Management of Financial Institutions

Chapter 22
Consumption and Investment

Dr. M. Jahangir Alam Chowdhury

Finance and Banking, DU

4 -1- 1

Management of Financial Institutions Nations that save and invest large fractions of their incomes tend to have rapid growth of output, income, and wages; This pattern characterized the United states in the nineteenth century, and the miracle economies of East Asia in the last three decades. By contrast, nations which consume most of their incomes like many poor countries in Africa and Latin America, invest little in new plant and equipment and show low rates of growth and productivity and wages. High consumption relative to income spells low investment and slow growth; high saving leads to high investment and rapid growth.

A. Consumption and Expenditure

Consumption is expenditures by households on final goods and services. Saving is that part of personal disposable income that is not consumed. Consumption is the largest single component of GDP, constituting 66 percent of total spending over the last decade.
Dr. M. Jahangir Alam Chowdhury

Finance and Banking, DU

4 -1- 2

Management of Financial Institutions

Budgetary Expenditure Patterns

Poor

families must spend their incomes largely on the necessities of life: food and shelter. As income increases, expenditure on many food items goes up. The proportion of total spending devoted to food declines as income increases. Expenditure on clothing, recreation, and automobiles increases more than proportionately to after-tax income, until high incomes are reached. Spending on luxury items increases in greater proportion than income. Finally, as we look across families, note that saving rises very rapidly as income increases. Saving is the greatest luxury of all.

Dr. M. Jahangir Alam Chowdhury

Finance and Banking, DU

4 -1- 3

Management of Financial Institutions

CONSUMPTION, INCOME AND SAVING

More

precisely personal saving is the part of disposable income that is not consumed; Saving equals income minus consumption. Economic studies have shown that income is the primary determinant of consumption and saving. Rich people save more than poor people, both absolutely and as a percent of income. The very poor are unable to save at all. Instead as long as they can borrow or draw down their wealth, they tend to dissave. That is, they tend to spend more than they earn reducing their accumulated saving or going deeper in to debt. Table 22-3

Dr. M. Jahangir Alam Chowdhury

Finance and Banking, DU

4 -1- 4

Management of Financial Institutions THE CONSUMPTION FUNCTION The consumption function function shows the relationship between the level of consumption expenditures and the level of disposable personal income. This concept introduced by Keynes, is based on the hypothesis that there is a stable empirical relationship between consumption and income. Figure 22-3 The relation between consumption and income shown in figure 22-3 is called the consumption function.

THE BREAK EVEN POINT

The break-even point where the representative household neither saves nor dissaves but consumes all its income. The 450 line tells us immediately whether consumption spending is equal to, greater than, or less than the level of disposable income.

Dr. M. Jahangir Alam Chowdhury

Finance and Banking, DU

4 -1- 5

Management of Financial Institutions The break even point on the consumption schedule that intersects the 450 line represents the level of disposable income at which households just break even. This break even point is at B in Figure 22-3. Here, consumption expenditure is exactly equal to disposable income - the household is neither a borrower nor a save. The relationship between income and consumption can be seen by examining the thin black line from E to E in Figure 22-3. At an income of $28,000, the level of consumption is $27,240 (see Table 223) and the level of savings is $760. Net saving is measured by the vertical distance from the consumption function up to the 450 line. The 450 line tells us that to the left of point B the household is spending more than its income. The excess of consumption over income is dissaving and is measured by the vertical distance between the consumption function and the 450 line.
Dr. M. Jahangir Alam Chowdhury

Finance and Banking, DU

4 -1- 6

Management of Financial Institutions The Saving Function Figure 22-4 The saving function shows the relationship between the level of saving and income. It is the vertical distance between the 450 line and the consumption function. The marginal propensity to consume is the extra amount the people consume when they receive an extra dollar of disposable income. The Marginal Propensity to Consume

The marginal propensity to consume is the extra amount that people consume when they receive an extra dollar of disposable income. The word marginal is used throughout economics to mean extra or additional. Propensity to consume designates the desired level of consumption. The MPC is therefore the additional or extra consumption that results from an extra dollar of disposable income. (Figure 22-5)
Dr. M. Jahangir Alam Chowdhury

