Theories of Consumption and

Investment
Part-II Unit IV
 Consumption
• In goods market, it is been demonstrated that output is equal to
income which is always equal to expenditure… Y=C+ I + G +
X-M
• In this chapter we will focus on the determinants of aggregate
private consumption expenditure C

• Consumption expenditure by households forms a very

significant percent of GDP (57.8 per cent)
• In order to understand the trends in private consumption
various theories are formulated
Theories of Aggregate
Consumption
 Major Contributions to the Theory
of Consumption
1. Keynesian Consumption Theory or Absolute-Income
Hypothesis,

2. Relative-Income Hypothesis,

3. Permanent-Income Hypothesis, and

4. Life-cycle Hypothesis.
 Keynesian Consumption Theory and
Its Properties
• The real consumption expenditure is a positive function of the real
current disposable income.

• The marginal propensity to consume (MPC) , the proportion of the

marginal income consumed , ranges between 0 and 1, that is, 0 <
MPC <1 .

• The MPC is less than the average propensity to consume (APC), that
is ∆C/∆Y < C/Y.

• The MPC declines as income increases, that is, the proportion of

marginal income consumed goes on decreasing.
Drawbacks of the Absolute Income
Hypothesis
• It is based more on ‘introspection’ than on observed facts.

• The second and fourth properties of the Keynesian

consumption function have not only failed to stand the
empirical test but have also been a major source of
controversy.

• The post-War studies based on the US data cast serious doubts

on the validity of the simple Keynesian consumption function.
 The Relative Income Hypothesis:
Duesenberry’s Theory

• The relative-income theory of consumption states that the

proportion of income consumed by a household depends on
the level of its income in relation to the households with
which it identifies itself, not on its absolute income.
• “ If the income of all the individuals in society increase by
the same percentage, then his relative income would remain
the same, though his absolute income has increased.”
The Ratchet Effect in Consumption
Behaviour
• Duesenberry argues that when absolute income increases,
absolute consumption increases, but when absolute income
decreases, the households do not cut their consumption in
proportion to the fall in their incomes.

• When consumption does not fall in proportion to the fall in

income, then APC rises and MPC falls. This is called ratchet
effect in consumption behavior.
The Permanent Income Hypothesis:
Friedman’s Theory of Consumption
• According to the permanent income hypothesis, it is the
permanent income, not the current income, which determines
the level of current consumption expenditure.

• Friedman’s theory postulates that consumption is the function

of permanent income, i.e.,

and that C is proportional to Yp, i.e.,

 The Permanent Income Hypothesis:
Friedman’s Theory of Consumption (Contd.)
• If all material, financial and human sources of income are
treated as wealth, then the permanent income of the current
year can be defined as,

where Yp is the permanent disposable income with reference to

the current year, W represents overall wealth and r is the rate
of return.
The Life-cycle Theory of Consumption:
The Life-cycle Hypothesis

• The life-cycle hypothesis postulates that individual

consumption in any time period depends on,

i. resources available to the individual,

ii. the rate of return on his capital, and

iii. the age of the individual.

 Basic Propositions of Life-cycle
Theory
• The total consumption of a ‘typical individual’ depends on his current physical and
financial wealth and his life-time labor income.

• Consumption expenditure is financed out of the lifetime income and accumulated

wealth.

• The consumption level of a typical individual is, more or less, constant over his lifetime.

• There is little connection between current income and current consumption.

 Consumption as per
neuroeconomics
• Consumption smoothing theory is not a behavioral theory but
a preference maximization theory where individuals are
forward looking.

• Intertemporal analysis is about the trade-offs when the

present choices affect the alternatives available in the future.
 Money Illusion
• Money illusion refers to consumers’ false feeling of richness
with increase in money income even if their real income is
falling due to increase in prices. With this false feeling of
richness, they tend to spend more on consumption.
Theories of
Investment
 Investment
• In general sense of the term, investment means using or
spending money on acquiring physical or financial assets
and skills that yield a return over time.

• In macroeconomics, investment means the sum of spending

made by the business firms per unit of time to build physical
‘stock of capital’.
 Capital and Investment
• Capital is a stock concept. It refers to the capital accumulated
over a period of time.

• Investment is a flow concept and it is measured per unit of

time, generally one year.

• Conceptually, investment refers to the addition to the

physical stock of capital.
 Autonomous and Induced
Investment
• The general form of investment function

• The investment caused by the increase in income (Y ) and

decrease in the interest rate (i) is called induced investment.

• Autonomous investment is the investment caused by the

factors other than the level of income and interest rate.
 Methods of Investment
Decision
• The Net Present Value Method, and

• The Method based on Marginal Efficiency of Capital.

 The Net Present Value (NPV) Method
• The net present value (NPV) is defined as the difference
between the present value (PV) of a future income stream and
the cost of investment (C). That is,
NPV = PV – C
• Present value of an amount expected at some future date is the
sum of money that must be invested today at a compound
interest rate to get the same amount at some future date.

• The present value of a receivable in the nth year

 The Net Present Value (NPV) Method
(Contd.)
• The present value of an income stream,

• The net present value,

• Decision rule- If NPV is substantially greater than C, then

the project under consideration is worth the investment. The
optimum level of investment is reached where NPV=0. In case
NPV < 0, then the project is rejected.
 The Marginal Efficiency of Capital (MEC) Method

• MEC is the rate of discount which makes the discounted

present value of expected income stream equal to the cost of
capital.

• The value of r can be obtained by,

• If a capital project costing C is expected to generate an income

stream over a number of years as R1, R2, R3, .... Rn, then MEC
of the project can be computed by,
 Decision Rule
• Once MEC or IRR is estimated, investment decision can be
taken by comparing MEC with the market rate of interest (i).
The general investment decision rules are:

i. If MEC > i, then the investment project is acceptable.

ii. If MEC = i, then the project is acceptable only on non-profit considerations.

iii. If MEC < i, then the project is rejected.

Questions
Next –Unit V