Principles of economics
Consumption and investment
Business fluctuations and the theory of
Aggregate Demand
Multiplier model
Consumption
• Consumption (C) is the largest component of
GDP (cca. 2/3 of GDP) and major part of AD
• Investment is a part of AD but its
accumulation increases K which increases AS
• Categories of consumption are:
1. Durables (12% in USA in 2002)
2. Non-durables (29% in USA in 2002)
3. Services (59% in USA in 2002)
Saving
• Saving (S) is the part of disposable income that is not
consumed:
Y=C+S
Consumption and saving changes as income (Y) changes:
• When there is no income some consumption exists
(autonomous consumption, c0)
• At certain level of income consumers consume exactly how
much they earn (break even point: Y = C since S = 0)
DI (or Y)
S
• After that level saving (S) is positive
0
-100
- c0 = 100
300
0
- Y = C when Y = 300
C
100
300
600
100
500
900
200
700
MPC and MPS
• Marginal propensity to consume (MPC or c1) is an extra
amount of consumption caused by a 1 kn income
increase:
𝐶𝑛 − 𝐶𝑛−1 ∆𝐶
𝑀𝑃𝐶𝑛 =
=
= 𝑐1
𝑌𝑛 − 𝑌𝑛−1 ∆𝑌
200/300 = 0.667
• Marginal propensity to save (MPS) is an extra amount
of saving caused by a 1 kn income increase:
𝑆𝑛 − 𝑆𝑛−1 ∆𝑆
𝑀𝑃𝑆𝑛 =
=
= 𝑠1
DI (or Y)
S
𝑌𝑛 − 𝑌𝑛−1 ∆𝑌
0
-100
100/300 = 0.333
C
100
300
0
300
600
100
500
900
200
700
Consumption and saving function
• Consumption function shows the relation
between the income and the consumption.
C(Y) = c0 + c1Y
• Saving function shows the relation between
the income and the saving.
Y = S(Y) + C(Y) = S(Y) + c0 + c1Y →
S(Y) = - c0 + (1 - c1)Y
where 1 - c1 = s1
C
C = f(Y)
c0
45°
0
Y
S
S = f(Y)
0
Y
Consumption and saving plot
C, S
C(Y)
300
S(Y)
100
0
-100
300
Y
DI (or Y)
S
C
0
-100
100
300
0
300
600
100
500
900
200
700
C = 100 + 0.667Y
S = -100 + 0.333Y
Determinants of consumption
• Current disposable income (Y)
• Permanent income and the Life-Cycle Model
of Consumption
• (Permanent income: trend level if income)
• Wealth
• Other influences
Investment
• Second major part of income
• It affects AD (short-run) since it is its
component and AS (long-run)since it increases
stocks of capital
• Financial investment: sale-purchase (not real
investment)
• Real investment increases ONLY WHEN
CAPITAL IS PRODUCED
Determinants of investments
• Revenues, which depend on demand for
output produced by new investment
• Costs (interest rates (i) and taxes (t) )
• Expectations (state of the economy)
Increase taxes and deterioration of
expectations shifts investment demand
curve towards the origin
Investment demand curve
• Investment demand curve shows the change
in the amount of investment when return on
investment (interest rate) changes:
Id = Investment demand
i
0
I
• Investment function: 𝐼 = 𝐼 − 𝑏𝑖 (𝐼 = autonomous
investment, b = propensity to invest)
Business Fluctuations
• Expansion: economic growth
• Recession: economic decline
• Depression is a long-lasting recession (more
than a year)
• They interchange
• Business cycle is an economywide fluctuation
in income, outout and employment.
