31 Consumption and Investment

Amit Kumar Basantaray

1. Learning Outcome

After completing this module the students will be able to:

Learn the meaning and definitions of Consumption. Understand various theories of consumption.

Learn the meaning and types of Investment.

Understand the difference between investment and capital.

Know the meaning of Marginal Efficiency of Capital (MEC) and Marginal Efficiency of Investment (MEI).

Learn various theories of investment.

2. Consumption

The  World  Bank  defines  consumption  expenditure  as  the  sum  total  of  household  final  consumption expenditure  and  final  government  consumption  expenditure.  Household  final  consumption  expenditure (formerly private consumption) is the market value of all goods and services, including durable products (such  as  cars,  washing  machines,  and  home  computers),  purchased  by  households.  Final  government consumption expenditure includes all government current expenditures for purchases of goods and services (including compensation of employees). It also includes most expenditure on national defence and security,but excludes government military expenditures that are part of government capital formation.

Consumption is a very important macroeconomic variable as it is determined by the level of national income and again the level of national income is also, besides other variables, depends upon the level of consumption expenditure. The variable holds a significant position in terms of its percentage to gross domestic product (GDP). In the year 2014 final consumption expenditure as a percentage of GDP in India stood at 71 per cent. It is a common intuition that unless people are ready to consume a product, it would not be produced in the economy. So the entire production sector’s demand comes from the consumption expenditure. Now when level of consumption expenditure is low; production would be low; investment would be low; employment would be low and so on. Therefore, it is said that level of economic activity is largely determined by the overall consumption expenditure. The very significance of this variable (that is consumption) needs us to have a very good understanding of the variable itself. And to understand this we need to know the factors affecting consumption expenditure and the relationship of the variable with these factors. For the above objective, a thorough discussion of the theories of consumption is needed which is done in the following section.

3. Theories of consumption:

In the era of classical economics, consumption expenditure was a function of rate of interest such that as the rate of interest increased consumption expenditure decreased and vice-versa. This argument was criticised by J.M. Keynes in his magnum opus ‘General Theory of Employment, Interest and Money (1936)’ and he argued that it is the real income that determines consumption expenditure. Since then there is a general agreement among economists that consumption expenditure is a function of income. But there are different concepts of income such as absolute income, relative income, current income, future expected income, short-run income, long-run or permanent income, income over the entire life cycle and so on. There are also factors other than income- such as wealth, tax policy of the government, interest rate particularly on consumer credits, inflation, consumer’s expectation on inflation and income distribution- on which consumption expenditures depend. These different concepts of income and factors other than income have been stated by different economists as the determinants of consumption expenditure which has given us following five major theories of consumption.

1. Absolute Income Hypothesis
2. Relative Income Hypothesis
3. Permanent Income hypothesis
4. Life-Cycle Hypothesis
5. Rational Expectation and consumption

3.1 The Absolute Income Hypothesis

This theory of consumption is otherwise known as Keynesian theory of consumption and it follows from the Keynesian consumption function. As we know consumption function is nothing but a functional relationship between consumption expenditure and its determinants. Keynesian consumption function states that consumption expenditure is a positive function of income that is when income rises consumption expenditure rises and vice versa. This relationship between consumption and income primarily follows from Keynes’ ‘fundamental psychological law of consumption’ which states that “men are disposed, as a rule and on average, to increase their consumption as their income increases, but not as much as the increase in their income’. In simple words it means when income of a person goes up (from let’s say Y to ΔY), consumption of that person increases (from C to ΔC) but not to the proportion to the increase in income (that is ΔC/ ΔY > 0). For example, if income increases by 40 per cent, consumption would increase not by 40 or more than 40 per cent but by less than 40 per cent and exact extent to which consumption would increase depend upon marginal propensity to consume (MPC).

3.1.1 Marginal Propensity to Consume (MPC)

The relationship between marginal income and marginal consumption is known as MPC. Symbolically it can be expressed as ΔC/ ΔY where ΔC is marginal consumption or exact increase in consumption from the previous level of consumption and ΔY is marginal income or exact increase in income from the previous level of income. Keynes said MPC decreases with the increase in income or when income increases people consume a decreasing portion of marginal income.

3.1.2 Average Propensity to Consume (APC)

The relationship between income and consumption is known as APC. Symbolically it is written as C/Y where C is consumption and Y is income. In simple words, it states the proportion on income spent on consumption.

