CONSUMPTION AND

INVESTMENT
FUNCTION
KEY CONCEPTS TO NOTE
CONSUMPTION

INVESTMENT

SAVINGS

DETERMINANTS OF THE
THREE
WHAT IS CONSUMPTION?
Consumption, in economics, is the use of goods
and services by households.
The purchase of goods and services by use of
households is called consumption expenditure.
Consumption differs from consumption expenditure
primarily because durable goods, such as
automobiles, generate an expenditure mainly in
the period when they are purchased, but they
generate “consumption services” (for example,
an automobile provides transportation services)
until they are replaced or scrapped.
 TYPES OF CONSUMPTION
Direct or Final consumption:
when the goods satisfy human
wants directly and immediately.
E.g. taking of meals, use of
furniture etc.
Indirect or Productive
consumption when the goods
are not meant for final
consumption but for
producing other goods which
will satisfy human wants, e.g.
use of fertilizer in agriculture
etc
WHY IS CONSUMPTION IMPORTANT?
 Consider this:

EFFORT
WANT SATISFACTION
(DESIRE)

More often than not, this satisfaction is derived from the act of
consumption.

From the large scale perspective, in a country, say India, the

consumption of any good can be directly related to the satisfaction
of wants.

This, in turn sets up demand. Demand induces supply and the cycle
goes on.
Household consumption decision is closely linked to saving decision.
(For given level of disposable income, deciding how much
to consume = deciding how much to save!)
THE CONSUMPTION FUNCTION
The consumption function, as the name suggests
has to be dependent on a certain variable.

From a macro economic point of view, this variable is

National Income.

So, national consumption depends on National

Income.

A general consumption function:

C = f(Y).
THE MATH

C = a + b*Y

a = ‘subsistence’ or minimal level of

Consumption
b=marginal propensity to consume
(MPC)
Y= income
And, C= total consumption expenditure
 MPC

The proportion of an aggregate raise in pay that a

consumer spends on the consumption of goods and
services, as opposed to saving it.
Marginal Propensity to Consume is present in Keynes'
consumption theory and determines by what amount
consumption will change in response to a change in
income.

Suppose an employee receives a Rs.500/- bonus in addition

to the annual earnings. They now have Rs.500/- more in
income than they did before. If they decide to spend Rs.400/-
of this marginal increase in income and save the remaining
Rs.100/-, the marginal propensity to consume will be 0.8
(Rs.400/- divided by Rs.500/-).
So, MPC= ΔC/ΔY , where C and Y have their usual meanings.

MPS

The MPS is also known as the Marginal Propensity to

Save.

It is defined as:

1-MPC=MPS
In this graphical illustration of the consumption function,
a= 5,000
MPC= 3/4
 SHIFTS IN THE CONSUMPTION CURVE

POSITIVE SHIFT:
NEGATIVE SHIFT:
• Increase in Real
Assets and money
• Increase in interest
holding rates
•Increase in
• Increase in taxes
expectation of future
prices.
POSITIVE SHIFT NEGATIVE SHIFT
SOME EXAMPLES

a= 100, b= 0.8, Y= Rs. 400

Then, using the formula:
C= 100+ 0.8*400
= 100+320
= 420
 a= 175, b=0.75
Now, the function becomes:

C= 175+ 0.75*Y

For a given value of income, we can calculate the consumption

expenditure.
In some cases, the function is represented as:

C= a+b(Y-T)

Here, T represents taxes that are subtracted from the

income.
THE INVESTMENT FUNCTION
 WHAT IS INVESTMENT?

Investment is the expenditure on capital goods

made for the purpose of income regeneration.

In other words, an investment is the purchase of

goods that is not used today but is used in the future
to create wealth or income.

The building of a factory used to produce goods and

the investment one makes by going to college or
university are both examples of investments in the
economic sense.
 INVESTMENT

AUTONOMOUS INDUCED
AUTONOMOUS INVESTMENT
Expenditure made that is independent of
economic growth. They are investments made
for the good of society and not for the goal of
making profits

For example: The Government invests on

infrastructure items, such as roads and highways,
and other investments that keep the economic
engine running.
It is shown that autonomous investment curve la is a horizontal straight line.
For example, when national income is 0Y1, the autonomous investment is
Rs. 10 billion. If national income increases to 0Y2, the autonomous
investment remains Rs. 10 billion and so on.
INDUCED INVESTMENT
Investment which changes with the changes in
the income level, is called as Induced
Investment.