Business cycle theories
• Exoneous vs. Internal Cycles
Exogenous cycles are caused by factors outside of
economic system
Internal cycles happen are caused by factors within
economic system
• Demand induced cycles
Contraction of aggregate demand causes cycles
(Keynesian theory)
Aggregate demand (AD) and its
components
P
AD2 AD3
AS
AD1
AD4
0
Y
At first AD boost increases income, but after a AS kink AD
expansion increases only inflation
Forecasting business cycles
• Forecast of business cycles are made using
econometric models
• Econometric models are estimated using sets
of statistical data with methods developed by
econometrics
𝒀 = 𝜷𝟎 + 𝜷𝟏 𝑿𝟏 + ⋯ + 𝜷𝒏 𝑿𝒏
• Time series, cross section data or both (panel
data)
Aggregate demand segments
P
C
I
G X
AD
0
q
• Consumption
(households)
• Investment
(companies)
• Government
purchases
• Net export
AD: movement along
and its shift
P
C
I
G X
• Movement along AD:
0
q
Change in the price level
• Shift od demand causes:
A. POLICY VARIABLES: Change in monetary and
fiscal policy shifts demand (expansive f.p. &
m.p. causes outward shift)
B. EXOGENOUS VARIABLES: Foreign output,
asset values, technology advances, etc.
AD
Exercise 1
a) Find APS, APC, MPS, MPC using the table below:
Income
0
10 000
20 000
30 000
40 000
50 000
•
•
Consumption
6000
12000
18000
24000
30000
36000
APC = C / Y
MPC= C /  DI
Income
0
10 000
20 000
30 000
40 000
50 000
Consumpti
on
6000
12000
18000
24000
30000
36000
APS = S / Y
MPS= S /  DI
Saving
APC
APS MPC
-6000
-2000
2000
6000
10 000
14 000
1,2 0,2 0.6
0,9 0,1 0.6
0,8 0,2 0.6
0,75 0,25 0.6
0,72 0,28 0.6
MPS
0.4
0.4
0.4
0.4
0.4
•
•
•
•
•
b) Express consumption function
C = A + MPC*DI
C= 6000 + 0,6*DI
b) Express saving function
S = MPS*DI - A
S= 0,4*DI - 6000
Exercise 2
Consumption function in a country is C = 800 + 0.7Y,
(Bill. $).
a) Find MPC and MPS and draw saving& consumption
function
C=800 + 0.7Y
MPC=0.7 - > MPS= 1-MPC = 1-0.7 =0.3
b) Find annual saving and consumption for the following
levels of income: 3000, 4000, 5000, 6000
Y
3000
4000
5000
6000
C
2900
3600
4300
5000
S
100
400
700
1000
APC
0.97
0.90
0.86
0.83
APS
0.03
0.10
0.14
0.17
Multiplier model
• Multiplier model explains how shocks in
exogenous expenditures (investment, taxes,
government spending, foreign trade,
household spending) affect output and
employment.
• Assumption:
1. wages are fixed
2. prices are fixed
3. there is available unemployed labour force
• The multiplier is the impact of a 1 HRK change
in exogenous expenditures on total output.
I = S output determination
• DI = C + S
• Savings are invested → S = I
• Let us assume investments are exogenous
S,I
𝑆 = −c0 + 1 − c1 Y
I = const.
0
Y
• The intersection of I and S determines equilibrium GDP toward
which national income will gravitate
• If S > I consumption is too small, invetories fill up and
companies sack workers. Output falls and the equilibrium is
obtained.
