Bec 3150 Macro Topic 3&4
Bec 3150 Macro Topic 3&4
Consumption Function
C Y
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Average propensity to consume, (APC) is the proportion of disposable income that is spent on
consumption. It is given by C/Y.
Therefore: from the above consumption function,
C Y
APC = = = + ,
Y Y Y
C dc
MPC = = =
Y dy
Savings Function
It describes the total amount of savings at each level of disposable personal income. Savings is the
difference between disposable income and consumption.
The savings function is upward sloping, implying that savings is an increasing function of income.
The slope of the savings function is the marginal propensity to save (MPS).
2
MPS is the change in savings resulting from a unit change in personal disposable income. The
average propensity to save (APS) is the proportion of disposable personal income that is saved. It
is given by S/Y, which implies that as income increases, APS decreases and vise versa.
C = f(Y)
C
0 Y
In classical economics, savings is a function of interest rate i.e. S = f (r). It is assumed that
depending on the interest rate in commercial banks, households decide how much to save, before
devoting the balance to consumption i.e. C = Y – S and S = f(r). Note that in this case S is an
increasing function of interest rate hence C is a decreasing function of interest rate (r).
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Whereas classical theory emphasizes consumption as a function of interest rates, Keynes’
emphasis is on income as the main determinant of consumption. Therefore, the following
inferences can be drawn:
- Consumption is a stable function of real income
- Generally, consumption increases as income increases, but not as much as the increase
in income
- Short run marginal propensity to consume is less than the long run marginal propensity
to consume.
- In the long run, a greater proportion of income will be saved as real income increases
hence the APC falls with increase in income.
Theories of Consumption
1. Absolute Income Hypothesis
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- Consumption behavior of individuals is interdependent.
- Consumption relations are irreversible over time.
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If income increases from Y0 to Y1, the consumer moves along the long run consumption function
to Y1 and consumes at point B from point A. The increase in income causes the short run
consumption function to shift from C0 to C1. However, a decrease in income does not lead to a
downward shift of the short run consumption. This is called the Ratchet effect.
Ratchet effect makes the consumer to move back along the short run consumption function
following a decrease in Y. When income falls back to Y0 consumption expenditure moves along
the short run consumption function C1 to point F from point B. F is clearly higher than A.
Note that YT can be positive, negative or zero, and that the sum of transitory incomes for a group
of persons is equal to zero, i.e. ΣYT = 0.
Like measured income, measured consumption (C) has two parts, permanent consumption (CP)
which is the normal or planned level of spending and it is a function of permanent income, and
transitory consumption (CT) which is unplanned, temporary and is a function of transitory income.
Thus
C = CP + CT.
Since ΣYT = 0, then ΣCT = 0.
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Therefore, we can write basic consumption function as a specific function in permanent income
given by
C = kYP,
Where k is the marginal propensity to consume
This hypothesis was formulated by Modigliani, Ando and Brumberg. It is therefore also called the
MBA hypothesis.
It states that consumption is a function of the expected stream of disposable income over a long
period of time and the present value of wealth.
Individuals are assumed to spread out the present value of all future income streams on
consumption through out their lifetime. Therefore, consumption is assumed to be a function of
lifetime income.
C,S,Y
C
S>0,
Net saver S<0, Net dis-saver
0 Time (Years)
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Where C = Consumption
Y = Income
S = Savings
When, C>Y, the individual is borrowing to consume and build up human capital;
Y>C, the individual is paying loans and saving for future consumption, investment
and for bequests; and when
C > Y, the individual is consuming out of savings, pension and social security
fund.
According to the life cycle income hypothesis, the average propensity to consume (APC) is high
in the early and late years of an individual’s life. This is why there is non-proportionality in income
and consumption relationship in the short run. In the long run however, consumption and income
relationship will be proportional.
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Other Determinants of Consumption
1. Rate of Interest: According to classical economists, individuals will save more and
spend less as interest rate increases
2. Relative Prices: This influences consumption behaviour with consumers shifting to relatively
cheaper goods.
3. Capital gains: According to Keynes, windfall gains/losses will influence consumption. Keynes
argued that consumption of wealth owners can be influenced by sudden changes in the money
value of their wealth. Sudden changes are common where the stock exchange market is
composed of speculators.
4. Wealth: High stocks of wealth lead to low marginal value of wealth and hence less desire to
accumulate more. As a result, this leads to increased consumption.
5. Money stock (Liquid assets): The higher the stock of liquid assets the higher the marginal
propensity to consume.