Induced Investment is positively related to the income

level. That is, at high levels of income entrepreneurs are
induced to invest more and vice-versa. At a high level of
income, Consumption expenditure increases this leads to
an increase in investment of capital goods, in order to
produce more consumer goods.
It is shown that the investment curve is positively
sloped. It indicates that as the level of national income
rises from 0Y1 to 0Y2, the level of induced
investment also rises from 011 to 012
 AN EXAMPLE
The owner of a pizza chain decides to purchase a new
Rs.10,000 pizza oven, paying for it by taking Rs.10,000
out of the savings account at the 87th National Bank.
This is an example of investment because the oven
purchased will further generate income for the owner.
 Investment Function
3000

2500

2000

1500
Induced Investment
Autonomous Investment

1000

500

0
1 2 3 4 5 6 7 8 9 10
Income Rs. Thousand
SAVINGS
 Definition

Savings are the amount left over when the cost of a

person's consumer expenditure is subtracted from the
amount of disposable income that he or she earns in a
given period of time.
 WHAT IS SAVINGS?

To economists, saving means not consuming

from a fixed amount of resources to enable
higher consumption in the future.

It is the decision to defer consumption and to

store this deferred consumption in some
form of asset.
 PURCHASE
OF
SECURITIES

SAVINGS

INCREASED
INCREASE CASH
IN BANK HOLDINGS
DEPOSITS
The extent to which consumers save is
affected by their preference for the
future over present consumption,
expectations of future income and
rate of interest.
 WHY DO PEOPLE SAVE?

People save—accumulate assets—to finance their

retirement, and they dissave—spend their assets—during
retirement.
The more young savers there are relative to old
dissavers, the greater will be a nation’s saving rate.
The precautionary motive—that is, the motive to save in
order to be prepared for various future risks—is one of
the key reasons people save.
By saving we can invest money to produce fixed capital,
which contributes to economic growth.
However, savings do not always correspond to increased
investment. If the money is not deposited into a
financial intermediary, it is not recycled in investment.
This can cause a shortfall of demand and recession
instead of economic growth.
 CASE STUDY #1

We said that Savings affect the workings of an economy?

The question is How?

Germany, in common with the rest of continental Europe,

has been suffering from a lack of demand, caused in
part by the Germans' high propensity to save. Other
European members, subject to similar macro economic
constraints, have done far better.

This is has led to a total lack of consumer confidence on

the part of the Government.
SOME THEORIES
 THEORIES OF CONSUMPTION

ABSOLUTE THEORY LIFE CYCLE THEORY

OF CONSUMPTION

RELATIVE
CONSUMPTION
THEORY
 ABSOLUTE THEORY OF
CONSUMPTION
It is also known as the Absolute Income Hypothesis.

The Absolute Income Hypothesis is theory of consumption

proposed by English economist John Keynes.

This theory states that real consumption is a function of real

disposable income, total income net of taxes. As income rises, the
theory asserts, consumption will also rise but not necessarily at the
same rate.

While this theory has success modeling consumption in the short

term, attempts to apply this model over a longer time frame have
proven less successful.
 RELATIVE CONSUMPTION
THEORY

• This theory was developed by James Duesenberry.

• It states that an individual’s attitude to consumption

and saving is not solely dependent on income. Hence,
the percentage of income consumed by an individual
depends on his position in the income distribution
demographic.
 THE LIFE CYCLE THEORY

This hypothesis addresses individual consumption

patterns
The life-cycle hypothesis implies that individuals both
plan their consumption and savings behaviour over the
long-term and intend to even out their consumption in
the best possible manner over their entire lifetimes
The key assumption is that all individuals choose to
maintain stable lifestyles. This implies that they usually
don't save up a lot in one period to spend furiously in
the next period, but keep their consumption levels
approximately the same in every period.
THE LIDUIDITY PREFERENCE
THEORY OF INVESTMENT
In the liquidity preference theory, Keynes said that people
value money for both "the transaction of current business
and its use as a store of wealth." Thus, they will sacrifice
the ability to earn interest on money that they want to
spend in the present, and that they want to have it on
hand as a precaution. On the other hand, when interest
rates increase, they become willing to hold less money
for these purposes in order to secure a profit.

Or, in other words:

The rate of interest is determined by the matching of demand and

supply of liquidity
According to Keynes, the demand for liquidity is
a result of three motives:

• The Transaction Motive: people prefer to have liquidity to assure

basic transactions, for their income is not constantly available. The
amount of liquidity demanded is determined by the level of income: the
higher the income, the more money demanded for carrying out increased
spending.