3.1.2 Keynes’ Consumption Theory

This theory states that current consumption expenditure is a function of current and absolute level of income. Hence C = f (Y); where C is current consumption, Y is current income, and f represents function. Since Keynes believed in the short-run (remember he is one who said in the short-run, we are all dead), this theory is also known as a short-run theory of consumption. The main properties of the theory are as follows.

First, the real consumption expenditure (consumption divided by price level) is a positive function of real current disposable income (here disposable income is income minus taxes and real current disposable income is current disposable income divided by price level). The theory can also be stated in the following two equations- C = f (Y) and ΔC/ ΔY > 0.

Second, MPC lies between 0 and 1. That is 0 < ΔC/ ΔY < 1.

Third, MPC is less than APC. That is ΔC/ ΔY < C/Y

Fourth, the MPC declines as the income increases or the proportion of ΔY that is used for ΔC goes on decreasing.

Out of the above four properties, first two are the pillars of the absolute income theory. The last two are rejected by the followers of Keynes (known as Keynesians) due to their notwithstanding of empirical testing. Keynesians hold a position that states APC = MPC.

3.2. The Relative Income Hypothesis

One biggest limitation of Keynes’ theory was that it did withstand empirical scrutiny. After the Second World War, many economists attempted to design consumption theory on the basis of empirical data. But none succeeded like Duesenberry who gave the relative income hypothesis based on the income-consumption data of 1940s in which he links consumption level of a household with the income and expenditure level of households with more or less same income bracket. In this theory Duesenberry used a term ‘demonstration effect’ which states that with regard to consumption a household imitate and compete with the consumption behaviour of households with comparable incomes. If a household with a lower income lives in a colony of households with higher incomes whose consumption expenditure is high then that household would spend a higher portion of its income on consumption by imitating its neighbours. This type of consumer behaviour is also known as ‘keeping up with the joneses’. According to relative income theory consumption expenditure of a household depends on the level of its income in relation to the households with which it identifies itself. By stating that consumption is a function of relative income it rejects the Keynes idea of consumption depending upon absolute income. Consider a household (call it A) living in a group of households (call it group A) with more or less same income level. Then relative income hypothesis states the following.

First, as income of all the households in group A increases by some rate then consumption level of that group including individual household A increases at the same rate and vice versa. That means ΔC/ ΔY remains the same for all the households if their income changes by the same amount.

Second, if the relative income of A remains same but its absolute income rises then absolute consumption and savings of A rise, but A’s ΔC/ ΔY remains the same as before the rise in its absolute income.

Third, income of household A remaining constant, if income of other households in the group A increases, then ΔC/ ΔY of household A with constant income increases.

Fourth, ΔC/ ΔY of household A decreases as it moves to a newer higher income group from an earlier lower income group.

Now you know that both absolute and relative income hypothesis states that consumption increases with an increase in absolute income and relative income respectively. Absolute income hypothesis maintained that in case of decrease in income consumption decreases proportionately. But relative income hypothesis states that consumption does not decrease in proportion to decrease in income. To be precise, Duesenberry said decrease in consumption is always less than the decrease in income. This is otherwise known as Ratchet Effect which means when absolute income increases, absolute consumption increases, but when absolute consumption decreases, the households do not cut their consumption (due to their resistance nature to fall in consumption after a decrease in income) in proportion to decrease in their income.

3.3 The Permanent Income Hypothesis

This theory is given by Milton Friedman, considered as father of monetary economics, who rejected the earlier two theories’ argument that consumption depends on current income (absolute income and relative income are current incomes only). According to him, consumption depends on permanent income not current income. In this theory, consumption is a function of permanent income. That is C = f (YP); where C is consumption and YP is permanent income and this relationship is a proportional relationship.

Now the question is what is permanent income? Simply put permanent income is the income about which there is no uncertainty. It is the average of all the incomes that a household is anticipating with large amount of certainty in the long run. It can also be called the opposite of transitory income which is a short-run income that has very surprising nature. Any windfall income is an example of transitory income. Income of a household consists of both permanent and transitory income. Typical nature of transitory income is that gain and loss of this cancels out in the long run. For example, households can receive transitory incomes through lottery wins, bonuses, and gifts from relatives and so on. They also face loss of transitory income due to sickness, accidents, unforeseen incidents, gifts that they pay to their relatives and so on. These receipt and payment cancel out each other in the long-run. Therefore, according to permanent income hypothesis, it is the permanent income that decides the consumption and further this hypothesis assumes no correlation between permanent and transitory incomes. Following are the basic properties of Friedman’s consumption theory.

