Chapter 5
More about Consumption,
Investment and Fiscal Policy
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Contents:
•
•
•
•
•
More about consumption function
More about saving function
More about investment function
Fiscal policy
Advanced Material 5.1 Net investment is sustained by
a favorable and continuous change in determinants
• Advanced Material 5.2 Short term and long term
effects of investment
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More about
Consumption Function
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Propensity to consume
Average propensity to consume (APC) is
the consumption per unit of disposable income.
C cYd  C *
C*
APC =

 c
Yd
Yd
Yd
Note: When Yd increases, APC drops.
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Graphical illustration
C
C
C1
Slope = C1/Yd1 = APC1
C*
APC1
+1
0
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Yd1
Yd
Marginal propensity to consume
Marginal propensity to consume (MPC) is
the change in consumption resulting from a unit
change in disposable income.
C [c(Yd  Yd)  C*]  (cYd  C*)
Yd
MPC=

c
c
Yd
Yd
Yd
Note: When Yd increases, MPC is unchanged.
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Graphical illustration
C Slope = ΔC/ΔY = MPC
d
C
C1
C*
+1
MPC
0
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Slope = C1/Yd1 = APC1
Yd1
Yd
Graphical representation of consumption function
Plotting C against Yd
C
C = cYd + C*
C
c
C*
0
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+1
Yd
Plotting C against Y
C = cYd+C* = c(Y-tY-T*+qY+Q*)+C*
= (c-ct+cq)Y + (C*-cT*+cQ*)
C
C
c (1-t+q)
C*- cT* + cQ*
0
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+1
Y
Determinants of consumption function
Change in determinant Effect on consumption function
(plotting C against Y)
Moves upward along C-function
National income 
Income taxes 
o Lump sum tax
 Shifts downward
o Proportional tax rate Tilts downward (slope)
Shifts upward
Wealth 
Interest rate 
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Shifts downward
Change in determinant
Effect on
consumption function
(plotting C against Y)
Expectation
o Future price level↑
o Future income↑
 Shifts upward
 Shifts upward
More willing to save
Shifts downward
Income redistribution
(low MPC  high MPC)
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Shifts upward
Q5.1:
What would happen to the aggregate consumption if
income is redistributed from
(a) the group of high MPC to the group of low MPC
(b) the group of high APC to the group of low APC
(c) the group of high C to the group of low C
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Q5.2:
(a) In general, who have a higher MPC, the rich
or the poor? Explain.
(b) In general, who have a higher MPC, the young
or the old? Explain.
Q5.3:
Explain why the cost of real consumption is the real
interest rate instead of the nominal interest rate.
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More about
Saving Function
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Propensity to save
Average propensity to save (APS) is the
saving per unit of disposable income.
S sYd  S *
S*
- C*

s
 (1  c) 
APS =
Yd
Yd
Yd
Yd
Note: As S* is negative, when Yd increases, APS increases.
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Graphical illustration
S
S
Slope = S1/Yd1 = APS1
APS1
S1
+1
0
S* = -C*
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Yd
Yd1
Marginal propensity to save
Marginal propensity to save (MPS) is the
change in saving resulting from a unit change in
disposable income.
S [s(Y d  Yd)  S*]  (sYd  S*) Yd
MPS =

s
 s  1- c
Yd
Yd
Yd
Note: When Yd increases, MPS remains unchanged.
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Graphical illustration
S
S
Slope = S1 /Yd1 = APS1
MPS1S1
+1
0
S* = -C*
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Yd
Yd1
Slope= ΔS/ΔYd = MPS
Relation between
consumption and saving
Yd
C
C

At Yd1
Yd1 < C1
S1 = Yd1 - C1
C* S1
0
C1

Yd1
Yd
S
S = (1-c)Yd - C*
S1 < 0
Dissaving
Yd1

S1
-C*
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
Yd
At Yd2
C
Yd2 = C2
S2 = Yd2 – C2 = 0
No dissaving or saving