6. Availability of consumer credit: Readily available and/or cheap consumer credit leads to
consumers borrowing for consumption purposes. This pushes up the aggregate consumption
function.
7. Attitudes and Expectations of Consumers: Both change in consumer attitudes and expectations
affect their consumption behaviour. If for instance, consumers expect a price increase of a
certain good, they may increase their current purchase of the same good.
8. Money Illusion: Consumption will go up when consumers suffer from money illusion. Money
illusion occurs when consumers fail to realize the price increase accompanying the increase in
their nominal income, thereby behaving as though their real income has increased when it has
not. Money illusion is also called Pigou or real cash balance effect.
9. Distribution of Income: Redistribution of income may cause a shift in the aggregate
consumption function, or lead to both a shift to a change in the slope of the function. It therefore
affects the level of aggregate consumption, if the recipients have different marginal propensity
to consume and average propensity to consume.
10. Composition of Population: Population composition in terms of age, sex and class determines
consumption.
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Investment refers to the addition of capital stock in an economy. Therefore, it is given by the value
of that part of aggregate output for any given year that takes the form of:
- Construction of new structures
- Changes in business inventories
- New capital investment
Types of Investment
1. Autonomous Investment (I0): This is investment that does not depend on the level of income.
It is determined by exogenous functions e.g. inventories, population growth, wealth changes,
research, etc.
5. Private Investment
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- It is investment made by private investors in an economy. It is normally made in
response to profit expectations. It depends on the interest rate and the marginal
efficiency of capital. It increases as the interest rate falls. It also increases as the
marginal efficiency of capital (MEC) increases.
6. Public Investment
- It is investment made by the government and other public enterprises.
Determinants of Investment
1. Interest rate (i): Investment is inversely related to interest rate.
2. Internal rate of Return (IRR): It is the rate of interest that equates the present value of benefits
from a project to the present value of its costs. A decision to invest is based on the comparison
between IRR and i.
If IRR > i, investment is made
IRR < i, no investment
IRR = i, other factors are considered in deciding whether or not to invest.
3. Expected future income flows;- if the investor expects high profits, then investment will be
undertaken and vise versa
4. Initial cost of the capital good and its useful life: - if the capital good is affordable then it will
be purchased and vise versa. An investor will purchase a good that is likely to last longer
5. Degree of certainty: An investor considers the risks and uncertainties involved in a particular
investment. if they are high he may not invest
6. Existing stock of capital: If the existing capital is large potential investors may be discouraged.
Similarly if there is excess or idle capacity in existing capital stock, investment may be
discouraged.
7. Level of income; a rise in the level of income in the economy due to rise in money wages and
other factors prices raises the demand for goods and services and this in turn will induce an
increase in investment
8. Business expectations; if businessmen are optimistic and confident regarding future returns
from capital goods they invest more.
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9. Consumer demand; If the current demand for consumer goods is increasing rapidly, more
investments will be made
10. Liquid assets; If investors posses large liquid assets then their inducements to invest is high
11. Invention and innovation: If investments and technological improvements lead to more
efficient methods of production, which reduce costs, the marginal efficiency of new capital
assets will rise, hence firms will invest more.
12. New products; if sale prospects of the new product is high and the expected revenue more than
costs, investment will be encouraged
13. Population growth; this implies that there is a growing market (demand) for goods and services
that must be met by increased production hence investment will increase to provide the capital
goods required to increase production..
14. Government policy: Government can encourage investment through reduction in taxes and
provision of social amenities for those investing in particular sectors.
15. Political climate and stability; if there is political instability in the economy, investment will
adversely be affected.
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4. EQUILIBRIUM INCOME DETERMINATION
Example:
Suppose that
C = 10 + 0.8Y
I = Ksh. 500
Compute Equilibrium Income ( Y )
Solutions:
Y=C+ I
Therefore:
Y = 10+0.8Y + 500
Y - 0.8Y = 10 + 500
(1 – 0.8)Y = 510
0.2Y = 510
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510
Y=
0.2
Y = Ksh. 2550
Alternatively,
Y Y I
Y Y I
Y (1 ) I
I
Y
1
Therefore
10 500 510
Y Ksh.2250
1 0.8 0.2
Equilibrium in the goods market requires that aggregate income (output) be equal to aggregate
expenditure. Therefore, the goods market equilibrium can be expressed as
C+S+T=C+G+I
S+T=G+I
Assuming that G = T, then equilibrium is achieved when I = S.
