Samuelson & Nordhaus. Economics. 18th Ed.

Chapter 22
Prepared by: Samuelson & Nordhaus, Macroeconomics. 15th Ed. Chapter 6
RSEL – DSS 7/20/2011
 Consumption, saving & investment play a
central role in a nation’s economic
performance.
 Nations that:
 Save & Invest large fractions of their incomes –
rapid growth of output, income & wages.

 Consume most of their incomes & invest little –

low rates of growth or productivity & wages
 Highconsumption relative income spells low
investment and slow growth.
 Ex. US & Japan

 High
savings lead to high investment & rapid
growth.
 Ex. Africa & Latin America
 Thisdiscussion considers consumption &
saving behaviour, beginning with individual
spending patterns and then looking at
aggregate consumption behaviour.

 CONSUMPTION- (personal consumption

expenditure) – expenditures by households on
final goods & services.

 SAVING– is that part of personal disposable

income that is not consumed.
 Largest single component of GDP.
 Major Elements:
Among the most important categories are:
 Housing
 Motor vehicles
 Food
 Medical Care

 Table
1 displays the major elements broken
down into 3 categories: durable goods, non-
durable goods & services.
 Table 1: The Major Components of Consumption
Category of Value of Category, Percent of Total
Consumption 2002 ($, Billion)
Durable Goods 872 11.9
Motor Vehicles & Parts 376.1
Furniture & HH Equip. 318.7
Other 177.1
Non-durable Goods 2,115 29.0
Food 1,029.4
Clothing & Shoes 324.3
Energy Goods 173.5
Other 587.8
Services 4,317 59.1
Housing 1,071.5
Household Operation 405.2
Transportation 275.8
Medical Care 1,148.5
Recreation 285.1
Other 1,130.7
Total Personal 7,304 100
Consumption
Expenditure
Source: US Dep’t of Commerce
 Nofamilies spend their disposable incomes in
exactly the same way.

 Yet,statistics show that there is a

predictable regularity in the way people
allocate their expenditures among food,
clothing and other major items.

 General Qualitative Patterns of Behaviour:

 Poor Countries – spend their income largely on
necessities of life: food & shelter.
 As income increases, expenditure on food items
goes up: People eat more & eat better.

 There are limits to the extra money people will

spend on food when their income rise.
 The proportion of total spending on food declines as
income increases.

 Expenditure on clothing, recreation &

automobiles increases more than proportionately
to after tax income, until high income are
reached.
 Spending on luxury items increases in greater
proportion than income.

 Saving rises rapidly as income increases.

 Saving is the greatest luxury of all.
 Income, consumption & saving are closely linked.
 Personal Saving – part of disposable income that
is not consumed.
Savings = Income (Y) minus Consumption (C)

Table 2: Saving Equals Disposable Income Less Consumption

Item Amount, 2002 ($, Billion)

Personal Income 8,929
Less: Personal taxes 1,114
Equals: Disposable Income 7,816
Less: Personal Outlays 7,525
Equals: Personal Saving 291
Memo: Personal saving as 3.7%
percent of disposable
income
 Economic studies have shown that income is
the primary determinant of consumption and
saving.

 Richpeople save more than poor people,

absolutely or as percent of income.

 The very poor are unable to save at all.

Instead, as long as they can borrow or draw
down their wealth, they tend to dissave.
 They spend more than they earn, reducing
savings or going deeper into debt.
 (1) (2) (3)
Disposable Income Net Saving (+) Consumption
($) Or Dissaving (-) ($)
($)
A 24,000 -200 24,200
B 25,000 0 25,000
C 26,000 200 25,800
D 27,000 400 26,600
E 28,000 600 27,400
F 29,000 800 28,200
G 30,000 1000 29,000

B - Break-even point: the household neither saves nor dissaves but

consumes all its income - $25,000
Below break-even point: household consumes more than its
income, it dissaves. - $ 24,000
Above break-even point: household is saving. – $26,000
 Tounderstand the way consumption affects
national output, we need to introduce some
new tools.

 We need to understand how many extra

dollars of consumption & saving are induced
by each extra dollar of income.
 Shows the relationship between the level of consumption
expenditures and the level of disposable personal income.

Figure 2: Plot of Consumption Function

C
Consumption
Function
28,000 G
F

26,000 E
D
C
A
B
24,000
Consumption
22,000

20,000

45°

DI
20,000 22,000 24,000 26,000 28,000
 Atany point on the 45° line, consumption
exactly equals income, and the household
has zero saving.

 When the consumption function lies above

the 45° line, the household is dissaving.

 When the consumption function lies below

the 45° line, the household has positive
saving.
 Shows the relation between the level of saving and income.

 Figure 3: The Saving Function is the Mirror Image of the

Consumption Function.
S

1000

800 G
600 F

400 E
D Saving
C
0 A
B
-200

45°

DI
20,000 22,000 24,000 26,000 28,000
 The extra amount that people consume when
they receive an extra dollar of disposable
income.
NOTE:
 “marginal” –extra/ additional
 “propensity to consume” – desired level of
consumption.