• The Precautionary Motive: people prefer to have liquidity in the

case of social unexpected problems that need unusual costs. The
amount of money demanded for this purpose increases as income
increases.
• Speculative Motive: People retain liquidity to speculate that bond
prices will fall. When the interest rate decreases people demand more
money to hold until the interest rate increases, which would drive
down the price of an existing bond to keep its yield in line with the
interest rate. Thus, the lower the interest rate, the more money
demanded (and vice versa).
 NET PRESENT VALUE (NPV)
The difference between the present value of cash inflows
and the present value of cash outflows. NPV is used in
capital budgeting to analyze the profitability of an
investment or project.

If the present values of all future cash inflows is greater than the
present value off all future cash outflows, NPV is positive.

If the opposite is true, then the NPV is negative.

RATE OF DISCOUNT: An approach to choosing the discount
rate factor is to decide the rate which the capital needed
for the project could return if invested in an alternative
venture. If, for example, the capital required for Project A
can earn 5% elsewhere, use this discount rate in the NPV
calculation to allow a direct comparison to be made
between Project A.
 INVESTMENT

INTIAL FUTURE CASH RATE OF

INVESTMENT INFLOW DISCOUNT
FACTORS DETERMINING
CONSUMPTION
SUBJECTIVE FACTORS OBJECTIVE FACTORS

1. Human nature 1. Level of income

2. Distribution of wealth

3. Expectations in change in price

4. Change in rat of interest

5. Changes in Fiscal Policy

6. Availability of goods

7. Attitude towards saving

 FACTORS
DETERMINING
INVESTMENT
The two primary factors that influence economic
investment are:

Income: An increase in income encourages higher

investment from both firms and individual
consumers.

Interest Rates: However, a high interest rate can

discourage investment because high interest rates
make it more expensive to borrow money. To
encourage investment, interest rates need to be
lower.
Because all investments come with a certain amount
of risk, the interest rate represents an
opportunity cost. Even when a firm uses its own
funds on an investment, there is an opportunity
cost of using the funds for investment, instead of
lending out the money for interest. The level of
risk can be seen to a certain extent when
analyzing the income and interest rates, which
allows the risks to be managed
INVESTMENT AND INCOME
INVESTMENT AND INTEREST RATE
DETERMINANTS OF
SAVINGS
There are a number of determinants of saving. These
determinants are the major forces that shape the economic
scenario of a country. At the same time, determinants of saving
are also responsible for the development or downfall of the
investment sector of a country.

The major determinants are:

• Income level

• Production level

• Consumerism

• The price difference between the domestic goods and the

foreign goods also influences the savings rate
Some financial decisions of the public sector also play
an important role as the determinants of savings.
The percentages of children and old people are
also among the determinants of savings. This
section of a country's population is not expected
to generate income. Because of this, the portion is
dependent on the remaining part of the population
for maintaining their livelihood. All these factors
cause the saving capacity of the workforce to
come down to a certain level.
 CASE STUDY #2

A COMPARATIVE STUDY IN
CONSUMPTION FUNCTION IN
IRAN AND INDIA
 ABSTRACT

India and Iran are two of the oldest countries in Asia

and both are the transition countries in the world.

Both countries have had several Five-Year Plans to

increasing the real per capita income, growth rate of
GDP etc.

Both countries demonstrate similar problems like high

unemployment rate (especially for educated people),
poverty, high growth rate of population etc.
 THE MAIN OBJECTIVE

The main objectives in this study are estimation of

Marginal Propensity to Consume (MPC) out of income
and wealth for both countries and then compare them
based on economics aspects. Another objective is to
show that which one of them is potentially going to
increase saving and Investment in the future.
 INDIA IRAN
GROWTH RATE 8% 3.9%

(%)

GDP 2908 410

(BILLION $)

PER CAPITA GDP 3.7 2.6

GROWTH

(%)
 INDIA IRAN

MPC OUT OF 0.221 0.189

WEALTH

MPC OUT OF 0.672 0.541

INCOME
0.8
0.7
0.6
0.5
0.4 India
0.3 Iran
0.2
0.1
0
MPC out of wealth MPC out of income
 CONCLUSION
This study has demonstrated the Marginal Propensity to Consume
of India is higher than that of Iran.

It has also revealed that not only MPC out of Income of India is
higher than Iran’s but also MPC out of wealth of India is more than
Iran’s.

This means that higher the MPC, greater the spending and
lesser the saving.

Hence, greater the demand!