Theories of Consumption, Savings, and Investment PDF

THEORIES OF CONSUMPTION OUTLINE Introduction Keynes’ Absolute Income Hypothesis Duesenberry’s Relative Income Hypothesis Friedman’s Permanent Income Hypothesis Modigliani-Brumberg’s Lifetime Income Hypothesis Conclusion Concept of Savings Concept of Inves...

THEORIES OF CONSUMPTION OUTLINE Introduction Keynes’ Absolute Income Hypothesis Duesenberry’s Relative Income Hypothesis Friedman’s Permanent Income Hypothesis Modigliani-Brumberg’s Lifetime Income Hypothesis Conclusion Concept of Savings Concept of Investment  INTRODUCTION The consumption function is the schedule that relates consumption expenditure to income. In other words, it is the term given to the systematic relationship between aggregate consumption expenditure and the aggregate level of income. Note that consumption expenditure is the largest component of aggregate demand in most economies. For this and other reasons, it is important to study the factors that determine aggregate consumption expenditures in modern economies.  ABSOLUTE INCOME HYPOTHESIS Keynes was the first to attempt an answer to the question of what determines aggregate consumption expenditure. According to him, the main determinants of aggregate consumption expenditure in an economy is the aggregate level of income. This theory is therefore known as the “Absolute Income” hypothesis. In his hypothesis, Keynes defined the propensity to consume as a functional relationship between a given level of real income and the expenditure on consumption. Thus, C = f (Y); f’> 0  The above function suggests that consumption is a rising function of income. Keynes expected this function to be fairly stable. It could be recalled that income not consumed is automatically saved. It follows therefore that a savings function is also formulated and this Keynes also assumed to be a rising function of income as follows: S = g (Y) ; g’ > 0  The following assumption ( i.e. f’, g’ > 0) have the implication that Rich countries will save a greater share of their income than poor countries A country will save a greater share of its income as it grows richer. A policy of income redistribution which reduces income inequality, will be expansionary. This is because a redistribution of income from the rich to the poor will increase the aggregate MPC which, ceteris paribus, will increase the aggregate demand and hence equilibrium income.  Keynes hypothesis did not perform well when it was subjected to empirical tests after World War II. For example, the results obtained by empirical researches revealed the following: The simple Keynesian consumption function was not stable. Current income did not explain most of the variations in consumption expenditures of households.  The aggregate savings ratio was found to be constant Wealth was found to be an important determinant of consumption There was not one but, in fact, two consumption function – the short-run consumption function and the long-run consumption function. The cyclical or short-run consumption function was Keynesian, that is, it had an intercept and the slope was relatively flat. The secular or long-run consumption function emanates from the origin and had a steep slope. It was found that the short-run consumption function drifts upwards over time.  C= C kY C2 = a2 + bY C1 = a1 + bY 0 Y  Figure 1: The “Ratchet” Model One general hypothesis that explains the existence of the two types of consumption function and the secular upward drift of the short-run functions is the “ratchet” model. This model postulates a “ratchet effect” the theory asserts that in the long run, consumption grows roughly in proportion to income. However, during cyclical interruptions of long run growth, consumers defend living standards already attained, and consequently consumption follows a flatter (lower MPC) “Keynesian” path.  In the diagram, C = kY is the long run consumption function while C1 and C2 are the short run consumptions functions which drift over time. Duesenberry and Modigliani, independent of each other formalised the ratchet idea and tested it statistically. In fact, Duesenberry’s association with the ratchet model led him to formulate a new theory of the consumption function as the ‘Relative Income”  THE RELATIVE INCOME HYPOTHESIS The relative income hypothesis was developed by James Duesenberry in 1949. It was one of the attempts to reconcile the conflicting evidence of the cross-sectional budget study and the short and long-run consumption. According to Duesenberry, the household consumption function is not a function of absolute income but rather of the household’s position in the income distribution of all households.  Duesenberry began by attempting to answer the question: what makes people with a given income increase their consumption over time? He found answers to this question in psychological and sociological factors. According to him, the short-run consumption function will drift upward over time because of the following reasons.  Demonstration effects: people generally prefer high quality goods to low quality goods. The “demonstration effect” resulting from the high living standard of those with high income levels and the desire to “keep up with the Joneses” constituted one way of explaining cross sectional variation in average propensity to consume.  Relative Income : Person’s consumption habits are affected by the consumption habits of his neighbourhood. Thus, given a level of income, an individual is likely to consume more of that income if he lives in an environment dominated by the wealthy in society than if he lives in a less affluent neighbourhood.  Efforts by the individual to maintain a certain economic status in his neighbourhood means he spends more out of his income to maintain that status. The consumer’s consumption is related to his relative income within the neighbourhood rather than to his absolute income. Average Propensity to consume will tend to be constant given a relatively constant income distribution  Interdependent utility function: utility functions are interdependent and this interdependence is based on psychological and sociological factors.  Irreversibility of consumption Relations This implies the existence of some kind of “ratchet effect” in consumption relation. The “ratchet effect” derives from the fact that consumption behaviour tends to be habitual; the habitual nature of consumption behaviour connotes that people try to maintain the standard of living they have become used to, notwithstanding the experience of a decline in income.  