İKTİSADA GİRİŞ II

CONSUMPTION AND SAVING

Households use the income they earn in three different ways. They can spend their income for the consumption of goods and services, saving money and paying taxes. If we consider that the tax, which will be included in the model later, is not the case at this stage, the income (Y) will be equal to the sum of consumption (C) and savings (S):

Y = C + S

Therefore, the portion of income that is not consumed can be defined as savings. It is not possible to distinguish between the factors that encourage consumption and those that encourage savings, which we are interested in.

The main factor determining the consumption expenditures to be made in a given period is the income level. Along with the increase in income, the desire and purchasing power of households to make consumption expenditures also increases. This linear and positive relationship between income and consumption expenditures is called consumption function.

CONSUMPTION AND SAVING

Households use the income they earn in three different ways. They can spend their income for the consumption of goods and services, saving money and paying taxes. If we consider that the tax, which will be included in the model later, is not the case at this stage, the income (Y) will be equal to the sum of consumption (C) and savings (S):

Y = C + S

Therefore, the portion of income that is not consumed can be defined as savings. It is not possible to distinguish between the factors that encourage consumption and those that encourage savings, which we are interested in.

The main factor determining the consumption expenditures to be made in a given period is the income level. Along with the increase in income, the desire and purchasing power of households to make consumption expenditures also increases. This linear and positive relationship between income and consumption expenditures is called consumption function.

Marginal Propensity to Consume and Marginal Propensity to Save

Consumption expenditures are composed of the sum of autonomous consumption and consumption expenditures related to the income (induced consumption). As we discussed above, an increase in the level of income also increases consumption expenditures related to income. This relationship between the change in income and the change in consumption is called marginal propensity to consume (MPC) and is defined as the ratio of consumption change to income change:

MPC = Change in consumption / Change in Income

Marginal Propensity to Consume and Marginal Propensity to Save

Consumption expenditures are composed of the sum of autonomous consumption and consumption expenditures related to the income (induced consumption). As we discussed above, an increase in the level of income also increases consumption expenditures related to income. This relationship between the change in income and the change in consumption is called marginal propensity to consume (MPC) and is defined as the ratio of consumption change to income change:

MPC = Change in consumption / Change in Income

On the other hand, the sum of marginal propensity to consume and marginal propensity to save has to be equal to 1 since the income that is earned must be consumed or saved: MPC + MPS = 1

Marginal Propensity to Consume and Marginal Propensity to Save Marginal propensity to consume is the slope of the consumption function and marginal propensity to save is the slope of the saving function. From your Introduction to Economics-I course, remember that the steeper the function is, the higher the slope will be. For example, starting from the same autonomous expenditure level, from two different consumption functions, the steeper one will have a higher slope. Therefore, the MPC, this consumption function represents will be higher relative to the other one.

Factors that Effect Consumption Expenditures

There are different factors that influence the consumption decisions of households. Some of these factors are not related to income. Changes in factors that affect consumption other than income are changes in autonomous consumption. In this case the consumption function shifts downward or upward as a whole. Now we can turn to principal factors that affect consumption expenditures.

Disposable Income,

Wealth: Wealth is the value of all assets that households have. These include houses, automobiles, bank accounts, stocks and all kinds of assets such as income expected to be obtained in the future. When the wealth of households increases, the available resources that can be allocated for spending increase, too. As a result, the amount of consumption expenditure at each income level will increase.

Expectations: Another important factor for determining consumption is the expectations about future income, prices and wealth. For example, if consumers expect a stagnation in the economy, they expect that they will lose their jobs or their working hours will be reduced. In this case, they will reduce their consumption expenditures and therefore they will save more.

Demographic Factors: When the other factors effecting consumption are assumed to be constant, an increase in population will increase consumption expenditures. Here, both the increase in the number of people in the country and the changes in the age composition of the population have an effect on the consumption expenditures. While the size of the population affects the location of the consumption function, the age composition of the population has an effect on the slope of the consumption function. Other factors being constant, an increase in the size of population leads to an increase in autonomous consumption, and therefore the consumption function shifts upward. Considering the age composition of the population, it is known that the young population spends more on durable consumption goods and therefore the young population has a higher marginal propensity to consume than the elderly population. Since the slope of consumption function is measured by MPC, the rising share of the young people in total population will make consumption function steeper.

INVESTMENTS

Investment expenditures cover the expenses incurred by firms in capital goods and inventories. Among the aggregate expenditures, investments are the most volatile one.

Factors Determining Investments

We have already stated that investment expenditures are made up of expenditures of firms on capital goods and stocks. Capital goods are the equipment they need to carry out production activities and the buildings that firms have. Stocks are composed of final unsold goods. Stocks may be planned or unplanned. For example, a tire firm will start to have enough winter tires in stock from the autumn to meet the winter tire demand which is expected to intensify in the winter months. Otherwise, the firm’s inadequate stock operation can lead to a reduction in sales and loss of revenue. For this reason, the investment made by this firm is a planned inventory investment - that is, a stock change. If the firm wants to keep as few unsold winter tires as possible in its stocks until the month of February, and there are still unsold winter tires in February when it comes, this is an unplanned inventory investment. Unplanned stock changes can be regarded as a sign showing that sales are not as good as expected and that there is too much production in the previous period.