First, a proportion of permanent income is devoted towards permanent consumption. And this proportion is determined by demographic and ethnic factors, interest rate, and components of permanent income.

Second, income consists of permanent income and transitory income.

Third, consumption is the sum total of permanent consumption and transitory consumption.

Fourth, there is no relationship between permanent income and transitory income.

Fifth, there is no relationship between permanent consumption and transitory consumption.

Last, there is no relationship between transitory income and transitory consumption.

3.4 The life-cycle theory of consumption

Although the life cycle hypothesis is credited to Ando and F. Modigliani, the origin of this idea can be traced back to Sir Irving Fisher. Fisher was the first who observed that rational consumers make intertemporal choices of consumption that is consumption in different time periods are depended upon each other. There is a trade-off between current and future consumption meaning the more the consumption today, the less will be the consumption tomorrow. Fisher also pointed out that consumption depends not upon current or permanent income but on income over the lifetime. Ando and Modigliani borrowed this idea and formulated life-cycle hypothesis in 1960s. According to this hypothesis, an individual’s life time consumption equals his/her life time income and there is no relationship between current income and current consumption. People in times of higher income, after meeting their consumption save more and in times of low income (particularly after retirement) to maintain their earlier consumption (or earlier standard of living) dissave. Thereby people, over their life time, maintain a steady level of consumption. The hypothesis states three determinants of individual consumption in any time and they are (i) resources available to the individual, (ii) the rate of return on his capital, and (iii) the age of the individual.

An Example:

Consider an individual (named A) who expects to live ‘n’ years. He has wealth ‘W’ andearns an income of ‘Y’ till he retires and that is ‘T’ years. Now the question is what smooth level of consumption (C) individual A wishes to maintain over his life time? To know the answer, first calculate the life time resources available to consumer which is W plus TY (wealth plus lifetime earnings which are income from whole working years). If W plus TY is the life time resource then per year resource is (W + TY)/n. Now consumption function = W/n + (T/Y)/n. if every individual behaves like this, then economy’s consumption would be the sum total of individual consumptions. Hence, aggregate consumption function depends upon both wealth and income and it can be written as C = αW + βY; where α is the proportion of wealth devoted to consumption (technically known as MPC out of wealth) and β is proportion of income devoted to consumption (technically known as MPC out of income).

3.5 Robert Hall’s Random Walk Theory

In all the previous theories, particularly in life-cycle theory and permanent income theory, there is no uncertainty with regard to the future income. Robert E. Hall based his theory on this flaw of earlier theories by incorporating the uncertainty of income to life-cycle and permanent income hypothesis. That is why theory is also known as consumption theory under uncertainty. Some also call this theory as modern life-cycle and permanent income hypothesis. It is in this theory Hall applied the theory of rational expectations. According to this, expected value of consumption is not observable. However, Hall said observed consumption behaviour in period t+1 depends upon consumption in the previous period t and the unexpected element of consumption. Accordingly, it can be written as Ct+1 = Ct + є; where Ct+1 is consumption in period‘t+1’, Ct is consumption in period‘t’ and є is expected consumption due to unexpected rise in income.

4. Investment

After consumption, investment is another variable which plays a very crucial role in the progress of an economy. The level of economic activity, in an economy, is largely determined by the level of investment. Macroeconomic variables such as output or production, employment, price level, foreign trade etc. are also greatly influenced by the level of investment. It is also responsible for boom and depression in an economy. When the level of investment is very low, there is an all-round pessimistic environment; and when level of investments are high, there is a chance of boom or most definitely optimistic environment inside the economy. Investment, in the national income accounting, means three things- (i) investment in plants, machineries etc. which is broadly called business investments; (ii) investment by people for residential buildings which is broadly called residential investments; and (iii) investment by business persons on building inventories (which is done to pile up stocks to meet unexpected or expected future rise in demand. For the purpose of our following analysis, we will focus on the first type of investment because various important issues of investment theories and investment decisions are based on this interpretation of investment.

4.1 Meaning and Types of Investment

Investment means spending money on anything with a purpose to yield a return. That is why when money is spent on physical and/or financial assets or when money is spent to upgrade human skills, it is called investment. Physical assets can be land, building, capital goods like machinery and equipment etc. Financial assets can be shares, bonds, insurance products and so on. Expenditure on higher/ technical/ professional education is made to upgrade human skills and thus can be considered as investment. Simple lending of money for the purpose of earning interest can also be called investment. But when it comes to ‘business investment’ it means investment on physical and/or financial assets for the purpose of making profit. To economists, investment usually means building ‘stock of capital’. In the term ‘stock of capital’, ‘capital’ means machinery and equipment, land/building, and inventories. Therefore, there is a difference between capital and investment. Further, whereas capital is a stock concept, investment is a flow concept.