Summarily, Duesenberry’s theory states that a person’s utility depends on his consumption relative to the consumption of others in the community. Keeping up with the joneses is a phrase consistent with the relative income hypothesis. Put differently, an individual’s attitude to consumption and savings is guided largely by his/her income in relation to others.  Duesenberry argued that people having become used to a standard of living find it difficult to lower same even in the face of declining income. The consumer bases his consumption on his previous peak income and his relative income within the society he lives. If his current income falls below his previous peak income, his current consumption would be related to the standard of living.  A major defect of the relative income hypothesis was its emphasis on the habitual behaviour and the demonstration effect arguments as the factors underlying consumption decisions of economic agents. These factors were found to be too sharply at variance with the utility maximization assumption of the consumer as well as the rational behavioural assumption of consumers.  PERMANENT INCOME HYPOTHESIS The permanent income hypothesis was propounded by Milton Friedman to explain the proportional/non proportional relational relationship between consumption and disposable income. Its basic premised is that consumption decisions are not based solely on the current level of disposable income but on past and expected future income as well.  Friedman asserted that the main determinant of consumption expenditure is not current income but permanent income. Permanent income refers to the average income which is expected to accrue to a household over a planning horizon. And he suggested that the planning horizon could be for a period of between 3-5 years.  According to the theory, measured income and measured consumption have both permanent and transitory components such that Y = Yp + YT.........................................(1) C = Cp + CT..........................................(2) Where, Y = Measured income Yp = Permanent income YT = Transitory income C = Measured consumption Cp = Permanent component of consumption CT = Transitory component of consumption  The implications of equations (1) and (2) is that permanent income may be obtained as measured income less transitory income and this also applies to permanent consumption in equation (2). Transitory income could be positive or negative as explained by all temporary income gains or losses.  The theory further asserts that the transitory components of income and consumption are uncorrelated one with the other and are also uncorrelated with their corresponding permanent components. It follows therefore that all positive transitory income will be saved and all negative transitory income will be fully offset by dissaving.  Permanent income is more persistent than transitory income. In this hypothesis, Friedman argued that consumption depends primarily on permanent income. Hypothesised that if consumers receive a one-time income bonus, then they will save most of it in the current year. According to the permanent income hypothesis, if consumers receive a permanent increase in their salary then they will spend most of it in the current year.  According to Friedman’s hypothesis, the marginal propensity to consume out of permanent income is greater than the marginal propensity to consume out of transitory income. He argued that, although household studies showed that high-income households generally have lower average propensities to consume, this phenomenon is due to the fact that these households have on average positive transitory income.  One key policy implication of the permanent income hypothesis is that: unless consumers perceive the increase in their income as permanent rather than transitory, any change in their income will not necessarily have an appreciable impact on their consumption behaviour. The implication of this for policy designed to affect disposable income is far reaching  Consumer’s failure to adjust their expenditure in response to a change in disposable income brought about, for example, by a fiscal policy action designed to affect output and employment will hardly be expected to exert the desired impact if consumers see the change in disposable income as transitory. Suppose the government is considering two tax cuts, one temporary and one permanent. Each cut will give each taxpayer the same amount in the first year. The permanent- income hypothesis predicts that the permanent cut will lead to more extra consumption in the first year.  The major defect of the permanent income hypothesis is the elusive nature of the key variables in the hypothesis. These variables are permanent income and consumption. These key concepts are difficult to isolate and utilize for statistical testing of the hypothesis. Past experiences and expectation determine a household’s permanent income.  Yet experience and expectations changes overtime, such change equally bringing about changes in permanent income. Thus, while it is difficult to obtain a measure of permanent income at the microeconomic level, the difficulty is by no means less viewed from the macroeconomic level. It is indeed this ‘unobservability’ of the permanent income variable that stands out as the major defect in the permanent income hypothesis.  The major conclusions of this theory are as follows: The savings ratio is independent of the level of absolute income. In other words, the theory derives the constancy of the aggregate savings ratio. The theory satisfactorily reconciles the long- run and the short-run consumption functions.  LIFETIME INCOME HYPOTHESIS The lifetime income hypothesis also called the life cycle hypothesis is credited to the works of F. Modigliani and R. E. Brumberg. The life cycle hypothesis asserts that individuals wish to spread life time income such that they would enjoy a pattern of consumption that is optimal over their lifetime.  This behaviour is consistent with the behaviour of individual’s income over their life cycle which in the early years is usually low and largely obtainable from labour services. In the later years, labour income is usually higher with this higher labour income being augmented by some return on wealth. However, income drops to zero on retirement and any consumption after retirement will be financed form accumulated wealth.  