Income, Consumption, and Saving

• Consumption and saving• Primarily determined by Disposable Income• Direct relationship – as DI increases, so does

consumption.• Saving is what’s left over, what’s not spent.• Households spend a higher percentage of a

small disposable income than of a large disposable income.

LO1 27-1

Important – This is all IN THE AGGREGATE. It does not represent each individual household, or even any individual household. It is all households combined, according to studies done by economists

Income, Consumption, and Saving

LO1 27-2

Consumption and Saving Schedules

Consumption and Saving Schedules (in Billions) and Propensities to Consume and Save

(1)Level of Output

and IncomeGDP=DI

(2)Consumption

(C)

(3)Saving

(S),(1) – (2)

(4)Average

Propensity to

Consume(APC),(2)/(1)

(5)Average

Propensity to Save (APS),(3)/(1)

(6)Marginal

Propensity to

Consume(MPC),(2)/(1)*

(7)Marginal

Propensity to Save(MPS),(3)/(1)*

(1) $370 $375 $-5 1.01 -.01 .75 .25

(2) 390 390 0 1.00 .00 .75 .25

(3) 410 405 5 .99 .01 .75 .25

(4) 430 420 10 .98 .02 .75 .25

(5) 450 435 15 .97 .03 .75 .25

(6) 470 450 20 .96 .04 .75 .25

(7) 490 465 25 .95 .05 .75 .25

(8) 510 480 30 .94 .06 .75 .25

(9) 530 495 35 .93 .07 .75 .25

(10) 550 510 40 .93 .07 .75 .25

LO1 27-3

Consumption and Saving Schedules

500

475

450

425

400

375

45°

50

25

0

370 390 410 430 450 470 490 510 530 550

370 390 410 430 450 470 490 510 530 550

C

S

Consumptionschedule

Saving schedule

Saving $5 billion

Dissaving $5 billion

Dissaving$5 billion Saving $5 billion

Co

nsu

mp

tio

n (

bil

lio

ns

of

do

llar

s)S

avin

g(b

illi

on

s o

f d

oll

ars

)

Disposable income (billions of dollars)LO1 27-4

Average Propensities

• Average propensity to consume (APC)• Fraction of total income consumed

• Average propensity to save (APS)• Fraction of total income saved

APC = APS =consumption

income income

saving

APC + APS = 1

LO1 27-5

Global Perspective

LO1 27-6

Marginal Propensities

• Marginal propensity to consume (MPC)• Proportion of a change in income

consumed• Marginal propensity to save (MPS)

• Proportion of a change in income saved

MPC = MPS =change in consumption

change in income change in income

change in saving

MPC + MPS = 1

LO1 27-7

Marginal Propensities

Disposable income

Co

nsu

mp

tio

nS

avin

g

S

CMPC =

MPS =

1520 = .75

C ($15)

DI ($20)

DI ($20)

S ($5)

520 = .25

LO1 27-8

Nonincome Determinants

• Amount of disposable income is the main determinant

• Other determinants• Wealth• Expectations• Real interest rates• Household Debt• Taxation – the only one that shifts both

consumption and saving in the same direction.LO2 27-9

Interest Rate and Investment

• Expected rate of return and the real interest rate.– If the expected rate of return is greater than the

real interest rate, then the firm should undertake the investment.

– Applies to borrowing or to cash on hand.

LO3 27-11

Investment Demand Curve

Exp

ecte

d ra

te o

f ret

urn,

ran

d re

al in

tere

st ra

te, i

(per

cent

s)

16

14

12

10

8

6

4

2

05 10 15 20 25 30 35 40

Investment (billions of dollars)

ID

(r) and (i)

Investment(billions

of dollars) 16% $ 0

14 5

12 10

10 15

8 20

6 25

4 30

2 35

0 40

Investmentdemandcurve

LO3 27-12

Shifts of Investment Demand

• Acquisition, maintenance, and operating costs

• Business taxes• Technological change• Stock of capital goods on hand• Planned inventory changes• Expectations

LO4 27-13

Shifts of Investment Demand

Exp

ecte

d r

ate

of

retu

rn,

r, a

nd

real

in

tere

st r

ate,

i (

per

cen

ts)

0 Investment (billions of dollars)

ID0ID1ID2

Increasein investmentdemand

Decrease in investmentdemand

LO4 27-14

Global Perspective

LO4 27-15