CHAPTER THREE

CONSUMPTION, SAVING AND INVESTMENT

 Whatever the type of economy, the main purpose of every

economic activity is consumption.

 Most people spend the major part of their income on the
consumption of goods and services and portion of income left
from consumption is saved.
 At the national level, developing countries spend a higher

proportion of their income on consumption than developed

countries.
 This implies, developing countries save a smaller proportion of

their income.
 A nation that saves a relatively small part of its income makes smaller
investments and exhibits relatively lower rates of growth in
productivity.
 On the other hand, nations that save and invest large parts of their
income exhibit higher rates of growth in income and output.
 From the above discussion, we can conclude that:
 Income, consumption, saving, and investment are closely interlinked.
 Consumption, saving, and investment are crucial factors in any country’s
economic performance.
3.1.Consumption
 It is known household consumption expenditure is one of the major
components of aggregate demand or aggregate expenditure in an
economy.
 Households spend their income (apart from savings) on consumption
of final goods and services for the satisfaction of their basic wants.
 Consumption may thus be defined as the expenditure by households
on final goods and services. The main elements of household
consumption are expenditures on food, housing, clothing,
transportation, medical care, etc.
 Does consumption depend upon income?
 Yes, consumption is a part of income and directly depends upon
income itself.
 However, we must note that consumption is necessary for survival
and thus takes place even if income is zero. In such a case,
households might be consuming from sources such as accumulated
wealth, borrowing, or begging (seeking charity).
 In this context, there are two categories of consumption:
 Consumption when income is zero – i.e., when a minimum level of
consumption must be maintained for survival. This is called
autonomous consumption, and it is independent of income level.
 Consumption when income rises: With an increase in income,
consumption also increases, but usually less than the income
increased. This part of consumption, which varies with income, is
called induced consumption.
Table 3.1: shows the relationship between increasing income
and increasing consumption.

Income (in units of money) Consumption expenditure (in

units of money)

0 100
200 200
400 300
600 400
800 500
1000 600
 As shown in the schedule in Table 3.1,
 There is always a minimum level of consumption expenditure, even if
income is zero.
 This is why, at zero income level, consumption expenditure is
represented by a positive value 100 units of money rather than zero
units.
 With increases in income, consumption expenditure also increases
but at lesser rate.
 This clearly shows that the relationship between income and
consumption expenditure is always positive or direct.
3.1.1.Determinants of Consumption Expenditure
 The previous section discussed consumption expenditure at the
individual (household) level.
 Adding together individual consumption expenditures gives us
national consumption expenditure.
 As discussed earlier, consumption expenditure as a macroeconomic
variable (national consumption expenditure) is crucial to any
economy’s performance.
 The major determinants of consumption expenditure at individual and
national levels are:
 Money Income: The relationship between money income and
consumption expenditure is positive and direct. The increase in
income results in an increase of consumption expenditure. This
principle also acts inversely.
 Level of Direct Taxes: A higher level of direct taxes leads to a lower
level of personal disposable income, and thus to a decrease in
consumption expenditure. This principle also acts inversely.
• Expectation of the Future: If prices are expected to rise in the future,
present consumption will be more.
• Rate of Interest: Increases in the rate of interest lead to a reduction of
consumption expenditure and an increase in saving.
• Level of Wealth: A higher wealth level leads to higher consumption
expenditure.
3.1.2.Consumption Function
 Consumption function is one of the most important tools in macroeconomics.
It shows the relationship between level of consumption and level of income .
The consumption function is also known as propensity to consume.
 The consumption function indicates how consumption responds to different
levels of income. The functional relationship between consumption and
income is generally expressed as:
C = f (Yd) ,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,4.1.
Where C = consumption expenditure, and
Yd = personal disposable income.
C = a + bYd, where
• a is autonomous consumption,
• b is percentage of income for consumption, and
• bYd is induced consumption.
• Example: Consider a consumer with a consumption function given by
C = 110 + 0.75Yd, and disposable income of Birr 4,800. Calculate the
consumer’s:
A. Autonomous consumption
B. Induced consumption
C. Total consumption
D. Saving
Solution: Given: Consumption function C = 110 + 0.75Yd
• Disposable income = 4,800
A) Autonomous consumption is the level of consumption when income is zero. Thus,
 Autonomous consumption = 110 + 0.75 × 0 = 110
B) Induced consumption is = Total consumption – Autonomous consumption
• Induced consumption = 0.75 × 4,800 = 3,600
C) Total consumption = Autonomous consumption + Induced consumption
• = 110 + 3,600 = 3,710
D) Saving = Yd – C = 4,800 – 3,710 = 1,090

• S = Yd – (a+ bYd)
 Note that propensity to consume does not mean desire to consume. It means the
actual consumption that takes place, or is expected to take place, out of varying
levels of income.
• Propensity to consume or consumption function demonstrates the
fact that, as income increases, consumption also increases but by
less than the increase in income.
• Further, even when income is zero, consumption is always positive
(i.e., there is always some minimum level of consumption even when
income is zero).
• The following hypothetical schedule and corresponding graph
illustrate the concept of consumption function.

