CONSUMPTION, SAVINGS AND INVESTMENTS

AGGREGATE DEMAND AND AGGREGATE SUPPLY

AGGREGATE DEMAND
Aggregate demand (AD) is the total demand for final goods and services in the economy at a given
time and price level. It is the amount of goods and services in the economy that will be purchased at
all possible price levels. This is the demand for the gross domestic product of a country when
inventory levels are static. It is often called demand. The aggregate demand curve is downward
sloping because at lower price levels a greater quantity is demanded.

Components of Aggregate Demand

An aggregate demand curve is the sum of individual demand curves for different sectors of the
economy. The aggregate demand is usually described as a linear sum of four separable demand
sources which are:

1. Consumption
Consumption expenditures (C) or consumption demand by households and unattached individuals;
its determination is described by the consumption function. The consumption function is
C= α + (MPC) (Y-T) OR C     Y
The function shows that consumption is an increasing function of income where;
o α is autonomous consumption, which is consumption expenditure that occurs when
income levels are zero. Expenditure does not vary with changes in income. Mainly
facilitated through borrowing.
o MPC is the marginal propensity to consume, which is the proportion of the disposable
income which individuals desire to spend on consumption. It is the proportion of
additional income that an individual desires to consume. It can also be described as
the change in consumption arising from a unit change in income and is represented
 C 
by    
 Y 
o (Y-T) is the disposable income.
Graphically, the consumption function is presented as follows:
C

Income as a Determinant of Consumption

Income is the major determinant of consumption. Keynesian consumption theory suggests that
consumption is linearly dependent on income so that in the short run, C =   Y.

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In Keynesian theory, savings is a function of income while investment is a function of interest rate
(r). In the long run, it is assumed that consumption entirely depends on income because with time as
Y becomes very large α disappears.
Diagrammatically this is shown as follows:

C = f(Y)
C

0 Y
Long run consumption function

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).

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.

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. Savings function is given by:
S=Y–C
Given the consumption function, we can derive the savings function.
Suppose C =    Y , then
S = Y -    Y  S = -   Y  Y ,
Therefore, S =    (1   )Y is the savings function.

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 S

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). 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 vice versa.

Theories of Consumption
1. Absolute Income Hypothesis
This hypothesis was postulated by Keynes.
According to this hypothesis, consumption is a function of current level of disposable personal
income. Consumption is directly, but not proportionately related to current level of aggregate
disposable income both in the short run and long run. This implies that C/Y decreases as income
increases. Keynes bases this assumption (disproportionate consumption change) on the argument
that consumers’ reaction to income change is not instant, but gradual since change in income may
not be permanent.
Therefore, Ct =  +  Y t + dCt-1.
This means that consumption over time (Ct) is not only dependent on income overtime (Yt), but also
previous level of consumption (dCt-1)
2. The Relative Income Hypothesis
This hypothesis was put forth by James Duesenberry in 1949. It makes two assumptions:
- Consumption behavior of individuals is interdependent.
- Consumption relations are irreversible over time.
(i) Consumption behavior of individuals is interdependent.
This means that the ratio of income consumed depends on the individual’s absolute income as well
as their relative income, i.e. consumption will depend on the individual’s percentile position in the
total income distribution within a community. In any given year, an individual will consume small
percentage of his/her income if increase in his/her income is accompanied by improvement in
his/her percentile position and vice versa. If his/her percentile position remains unchanged over
time, the individual will consume the same percentage of his/her income despite changes in the
absolute income.

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(ii) Consumption relations are irreversible over time.
This assumption makes the relative income hypothesis to be referred to as previous peak theory. It
means that when income falls during cyclical downswing the resultant fall in consumption will be
less than proportionate because individuals base their consumption patterns on previous levels of
income. When income increases, consumption increases proportionately, but when income falls
below the previous peak, consumption does not fall proportionately.

C = f(Y) = Long run consumption function.

C0 & C1 = short run consumption functions.

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.