Therefore, I = S is the equilibrium condition in the goods market, meaning that the economy
should be at equilibrium at any point along S = I line.
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AD
(C+I+G) I=S
AD
Y*
Income(Y)
AD(C,I,G) I=S
AD C + I +G
Y1 Y* Y2 Y
These situations of disequilibrium are normally short-lived as there is tendency for income to move
towards Y*.
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If consumption is a function of income, i.e. C = f(Y), and investment is constant, then equilibrium
income can be shown as follows:
AD I=S
(C+I)
AE=C+I
I
I
Y
Y*
When savings is equal to investment, the addition to demand due to increase in investment is equal
to subtraction from demand due to less spending by households.
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C+I+G
C+I
C=f(Y)
The above diagram shows that equilibrium income increases with every addition of injections into
the economy in form of investment and government expenditures.
We have seen that equilibrium in the goods market require that S = I. all factors that cause changes
will Consumption, Savings and Investments will therefore influence the equilibrium position
Suppose the consumption (C) and investment functions are given as
C = α + βY; 0<β<1
I = I0 – kr; 0<k<I
1. Using the expenditure approach of deriving the IS equation, and we assume absence of
government
Y=C+I
Y = α + βY + I0 - kr
Y - βY = α + I0 – kr
Y(1 – β) = α + I0 – kr
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kr = α + I0 – Y (I – β)
I 0 ( I )Y
r= IS equation
k k
2. Using the savings approach of deriving the IS equation we recall that S = sY; where s is a
parameter and 0 < s < I
At equilibrium S = I; therefore
sY = I0 – kr
kr = I0 – sY
Hence
I 0 sY
r= IS equation
k k
The IS equation expresses the interest rates as a function of Income. From the equation it can be
noted that at equilibrium in the goods market, interest rates and Incomes are inversely related.
Therefore the IS curve is downward sloping
IS
Y
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The IS curve can therefore be derived as follows
AE
IS
The IS curve shows the equilibrium positions where desired expenditure is equal to desired
income. It is downward sloping since investment is an inverse function of interest rate. At higher
the interest rates, there is lower investment spending, hence the lower the aggregate income.
From the above diagram, at E1, interest rate is r1 and corresponding income is Y1. As interest falls
to r2 and then r3, aggregate expenditure curve shifts to E2 and then E3 while income increases to Y2
and then Y3.
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On the IS curve, E = Y and hence the goods market is in equilibrium. The IS curve is defined as
the locus of points corresponding to rates of interest and levels of income that produce equilibrium
in the goods/product market.
An outward (inward) shift of the IS curve will be caused by an increase (decrease) in any of the
following:
- autonomous investment
- autonomous consumption
- government expenditure
- exports (Net)
Dis-equilibrium Income
This occurs when I is not equal to S.
This leads to accumulation of inventory forcing firms to reduce production and induce a decline
in income and employment until S = I.
This means inventories will be sold and businesses will produce more leading to increase in supply
of goods and income until S = I.
Planned investment and planned savings don’t always equal each other. Changes in employment,
production and income occur causing changes in savings and investment. The direction of these
changes will be towards equality of Savings and Investments (S=I)
If planned investment and planned savings differ, changes in production will force consumers to
change their savings plans or firms to change their investment plans (or both will occur) until I =
S.
It is only at equilibrium that both planned and realized investments and savings will be equal.
However, realized investment and realized savings are always equal.
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The Multiplier concept
The multiplier is the number by which national income changes due to a unit change in any of its
components.
Y = + βY + I0
Y – βY = + I0
(1 – β)Y = + I0
Hence
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Ye =
1
Now suppose that autonomous investment I0 increases by ΔI; the new equilibrium income will be
given as
YN = Y1 + ΔY
10 I
YN = +
1 1
10 I 10 I
Therefore: ΔY = YN – Y = - =
1 1 1 1
1
Therefore: ΔY = ΔI
1
And
Y 1
I 1
= which is the simple investment multiplier.
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Example
Suppose Y0 = 100
ΔI = 25
MPC = = 0.8,
1 25
ΔY = x 25 = = 125
1 0.8 0.2
Y 1 1
= = =5
I 1 0.2
125
= =5
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Y = C + I0 + λY.
But C = +
Therefore:
Y = + + I0 + λY.