Income (in units of money) Consumption expenditure (in

units of money)
0 50
50 75
100 100
150 125
200 150
250 175
300 200
  Consumption (i.e., autonomous consumption) can never be zero,
even if income is zero, because a minimum level of consumption
must be maintained for survival.
 That is why the consumption function curve starts from point C and
not from zero.
 In such a situation, the economy draws on past savings in the
absence of current income.
• The point at which the consumption function curve intersects the 45° line is

known as the break-even point. It indicates equality between consumption

and income.
• Above the 45° line, consumption spending is more than income (indicating

dissaving), whereas below this line consumption expenditure is less than

income
• The amount of dissaving or positive saving is measured by the vertical

distance between the consumption curve( Line CC) and the 45° line.
• The relationships between consumption and income (propensity to consume)

are expressed in the following ways via

 Average Propensity to Consume (APC)

 Marginal Propensity to Consume (MPC)

I Average Propensity to Consume (APC)
• APC is the ratio of total consumption expenditure (C) to total income (Yd) at a
given level of income in an economy. Symbolically,
C
APC 
YD

• For example, if at a particular time, the income level in an economy is Birr 250
million, and consumption
C is Birr 175 million,
APC 
YD

= 0.7 or 70%
• This example indicates that 70% of income was spent by way of consumption
expenditure. But if aggregate income is very low — for example, Birr 50 million
– and if aggregate consumption is Birr 75 million, APC = 75/50 = 1.5.
• Thus the value of APC may be greater than 1, because when income is at a very
low level, consumption exceeds income to meet the very basic necessities. (Then
saving becomes negative).
• Table below demonstrates the estimation of APC, using a hypothetical situation.

Income (in million Consumption (in

C
Birr) million Birr) APC 
(Yd) YD
(C)
200 150 0.75
250 175 0.7
300 200 0.66

• Observe that APC continues to decline as long as income increases.

II Marginal Propensity to Consume (MPC)
• The ratio of change in consumption (ΔC) to change in income (ΔYd)
is called marginal propensity to consume.
• Literally, marginal means additional (or incremental) and propensity
to consume means desire (or urge) to consume.
• Thus MPC is the ratio of additional consumption expenditure to
additional income. It indicates the proportion of the additional income
that is spent on additional consumption. Symbolically,
• For example if a country’s national income increases from Birr 200
million to Birr 250 million, and as a result consumption expenditure
goes up from Birr 150 million to Birr 175 million, then
C 25
MPC    0.50
Yd 50

• Note that, with an increase in income, consumption

expenditure also increases. (i.e., MPC > 0), but the entire
increase in income is not spent on consumption, that
means, MPC < 1.
 Income (in Change in Consumption Change in
C
million Birr) Income (ΔYd) (in million Consumption MPC 
Yd
(Yd) birr) (C) (ΔC)
150 — 100 — —
250 100 150 50 0.5
350 100 175 25 0.25
The above shows that, with increase in income, consumption also
increases but by less than the increase in income.
Therefore,
C 25
MPC    0.50
Yd 50

This indicates that people spent 50% of the increased income. Also
observe that MPC goes on declining with increases in income.
Properties of MPC
• MPC is greater than zero but less than one This is because,
with an increase in income, consumption expenditure also
increases. But the entire increase in income is not spent —
part of it is saved. Thus, MPC > 0, but MPC < 1.
• MPC falls with increase in income. As the community
becomes richer, it tends to consume a smaller percentage of
each increment to its aggregate income.
• MPC of the poor class is higher than those of other classes: In
the case of poor people, most of their basic needs remain
unfulfilled. As a result, an additional increment to income
leads to greater consumption.
• MPC is stable in the short run: This is because it depends upon
psychological factors which do not change in the short run.
3.2 Saving
• Since income is either consumed or saved, the part of income which
is not spent on consumption is called savings.
• Thus, we may say ‘Savings is an excess of income over consumption
expenditure’. By deducting consumption expenditure (C) from income
(Yd), we get savings (S). Symbolically:
• S = Yd – C........................................... (4.4)
Note the following points in the context of saving:
i. Just like consumption, saving depends directly upon income.
ii. As income increases, savings also increase, but the rate of increase in
savings is more than the rate of increase in income. This means that as
income increases, the proportion of income saved increases (and the
proportion of income consumed decreases).
iii. At low income levels, savings is negative. In other words, when there
is no income or a very low level of income, consumption expenditure is
more than income, leading to negative saving (i.e., dissaving).
 Determinants of Saving

