Explain the concept of consumption,savings and investment and discuss their determinates
Answers
The main hypothesis of Keynes is that the real consumption depends on disposable income. This hypothesis you can express like this:
C = C(Y).
In that case consumption (C) and disposable income (Y) are measured in units. [1]
Kenynes also said that people enhance consumption when their disposable income increases. But the increase of consumption is smaller than the increase of disposable income. This hypothesis you can describe with the marginal propensity to consume. It describes the increase of consumption when disposable income rises. [2]
The marginal propensity to consume is defined as
C’ = =
Because of the fundamental-psychological law the marginal propensity to consume is between “0” and “1”. [3]
0 < < 1.
When the marginal propensity to consume is 0.8, consumption increases 0.8 units. At once disposable income increases one unit. The fundamental-psychological law is fullfilled because increase of consumption is smaller than increase of disposable income. When 0.8 units are used for consumption the remaining 0.2 units are obviously used for savings. The proof is expressed by following formula:
Y = C + S
1 = 0.8 + S I – 0.8
S = 0.2 .
Therefore we define the marginal propensity to save money as differential quotient dS /dY. The marginal propensity to save shows how much the savings grow due to increasing disposable income. Through differentiation of the budget restriction after Y you can see that after adding the marginal propensity to consume and the marginal propensity to save the result always amounts “1”.
=
1 I = .
That shows you that every additional income has to be used either way. [4]
The formula below is the consumption function:
C = Caut + C’ · Y .
Caut is autonomous consumption. You can interpret the consumption function like a normal formula which you know from mathematics. Therefore Caut is the intersection point with the ordinate and C’·Y the gradient. The last formula which is important to know concerning the consumption function according to Keynes is the consumption rate. It serves to find out which quantity of disposable income is used for consumption. The formula is
c:= . [5]
So far almost always mathematical background has been mentioned. But it is also necessary and maybe easier to summarize consumption in my own words. This will help to explain the relationship between consumption, savings and investments according to Keynes.
We expect, that the average consumption and disposable income was 1700€ and 2000€. In a formular you find following average propensity to consum:
c0 = = 0.85. The result says that 85% of disposable income is used for consumption. One year later the disposable income increases more than the consumption expenditures:
c1 = = 0.84. The result says that now 84% of disposable income is used for consumption. Now it is possible to calculate the marginal propensity to consum.
C’ = = = .
Now you see that consumption increases 0.75 units when disposable income increases about 1 unit.
While explaining the consumption function different facts were metioned. Also consumptions and savings. One word is still missing – investments. In the consumption function according to Keynes investements have not been borne in mind. There is only a relationship between consumption and savings. It was mentioned that you have an disposable income which you use for your consumption expenditures. When consumption does not exceed the disposable income you have a specified amount which you can save. This is expressed by this formular:
Y = C + S
1 = 0.6 + S I – 0.6
S = 0.4 .
Consumption is 0.6 units. Therefore you are able to spend 0.4 units.
But when you take a look at the incomne-expenditure model or the equilibrium for good markets [8] you find other different relations between consumption, savings and investments. [9]
The first important formular is Y = C + I + G. This formular describes the equation for equilibrium in the goods market. [10] Immediately you find consumption, investments and government spending. You see that there is an existing relationship. Now there is the possibility to “play” with the formular what could be interesting to identify the different relationships. Therefore taxes (T) and consumption (C) have to be subtracted from Income (Y). It is also necessary to subtract taxes from government spending. The new formular looks like this:
Y – T – C = I + G – T.
We know that S = Y – T -C takes effect. Therefore the term reads
S = I + G – T .
The term on the left side is private saving. On the right side you find investment (I) and public savings (G – T). The government is able to run a budget surplus. This happens when taxes exceed government spending. But when government spending is higher than taxes there is a budget deficit. That means that the country consumed too much. [11]