Lesson 3: Consumption, Savings, and Investment

The Consumption Function

• C= f (Y) (Read as C is a function of Y or Consumption is equal to the function of income)
Where: C= Consumption
Y= Income or Disposable Personal Income
Note: DPI is personal income less direct taxes, SSS, Philhealth, and Pag-ibig contributions.
Income that is free to spend directly by the household.

X-axis- income
Y-axis- level of consumption or investment
• Consumption function reflects the direct consumption–disposable income relationship. • In
the aggregate, households increase their spending as their disposable income rises and spend
a larger proportion of a small disposable income than of a large disposable income. • The
consumption function, or Keynesian consumption function, is an economic formula that
represents the functional relationship between total consumption and gross national income.
• The classic consumption function suggests consumer spending is wholly determined by income
and the changes in income. If true, aggregate savings should increase proportionally as gross
domestic product (GDP) grows over time.
• The line C that is loosely fitted to these points shows that consumption is directly (positively)
related to disposable income; moreover, households spend most of their income.
• The 45-degree line is a reference line. Because it bisects the 90-degree angle formed by the two
axes of the graph, each point on it is equidistant from the two axes. At each point on the 45-
degree line, consumption would equal disposable income, or C - DI. Therefore, the vertical
distance between the 45-degree line and any point on the horizontal axis measures either
consumption or disposable income. If we let it measure disposable income, the vertical
distance between it and the consumption line labeled C represents the number of saving (S)
in that year.
• Saving is the amount by which actual consumption in any year falls short of the 45-degree line
—(S=DI-C).
• Observe that the vertical distance between the 45-degree line and line C increases as we move
rightward along the horizontal axis and decreases as we move leftward. Like consumption,
saving typically varies directly with the level of disposable income.
• The graph shows that there is a direct relationship between saving and DI but that saving is a
smaller proportion of a small DI than of a large DI. If households consume a smaller and
smaller proportion of DI as DI increases, then they must be saving a larger and larger
proportion.
• Remembering that at each point on the 45-degree line consumption equals DI, we see that
dissaving (consuming in excess of after-tax income) will occur at relatively low dis. •
Graphically, the consumption schedule cuts the 45° line, and the saving schedule cuts the
horizontal axis (saving is zero) at the break-even income level.
Marginal Propensity to Consume (MPC)
• Change in the level of consumption (C) that occurs as a consequence of a change in income (Y)
or simply the ratio Change in C/ Change in Y.
• The value of the MPC is usually less than 1.
• The proportion, or fraction, of any change in income consumed is called the marginal
propensity to consume (MPC), “marginal” meaning “extra” or “a change in.” • Equivalently,
the MPC is the ratio of a change in consumption to a change in the income that caused the
consumption change.
• The MPC is the numerical value of the slope of the consumption schedule. • MPC refers to
the proportion of extra income that a person spends instead of saves. It measures the change
in the average propensity to consume.
• MPC is useful because it relates to how a government stimulus might affect the economy. •
An MPC of one means a person spent all additional income. An MPC of zero means they
spent none of it and, instead, invested it.
Average Propensity to Consume (APC)
• C/Y
• It is based on totals
• It is clear that even if there is no income, some consumption will still take place
• The fraction, or percentage, of total income that is consumed is the average propensity to
consume (APC).
• APC measures the percentage of income that is spent rather than saved. • Higher average
propensity to consume signals greater economic activity as consumers are demanding goods
and services.
• When annotated as a decimal, average propensity to consume ranges from zero to one. At
zero (or 0%), all income is being saved. At one (or 100%), all income is being consumed.
Average and Marginal Propensity to Consume
Hypothetical Data for a Closed Economy (in billion pesos)

MPC= 0.80, you are spending 80 centavos each time you earn 1 peso and saving 20 centavos.
• An increase in the level of disposable income of households causes aggregate consumption
to rise, but always by less than the increase in income, as determined by MPC • There exists
a level of income at which it is just equal to consumption, and it is called break-even level,
where APC = 1 (All income have been spent, nothing saved) • At income levels lower than
the break-even, APC is greater than 1 and, above this breakeven level, APC is less than 1
• Low Incomes- Households can consume more than their current incomes by liquidating
(selling for cash) accumulated wealth or by borrowing.
• Break-even- This is the income level at which households plan to consume their entire
incomes
• High Incomes- At all higher incomes, households plan to save part of their incomes.