The major determinants of saving at the individual and national levels

are:
• Level of Income: As stated above, as income increases, saving also
increases. But the rate of increase in saving is higher than the rate of
increase in income. This is because, with an increase in income,
consumption increases but by less than the increase in income.
• Distribution of Income: Saving increases when income inequality
increases. This is because the tendency to save is greater for rich
people than poor people.
• Rate of Interest: A higher rate of interest induces greater saving. This
principle also acts inversely.
• Expectation for the Future : If prices are expected to fall in the future,
present consumption is less, and hence saving is more. This principle
also acts inversely. Similarly, an expected future increase in income,
reduces present saving, and the inverse.
• Level of Wealth: A lower wealth level leads to a lower saving level.
This principle also acts inversely.
• Level of Direct Taxes: A higher level of direct taxes produces a lower
level of personal disposable income and hence reduced savings. This
principle also acts inversely.
• Individual Nature: Saving is directly related to the nature of the
individual. For example, a miser saves more than a spendthrift.
3.2.3.Saving Function
• The functional relationship between saving and income is called
saving function (or propensity to save). The saving function is the
proportion of income which is saved. Thus saving (S) is a function (f)
of income (Yd). Symbolically:
S = f (Yd) or S = Yd – C.................................... (4.5)
• The saving function shows the tendency of households to save at
given levels of income. Thus the saving function is a corollary or
reciprocal of the consumption function.
• The following hypothetical schedule and corresponding graph
illustrate the concept of the saving function.
Income (Yd) Consumption (C) Savings (S)
0 50 –50
50 75 –25
100 100 0
150 125 25
200 150 50
250 175 75
300 200 100
• Figure 4.4 also shows that saving is negative until income
reaches Birr 100 million.
• Point B in Figure 4.4 represents the break-even point,
because at this point savings are zero — i.e., consumption
is equal to income.
• The shaded area reflects dissavings, which are equal to
autonomous consumption.
• As in the case of the consumption function, the relationships between
saving and income (propensity to save) are expressed in the
following ways via
o Average Propensity to Save (APS)
o Marginal Propensity to Save (MPS)

I. Average Propensity to Save (APS)

• Average propensity to save is the ratio of total savings (S) to total
income (Y). It is the part of total income which is saved. Symbolically:
S
APS 
Yd
……………………………………4.6
• For example, if income (Yd) is Birr 250 million and saving(s) is Birr 75
million,

• Table 4.6: Hypothetical APS estimation

S 75
APS    0.3  30%
Yd 250

Income (in million Birr) (Yd) Saving (in million Birr) (S) APS 
S
Yd

200 50 0.25

250 75 0.3

300 100 0.33

• Observe that APS continues to increase as long as income

increases.
 ii. Marginal Propensity to Save (MPS)
• It is the ratio of the change in saving ( ΔS) to the change in
income (ΔYd).
• Symbolically
S
MPS 
YD
• For example, if a country’s national income increases from Birr
200 million to Birr 250 million, and saving increases from Birr 50
million to Birr 75 million, then

S 25
MPS    0.5
YD 50
• Table 4.7: Hypothetical MPS estimation

Income (in million ΔYd Saving (in million ΔS

Birr) (Yd) Birr) (S) S
MPS 
YD
150 150 50 50 0.33
250 100 100 50 0.50
350 100 175 75 0.75

• Table 4.7 shows that, when income increases, saving also increases.
• For example, when income increases in the hypothetical situation
from Birr 150 million to Birr 250 million, saving increases from Birr 50
million to Birr 100 million. Therefore,
S 50
MPS    0.5
YD 100

• This indicates that people saved 50% of the increased income.

