Consumption, Savings and
Investment
 Consumption function
 Determinants of Consumption
 Engel's law
 Savings
 Determinants of Investment
 The Multiplier
Autonomous consumption
 Autonomous consumption expenditure CA
occurs when income levels are zero. Such
consumption does not vary with changes in
income.
 If income levels are actually zero, this
consumption is financed by borrowing or
using up savings.
Induced consumption
 Induced consumption CI describes
consumption expenditure by households on
goods and services which varies with
income.
 Consumption is considered induced by
income.
Marginal Propensity to
Consume
 The marginal propensity to consume
(MPC) is the extra amount that people
consume when they receive an extra unit of
income.
MPC = ΔC / ΔY
MPC is the first derivation of consumption
function.
 Induced consumption can be described by
formula:
CI = MPC . Y
The Consumption Function
 The consumption function shows the
relationship between the level of consumption
expenditure and the level of income.
C = f (Y)
If autonomous and induced consumption is
identified then: C = CA + CI
C = CA + MPC . Y
The Consumption Function
C
Savings
Consumption
function C = f(Y)
CA
Consumption
45˚
0
Y1
Y
2
Y
The Consumption Function
 45˚ line: at any point on the 45˚line
consumption exactly equals income and the
households have zero saving.
 MPC is the slope of the consumption
function, which measures the change in
consumption per unit change in income.
Engel's Law
 The nineteen century Prussian statistician
Ernst Engel noticed that as income
increases, expenditures on many items go
up, but there are limits to the extra money
people will spend on food when their
income rise.
 Engel's Law: The proportion of total
spending devoted to food declines as
income increases.
Nonlinear Consumption
function
45°
C
E
C = f(Y)
CA
YE
Y
Determinants of Consumption
 Current disposable income: it is the central factor
determining a nation's consumption.
 Permanent income: it is the level of income that
households would receive when temporary influences
are removed.
 Wealth: it is the net value of tangible and financial
items owned by a nation or person at a point of time.
 Other (interest rate, inflation, expectations).
Savings
 Saving is that part of income that is not
consumed. Saving equals income minus
consumption: S = Y – C
 Income is the sum of consumption and
savings: Y = C + S
 then
C S
 1
Y Y
and
C S

1
Y Y
Savings
 The marginal propensity to save
S
MPS 
Y
is defined as the fraction of an extra unit of
income that goes to extra saving.
 MPC + MPS = 1 because the part of each
unit of income that is not consumed is
necessarily saved.
Saving Function
 Like consumption saving is also the function
of income: S = f(Y)
 If autonomous consumption exists then
autonomous saving exists as well and saving
function is: S = -CA + MPS.Y
 Saving is a source for investment.
The Consumption and Saving
Function
C, S
C = f(Y)
S = f(Y)
CA
0
45˚
Y
-CA
E
Y
The saving
function is the
mirror image of
the consumption
function. It shows
the relationship
between the level
of saving and
income.
Investment
 Investment pays two roles in
macroeconomics:


It can have a major impact on AD (real output
and employment)
It leads to capital accumulation (it increases
the nation's potential output and promotes
economic growth in the long run)
Determinants of Investment
 Revenues: an investment should bring the
firm additional revenue.
 Costs: interest rate influences the costs of the
investment.
 Consumer demand: the bigger the increase in
consumer demand, the more investment will
be needed.
 Expectation: business expectation about
future state of economy.
The Investment Demand Curve
Interest
rate i
Higher Output
D1
D
Investment spending
The Investment Demand Curve
Interest
rate i
Higher Taxes
D
D1
Investment spending
The Investment Demand Curve
Interest
rate i
Pessimistic Expectation
D
D1
Investment spending
The Simple Theory of
Investment
 In the simple Keynesian model,
investment is independent of national
income (autonomous investment).
 The investment function will be a
horizontal straight line.
The Investment Function
I
I2
I1
0
I2
In the short-run it
is reasonable to
assume that
investment is
independent of
national income.
I1
Y
Consumption and Investment
Functions
 The spending curve shows the level of
desired expenditure by consumers (CA +
MPC.Y) and businesses (I) corresponding
to each level of output.
Consumption and Investment
Functions
C, I
C + I = CA + MPC . Y + I
C = CA + MPC . Y
I
I
0
Y
Consumption and Investment
Determine Output
 If the level of output is e. g. Y1 at this level
of output the C+I spending line is above
45˚line, so planned spending is greater than
planned output.
 This means that consumers would be buying
more goods than the businesses were
producing. Thus spending disequilibrium
leads to a change in output.
Equilibrium National Income
C, I
C + I = CA + MPC . Y + I
E
Consumption and
investment determine
output
45˚
0
Y1
YE
Y2
Y
Saving and Investment
Determine Output
 Equilibrium occurs when desired saving of
households equals the desired investment of
businesses.
 When desired saving and desired investment
are not equal, output will tent to adjust up or
down.
Saving and Investment
Determine Output
S, I
S = f (Y)
E
I
0
Y1
-
YE
Y2
Y
Saving and Investment
Determine Output
 At output level Y2 families are saving more
than businesses are willing to go on
investing. Firms will have too few
customers and large inventories of unsold
goods than they want. Then, businesses
will cut back production and lay off
workers. This move output gradually
downward and economy returns to
equilibrium YE.
Investment Multiplier
 The Keynesian investment multiplier model
shows that an increase in investment will
increase output by a multiplied amount – by
an amount greater than itself.
 The multiplier is the number by which
the change in investment must be
multiplied in order to determine the
resulting change in total output.
Investment Multiplier
C + I2
C, I
I2 = I1 + ΔI
E2
C +I1
ΔY = k . ΔI
E1
Y
k 
I
ΔI
45˚
0
Y1 ΔY
Y2
Y
Investment Multiplier
S
S = f (Y)
E2
ΔI
E1
I2
I1
0
Y1 ΔY Y2
-
Y
Investment Multiplier
 The size of the multiplier k depends upon how
large the MPC is.
Y
Y
1
1
1
k




I Y  C 1  C 1  MPC MPS
Y