The Investment Function and
Consumption as a Function of Real
National Income
J.A.SACCO
Consumption Function of Real National Income



We’ve looked at
consumption based
on the level of RDI
per year.
This was an analysis
of one person/family
Now must create a
consumption
function model for
entire
macroeconomy
Must make
adjustments to RDI
to RNI (Output)
The Consumption
and Saving Functions
C=Yd
20,000
Saving
K
16,000
Planned Real Consumption
(C, dollars per year)

J
I
Break-even
income
12,000
Autonomous
consumption
H
F
G
Consumption
function
E
8,000
D
C
B
4,000
2,000
0
A
Dissaving
450
4,000 8,000 12,000 16,000 20,000
Real Disposable Income (Yd dollars per year)
Economics Today Chapter 12: Consumption, Income, and the Multiplier
Slide # 1
7
Consumption as a Function
of Real National Income “Y”= Real
Planned Consumption per Year
($ trillions)
AE 2.5
Y axis called
AE=Y
C is a function of
real national income.
Assume MPC = .8
2.0
C
National Income
(Output)
Where “C” intersects the
45º Line, Consumption
Expenditures equals
Real National Income
*all Income/Output
Consumed
Autonomous
consumption EQUILIBRIUM!
1.5
1.0
0.5
0.3
0
45o
0.5
1.0
1.5
2.0
2.5
Real National Income per Year (Output)
($ trillions)
3
Keynesian Expenditure Model
Now let’s build the Keynesian
macroeconomic
 First must look at “I” component

AD  C  I  G  X
Historically
Investment has been more volatile than
consumption
Why?
4
An Intro to Investments and its Determinants
Starter- What is investment in the context of consumption and GDP?
C+I+G+(X-M)=GDP
Real Consumption
 Less variable/more consistent
 Consumption expenditures are
less subject on how economy
looks in future
 People will always spend
Real Investment
 More variable over time
 Based on decisions of business
people on variable/subjective
elements of economy
 Expectations play a role on the
investment function-accounts for
instability of investment over
time.
 Large impact on GDP- Change in
“I” often affects “C”
5
Planned Investment Function
Investment depends on the interest rate
 Remember the “Classical Economists”
Interest Rate High/ Investment Low
Interest Rate Low/Investment High
 Businesses have an array of investment
opportunities with rates of return that are low
and some high.
 When do you Invest? Investment is profitable if
the rate of return is greater than the
opportunity cost (interest rate) of the
investment.

Decision to Invest



The decision of a firm to invest on machinery or
construction is simply a decision based upon marginal
benefits and marginal costs.
Marginal Benefit of an Investment -is the expected real
rate of return (R) the firm anticipates receiving on the
expenditure.
Marginal Cost of an Investment- is the real rate of
interest (I), or the cost of borrowing.
Rule of Thumb
If Rate of Return% >Real Rate of Interest %, make the
investment.
If Rate of Return% < Real Rate of Interest %, don’t make
investment.
Planned Investment Schedule
Rate of Interest
(percent per year)
15
14
13
12
11
10
9
8
7
6
Planned investment
per Year
($ trillions)
.2
.3
.4
.5
.6
.7
.8
.9
1.0
1.1
i% up, Investment down
i% down, Investment up
8
Rate of Interest (percent per year)
Planned Investment
Just like demand, Investment increases
as the price falls. As interest rate falls
more investment opportunities become
more profitable, and vice-versa.
15
14
13
12
11
10
9
8
7
6
I
0
.1
.2
.3
.4
.5
.6
.7
.8
.9
1.0
1.1
Planned Investment per Year ($ trillions)
9
Non- Interest Rate Determinants of
Investment
What Causes the Investment Function to Shift?
 When any non-interest rate determinant of
investment changes, the investment function (I)
will shift.
1) Expectations/ Changes in GDP
2) Productive technology- Need to invest in
capital goods to keep up with increased sales
3) Business taxes