Shifts in the Consumption Function

A.) Wealth
• A household’s wealth is the dollar amount of all the assets that it owns minus the dollar
amount of its liabilities (all the debt that it owes).
• Households build wealth by saving money out of current income. The point of building
wealth is to increase consumption possibilities. The larger the stock of
Wealth that a household can build up, the larger will be its present and future
consumption possibilities.
• Events sometimes suddenly boost the value of existing wealth. When this happens,
households tend to increase their spending and reduce their saving. This so-called
wealth effect shifts the consumption schedule upward and the saving schedule
downward.
• They move in response to households taking advantage of the increased consumption
possibilities afforded by the sudden increase in wealth.
 • Examples: In the late 1990s, skyrocketing U.S. stock values expanded the value of
household wealth by increasing the value of household assets. Predictably,
households spent more and saved less. In contrast, a modest “reverse wealth effect”
occurred in 2000 and 2001, when stock prices sharply fell.
B.) Consumer and Savings Habits
C.) Size and age distribution of the population
D.) Income distribution
E.) Credit Availability or Borrowing
• Household borrowing also affects consumption.
• When a household borrows, it can increase current consumption beyond what would be
possible if its spending were limited to its disposable income. By al lowing
households to spend more, borrowing shifts the current consumption schedule
upward.
• But note that there is “no free lunch.” While borrowing in the present allows for higher
consumption in the present, it necessitates lower consumption in the future when the
debts that are incurred due to the borrowing must be repaid. Stated a bit differently,
increased borrowing increases debt (liabilities), which in turn reduces household
wealth (since wealth = assets - liabilities).
• This reduction in wealth reduces future consumption possibilities in much the same
way that a decline in asset values would. But note that the term “reverse wealth
effect” is reserved for situations in which wealth unexpectedly changes because asset
values unexpectedly change. It is not used to refer to situations such as the one being
discussed here where wealth is intentionally reduced by households through
borrowing and piling up debt in order to increase current consumption.
F.) Expectations of Change in Prices
• Household expectations about future prices may affect current spending and saving.
• For example, expectations of rising prices tomorrow may trigger more spending and
less saving today. Thus, the current consumption schedule shifts up and the current
saving schedule shifts down.
G.) Expectations of Future Income
• Household expectations about future income may affect current spending and saving.
• Expectations of a recession and thus lower income in the future may lead households to
reduce consumption and save more today. If so, the consumption schedule will shift
down and the saving schedule will shift up.
H.) Interest Rates or Real Interest Rates
• When real interest rates (those adjusted for inflation) fall, households tend to borrow
more, consume more, and save less.
• A lower interest rate, for example, induces consumers to purchase automobiles and
other goods bought on credit.
• A lower interest rate also diminishes the incentive to save because of the reduced
interest “payment” to the saver.
 • These effects on consumption and saving, however, are very modest. They mainly
shift consumption toward some products (those bought on credit) and away from
others. At best, lower interest rates shift the consumption schedule slightly upward
and the saving schedule slightly downward. Higher interest rates do the
opposite.
Engel’s Law
• Introduced in 1857 by Ernst Engel, a German Statistician, stating that the percentage of income
allocated for food purchases decreases as income increases.
• As a household's income increases, the percentage of income spent on food decreases while the
proportion spent on other goods (such as luxury goods) increases.
• This is because the amount and quality of food a family can consume in a week or month is
fairly limited in price and quantity.
• As food consumption declines, luxury consumption and savings increase in turn. • E.g. A
family that spends 25% of their income on food at an income level of $50,000 will pay
$12,500 on food. If their income increases to $100,000, it is not likely that they will spend
$25,000 (25%) on food, but will spend a lesser percentage while increasing spending in other
areas.

