Consumption and Investment Functions
O
Oiyo Contributor
Chapter 10: Consumption and Investment Functions
Understanding what determines Consumption (C), the largest part of aggregate demand, and Investment (I), which is highly volatile, is the foundation for analyzing business cycles.
1. Consumption Theory
(1) Absolute Income Hypothesis (Keynes)
- Consumption is determined solely by current disposable income.
- As income increases, consumption also increases, but not as much as the increase in income (Marginal Propensity to Consume < 1).
(2) Permanent Income Hypothesis (Friedman)
- Consumption is determined by Permanent Income—the income expected to be maintained over a lifetime—rather than temporary changes in income.
- This explains why temporary tax cuts (temporary policies) have little effect on boosting consumption.
(3) Life-cycle Hypothesis (Modigliani)
- Individuals aim to smoothen their consumption over their entire life cycle, considering their total lifetime income.
- People tend to incur debt in their youth, save during their middle/working age, and use those savings in their old age.
2. Investment Theory
Investment reflects expectations for the future and is therefore much more volatile than consumption.
(1) Present Value Method
- Investment is undertaken if the sum of the present values of expected future returns is greater than the investment cost.
- As the interest rate rises, the present value decreases, and thus investment decreases.
(2) Tobin’s q
- q = (Market value of the firm) / (Replacement cost of physical capital)
- If q > 1, it is more advantageous to invest in new equipment than to buy a firm in the market, so investment increases.
(3) Accelerator Principle
- A theory stating that investment is determined proportionally by the increase (rate of change) in income, rather than the absolute level of income.
3. Summary and Implications
| Theory | Key Point |
|---|---|
| Permanent Income Hypothesis | Emphasizes the importance of long-term income prospects |
| Life-cycle Hypothesis | Explains the impact of changes in population structure on savings rates |
| Tobin’s q | A channel through which stock market valuation leads to physical investment |
Key Checklist
- Does a temporary windfall, like winning the lottery, lead to a massive increase in consumption according to the Permanent Income Hypothesis? (Answer: No)
- If Tobin’s q is less than 1, will firms increase or decrease equipment investment? (Answer: Decrease)
- How does investment demand change when interest rates fall? (Answer: Increases)
- Which hypothesis explains the tendency to maintain a constant level of consumption throughout one’s life? (Answer: Life-cycle Hypothesis)
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