
INVESTMENT
Replacement
Capital
Net Investment
Gross
Investment
Four periods of growth are shown—with
consumption, as well as investment,
increasing in each period.
The actual rate of expansion of the PPF
depends upon many factors. For instance,
with economic expansion, more resources
are needed for capital replacement. And
the desired trade-off between consuming
and investing can itself change as the
economy generates more wealth.
CONSUMPTION
Watch the economy grow.
INVESTMENT
Watch the movement
along the PPF.
Importantly, we note that forgoing some consumption with an eye toward
consuming more in the future triggers a movement along the initial PPF
and hence affects the rate at which the PPF expands outward.
Increased thriftiness makes the difference.
CONSUMPTION
Now watch the economy grow.
YEAR 4
0
1
2
3
Let’s compare the high-growth economy
with the original low-growth economy.
INVESTMENT
CONSUMPTION
CONSUMPTION
INVESTMENT
INVESTMENT
Note the difference that an initial trading off of consumption for investment
makes in the subsequent pattern of consumption and investment.
Without an initial increase in investment, consumption and investment
increase modestly from period to period.
With an initial increase in investment at the expense of consumption, both
consumption and investment increase dramatically from period to period.
By the fourth period, that initial increase in investment pays off as a
higher level of consumption than would otherwise have been possible.
We can add to our understanding if we
represent time explicitly on a horizontal
axis and then keep track of consumption
on the vertical axis.
CONSUMPTION
The time dimension is represented by
the sequence of shifts of the PPF.
CONSUMPTION
INVESTMENT
TIME
Explicitly
In both representations,
tracking the level of
consumption
consumptionover
is seen
timetoallows
fall
us
asto
the
see
economy
that theistradeoff
adapting
is
essentially
to a higheran
growth
intertemporal
rate, after
tradeoff.
which consumption rises
more rapidly than before…
Consumption in the present
and eventually surpasses the
and near future is traded for
old projected growth path.
greater consumption in the
more distant future.
Suppose that gross investment in the
economy is just enough to replace
worn out and obsolete capital—which
means that net investment is zero.
The levels of consumption and (gross)
investment would be maintained, but
the economy would not grow.
Watch the economy not grow.
CONSUMPTION
There is nothing pre-ordained about
the economy actually having a positive
rate of growth.
YEAR 4
0
1
2
3
INVESTMENT
Replacement
Capital
Net Investment
Net Investment
=0
Gross
Gross
Investment
Investment
Yes, there is still some scope for
movement along the PPF in the
direction of more consumption and
less investment.
CONSUMPTION
In a no-growth economy (meaning no
net investment), would it be possible for
people to increase consumption?
YEAR 4
0
1
2
3
INVESTMENT
Replacement
Capital
But what would be the consequences for the PPF in subsequent years?
Watch the economy experience negative growth, i.e., watch it contract.
Gross
Investment
Notice that consumption rises initially and then falls as the economy’s
productive capacity diminishes over time.
CONSUMPTION
As in the case of a clockwise movement
along the PPF, we can add to our
understanding of this counterclockwise
movement by representing time
explicitly on a horizontal axis and then
keeping track of consumption on the
vertical axis.
INVESTMENT
CONSUMPTION
In both representations,
consumption
is consumption
seen to rise
The
increase in
thepresent
economy
adapting
inasthe
andisnear
future
to a negative
growth rate,
comes
at the expense
of a
after which
consumption
declining
rate
of consumption
—soon
falling
below
indeclines
the more
distant
future.
the initial level.
TIME
CONSUMPTION
If gross investment exceeds
replacement capital, the
economy expands.
CONSUMPTION
TIME
If gross investment falls
short of replacement capital,
the economy contracts.
TIME
On what
Each
PPF
basis
is broadly
can you
descriptive
make a of
two particular
prediction
about
countries
the sizes
at of
thethe
end
of World
two
economies,
War II. say, two or three
decades after the war?
Apart from their differing sizes, one
Japan
grew
much difference
faster thanisthe
possibly
relevant
that
United
States—not
had
the small
country’s because
economyithad
been
because to
thea
beenbombed,
wrecked but
by bombing
consumption-investment
much greater extent thantradeoff
the large
incountry’s
post-wareconomy.
Japan was made in
favor of a high level of investment.
In
What
the United
two countries
States,are
the these?
tradeoff
was made in the opposite direction
by the consumption-oriented
Americans.
CONSUMPTION
INVESTMENT
Post-war United States
CONSUMPTION
Consider two separate economies,
one large and one small.
INVESTMENT
Post-war Japan
Suppose, though, that during a given
year, some market malfunction (or
some perverse policy) takes the
economy off its PPF.