3. Permanent Income Hypothesis

It was put forward by Friedman in 1957. It states that consumption depends on permanent income.
Permanent income is defined as the present value of the expected flow of long-term income.
According to this hypothesis, permanent consumption (CP) is proportional to permanent income (YP),
i.e. CP = f(YP). The ratio of consumption (CP) to induced consumption (βYP) is constant at all levels of
income. Income consists of two components namely: permanent income (YP) and transitory income
(YT). Transitory income refers to temporary unexpected rise or fall in income. It is given by the
difference between measured income (Y) and permanent income (Yp), i.e. Y = YP + YT.
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

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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.
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

4. Life Cycle Income Hypothesis

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 throughout their lifetime. Therefore,
consumption is assumed to be a function of lifetime income.
Graphically this is shown as follows:
C,S,Y

C
S>0,
Net saver S<0, Net dis-saver

S<0, Net borrower

0 Time (Years)
Where C = Consumption
Y = Income
S = Savings
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.

Other Determinants of Consumption

1. Rate of Interest: According to classical economists, individuals will save more and spend less as
interest rate increases

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2. Relative Prices: This influences consumption behavior 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 behavior. 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.

2. Gross Domestic Investment

Gross private domestic investment (I), such as spending by business firms on factory construction.
This includes all private sectors spending aimed at the production of some future consumable.
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.
2. Induced Investment: This is investment that depends on income or profit. It is influenced by the
factors, which affect income and profit e.g. prices, wages, interest, etc.
Induced investment is a function of income and is given by the equation
I = I0 +  Y,
Where  Y = Induced Investment

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  = Marginal propensity to invest (MPI)
I0 = Autonomous Investment
MPI is the change in investment due to a unit change in income i.e. ΔI/ΔY, while API is the
ratio of investment to income i.e. I/Y.
3. Gross and Net Investment:
Gross investment is the total increase in capital stock in a year.
Net investment is the net addition to capital stock in an economy after deducting capital
consumption allowance from gross investment.
4. Intended and Unintended Investment
Intended (voluntary/planned) investment refers to deliberate accumulation of capital stock
aimed at achieving a specific objective.
Unintended (Involuntary/unplanned) investment is where capital stock accumulated due to
unexpected fall in demand.

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.
9. Consumer demand; If the current demand for consumer goods is increasing rapidly, more
investments will be made
10. Liquid assets; If investors possess 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.

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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.

3. Government Expenditures
Gross government investment and consumption expenditures (G).

4. Net Exports
Net exports (X-M)), i.e., net demand by the rest of the world for the country's output.

In sum, for a single country at a given time, aggregate demand

AD = C + Ip + G + (X-M).

Aggregate demand curves

Understanding of the aggregate demand curve depends on whether it is examined based on changes
in demand as income changes, or as price change. Sometimes, aggregate demand refers to an entire
demand curve that looks like that in a typical aggregate supply and aggregate demand diagram.

Typically, the aggregate quantity demanded (Yd) rises as the average price level (P) falls, as with the
AD line in the diagram. The main theoretical reason for this is that if the nominal money supply (Ms)
is constant, a falling P implies that the real money supply (Ms/P)rises, encouraging lower interest
rates and higher spending. This is often called the "Keynes effect."

Carefully using ideas from the theory of supply and demand, aggregate supply can help determine
the extent to which increases in aggregate demand lead to increases in real output or instead to
increases in prices (inflation). In the diagram, an increase in any of the components of AD (at any

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given P) shifts the AD curve to the right. This increases both the level of real production (Y) and the
average price level (P).

But different levels of economic activity imply different mixtures of output and price increases. With
very low levels of real gross domestic product and thus large amounts of unemployed resources, most
economists of the Keynesian school suggest that most of the change would be in the form of output
and employment increases. As the economy gets close to potential output (Y*) or full employment
level, we would see more and more price increases rather than output increases as AD increases.

Beyond Y*, this gets more intense, so that price increases dominate. Worse, output levels greater than
Y* cannot be sustained for long. The AS is a short-term relationship here. If the economy persists in
operating above potential, the AS curve will shift to the left, making the increases in real output
transitory.

At low levels of Y, the world is more complicated. First, most modern industrial economies
experience few if any falls in prices. So the AS curve is unlikely to shift down or to the right. Second,
when they do suffer price cuts (as in Japan), it can lead to disastrous deflation.