Total expenditure approach in output
determination
TE
C + I = TE
C
c0+I
c0
45°
0
Y*
Y
• Intercept of
TE and 45°
line shows
the
equilibrium
output
Investment multiplier
𝑌
𝑆
𝐶
𝑌
𝑌
=
=
=
=
−
𝐶 + 𝑆
𝐼
𝑐0 + 𝑐1 𝑌
𝑐0 + 𝑐1 𝑌 + 𝐼
𝑐1𝑌 = 𝑐0 + 𝐼 |: (1 − 𝑐1)
𝑐0
𝐼
𝑌 =
+
1 − 𝑐1 1 − 𝑐1
1
1
Δ𝑌 =
∆𝐼 =
∆𝐼
1 − 𝑐1
𝑀𝑃𝑆
Equilibrium output and the multiplier
TE
Y = 𝑐0 + 𝑐1𝑌 + 𝐼
C = 𝑐0 + 𝑐1𝑌
ΔI
C0+I
ΔY
YN = potential output
c0
0
45°
Y
S
𝑆 = −c0 + 1 − c1 Y
𝐼
0
Y
TE
Y = 𝑐0 + 𝑐1𝑌 + 𝐼
C = 𝑐0 + 𝑐1𝑌
C0+I
YN = potential output
c0
0
45°
Y
𝐴𝑆
P
𝐴𝐷: 0 investment demand
𝐴𝐷′: non 0 investment demand
𝐴𝐷
0
𝐴𝐷′
Y
Investment, government spending and
tax multiplier
𝑌
𝑆
𝐶
𝑌
𝑌
=
=
=
=
−
𝐶+𝐺+ 𝑆
𝐼
𝑐0 + 𝑐1 (𝑌 − 𝑇)
𝑐0 + 𝑐1 𝑌 − 𝑇 + 𝐺 + 𝐼
𝑐1 𝑌 = 𝑐0 − 𝑐1 𝑇 + 𝐺 + 𝐼 |: (1 − 𝑐1 )
𝑐0
𝑐1
𝐺
𝐼
𝑌 =
−
𝑇+
+
1 − 𝑐1 1 − 𝑐1
1 − 𝑐1 1 − 𝑐1
𝑐1
1
1
Δ𝑌 = −
∆𝑇 +
∆𝐺 +
∆𝐼
1 − 𝑐1
1 − 𝑐1
1 − 𝑐1
Taxes
multiplier
Government
expenditure
multiplier
Investment
multiplier
Haavelm theorem
• Let us assume G = T (leveled budget). Let taxes
be increased by 1 HRK and as a result a
government spending increased by 1 HRK.
GDP will increase by 1 HRK.
• Proof:
𝑐1
1
Δ𝑌 = −
∆𝑇 +
∆𝐺
1 − 𝑐1
1 − 𝑐1
Δ𝑌 = −
𝑐1
1
1−𝑐1
+
1
1
1 − 𝑐1
=
1− 𝑐1
1 − 𝑐1
Total effect is positive.
=1
Exercise 1
• Find investment multiplier if an increase in
GDP by $ Mill. 180 was caused by the
investment increase of $ Mill. 120. Also find
MPC and MPS.
solution
• k = Δ BDP / Δ I
• k = 180 / 120 = 1.5
• k = 1 / MPS
• MPS = 1 / k = 1 / 1.5 = 0,67
• MPC = 1 – MPS = 0.33
Exercise 2
• Consumption function is C = 10 + 0.5*Y, while
investments are $Mill. 20.
– a) Find the equilibrium level of income.
– b) Find value of the investment multiplier.
a)
•
•
•
•
•
•
•
•
Equilibrium: S = I
S = MPS*Y – c0
MPS = 1 – 0.5
MPS = 0.5
S = 0.5*DI – 10
0.5*DI – 10 = I
0.5*DI – 10 = 20
Y =60 mil $
b)
•
•
•
•
Multiplier
k = 1 / MPS
k = 1 / 0.5
k=2
Exercise 3
• Autonomuos consumption is 50 Billion HRK.
Citizens save 25% of their income at all levels of
income. Government spending is 35 Bill. HRK and
investment is 15 Bill. HRK.
a) Find the equilibrium level of output
b) Government decides to increase its spending by
5 Bill. HRK in order to fight recession, but also
raises taxes by 5 Bill. HRK. Investment fell
further down by 1 Bill. HRK. Find all multipliers
and the total effect.
a)
C = 50 + 0.75Y, I = S
Y = 50 + 0.75Y + 35 + 15
0.25Y = 100
Y = 400 Bill. HRK
C = 50 + 300 = 350
b)
𝑐1
1
1
Δ𝑌 = −
∆𝑇 +
∆𝐺 +
∆𝐼
1 − 𝑐1
1 − 𝑐1
1 − 𝑐1
Δ𝑌 = −3∆𝑇 + 4∆𝐺 + 4∆𝐼
kg = kI = 4, kt = 3
Δ𝑌 = −3×5 + 4×5 – 4×1 = 1 Bill. HRK