C*
0
S
-C*
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Yd
C
C2 =Yd2

Yd2
Yd
S = (1-c)Yd - C*
S2 = 0

Yd2
Yd
C
Yd3 > C3
Yd
S3
C
S3 = Yd3 – C3
C3
At Yd3
C*
S3 > 0
0
Saving
S
Yd3
S = (1-c)Yd - C*
S3
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Yd
-C*
Yd3
Yd
Mathematical relation:
S = Yd - C
APS = (Yd - C)/Yd = 1 - APC
MPS = S  Yd  C  1  MPC
Yd
Yd
S
Q5.5:
Refer to the given diagram. When
Yd increases, what would happen
to C, APC, MPC, S, APS and
MPS?
0
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S
Yd
Determinants of saving function
T
Y
T
Y
C
Yd
C
Yd
S
S
T
Y
C
Yd
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S
Determinants of saving function
Change in determinant
National income 
Effect on saving function
(plotting S against Y)
Moves upward along
S-function
Income taxes 
• Lump sum tax
• Proportional tax rate
Wealth 
 Shifts downward
Tilts downward (slope)
Shifts downward
Interest rate 
Shifts upward
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Change in determinant
Expectation
• Future price level 
• Future income 
More willing to save
Income redistribution
(low MPC  high MPC)
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Effect on
saving function
(plotting S against Y)
 Shifts downward
 Shifts downward
Shifts upward
Shifts downward
More about
Investment Function
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Components of investment function
Gross investment = Depreciation + Net investment
 The amount spent on replacing depreciated capital
(depreciation) is positively related to:
 amount of capital possessed
 rate of utilization
 advancement of technology
 but is negatively related to:
 interest rate
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Components of investment function
 The amount spent on raising capital stock
(net investment) is positively related to:
 the desired increase in capital stock
 but is negatively related to:
 interest rate
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Determinants of net investment function
Suppose expected net receipts = {Y1, Y2, Y3, …}
purchase price of capital = Pc , and MEC = e.
Then
Y1
Y2
Y3
Pc 


 ...
1
2
3
(1  e) (1  e) (1  e)
Whenever e  r, it is worth buying until e = r.
 The MEC curve is the demand curve for capital.
When r falls, the optimal size of capital stock increases.
 The difference is the amount of net investment.
 The portion of MEC curve below r0 is the net I curve.
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The net investment function
%
r0
MEC curve
= Demand
for capital
r1
%
r0
The larger the  in r

The larger the  in
the optimal size of
capital stock & net I

I = br + I*; & b < 0
r1
I
0
K0
0
K1Capital Stock
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I1
(I1=K1-K0)
Net investment
Determinants of net investment function
Change in determinant
Interest rate 
National income 
Purchase price of capital

Operating cost of
other factors 
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Effect on
investment function
Moves upward
along I-function
Shifts upward (rightward)
Shifts downward (leftward)
Shifts downward
Change in determinant
Profits tax rate 
Effect on investment
function
Shifts downward
Technological
improvement and
innovation
Shifts upward
Optimistic expectation on
future net receipts
Shifts upward
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Fiscal Policy
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What is fiscal policy?
 Fiscal policy is the government measure
which achieves economic objectives through
manipulating the government revenue and
expenditure.
Types:
 Automatic fiscal policy
 Discretionary fiscal policy
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Automatic fiscal policy
Automatic stabilizers or built-in stabilizers
are government measures that reduce cyclical
fluctuations of an economy automatically.
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Instruments:
Those transfer payments (injection) which are
negatively related to income e.g. unemployment benefits, comprehensive
social security assistance
Those taxes (withdrawal) which are positively
related to income e.g. property tax, salaries tax and profits tax
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Recovery
Recession
 The
Transfer payments (injection) 
Automatic
stabilizing
effect
stabilizers
of automatic
reduce

Income taxes (withdrawals)

the size of is
Risein
innational
nationalincome
incomeisisreduced
reduced. stabilizers
Fall
reflected
fluctuations
by the
and
%
drop
stabilize
in the
national
size of
Boom
multipliers.
income.


