Chapter 6

Personal disposable
income
Y=C+S
Where,Y=disposable income
C=Consumption
S=savings
 Consumption brings benefits by way of
satisfaction of human needs, while saving is
needed for old age, rainy days and bequest.
 Consumption expenditure is the most dominant
component of aggregate demand.
 It accounts for 2/3 of the GDP
Consumption (C)
Definition:
The value of all goods and services bought by
households. Includes:
durable goods
last a long time
ex: cars, home appliances
nondurable goods
last a short time
ex: food, clothing
services
work done for consumers
ex: dry cleaning,
air travel.
Consumption function
C= f (Y,Ys,Ymp,W,i,CA,CE,IWD,u)

 C= Consumption
 Y =Income of consumers
 Ys = Consumers’ expectations about future income
 Ymp = Consumers’ max. past income
 W=wealth
 i=interest rate
 CA=credit aviability
 CE= Consumers’ expectations about future price
 IWD =Distribution of wealth and income
 F1, f2, f3, f4,f7 >0 > f5, f9 : f8, f6, f10
 Graph 1: Disposable Income,
Consumption, and Saving

The relationship
between disposable
income and
consumption has
been relatively
constant and stable
over time
Saving is the
difference between
disposable income
and consumption
Graph 2: U.S. Consumption Depends on
Disposable Income
The Consumption Function
The relationship between consumption and income,
other things constant
 Consumption is the dependent variable
 Disposable income is the independent variable.
Because consumption depends on income, it is a
function of income
 Graph 3: The Consumption Function

Both disposable
income and
consumption are
measured in real
terms, or in
inflation-adjusted
dollars
Consumption
increases with
disposable income,
assuming other
determinants of
consumption
remain constant
Nonincome Determinants
What are these factors that could cause the entire
consumption function to shift?
 Net wealth and consumption
 Price level
 Interest rate
 Expectations
Net Wealth

Net wealth is the value of all assets that households

own minus any liabilities, or debts owed
A decrease in net wealth would make consumers less
inclined to spend, more inclined to save
Increase in net wealth increases consumption
 C"

•Increase in C
net wealth
C'
shifts Real Consumption

consumption
function from
C to C''
•Decrease in
net wealth
shifts it from
C to C'
0
Real disposable income
Shifts and Movements Along
Difference between a movement along the
consumption function and a shift of the
consumption function

Movement along the consumption function

results from a change in income

Shift of the consumption function results from a

change in one of the non income determinants of
consumption
Price Level
When price level changes, real value of
rupees-denominated financial assets (bank
accounts, cash) also changes
 Increase in the price level reduces the purchasing
power of wealth held in fixed rupees assets –
households consume less and save more
 Decreases in the price level increase the purchasing
power of wealth held in fixed assets – households
consume more and save less
Interest Rate
Interest
 The reward savers earn for deferring consumption
 The cost paid by borrowers for current spending
power
The higher the interest rate, the less is spent on
items purchased on credit (households save
more and borrow less) and the consumption
function shifts downward
Conversely, a lower interest rate shifts the
consumption function upward
Expectations
Changing expectations about price levels, interest
rates, job security and other such factors influence
consumer behavior

If expectations become more pessimistic, then

consumption function shifts downward

If expectations become more optimistic, then

consumption function shifts upward
 Investment
Investment consists of spending on
 New factories and new equipment
 New housing
 Net change in inventories

Firms invest in capital goods now in the expectation of a

future return
Since return is in the future, investors must estimate
how much a particular investment will yield in all years
of its productive life
Determinates of investments function:
 I = f (Y,r,w,Q,FMP,F,T,BC,Y ,K-1 ,u)
-1
=> I = net investment
⇒ Y = output (income)
⇒ r = real interest rate
⇒ w = real wage rate
⇒ Q = Tobin’s Q
⇒ FMP = fiscal (tax) and monetary (credit) policies
⇒ F = financial constraints
⇒ T = technology
⇒ BC = business confidence
⇒ Y-1 = output in the previous year
⇒ K-1 = stock of capital in the previous year
⇒ u = ‘other’ factors
Demand for Investment
Firms buy new capital goods only if they expect
this investment to yield a greater return than
other possible uses of their funds
The expected rate of return equals the annual
rupees earnings expected from the investment
divided by the purchase price
Market interest rate is the opportunity cost of
investing in capital
•Shows the inverse
relationship between the
quantity of investment
demanded and the
market interest rate,
other things constant.
•Sums the investment
demanded by each firm at
each interest rate.
•At lower interest rates,
more investment projects
become profitable for
individual firms, so total
investment in the
economy increases.
Planned Investment and
Income
Investment depends more on interest rates and on
business expectations than on the prevailing level of
income

Thus, the investment decision is said to be “forward

looking,” based more on expected profit than on
current levels of income and output
Investment Function
The investment function isolates the
relationship between the level of income in the
economy and planned investment – the amount
firms would like to invest, other things constant

Two determinants of investment assumed to be

constant are
 The market interest rate
 Business expectations
Market Interest Rate
A decline in the rate of interest, other things
remaining constant, will reduce the cost of
borrowing and increase planned investment:
investment function shifts upward
Conversely, when the interest rate increases, the
planned investment function shifts downward
 The horizontal
Real planned investment

investment
(millions of rupees)

functions
imply that
1.1 I"
planned
1.0 I investment
does not vary
0.9 I'
with real
disposable
income, it is
autonomous

0 2.0 4.0 6.0 8.0 10.0 12.0 14.0

Real disposable income
(millions of rupees)
Investment Spending
and Interest Rates
The decision to invest is based on the principle
of opportunity cost.

PRINCIPLE of Opportunity Cost

The opportunity cost of something is what you
sacrifice to get it.
• The interest rate prevailing in the economy
provides a measure of the opportunity cost of
investment.
Investment Spending
and Interest Rates
A firm has a menu of investment projects it
would like to undertake.
If the net return from an investment
exceeds the opportunity cost of the funds,
the investment should be undertaken.
As market interest rates rise, there will be
fewer profitable investments.
Interest Rates and
Investment There is a negative
relationship between real
investment spending and
the real interest rate.

• As the real rate of interest

rises, fewer investment
projects will be profitable.
Interest Rates and
Investment
Remember, nominal rates of interest are not
a good indicator of the true cost of investing.
The firm makes its investment decisions by
comparing the expected real net return from
investment to the real rate of interest.
Q-theory of Investment
The Q-theory of investment, developed by
Nobel laureate James Tobin of Yale University,
links investment spending to stock prices. It
states that investment spending increases
when stock prices are high. Then, the firm uses
its proceeds from the sale of stock to undertake
new investment.
 Y C S APC MPC APS MPS
(Income) (Consumption) (Savings)

0 60 -60 - - - -

100 150 -50 1.5 0.90 -0.5 0.10

200 220 -20 1.1 0.70 -0.1 0.30

250 250 0 1 0.60 0 0.40

350 300 50 0.89 0.50 0.11 0.50

450 345 105 0.77 0.45 0.23 0.55