*Change of Interest rate will not shift the
investment function.You will only move
up and down the function.
10
Rate of Interest (percent per year)
Graphing Changes
in Investment/Increase
Positive profit
outlook
r1
I1
I1
I2
I2
Planned Investment per Year ($ trillions)
11
Rate of Interest (percent per year)
Graphing Changes
in Investment/Decrease
Taxes
Increase
r1
I2
I2
I1
I1
Planned Investment per Year ($ trillions)
12
Real Investment per Year
($ trillions)
Combining Consumption
and Investment
The second component of
aggregate demand is investment
spending, “I".
0.7
0
I
1
2
3
4
5
6
7
$700 B. Investment per
year
Autonomous with respect
to real national income.
We will assume this
investment is constant,
regardless of the level
of income
I is autonomous
Real National Income per Year
($ trillions)
13
Combining Consumption
and Investment
Planned Consumption per Year
($ trillions)
AE
6.0
C+I
C
5.0
$.7 Trillion
of auto. “I”
4.0
C+I=Y
3.0
1) C + I = total planned
expenditures (AE)
2) Equilibrium: C + I = Y
3) Equilibrium Y = $5 trillion
2.0
1.0
0.3
0
45o
1.0
2.0
3.0
4.0
5.0
6.0
Real National Income per Year (Output)
($ trillions)
14
Keynesian Equilibrium with
Government and the Foreign Sector Added

Government (G) - C + I + G
◦ Federal, state, & local
 Does not include transfer payments
 Is autonomous
 Lump-sum taxes

Lump-sum tax
◦ A tax that does not depend on income or the
circumstances of the taxpayer
In our model Autonomous Government
Spending “G” is $1Trillion dollars
15
Keynesian Equilibrium with
Government and the Foreign Sector Added

The Foreign Sector -- C + I + G + X
◦ Net exports (X) = exports - imports
◦ Autonomous
◦ Depends on the economic conditions in each
country
In our model Autonomous Net Exports “X”
is $.1 Trillion.
16
The Determination of Equilibrium
Real National Income with Net Exports
1
2
3
“C”
4
4+5 Inc. Auto “C”
Real
Taxes
Real
National
Disposable
Planned
Income/
Income
Consumption
Output
(“X” axis)
5
3-4
“I”
“G”
“X”
8
9
Auto
Auto
Auto
4+6+7+8
6
7
Net Exports Total Planned
Planned Planned Government (exports- Expenditures
Saving Investment Spending
imports)
(“Y’ axis)
10
Direction
1-9
of Change
Unplanned in Real
Inventory National
Changes
Income
2.0
1.0
1.0
1.1
-.1
.7
1.0
.1
2.9
-.9
Increase
2.5
1.0
1.5
1.5
0
.7
1.0
.1
3.3
-.8
Increase
3.0
1.0
2.0
1.9
.1
.7
1.0
.1
3.7
-.7
Increase
4.0
1.0
3.0
2.7
.3
.7
1.0
.1
4.5
-.5
Increase
5.0
1.0
4.0
3.5
.5
.7
1.0
.1
5.3
-.3
Increase
6.0
1.0
5.0
4.3
.7
.7
1.0
.1
6.1
-.1
Increase
6.5
1.0
5.5
4.7
.8
.7
1.0
.1
6.5
0
7.0
1.0
6.0
5.1
.9
.7
1.0
.1
6.9
+.1 Decrease
8.0
1.0
7.0
5.9
1.1
.7
1.0
.1
7.7
+.3 Decrease
Neither
17
The Equilibrium Level
of Real National Income
C + I + G + (X-M)
Consumption, Investment, Government
Purchases, and Net Exports
($ trillions)
AE
7.0
RNI < C+I+G+X-M
E’
C
Less savings/more
consumption causes
shortage. Business
increase output!
6.0
5.0
4.0
RNI > C+I+G+X-M
More savings/ less
consumption causes
surplus. Cut back
Production!
AE> I/O
3.0
Income/Output > AE.
I
E
1.0
0.3
0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Real National Income/Output per
Year (Y)
($ trillions)
8.0
18
The Equilibrium Level
of Real National Income

Observations
◦ If C + I + G + X (AE) = Y (RNIncome/Output)
 Equilibrium
◦ If C + I + G + X (AE) > Y (RNIncome/Output)




unplanned drop in inventories (shortage/negative)
“Negative Unplanned Inventory Investment”
businesses increase output
Y returns to equilibrium
◦ If C + I + G + X (AE) < Y(RNIncome/Output)
 unplanned rise in inventories (surplus/positive)
 “Positive Unplanned Inventory Investment”
 businesses cut output
 Y returns to equilibrium
*Note equilibrium IS NOT full employment/potential of
the economy
19
The Equilibrium Level
of Real National Income

How does our study of Consumption,
Real National Income, and Equilibrium
help in Macroeconomics?