• Observe that MPS continues to increase as long as income
increases.
Properties of MPS
The main properties of MPS are:
•  Value of MPS lies between 0 and 1. In other words, 0 < MPS < 1.
•  MPS increases with increase in income.
•  The MPS of the poor is lower than that of the rich.
3.3 Relationship Between Consumption And Saving
• As you already know, the consumption function and the saving
function are interrelated and counterparts of each other.
• Consumption and saving both depend on income, and their sum total
is equal to total income i.e., C + S = Yd.
• From this, it also follows that the concepts of APC and MPC are
respectively related to the concepts of APS and MPS.
i. Relationship between APC and APS
• We know Yd = C + S, dividing both sides by Yd, we get
YD C S
 
YD YD YD

1  APC  APS

or; APC  1  APS ; or; APS  1  APC

• We may conclude: the sum of APC and APS is always equal to unity
(1). This is because income is either consumed or saved.
• Note that the value of APS is negative when consumption
expenditure is greater than income.
ii. Relationship between MPC and MPS
• We know
YD  C  S
YD  C  S
• Dividing both sides by ΔYd, we get
YD C S
 
YD YD YD
• 1 = MPC + MPS
• or MPC = 1 – MPS, ad MPS = 1 – MPC
• We may conclude: the sum of MPC and MPS is always equal to
unity (1). The following list shows this inter-relationship:
APC + APS = 1
APS = 1 – APC
APC = 1 – APS
MPC + MPS = 1
MPS = 1 – MPC
MPC = 1 – MPS
3.4 Investment
3.4.1.Meaning of Investment
• In economics, the meaning of investment is quite different
from its common use by an ordinary person who speaks of
‘investing’ when he or she purchases a piece of land, an
old house, securities, debentures, etc.
• In economic analysis, these transactions are simply the
transfer of ownership rights from one person to the other
and, as such, result in no increase in income and
employment.
• In economics, investment means an addition, during a predefined
‘current period’, to national resources such as: existing stock of
physical (or real) assets for example, the building of new factories, new
machines or equipment; existing stock of finished goods or raw
materials.
• Investment can be induced as well as autonomous.
i. Induced Investment
• Induced investment is investment which is made with the motive of
earning a profit as in the private sector.
 Induced investment depends directly upon profit expectations. It is
income-elastic.
• If national income goes up, induced investment also goes up – an
increase in income induces investment.
• This occurs because an increase in national income leads to an
increase in the demand for goods and services, which increases
investor interest in meeting that demand, and therefore leads to
investment.
• Thus, we can say that induced investment takes place when levels of
income and demand in the economy go up. That is why the induced
investment curve, like the supply curve, is positively sloped, as
shown in Figure 4.8 below.
• Graphically;
• ii. Autonomous Investment
• Autonomous investment refers to investment which is made
irrespective of income level. This approach is generally taken in the
government sector.
 Autonomous investment is income inelastic – it is not affected by
changes in income level.
• The volume of autonomous investment is the same at all levels of
income. That is why the autonomous investment curve is a straight
line, parallel to the X-axis, as shown in Figure 4.9.
• Graphically;
• Autonomous investment is generally affected by autonomous factors
(other than income) such as public utility works, construction of
railways and roads, changes in the nature of consumer demand,
increase in population, discovery of new resources, new technology,
etc.
• For instance, government investment in public utilities like the
construction of railways, roads, post and telegraph, electricity, etc., is
normally autonomous investment.
 3.4.2.Determinants of Investment

What are the determinants of investment?

• Business firms make investment in plant and equipment in order to
make profits(which is the excess of revenue over production cost).
• They wish to spend money on investment if they expect the
investment to yield a net return over all its costs.
• Various factors affect these expectations and thus determine the
amount of aggregate desired investment expenditures in the
economy. The following factors usually influence investment
decisions
i. Profit Expectation:
• Business investment depends upon the expectations of the business
firms involved(i.e. investment is the state of expectations and
business confidence).
• If the business people feel confident that opportunities for making
profits in the future exist, they will be prepared to undertake
investment expenditure. On the other hand, if they do not expect to
make profits, they will not invest.
• Investment is about all a gamble on the future. For example when
businesses see the likelihood of a sharp business recovery in the
near future, they begin to plan for plant expansion.
ii. Rate of Interest (the cost of borrowing money)
• After business expectation of profit opportunities is taken into account,
investment depends upon the rate of interest, on the one hand, and
upon the expected rate of return on capital. This expected rate of return
is called marginal efficiency of capital or marginal efficiency of
investment.
• The rate of interest is the cost of capital to the firm. If the firm borrows
money from financial institutions to spend on investment, it has to pay
the market rate of interest. If, on the other and, the firm is having
sufficient internal resources, the real cost of capital is its opportunity
cost.
• The lower the rate of interest, the lower the cost of borrowing money to
acquire an income-earning asset like a machine.
• If investment is to be profitable, then the expected rate of profit cannot
be less than the current rate of interest in the market. For instance, if an
entrepreneur finds out that funds for a project must be borrowed at a
15% interest rate, then the proposed investment would be undertaken
only if the project’s expected rate of profit were more than 15%.
• We thus see that investment depends upon the marginal efficiency of
investment, on the one hand, and upon the rate of interest, on the other.
iii. Government policies: fiscal and monetary
• Because of the importance of investment in both short run economic

