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Consumption And Investment Function

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Consumption And Investment Function

  1. 1. CONSUMPTION AND INVESTMENT FUNCTION - A Group K Presentation
  2. 2. KEY CONCEPTS TO NOTE  CONSUMPTION  INVESTMENT  SAVINGS  DETERMINANTS OF THE THREE
  3. 3. 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.
  4. 4. 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
  5. 5. WHY IS CONSUMPTION IMPORTANT?
  6. 6. Consider this: WANT (DESIRE) EFFORT SATISFACTION 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!)
  7. 7. THE CONSUMPTION FUNCTION
  8. 8. 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).
  9. 9. 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
  10. 10.  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/-).
  11. 11. 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
  12. 12. In this graphical illustration of the consumption function, a= 5,000 MPC= 3/4
  13. 13. SHIFTS IN THE CONSUMPTION CURVE POSITIVE SHIFT: • Increase in Real Assets and money holding •Increase in expectation of future prices. NEGATIVE SHIFT: • Increase in interest rates • Increase in taxes
  14. 14. POSITIVE SHIFT NEGATIVE SHIFT
  15. 15. SOME EXAMPLES  a= 100, b= 0.8, Y= Rs. 400 Then, using the formula: C= 100+ 0.8*400 = 100+320 = 420
  16. 16.  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.
  17. 17. In some cases, the function is represented as: C= a+b(Y-T) Here, T represents taxes that are subtracted from the income.
  18. 18. THE INVESTMENT FUNCTION
  19. 19. 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.
  20. 20. INVESTMENT AUTONOMOUS INDUCED
  21. 21. 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.
  22. 22. 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.
  23. 23. 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.
  24. 24.  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
  25. 25. 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.
  26. 26. 0 500 1000 1500 2000 2500 3000 1 2 3 4 5 6 7 8 9 10 InvestmentinRs. Income Rs. Thousand Investment Function Induced Investment Autonomous Investment
  27. 27. SAVINGS
  28. 28. 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.
  29. 29. 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.
  30. 30. SAVINGS INCREASE IN BANK DEPOSITS PURCHASE OF SECURITIES INCREASED CASH HOLDINGS
  31. 31. 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.
  32. 32.  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. WHY DO PEOPLE SAVE?
  33. 33.  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.
  34. 34. 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.
  35. 35. SOME THEORIES
  36. 36. THEORIES OF CONSUMPTION ABSOLUTE THEORY OF CONSUMPTION RELATIVE CONSUMPTION THEORY LIFE CYCLE THEORY
  37. 37. ABSOLUTE THEORY OF CONSUMPTION The Absolute Income Hypothesis is theory of consumption proposed by English economist John Keynes. It is also known as the Absolute Income Hypothesis. 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.
  38. 38. 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.
  39. 39. 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.
  40. 40. THE LIDUIDITY PREFERENCE THEORY OF INVESTMENT
  41. 41. 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
  42. 42. • 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. According to Keynes, the demand for liquidity is a result of three motives: • 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).
  43. 43. 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.
  44. 44.  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.
  45. 45. INVESTMENT INTIAL INVESTMENT FUTURE CASH INFLOW RATE OF DISCOUNT
  46. 46. FACTORS DETERMINING CONSUMPTION
  47. 47. 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
  48. 48. FACTORS DETERMINING INVESTMENT
  49. 49. 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.
  50. 50. 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
  51. 51. INVESTMENT AND INCOME
  52. 52. INVESTMENT AND INTEREST RATE
  53. 53. DETERMINANTS OF SAVINGS
  54. 54. 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
  55. 55. 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.
  56. 56. CASE STUDY #2 A COMPARATIVE STUDY IN CONSUMPTION FUNCTION IN IRAN AND INDIA
  57. 57. 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.
  58. 58. 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.
  59. 59. INDIA IRAN GROWTH RATE (%) 8% 3.9% GDP (BILLION $) 2908 410 PER CAPITA GDP GROWTH (%) 3.7 2.6
  60. 60. INDIA IRAN MPC OUT OF WEALTH 0.221 0.189 MPC OUT OF INCOME 0.672 0.541
  61. 61. 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 MPC out of wealth MPC out of income India Iran
  62. 62. 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!
  63. 63. That’s all folks!

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