Engel’s Law and Consumption

• As the income of a family increases, a smaller percentage is spent for food • The
percentage of expenditure for clothing remains approximately the same • There is
constantly increasing percentage spent for education, health, recreation,
amusement, etc.
• The percentage expenditures for rent, fuel and light remain approximately the same

Savings

• Income not spent

• Savings = Disposable Income – Consumption
 • Savings refers to the money that a person has left over after they subtract out their
consumer spending from their disposable income over a given time period. • Savings,
therefore, represents a net surplus of funds for an individual or household after all
expenses and obligations have been paid.
• 3 Sources of National Savings:
O Households (Personal Savings)- are part of the disposable income that is not
consumed.
O Businesses (Corporate Savings)- mainly comprise retained earnings (after
corporate tax and dividend payments, but before investment).
O Government- the excess of the government revenues over current expenditures of
central and local governments.
• Note: All 3 constitute NET DOMESTIC SAVINGS! (is GDP – final consumption
expenditure)
Other Important Terms
A.) Retained earnings
• Retained earnings are the cumulative net earnings or profits of a company after
accounting for dividend payments.
• Retained earnings are an important variable for assessing a company’s financial
health because it shows the net income that a company has saved over time, and
therefore has the ability to reinvest in the business or distribute to shareholders.
B.) Depreciation allowance
• An estimate of the annual cost of using an item that is based on its acquisition cost
divided by its assumed or estimated useful life.
C.) Gross domestic savings
• Gross Domestic Saving is GDP minus final consumption expenditure. It is
expressed as a percentage of GDP.
D.) Gross national savings (Gross Domestic Savings + Net Capital Transfer from Abroad)
Determinants of Household Savings in the Philippines
• Income- As incomes rise, households tend to have a higher marginal propensity to
save. This is because with higher incomes there is a diminishing marginal utility to
consumption – households with extra income are more likely to save it.
• Interest Rates- Higher interest rates will encourage more people to invest. (v/v)= •
Demographics- During a person’s student years, they will typically borrow (student
loans), then in their 40s and 50s, with high income, they will save. Then during
retirement, they will run down their savings. An ageing population can lead to a
fall in the saving ratio.
• Exchange Rates- How much PHP would take you to purchase dollar.
Investments
• Are spending for goods used for future rather than current consumption
• Goods used to produce other goods
• May also be called as capital formation --- the building up of a nation’s stock of capital
goods or its productive capacity
 • Concept of unplanned investment --- unplanned inventories
• An investment always concerns the outlay of some capital today—time, effort, money, or
an asset—in hopes of a greater payoff in the future than what was originally put in.
Net Investment
• Gross Investment (GI) less depreciation allowance
• 3 possible cases that can arise:
O GI – Dep = (NI = +) K increases
O GI – Dep = (NI = -) K decreases
O GI – Dep = (NI = 0) K no change
• Net investment indicates how much a company is spending to maintain and improve its
operations.
• If net investment is positive, the company is expanding its capacity.
• If net investment is negative, its capacity is shrinking
Points of Discussion
• Investment: An inflow
• Investments: Add to productive capacity
• Factors affecting Investments
O Role of expectations
O may be influenced by external factors such as: a shift in global balance of power; a
change in foreign policy of trading partners; and, regional cooperation and
conflicts, etc.
O domestic policies, legislations, and institutions
The Investment Decision
• If expected additional profits of investment exceeds the expected opportunity cost of this
investment
• Relates to the decision made by the investors or the top level management with respect to the
amount of funds to be deployed in the investment opportunities.
• Simply, selecting the type of assets in which the funds will be invested by the firm is
termed as the investment decision.
• These assets fall into two categories
O Long Term Assets
O Short-Term Assets
Innovation (as defined by Joseph Schumpeter)
• The introduction of a new good
• The introduction of a new method of production
• The opening of a new market into which a good/service has not previously reached
• The conquest (or development) of a new source of supply of raw materials • The
carrying out of the new organization of any industry