activity and long run economic growth and economic development,

policymakers often desire to increase the level of private investment.

What channels exist for policy to affect investment?

• The most powerful effect is through monetary policy, which affects

interest rates and the cost of capital. The major point to understand is

that the central bank, the Federal Reserve System, can operate

monetary policy to raise or lower interest rates and thereby affect

investment.
• A second major policy action to affecting investment is through tax
policy or fiscal policy. Similarly the government can encourage
investment by reducing the tax rate charged on investors. It is also
possible to discourage them by charging higher rate. For example;
taxes are imposed by governments on corporations (Corporate Tax).
• A corporation uses part of its revenues to pay these taxes. The higher
the tax rate is, the more that paying taxes reduces revenues and, in
turn, reduces profits. Therefore, we can say that a decrease in the
rate of corporate tax induces investment. This principle also acts
inversely.
iv. Revenues
• An investment will bring the firm additional revenues only if
investing allows the firm to sell more. This suggests that a
very important determinant of investment will be the overall
level of output. When factories are sitting idle, firms have
relatively little need for new factories, so investment is low.
• More generally, investment depends upon the revenues
that will be generated by the state of overall economic
activity.
v. The costs of production
• In addition to the cost of borrowing money that is interest
rate the cost and availabilities of raw materials or inputs are
affecting the investment level. If the cost of production is
low the investment level is become large. The reverse is
occurring if the cost of production is high.
vi. Level of National Income: If national income goes up, induced
investment also goes up. The reason is that an increase in national
income leads to an increase in the demand for goods and services
and in investors’ interest in supplying them, which leads to increased
investment. Therefore, we can say that a higher level of national
output induces investment. This principle also acts inversely.
3.4.3.Role of Investment in Economic Growth
• Economic growth refers to an increase in the total output of a nation
over time. Investment plays a crucial role in the economic growth of a
nation. Nations that invest a large part of their income tend to have
rapid output growth.
• As you know, investment in an economy can be in the private sector
and in the public (government) sector. The roles of these two types of
investment in economic growth are discussed below.
3.4.3.1.Role of Private Investment in Economic Growth
• Investment made by the private sector in the form of new
machinery and equipment, the building of new factories,
increases in inventories, etc., increases the productive capacity
of the economy and hence increases output and income.
• Note that, whenever investment is increased in a country,
income and output increase many times more than the increase
in investment. Therefore, we can say that an increase in the
level of investment brings rapid economic growth to a country.
3.4.3.2. Role of Public Investment in Economic Growth
• Public investment plays an active role in promoting economic growth,
especially in developing countries.
• Public investment promotes economic growth directly by developing
social overhead and infrastructure, by establishing capital-good
industries, basic and key industries, etc.
• Public investment can stimulate economic growth indirectly by
providing education, training, and research facilities.
• Public investment in education and training and in public health
and social security schemes increases peoples’ efficiency and
skills, and thereby contributes to economic growth.
• Public investment reduces disparities in income and wealth as
well as regional disparities. Thus public investment promotes
the achievement of economic growth with social justice.
END OF CHAPTER 3

THANK YOU
 Quiz (5%)

1. If consumption function is given as:

C= 300 + 0.85Yd and Yd= 6,500 birr, then;

a) What is autonomous consumption ?

b) What is the total consumption?

c) What is the average propensity to consume (APC)?

d) What is the marginal propensity to consume (MPC)?

e) What is marginal propensity to save (MPS)?

 Quiz (5%)

1. Explain the difference between induced and autonomous

investment.

2. List at least three determinants of investment

Say True or False

3. An increase in interest rate leads to an increase in

investment__________

4. When tax rate increase, investors will be motivated to invest

more_______