Finance and Banking, DU

4 -1- 7

Management of Financial Institutions THE MAGRINAL PROPENSITY TO SAVE Along with the marginal propensity to consume goes its mirror image, the marginal propensity to save or MPS. The marginal propensity to save is defined as the fraction of an extra dollar of disposable income that goes to extra saving. Thus if MPC is 0.85, then MPC must be 0.15. MPC and MPS must always add up to exactly 1, no more and no less Everywhere and always, MPS=1-MPC. Consumption is a major component of aggregate spending. When consumption changes sharply, the change is likely to affect output and employment through its impact on aggregate demand. Consumption behavior is crucial because what is not consumed that is, what is saved - is available to the nation for investment in new capital goods. capital serves as a driving force behind long learn economic growth.
Dr. M. Jahangir Alam Chowdhury

Finance and Banking, DU

4 -1- 8

Management of Financial Institutions Consumption and saving behavior are key to understanding economic growth and business cycles

Determinants of Consumption
Current Disposable Income Current level of disposable income is the central factor determining a nations consumption. Permanent income and the Life Cycle Model of Consumption The simplest theory of consumption uses only the current years income to predict consumption expenditures. Consider the following examples, which suggest otherwise: If bad weather destroys a crop, farmers will draw upon their previous saving. Similarly, law-school students borrow for consumption purposes while in school because they believe that their postgraduate incomes will be much higher than their meager student earning. Given my current and future income, how much can I consume today without incurring excessive debts ?
Dr. M. Jahangir Alam Chowdhury

Finance and Banking, DU

4 -1- 9

Management of Financial Institutions Careful studies show that consumers generally choose their consumption levels with an eye to both current income and long run income prospects. In order to understand how consumption depends on long term income trends economists have developed the permanent income theory and the lifecycle hypothesis3. Permanent income is the trend level of income that is income after removing temporary or transient influences due to the weather or windfall gains or losses. According to the permanent income the theory, consumption responds primarily to permanent income. This approach implies that consumers do not respond equally to all income shocks. If a change in income appears permanent (such as being promoted to a secure and high paying job), people are likely to consume a large fraction of the in crease in income. On the other hand, if the income change is clearly transitory (for example, if it arises from a one-time bonus or a good harvest), a significant fraction of the additional income may be saved.
Dr. M. Jahangir Alam Chowdhury

Finance and Banking, DU

4 -1- 10

Management of Financial Institutions The life cycle hypothesis assumes that people save in order to smooth their consumption over their life time. One important objective is to have an adequate retirement income. Hence, people tend to save while working so as to build up a nest egg for retirement and then spend out of their accumulated saving in their twilight years. Social security, which provides a generous income supplement for retirement, will reduce saving by middle waged workers since they no longer need to save as much for retirement.

WEALTH AND OTHER INFLUENCES:

Higher wealth leads to higher consumption is called the wealth effect. Wealth usually changes slowly from year to year, when wealth grows or declines rapidly this can cause sharp movements in consumption.

Dr. M. Jahangir Alam Chowdhury

Finance and Banking, DU

4 -1- 11

Management of Financial Institutions

The National Consumption Function The level of disposable income is the primary determinant of the level of national consumption. Alternative Measures of Savings Saving looks different to the household than to the nation as a whole. This is so because savings is measured in the national income and product accounts is not the same as that measured by accountants or in individual balance sheets. The national accounts measure of saving excludes capital gains (increases in asset values). while balance sheet measures include capital gains. A rise in stock market valuations on existing assets may not reflect the productivity or real wealth of the economy. Although people feel richer when asset prices rise in a speculative bubble, the economy cannot produce more cars, computers, food, or housing. Moreover if everyone decided to cash in their stocks they would find the prices would fall and they could not convert their paper wealth in to consumption. While consumers may feel richer because of the booming stock market, the nation is actually richer only when its productive tangible and intangible assets increase.
Dr. M. Jahangir Alam Chowdhury

Finance and Banking, DU

4 -1- 12

Management of Financial Institutions

Thanks

Dr. M. Jahangir Alam Chowdhury

Finance and Banking, DU

4 -1- 13