Both types of inventory investments or stock changes are considered investment. However, only planned investments, together with other planned expenditures, are effective in determining the level of equilibrium production in an economy. Unplanned investments and undesirable stock changes do not have any impact on the equilibrium level of income. For this reason, economists are interested in factors that affect planned investments.

Interest Rate: The investment objective of a firm is to be able to obtain profit from this investment. For this reason, the higher the expected profitability of the investments is, the higher the investment amount will be. The main factor determining whether an investment is profitable is the interest rate. Interest rate can be defined as the cost of borrowing funds. A large part of the investment expenditures made by the enterprises is covered by borrowing. If the cost of borrowing, i.e., interest rate, increases, fewer investment projects will become profitable. Accordingly, when the interest rate increases, investment expenditures will decrease and when the interest rate falls, investments will increase.

Expected Profit: We have stated that firms are aiming for profit from investing. It is clear that the profit to be gained from an investment that a firm will realize is not certain. For this reason, in order to determine the appropriate amount of investment, firms use economic analyzing techniques to estimate the cost of the investment and the revenue to be obtained from that investment. For this reason, the factor that determines the amount of investment is the expected profitability of investment. There are a number of factors that affect the expected profitability of investments. These include, for example, entry of new firms into the market, political instability in the country, newly enacted laws, taxes or tax advantages provided by the government and general economic conditions in the world.

Technological Change: One of the main driving forces behind new investments is technological change. Realizing the production of a new product or using a new production technology can be extremely important in terms of staying within the industry. Technology is important for companies as it increases productivity at each stage in production processes. The use of technology also contributes to a reduction in production costs.

Cost of Capital Goods: Another factor that affects investment expenditures is the cost of capital goods. As the price of capital goods increases, the expected profitability of the investment will decrease and a contraction in investment volume will occur. One of the factors that cause rapid change in the cost of capital goods is the government’s tax policy. The investment incentives provided by the government (i.e., the tax deduction of the cost of the investment) will affect the cost as well as the amount of investment. In this sense, a reduction in the cost of the investment will result in an increase in investment expenditures.

Capacity Utilization: If a firm intensively uses the capital stock that it owns, it will want to add that stock. However, if part of the current capital stock is idle, the firm does not tend to make any increase in the capital stock it owns. When we look at the economy as a whole, the fact that the current capacity is used at a higher rate will put pressure on the increase of capital goods production and the expansion of productive capacity. On the other hand, when the capacity utilization rate is low (that is, the amount of plants and equipment that are idle in the economy increases), investment expenditures will also tend to decrease.

Net Export Function

In your textbook, the last column of Table 2.3 contains the net export values defined as the difference between exports and imports. Remember that we assumed export amount as autonomous (independent from domestic income) and imports increase depending on the increase in income. For this reason, the net export volume will decrease as income increases. Given this tendency of net export it is possible to draw the net export function (NX) as in Figure 2.6. This tendency of the net export function, which shows a decreasing sloping pattern, is actually equal to the marginal propensity to import.

Another feature of the net export function is that it is the only component that can have a negative value in aggregate expenditures. We have already mentioned that the negative net export value can emerge in cases where the import volume of the home country exceeds her export volume.

Net export function will move up or down depending on changes in income levels, prices of similar goods, preferences of other countries, restrictions imposed by governments on international trade and foreign exchange rates. For example, an increase in the income of other countries causes an increase in the export volume of the home country and by raising the net export volume, it shifts the net export function upward.

AGGREGATE EXPENDITURE FUNCTION

The aggregate expenditure function is obtained by summing up each of the planned expenditure functions described above. Aggregate expenditures (AE) are composed of consumption (C), investment (I), government expenditure (G) and net export (NX): AE = C + I + G + NX

The aggregate expenditure function (AE) can also be obtained graphically with the vertical aggregation of individual expenditure functions. If we first draw the consumption function (C) and add the 500 TL planned autonomous investments at each level of income, we obtain the C + I curve. Then if we add 700 TL planned government expenditures at each level of income, we get the C + I + G curve. Finally, by adding the net export function that will be realized at each level of income, the C + I + G + NX curve or the AE function is attained.

When we carefully examine the figure, we see that the functions C, C + I and C + I + G are parallel to each other. This indicates that all of the mentioned functions have the same slope, which is equal to the marginal propensity to consume. That is why I and G are autonomous in the model. On the other hand, the slope of the AE function is smaller than the slope of the other functions. The reason is that the net export function has a negative slope. When we add the NX function to the C + I + G function, the slope of the aggregate expenditure function decreases. For this reason, the AE function is more horizontal than the C + I + G function.

Consumption function refers to the positive linear relationship between income and consumption expenditures

Saving function refers to the relationship between income level and savings

Marginal propensity to consumption is 0.70 where consumption expenditures increase by 700 TL in return for increase of every 1,000 TL in income

In a model where marginal propensity to consume is calculated to be 0.70, the marginal propensity to save is 0.30

Average propensity to consume is the following does refer to the ratio of consumption expenditures to income

Average propensity to save is the ratio of savings to income

Marginal propensity to import is the ratio of change in import to change in income

An increase in consumption shifts upwards the aggregate expenditure (AE) function as a whole

Existence of autonomous investment expenditures is the reason for drawing the C +G function parallel to the C + I + G function

If your answer is incorrect, review “Import”.