 Thus, MPC is:

 Additional or extra consumption that results from
extra dollar of disposable income.
 (1) (2) (3) (4) (5)
Disposable Income Consumption Marginal Net Saving Marginal
(after taxes) Expenditure Propensity to ($) Propensity to
($) ($) Consume (4) = (1) – (2) Save
(MPC) (MPS)
A 24,000 24,200 -200
800/1000 = 0.80 200/1000=0.20

B 25,000 25,000 0
800/1000 = 0.80 200/1000=0.20

C 26,000 25,800 200

800/1000 = 0.80 200/1000=0.20

D 27,000 26,600 400

800/1000 = 0.80 200/1000=0.20

E 28,000 27,400 600

800/1000 = 0.80 200/1000=0.20

F 29,000 28,200 800

800/1000 = 0.80 200/1000=0.20

G 30,000 29,000 1,000

 Column (3) shows how to compute the MPC.
From B to C, income rises by $1000, going
form $25,000 to $26,000.

 How much does consumption rise?

 Consumptions grows from $25,000 to $25,800, an
increase of $800. The extra consumption is
therefore 0.80 of the extra income.

 Outof each extra dollar of income, 80 cents

goes to consumption and 20 cents goes to
savings.
 The slope of the function is the same as the MPC
 “the rise over the run”

Figure 4: The Slope of the Consumption Function is its MPC

C
Consumption
Function
28,000 G
F

26,000 E
D
C
A $800
B $800/$1,000 = 0.80
24,000
$1,000
22,000

20,000

45°

DI
20,000 22,000 24,000 26,000 28,000
 Definedas teh fraction of an extra dollar of
disposable income that goes to extra saving.

 Whyare MPC and MPS related like mirror

image?
 Disposable income equals consumption plus
savings.
 Thus, if MPC is 0.80, then MPS must be 0.20.
 MPS + MPC = 1, always and every where.
1. The consumption function relates the level
of consumption to the level of disposable
income.
2. The saving function relates saving to
disposable income. Because what is saved
equals what is not consumed, saving &
consumption schedules are mirror images.
3. The MPC is the amount of extra
consumption generated by an extra dollar
of disposable income. Graphically, it is
given by the slope of the consumption
function.
4. The MPS is the extra saving generated by an
extra dollar of disposable income.
Graphically, this is the slope of the saving
schedule.
5. Because the part of each dollar of
disposable income that is not consumed is
necessarily saved, MPS = 1 - MPC
 Whyare we interested in national
consumption?
 Consumption behaviour is crucial for
understanding both short term business cycles
and long term economic growth.

 Short-run: consumption is major component of

aggregate spending.

 Long-run: what is not consumed– that is what is

saved is available to the nation for investment in
the new capital goods; capital serves as a driving
force behind economic growth.
 Current Disposable Income – central factor
determining a nation’s consumption.

 Permanent Income and the Life-Cycle Model

of Consumption :
 Consumer generally choose their consumption
levels with an eye to both current income and
long run income prospects.
 Permanent income – the trend level of income
that is, income after removing temporary or
transient influence due to weather or losses./
  Life-cycle hypothesis – assumes that people save
in order to smooth their consumption over their
life time.
 Wealth and Other Influence
 Higher wealth leads to higher consumption or
the wealth effect.
 Having reviewed the determinants of
consumption, we may conclude that the level
of disposable income is the primary
determinant of the level of nation
consumption.
 National Accounts Measure of Saving
 The difference between disposable income
(excluding capital gains) and consumption.

 The Balance Sheet Measure of Saving

 Calculates the change in real net worth (that is,
assets less liabilities, corrected by inflation) from
one year to the next; includes capital gains.
 Thesecond major component of private
spending is investment.

 Investment plays 2 roles in macroeconomics:

 It is a large and volatile components of spending,
investment often leads to changes in aggregate
demand and affects the business cycle.
 Investment leads to capital accumulation ---
increases the nation’s potential output and
promotes economic growth in the long run.
 Revenues – investment will bring firms
additional revenue if it helps the firms sell
more product.

 Costs– the cost of investing. What is the cost

of borrowing?

 Expectations– profit expectations and

business confidence. Investment is a gamble
on the future, a bet that the revenue from
an investment will exceed its costs.
 (1) (2) (3) (4) (5) (6) (7)
Proj. Total Annual Cost per $1,000 Cost per Annual Net Annual Net
Investment Revenues of Project at $1,000 of Profit per Profit per
in project per $1,000 Annual Interest Project at $1,000 $1,000
($,million) investment Rate of 10% Annual Interest invested at invested at
Rate of 5% Annual Annual
Interest Rate Interest Rate
of 10% of 5%
(6)=(3)-(4) (7) =(3)-(5)

A 1 1,500 100 50 1,400 1,450

B 4 220 100 50 120 170
C 10 160 100 50 60 110
D 10 130 100 50 30 80
E 5 110 100 50 10 60
F 15 90 100 50 -10 40
G 10 60 100 50 -40 10
H 20 40 100 50 -60 -10
 Toshow the relationship between interest
rates and investment, economist use a
schedule called investment demand curve.
 In choosing among investment projects, firms
compare the annual revenues from an
investment with the annual cost of capital
which depends upon the interest rate.

 The difference between the annual revenue

and annual cost is the annual net profit.

 When annual net profit is positive, the

investment makes money, while negative net
profit denotes that the investment loses
money.
 We have seen how interest rates affect the
level of investment.
 Investment is affected by other forces as
well.
 An increase in GDP will shift investment demand
curve out.
 An increase in business taxation would depress
investment
 Importance of expectations: business optimism
shift out the investment demand schedule like
“new economy”.
 Higher Output Higher Taxes Internet Euphoria

Return on investment
Return on investment

Return on investment

Investment spending
Investment spending Investment spending
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