Factors that can shift an aggregate demand curve include:

 Real Interest Rate Changes - Such changes will impact capital goods decisions made by
individual consumers and by businesses. Lower real interest rates will lower the costs of
major products such as cars, large appliances and houses; they will increase business capital
project spending because long-term costs of investment projects are reduced. The aggregate
demand curve will shift down and to the right. Higher real interest rates will make capital
goods relatively more expensive and cause the aggregate demand curve to shift up and to the
left.
 Changes in Expectations - If businesses and households are more optimistic about the
future of the economy, they are more likely to buy large items and make new investments;
this will increase aggregate demand.
 The Wealth Effect - If real household wealth increases (decreases), then aggregate demand
will increase (decrease)
 Changes in Income of Foreigners - If the income of foreigners increases (decreases), then
aggregate demand for domestically-produced goods and services should increase (decrease).
 Changes in Currency Exchange Rates - From the viewpoint of the U.S., if the value of the
U.S. dollar falls (rises), foreign goods will become more (less) expensive, while goods
produced in the U.S. will become cheaper (more expensive) to foreigners. The net result will
be an increase (decrease) in aggregate demand.
 Inflation Expectation Changes - If consumers expect inflation to go up in the future, they
will tend to buy now causing aggregate demand to increase. If consumers' expectations shift
so that they expect prices to decline in the future, t aggregate demand will decline and the
aggregate demand curve will shift up and to the left.

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 AGGREGATE SUPPLY

The aggregate supply curve depicts the quantity of real GDP that is supplied by the economy at
different price levels. The reasoning used to construct the aggregate supply curve differs from the
reasoning used to construct the supply curves for individual goods and services. The supply curve
for an individual good is drawn under the assumption that input prices remain constant. As the price
of good X rises, sellers' per unit costs of providing good X do not change, and so sellers are willing to
supply more of good X‐hence, the upward slope of the supply curve for good X. The aggregate supply
curve, however, is defined in terms of the price level. Increases in the price level will increase the
price that producers can get for their products and thus induce more output. But an increase in the
price will also have a second effect; it will eventually lead to increases in input prices as well, which,
ceteris paribus, will cause producers to cut back. So, there is some uncertainty as to whether the
economy will supply more real GDP as the price level rises. In order to address this issue, it has
become customary to distinguish between two types of aggregate supply curves, the short‐run
aggregate supply curve and the long‐run aggregate supply curve.

Short‐run aggregate supply curve. The short‐run aggregate supply (SAS) curve is considered a
valid description of the supply schedule of the economy only in the short‐run. The short‐run is the
period that begins immediately after an increase in the price level and that ends when input prices
have increased in the same proportion to the increase in the price level.

Input prices are the prices paid to the providers of input goods and services. These input prices
include the wages paid to workers, the interest paid to the providers of capital, the rent paid to
landowners, and the prices paid to suppliers of intermediate goods. When the price level of final
goods rises, the cost of living increases for those who provide input goods and services. Once these
input providers realize that the cost of living has increased, they will increase the prices that they
charge for their input goods and services in proportion to the increase in the price level for final
goods.

The presumption underlying the SAS curve is that input providers do not or cannot take account of
the increase in the general price level right away so that it takes some time–referred to as the short‐
run–for input prices to fully reflect changes in the price level for final goods. For example, workers
often negotiate multi‐year contracts with their employers. These contracts usually include a certain
allowance for an increase in the price level, called a cost of living adjustment (COLA). The COLA,
however, is based on expectations of the future price level that may turn out to be wrong. Suppose,
for example, that workers underestimate the increase in the price level that occurs during the multi‐
year contract. Depending on the terms of the contract, the workers may not have the opportunity to
correct their mistaken estimates of inflation until the contract expires. In this case, their wage
increases will lag behind the increases in the price level for some time.

During the short‐run, sellers of final goods are receiving higher prices for their products, without a
proportional increase in the cost of their inputs. The higher the price level, the more these sellers will
be willing to supply. The SAS curve—depicted in Figure (a)—is therefore upward sloping, reflecting

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the positive relationship that exists between the price level and the quantity of goods supplied in the

short‐run

Long‐run aggregate supply curve. The long‐run aggregate supply (LAS) curve describes the
economy's supply schedule in the long‐run. The long‐run is defined as the period when input prices
have completely adjusted to changes in the price level of final goods. In the long‐run, the increase in
prices that sellers receive for their final goods is completely offset by the proportional increase in the
prices that sellers pay for inputs. The result is that the quantity of real GDP supplied by all sellers in
the economy is independent of changes in the price level. The LAS curve—depicted in Figure (b)—is
a vertical line, reflecting the fact that long‐run aggregate supply is not affected by changes in the price
level. Note that the LAS curve is vertical at the point labeled as the natural level of real GDP. The
natural level of real GDP is defined as the level of real GDP that arises when the economy is fully
employing all of its available input resources.

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