According to the life cycle model, an individual’s consumption depends not primarily on current income but rather on expected lifetime income and his planning horizon is not 3-5 years as in Friedman’s model but rather his entire lifetime. Some of the assumptions of this model include: The planning horizon of the individual is his lifetime The individual saves during his earning span and dissaves the entire amount during his retirement span. The individual attempts to spread his lifetime consumable resources evenly over his life. The division of life between work and retirement is institutionally given and is independent of income. The analysis abstracts from uncertainty  According to the lifecycle hypothesis, middle- aged people have a relatively low propensity to consume in relation to young people and old people. Franco Modigliani’s lifecycle hypothesis puts great emphasis on saving for retirement. It assumes that consumers save and borrow to smooth consumption over their life cycle. Held, the principal determinants of consumption are income and wealth. He posited that if a consumer wants equal consumption in every year and the interest rate is zero, then the marginal propensity to consume out of wealth increases as years of life remaining decreases. Following, the time of life at which an individual has the largest amount of wealth is at retirement.  Defects of the Life Cycle Hypothesis Like the permanent income hypothesis, it cannot be subjected to the rigours of empirical testing because of the unobservable nature of one of its key explanatory variables, i.e. the expected labour income. The inability to observe lifecycle income has protected the hypothesis from serious testing and the possibility of rejection.  THE CONCEPT OF SAVINGS A saving function is an expression of the relationship between savings and its determinants. The expression could take the form of equation, table or graph. However, unlike the consumption function, a saving function usually exhibits a negative intercept, reflecting the financing of autonomous consumption by dissaving. Recall that, C = a + bYd.............................(1) Thus, S = Yd – C..................................(2) Hence, S = Yd – (a + bYd)...........................(3) S = Yd – a – bYd.................................(4) Equation (4) can be rearranged to obtain S = Yd – bYd – a S = Yd (1 – b) – a.......................................(5) S = -a + (1 – b)Yd  Determinants of Saving The factors influencing saving can be grouped into two broad categories – objective and subjective factors. Objective Determinants These are the quantifiable and verifiable determinants of saving. These factors include, The level of income The level of interest rate The inflation rate Availability of saving facility  Level of Income: Individuals with higher levels of income tend to save more than those with lower income levels. In other words, the higher the level of income, the higher the saving Interest Rate: This represents a return on saving being the reward for abstinence. However, a low rate of interest constitutes a poor return on saving and vice versa. Consequently, there is a direct relationship between saving and interest rate.  Inflation rate: High rates of inflation erodes the purchasing power of money thereby discouraging saving. Availability of saving facility: Individuals propensity to save tends to rise with the availability of outlets into which their saved funds can be kept and channelled for example, the availability of commercial banks.  Non-Quantifiable or Subjective Determinants The instinct for precaution The desire for bequest Habits Cultural factors  THE CONCEPT OF INVESTMENT This refers to such capital expenditure, consumer durables, residential constructions (buildings) and plants and machinery. Thus, investment from this perspective refers to the purchases of real tangible assets such as machineries, factories or stocks of inventory which are used in the production of goods and services for future as opposed to present consumption.  On a broader perspective, however, investment can be viewed as the sacrifice of certain present values of consumption for future value/ consumption. It is the commitment of money in order to earn a financial return or the purchase of financial assets such as stocks or bonds with future end date in mind. One remarkable character of investment as a component of aggregate spending is its fluctuating nature. Investment is expected to fluctuate more than any other component of national income. Hence, investment is considered to be the most dynamic and erratic element of all macroeconomic aggregates.  TYPES OF INVESTMENT There are three major types of investment namely, Fixed investment Inventory investment and Replacement investment  Fixed Investment refers to purchases by firms of newly produced capital goods such as production machinery, newly built structures, offices, equipment etc. Inventories are stocks of goods which have been produced by businesses but are yet unsold. Inventory investment refers to changes in stock of finished products and raw materials firms keep in their warehouse. Replacement investment: refers to investment made to replace worn-out capital goods resulting from their use in the production.  DETERMINANTS OF INVESTMENT These are factors that influence how much a firm is willing to expend in procuring investment goods. The User Cost of Capital It is obtained as the sum of interest rate (implicit and explicit) paid on funds used in producing investment goods and depreciation which is the wear and tear of a piece of machinery usage. The classical economists considered the rate of interest as the main thrust of investment spending. In the aggregate, investment is inversely related to the rate of interest.  Profit Expectation Keynes states that profit expectation from future economic activity on the part of businessmen was the most important determinant of investment behaviour. Technical Progress The investment decision of firms can also be influenced by the rate of innovation. Innovation brings about technical progress. Rapid technical progress encourages firms to invest more on capital goods than on consumer goods.  Existing Capital Stock The existing Capital stock is a relevant variable in determining investment behaviour. If confirms the hypothesis that net investment is constrained by the existing stock of capital goods. In this regards, it is reasoned that the decision to invest in new plant and machinery. Corporate Profit Taxes Corporate taxes also constitute a major determinant of firm’s investment behaviour. Low corporate taxes and high corporate profits will provide impetus for firms to invest in capital goods and vice versa.