Y - - λY = I 0
Y (1 - - λ) = I0
I0 I0
Ye = =
1 1 MPC MPI
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Now suppose that autonomous investment (I0) increases. The new equilibrium income will be
I0 I
YN = Y + ΔY =
1
I 0 I
YN = +
1 1
I0 I I0
ΔY = YN – Y =
1 1 1
I 1
ΔY = = ΔI
1 1
Therefore:
Y 1
The multiplier with induced investment
I 1
Given
Y = C + I + G and Y = C + S + T
At equilibrium, Y = C + I + G = C + S + T
Therefore:
Y = (Y – T) + I + G
Y= Y- T+I+G
Y - = T + I + G
(1 - )Y = T + I + G
Hence
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Ye =
1
T I G Where the coefficient
1
is the multiplier
1 1
Government expenditure multiplier is derived as the effect on income arising from a unit change
in government expenditure (ΔG).
1
Therefore: ΔY = (ΔG)
1
Hence
Y 1
The government expenditure multiplier
G 1
1
YN = Y + ΔY = Y* + ΔG
1
ΔY =
1
T = ΔT
1 1 B
Therefore
Y
Tax multiplier
T 1
Example
Suppose MPC = 0.8, Y = ksh.1160 and ΔT = ksh.40. Compute the change in income.
B 0.8 0.8
ΔY = (ΔT) = x 40 = x 40 = -4 x 40 = -160/=
1 B 1 0.8 0.2
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Balanced Budget Multiplier
If taxes and government spending change simultaneously, the combined effect on income is
given by:
G BT
ΔY =
1 1
Example:
Suppose = 0.75,
Y 1 1
4,
G 1 0.75 0.25
Y 0.75 0.75
3
T 1 1 0.75 0.25
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This means that a change in tax will change income by a multiple of 1 less than an equal change
in G. A balanced budget therefore does not have a neutral impact on the system.
But
Y C I G
C (Y T )
Y T
Y (t 0 t1Y )
t 0 Y Bt1Y
Thus
Y t 0 Y Bt1Y I G
Y Y t1Y t 0 I G
Y [1 (1 t1 ) t 0 I G
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Therefore
Y
1
t 0 I G
1 (1 t1 )
In equilibrium,
Y = C + I + G + ( X - M )……………………………………(1)
C = (Y T ) …………………………………………… (2)
T = tY …………………………………………….(3)
M = M0 + dY........ …………………………………………... (4)
Y = (Y tY ) I + G + X - M0 – dY
= tY I + G + X - M0 – dY
Y – βY + βtY + dY = I + G + X - M0
Y(1 - t d ) = I + G + X - M0
I
Y=
1 (1 t ) d
I
=
1 (1 t ) d
1
Therefore the injections multiplier is given by:
1 (1 t ) d )
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Note: Changes in G and X will have the same multiplier effect on national income as changes
in I . However, effect of change in T is given by:
T
1 (1 t ) d )
Paradox of Thrift
This shows that an attempt by the community to save more out of any given income will lead to a
decrease in the actual amount it succeeds to save.
S + ΔS
I, S S
S1
S2
Y2 Y1 Income (Y)
With the original savings function (S) and the investment function (I) equilibrium income is Y1
and realized savings is S1. An upward shift in the savings function to S + ΔS, which shows the
community’s effort to save more (increase in the marginal propensity to save), leads to a new
equilibrium income Y2 and new realized savings of S2. Note that S2 < S
Inflationary and Deflationary Gaps
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Inflationary gap arises when an increase in spending moves the economy away from the
equilibrium at full employment position. Inflationary gap is the amount by which aggregate
demand rises above the level necessary for full employment in the economy.
C, I
C+I+∆I
I-G C+I
C+I-∆I
D-G
When aggregate demand increases from C + I to C + I + ΔI, YIG becomes the equilibrium income.
However, YIG is unattainable since at YF all resources are fully employed. This means that people
have more money chasing fewer goods and services, hence prices of products increase, pushing
up the nominal national Income to YIG. The difference between YF and YIG is due to inflation and
it is called the inflationary gap.
Deflationary gap is the amount that demand falls short of the necessary level required for full
employment in an economy. When aggregate demand falls from C + I to C + I – ΔI, YDG becomes
the equilibrium income. However, this level is undesirable, as it causes unemployment. This means
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that the consumers have less money chasing too many products, hence a slump in prices and
employment. The difference between YDG and YF is the deflationary gap. The deflationary gap can
be removed by a combination of some or all the following:
- increasing people’s incomes through reduction of income taxes
- reducing prices through reduction of indirect taxes
- increase in government expenditures.
NOTE: Increase (decrease) in spending (aggregate demand) arises due to an increase (decrease)
in investment.
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