Macro EconomicsChapter 3

Topics: Macroeconomics, Economics, Consumption function Pages: 74 (4899 words) Published: March 22, 2015
Chapter 3
Consumption and Investment

Consumption (C) and
investment (I)








Since we are more concerned with two
sector model in our course, we will discuss
about consumption and investment.
In a two sector model, a simple but an
imaginary assumption of no government
and no foreign trade is made.
Here Yd =C+S or Yd =AD (aggregate
demand)
This also implies that C+S=C+I

Consumption







Introducing you with: (Think yourself in advance)
What is consumption?
What is consumption function?
What are the determinants of consumption?
What is MPC?
What is APC?

Consumption
“Consumption is the sole end and purpose of
all production.” Adam Smith
 Consumption is the act of spending income for
buying goods and services to satisfy wants.
 Determinants of consumption are disposable
income (after tax income) of the consumers,
their accumulated wealth or assets, their
expected future income, the actual price level,
the expected general price level, rate of interest,
thriftiness, their age, sex and family size etc.

Consumption function
A relation between consumption
and its various determinants is
called the consumption function.
The consumption function taking
all these determinants into account
can be written as:
C=f (Yd, W, Ye, P, Pe, r, s, DF…..)


Keynesian Consumption
function
Keynes, however, asserts that income alone is
the
most
important
determinant
of
consumption. Here, income refers to the
disposable
income.
The
Keynesian
consumption function, thus, can be written as:
 C=f (Y ), 1>f>0
d
 Where,
C=Consumption demand
Yd = Disposable income= (Y-T)
Y=Personal income
T=Taxes (related to income)


Keynesian Consumption
function






The assumption of the Keynesian consumption
function is that consumption depends on
income, other things being equal. The higher
the income, higher is the consumption, ceteris
paribus.
Keynes’ psychological law of consumption (The
concept of the marginal propensity to consume).
Keynes argue that when the income increases,
consumption also increases but not to the same
extent as the increase in income.

Keynesian Psychological
Law
“ The fundamental psychological law, upon which



we are entitled to depend with great confidence
both a priori from of our knowledge of human
nature and from the detailed facts of
experience is that men are disposed of, as a
rule and on the average, to increase their
consumption as their income increases, but not
by as much as the increase in their income.”
The idea is that when the income increases,
consumption also increases but less than
proportionately. Alternatively, marginal
propensity to consume (MPC) is positive but
less than unity (0∆Yd

Marginal Propensity to
Consume








Suppose, initial income level is Rs. 1000 and
consumption demand is Rs. 800. When income
level increases to Rs. 1500, and consumption
demand to Rs. 1200, MPC will be:
=∆C/ ∆Yd =400/500=0.80
This implies that when income increases by Rs.
100, consumption demand increases by Rs 80.
And the difference Rs. 20 is the saving.
This means Yd = C+S
i.e. Disposable income=Consumption+Saving

Consumption function


Short run Keynesian consumption
function is often written as: C=C a+bYd



Ca is autonomous consumption function.
This implies that Ca is not related to
income level (Yd) since a minimum level
of consumption is required just for
survival even if there is no income.
And “b” is MPC.



Average Propensity to
Consume










The fraction of total...
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