Investment can be of two types- gross and net investment. Gross investment is the total change in capital goods per unit of time, normally one year. Net investment, is the real/actual change in capital goods per unit of time. It is gross investment minus depreciation where depreciation is the part of capital goods which cannot be used further in the process of production.

On the basis of determinants of investment, it is further divided into two types- autonomous investment and induced investment. Investment that is a function of income and interest rate only is called induced investment. It is positively related to income and negatively related to interest rate. Investment that is determined by the factors other than the level of income and interest rate is known as autonomous investment. These ‘other’ factors are also called exogenous factors whose examples are discovery of new markets, higher demand, population growth, optimistic environment in the economy and so on.

The question that we will take up in the following section is a very fundamental question of how an investment decision is made. Following are the two important methods by which firms make investment decisions.

4.2 The Net Present Value (NPV) Method

Whenever an investment is made on a project, revenue from that project is expected to come in each year, after a gestation period, over the life span of that project. According to the NPV method, investment decisions are made on the basis of the difference between present value of all the incomes to be accrued in future and cost of investment. Then how can we calculate the present value of future income streams?

Present value of a future income is nothing but the discounted value of future income at the market rate of interest under assumption of constant prices. The discount of future income is based on the ‘time theory of value’ which states that one rupee today is preferable to that same one rupee at some future date. The logic of this theory is that by receiving one rupee today one can earn interest on it by depositing it in a bank and by getting that same one rupee at a future date, one has to forego the earlier mentioned interest. Suppose a person get rupees 1000 and deposits this in a bank at a rate of interest of 10 per cent.

After 1 year, rupees 1000 becomes {1000 + (1000 ˟ 10%)} = {1000 + (1000 ˟ 0.1)} = 1000 (1 + 0.1) = Rupees 1100.

Again after one year 1100 is deposited at the same rate of interest. After two years, that person has {1100 + (1100 ˟ 10%)} rupees.

{1100 + (1100 ˟ 10%)} = {1100 + (1100 ˟ 0.1)} = 1000 (1 + 0.1) (1 + 0.1) = 1000 (1 + 0.1)2. {Because 1100 = 1000 (1 + 0.1)}

After three years, initial rupees 1000 becomes 1000 (1 + 0.1)3.

After ‘n’ years, initial rupees 1000 becomes 1000 (1 + 0.1)n.

So initial rupees 1000, after n years, becomes 1000 (1 + 0.1)n or we can say present value of future amount 1000 (1 + 0.1)n is 1000.

Or 1000 = 1000 (1 + 0.1)n /(1 + 0.1)n

Thus, formula of present value = future value/ (1+ rate of interest) number of years.

Now, if a project has a life span of 5 years and each year it gets different revenue such as R1 in year-1, R2 in year 2, R3 in year 3, R4 in year 4, and R5 in year 5; and ‘i’ is the rate of interest then the total present value of the project is TVP, where

Given the calculation method of NPV, a project is worth investment if NPV > 0. In the case where NPV < 0, investment is not made. The optimum level of investment is reached when NPV = 0.

4.2 The Marginal Efficiency of Capital (MEC) Method

This method of taking investment decision is given by J.M. Keynes and is otherwise known as Internal Rate of Return (IRR) method. Keynes defined MEC as “that rate of discount which makes the present value of the series of annuities given by returns expected from the capital asset during its life just equal to its supply price”. Simply put, MEC is the rate that equals the discounted present value of series of expected future income with the cost of capital. For example, if the cost of an investment project is ‘C’ and the project gives a return of ‘R’ for only one year (that is life span of the project is one year), then MEC is the rate that equalises present value of ‘R’ with cost of project ‘C’.

That is MEC = R/(1+r) = C

This implies R/C = 1+r. Finally, r = R/C – 1. Here ‘r’ is MEC. Same method is applied to calculate MEC an investment project has the life span of ‘n’ years and there is an expected future stream of income from that project.

After the calculation of MEC or IRR, investment decision is taken on the basis of comparison between MEC (r) and market rate of interest (i).