Trough
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Growth rate
of real
national
income
4 phases of a
business cycle
Limitations
Automatic stabilizers can only reduce, but not eliminate
cyclical fluctuations.
Discretionary fiscal policy is essential to achieve
other macroeconomic objectives, e.g., full employment,
economic growth, equitable income distribution, etc.
Fiscal drag will weaken the effectiveness of
discretionary fiscal policy.
Built-in stabilizers bring disincentives to work and
investment.
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Q5.8:
Are corporate savings and family savings
built-in stabilizers? Do they create disincentives?
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Discretionary fiscal policy
Discretionary fiscal policy is the deliberate
government measure which achieves
economic objectives through manipulating
the government revenue and expenditure.
Instruments:  Government expenditures (G)
 Transfer payments (Q)
 Taxes (T)
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Mechanisms:
  in G   aggregate expenditure
 brings a multiple  in income
  in transfer payment   disposable income
  in consumption  a multiple  in income
  in (direct) tax   disposable income
  in consumption  a multiple  in income
Opposite cases also apply.
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Corresponding multipliers:
Instrument
Multiplier
Government
expenditure
1
1  c  i  ct  cq  m
Transfer payment
c
1  c  i  ct  cq  m
Tax
-c
1  c  i  ct  cq  m
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What is government budget?
Budget is a financial statement proposing
the estimated revenue and expenditure of
the public sector in a fiscal year.
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Type of budget:
Balanced budget
(平衡預算)
Estimated
revenue
Deficit budget
(赤字預算)
Estimated
revenue
Surplus budget
(盈餘預算)
Estimated
revenue
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=
Estimated
expenditure
<
Estimated
expenditure
>
Estimated
expenditure
Balanced budget
 A balanced budget is expansionary.
 Its effect on equilibrium income :
= ΔG • G-multiplier + ΔT • T-multiplier
= ΔBudget • (G-multiplier + T-multiplier)
1

c
Balanced budget multiplier =
1  c  i  ct  cq  m
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 If income is not subjected to taxation, only a
part of it is consumed while the other part is saved.
 Under a balanced budget, the whole amount of
income taxed is spent on government consumption.
a net increase in aggregate expenditure
(= the amount of income saved before taxation)
 brings a multiple increase in national income.
Note: An annually balanced budget is destabilizing (pro-cyclical)
while a cyclically balanced budget is stabilizing (counter–cyclical).
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Deficit budget and surplus budget
 A deficit budget is more expansionary than a
balanced budget.
 The effect of a surplus budget can be:
 expansionary
 neutral
 or contractionary
 Yet, when it is applied, it is usually aimed at
bringing in a contractionary effect.
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What is public debt?
 Public debt is the borrowing of the government.
Burden of public debt
 Microscopically or individually, it is the future
taxpayers who bear the burden of public debt.
 Macroscopically or in the view of a generation,
it is the present generation who bears the burden.
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Yet, the future generation still bears some burden because:
Taxation brings adverse effects -- indirect taxes
bring deadweight losses while direct taxes create
disincentives to work & investment.
Issuance of gov’t bonds raises the interest rate
which crowds out private investment
Repayment of an external debt involves
a net export of goods and services in the future.
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Situations
-- that may minimize the burden on the future generation:
1. The economy is under a serious depression.
2. The debt is for financing public investment.
3. The debt is an internal debt.
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Advanced Material 5.1
Net investment is sustained by a favourable and
continuous change in determinants
If the determinants (including interest rate,
national income, etc.) remain constant, the optimal
size of capital stock will not be changed.
Hence net investment is sustained only if the
determinants have favourable changes continuously.
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Advanced Material 5.2
Short-term and long-term effects of investment
Net investment raises
the aggregate demand in the short term
the amount of capital stock, productivity
and the aggregate supply (the potential GNP) in
the long term
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Correcting Misconceptions:
1. C = cY + C*; APC = C/Y; MPC = ΔC/ΔY
2. An increase in C is represented by an
upward shift of the C-function.
3. When income is redistributed from
consumers of low APC to consumers of high
APC, aggregate consumption increases.
4. An increase in C implies a decrease in S.
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Correcting Misconceptions:
5. Net investment function relates interest rate
to net investment.
6. Transfer payments and taxes are automatic
stabilizers.
7. Automatic stabilizers eliminate cyclical
fluctuations.
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Correcting Misconceptions:
8. All stabilizers create disincentive effects.
9. A balanced budget is neutral to an economy.
10. A surplus budget is contractionary.
11. An annually balanced budget and a
cyclically balanced budget bring similar effect
to an economy.
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