CONSUMPTION
To this point, we’ve assumed that the
economy is either on its PPF or is being
expeditiously moved by market forces
toward a point on its shifting PPF.
INVESTMENT
If the economy is pushed beyond the PPF, its unemployment rate being
driven below the 5-6 percent band, we say the economy is “overheated.”
Points very far beyond the PPF are simply out of reach (in real terms).
Strong market forces pushing in this direction will impinge on prices
rather than on quantities. The economy will experience price and wage
inflation. In extreme cases, it can experience hyper-inflation.
Suppose, though, that during a given
year, some market malfunction (or
some perverse policy) takes the
economy off its PPF.
CONSUMPTION
To this point, we’ve assumed that the
economy is either on its PPF or is being
expeditiously moved by market forces
toward a point on its shifting PPF.
INVESTMENT
If the economy is pushed beyond the PPF, its unemployment rate being
driven below the 5-6 percent band, we say the economy is “overheated.”
Points very far beyond the PPF are simply out of reach (in real terms).
Strong market forces pushing in this direction will impinge on prices
rather than on quantities. The economy will experience price and wage
inflation. In extreme cases, it can experience hyper-inflation.
If the economy is pushed inside its PPF, its unemployment rate rising
above the 5–6 percent band, we say that the economy is in a recession.
If the economy is pushed far inside its PPF for an extended period of
time, we say that the economy is in a depression.
CONSUMPTION
Notice that, together with the locus of
the fully employed economy, the
various possible market malfunctions
(or consequences of perverse policy)
are arrayed along a linear path:
A depressed economy
A recessed economy
A fully employed economy
An over-heated economy
An inflated economy
A hyper-inflated economy
What do you suppose is the
significance of the straight line that
passes through these points?
INVESTMENT
Economists who believe that the
“markets
market
economy
work” argue
is inherently
that
market argue
flawed
forcesthat
canmarket
move the
forces
economy
will
move along
the economy
the PPFalong
in the
response
linear
pathtoproducing
changes in
periodic
intertemporal
bouts
of unemployment
preferences.
and
inflation.
They argue that movements off
the PPF
They
argue
arethat
largely
“stimulus
a
consequence
packages”
andofinterest-rate
perverse
macroeconomic
manipulation
arepolicy.
needed to
restore macroeconomic health.
EXPENDITURES
C = a + bY
INCOME
Yfe
CONSUMPTION
C+I
INVESTMENT
The nature of the Keynesian-styled spiraling associated with
recession, depression and inflation becomes more transparent
with the production possibility frontier in play.
W
S
Also, the PPF helps to show
how the Keynesian framework is
related to pre-Keynesian Dideas.
N
EXPENDITURES
C = a + bY
Yfe
INCOME
CONSUMPTION
C+I
INVESTMENT
A waning of animal spirits causes
investment to decrease and with it
income and consumption. The
economy falls inside its PPF.
W
S
D
N
C = a + bY
Yfe
INCOME
CONSUMPTION
EXPENDITURES
C+I
INVESTMENT
Note that if investment
A further
were towaning
fall to zero,
sendsthe
theeconomy
economywould
settle into an income-expenditure
deeper into the
equilibrium
PPF’s interior.
with Y = C.
Movements inside the frontier (and beyond
Thus,
the
vertical
intercept
of the Keynesian demand constraint
W
it) trace out a linear relationship, showing
is aligned withS the intersection of the consumption function and
how consumption varies with investment.
the 45o line.
D
The straight line that passes through these
N
points is the Keynesian demand constraint.
CONSUMPTION
Y = C + I
C = a + bY
C = a + b(C + I)
C = a + bC + bI
C – bC = a + bI
(1–b)C = a + bI
INVESTMENT
a
b
C =
+
I
(1-b) (1-b)
The straight line that
passes through
these points is the
Keynesian demand
constraint.
EXPENDITURES
C+I
C = a + bY
CONSUMPTION
a
b
C = (1 – b) + (1 – b) I
b
1–b
a
(1 – b)
Yfe
INCOME
INVESTMENT
For simplicity, let a = 0 and b = 0.90. Then C = a + bY becomes C = 0.90Y.
And C = a/(1-b) + b/(1-b) I becomes C = 9(I), which led Keynes to write:
“If,
forformula
example,
the public
are in
the so
habit
of spending
of their
“The
is not,
of course,
quite
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The Production Possibilities Frontier
Adapted from Time and Money:
The Macroeconomics of Capital Structure
by Roger W. Garrison
London: Routledge, 2001
The Consumption-Investment Tradeoff
And the Essence of Economic Growth
2009