- Study Guide (Course-wide Content)
A. Consumption and Saving
- Disposable income is an important determinant of consumption and saving. The consumption function is the schedule relating total consumption to total disposable income. Because each dollar of disposable income is either saved or consumed, the saving function is the other side or mirror image of the consumption function.
- Recall the major features of consumption and saving functions:
- The consumption (or saving) function relates the level of consumption (or saving) to the level of disposable income.
- The marginal propensity to consume (MPC) is the amount of extra consumption generated by an extra dollar of disposable income.
- The marginal propensity to save (MPS) is the extra saving generated by an extra dollar of disposable income.
- Graphically, the MPC and the MPS are the slopes of the consumption and saving schedules, respectively.
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- Adding together individual consumption functions gives us the national consumption function. In simplest form, it shows total consumption expenditures as a function of disposable income. Other variables, such as permanent income or long-term income trends as well as wealth, also have a significant impact on consumption patterns.
- The personal saving rate has declined sharply in the last three decades. To explain this decline, economists point to social security and government health programs, changes in financial markets, and wealth effects. Declining saving hurts the economy because personal saving is a major component of national saving and investment. While people feel richer because of the booming stock market, the nation's true wealth increases only when its productive tangible and intangible assets increase.
- The second major component of spending is gross private domestic investment in housing, plant, software, and equipment. Firms invest to earn profits. The major economic forces that determine investment are therefore the revenues produced by investment (primarily influenced by the state of the business cycle), the cost of investment (determined by interest rates and tax policy), and the state of expectations about the future. Because it depends on highly unpredictable future events, investment is the most volatile component of aggregate spending.
- An important relationship is the investment demand schedule, which connects the level of investment spending to the interest rate. Because the profitability of investment varies inversely with the interest rate, which affects the cost of capital, we can derive a downward-sloping investment demand curve. As the interest rate declines, more investment projects become profitable.