In reality, a firm has number of projects on which investment decisions would be made. Now if we combine all the projects together and plot MEC of each project and investment on a graph, we would get MEC schedule of the individual firm. Investment is made to create stock of capital. That is why the locus of different combinations of MEC and stock of capital can be called the MEC schedule. The schedule is also called the investment demand curve of the individual firm.

4.3 Difference between Marginal Efficiency of Capital (MEC) and Marginal Efficiency of Investment (MEI)

As MEC is nothing but the investment demand, if we add all individual firms’ demand for investment we would get the aggregate demand schedule for the economy as whole. From the understanding of MEC, it is clear that when rate of interest decreases MEC schedule goes up meaning demand for investment goes up. But this may not be necessarily true always. It can be true for an individual firm but when it comes to the aggregate economy there is a doubt. Because as interest rate falls, demand for capital goods (which is the major determinant of capital stock) increases and if the capacity of capital goods industry is not unlimited then it is bound to increase the prices of capital goods implying a reduction in its demand and thus linking capital stock only to interest rate may be misleading in so far as the entire economy is concerned. Therefore, when interest rate falls (rises), increase (decrease) in investment is not same as predicted by MEC. Thus, the cost of investment increases if demand, due to a fall in interest rate, increases more than the production capacity of capital goods industries. When cost of investment increases, MEC decreases leading to fall in investment. The relationship between interest rate and total investment in the economy is represented by MEI curve.

Finally, we can say that whereas MEC links investment demand of an individual firm with the interest rate, MEI links the investment demand of all the firms (or of the economy as a whole) with the interest rate. MEI schedule is also otherwise interpreted as investment function which is written as

I = f (i); where I is investment and i is interest rate.

4.4 The Accelerator Theory of Investment (ATI)

The theory is based upon the idea that investment is related to income. More precisely, acceleration principle states that the size of the optimum stock of capital is decided by the level of output. This theory describes the technological relationship between the changes in capital stock and the change in the level of output. We know that capital-output (  /  ) ratio is the technological relationship between capital and output.

Suppose a firm uses capital stock (    ) to produce(    ). And the demand for the firm’s output is in period t. given our understanding of capital-output ratio, relationship between capital stock and output can be written as:

= (Here k> 1)

Let us again assume that demand for firms’ output in period t+1 is + 1. It can be written as

4.5 Tobin’s q Theory of Investment

This theory was developed by James Tobin (thus called Tobin’s q theory) who acknowledged the reality that a large portion of investment in a firm is raised from the capital market along with money market. This reality is incorporated in this theory. Here investment is decided by the share price of a firm which is determined in the stock market. Price of a share in a company represents the shareholder’s claim in that company and therefore, when share prices go up value of the shareholder’s asset go up resulting in a higher investment. The higher the share price, the higher is the investment. Since share price of a company depends upon the realised profits and expected future profit of the company, when share price rise it is an indication of more opportunities for investment. Tobin’s ‘q’ is measured by the following formula:

q =————-

Installed capital means the existing capital that is created in the company and market value of this is derived by multiplying the market price (in this case share price). This is nothing but the market capitalisation of the company in the stock market or simply, value of the company in the stock market. The denominator is the price to be paid to replace the depreciated capita of the company. Therefore, q is the ratio of market value of the company to its replacement cost and on the basis of q, according to this theory, investment decisions are made in the following manner.

In this module, we dealt with two very important macroeconomic variables, namely, consumption and investment in detail. With the help various theories of consumption we tried to analyse the main determinants of it and saw how the very concept of income changes, from absolute to relative to permanent income, in all those theories. Also we discussed the role of unexpected change in income on consumption through Robert Hall’s theory. Similar kind of analysis is done on investment. We discussed various types of investment from gross and net investment to autonomous and induced investment. The question of how investment decision is made was tackled with the help of NPV method and MEC method. We finished this module with the analysis of accelerator and ‘q’ theory of investment.

Sources for Further Reading on Macroeconomic aggregates and Concepts

1. Dornbusch, Rudiger, Stanley Fisher, and Richard Startz. Macroeconomics, 9E. NewDelhi: Tata Tata McGraw-Hill Education Private Limited, 2004.

2. Dwivedi, D.N. Macroeconomics: Theory and Policy, 3E. NewDelhi: Tata McGraw-Hill Education Private Limited, 2010.

3. Froyen, Richard T. Macroeconomics: Theory and Policies, 8E. New Delhi: Pearson Education Inc., 2005.

4. Mankiw, N. Gregory. Macroeconomics, 8E. New York: Worth Publishers, 2012.