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Analysis of Consumption and Investment

Consumption and investment have always been a significant part of economic development. Together, they account for about 80% of GDP in the US and a similar share in the GNP of many other major economies. It is, therefore, vital to understand consumption and investment behaviors in response to these components, and as the effect changes on income, as well as changes in asset markets. It has been a norm since the 1950s for economic theories of consumption behaviors to deeply appreciate that consumers consider their lifetime resources when making decisions, as opposed to simply current income, as many may have thought. Hence, applying a simple permanent income model to the consumption of perishable goods, as well as understanding the consumption of durable goods ad service, has to be considered critically. And since durable goods are usually consumed over a long time, their rate of consumption and production cannot be similar to non-durable goods.

Understanding the consumption function

Consumption function, also known as the Keynesian consumption function, is a formula of economics that shows the functional link between total consumption and gross national income. This formula was introduced by John Maynard Keynes, who stated that the function could be applied in tracking and predicting aggregate consumption expenditures.

In the traditional consumer function, a consumer’s expenditure is fully determined by income and income changes. This means people only spend according to what they earn, and they will increase their consumption when there is more income. If this were true, it could mean aggregate savings should include proportionally to the Gross Domestic Product (GDP) over a specified period. Hence, the thought of building a mathematical relationship between disposable income and consumer spending works only on aggregate levels.

When considering the consumption function based on Keynes’ Psychological Law of Consumption, more so when considering in contrast with the volatility of an investment, the stability of the function is critical, in reference to the Keynesian theory of macroeconomics. Many thinkers who came after Keynes and his thought agree that there is stability in the function over a long period because consumer behavior changes with change in income.

The function is represented as C=A + MD.


C is what the consumption spends. In other words, what can be seen?

A is autonomous consumption, which comes as part of C.

M is the marginal propensity to the consumer.

D is the consumer’s real disposable income.

There are several assumptions and implications in this function. First, it is vital to note that the Keynesian belief is built around the frequency at which a selected population consumer or saves income. Three of the most critical aspect of this thought are the multiplier, the consumption function, and the marginal propensity to spend, which further explains spending and aggregate demand.

It is assumed that the consumption function is stable and immovable, whereby the level of national income determines all the expenditures. However, Savings is different, a situation Keynes calls “investment,” and one that many people confuse with government spending, which is also an investment, as Keynes defines it. However, the model can only be valid where the consumption function and investment remain constant for long enough to allow national income to hit equilibrium. When it gets to balance, it means business expectations and consumer expectations are the same. There is a problem with this assumption, though, as consumption function has no ability to withstand variations in income and wealth distributions. And where these changes occur, they may also influence autonomous consumption as well as the marginal propensity to spend.

Adjustments in the Keynesian theory

The Keynesian thought has been quoted many economists over time. However, many have found the need to make adjustments to the consumption function. Today, it includes variables such as employment uncertainty, borrowing limits, and even life expectancy, which now forms the function more functional. For instance, there is a number of standard models that come from the “life-cycle” thought by Franco Modigliani. In his case, he looks at the adjustments based on how income and liquid case brings about balances, which consequently affects one’s marginal need to spend. According to this hypothesis, therefore, less earning individuals spend a net income more than wealthy ones.

Another version is presented by Milton Friedman, calling it the ‘permanent income hypothesis. This thought tries to draw the difference between permanent and temporary income, which also extends into the life expectancy to infinity use.

There are many more, even complicated functions that don’t include disposable income. Instead, they follow taxes, transfers, and many other income channels. Nevertheless, the not empirical test has been able to relate directly to the predictions by consumption function. According to statistics, there are frequent and perhaps dramatic changes in the consumption function, affect by general changes in consumption and investment processes.

Aggregate demand and Keynesian Analysis

As discussed above, the main feature of the Keynesian theory is aggregate demand, which an idea that firms’ output and production only happens is they expect to sell. In other words, a firm will only consider investing in a new product, or otherwise process, if they have confirmed a ready market for what they are offering. As such, while different factors determine production and the nation’s potential GPD, the number of goods that can be, or are being sold, (also GDP), is determined by the existing demand with the entire economy. As Keynes argued, there is no sure stability demand.

Look at the graph above. Let’s say; the economy begins where AD0 forms the intersection with RSAS as P0 and Yp. Yp, in this case, represents full potential output, which means the economy is at its best. However, we have already seen that aggregate demand is not stable, in which case, chances of it failing are very high. In other words, we may even begin at point Yp, but the results will always be the same, as Keynes called it the “recessionary gap.” We may also note that at equilibrium, the economy is under less employment, as demonstrated at Y1. So, Keynes’ culture is that economy would always stay in this recession gap, accompanied by unemployment, at least most the time.

Another concept on the same idea is the inflationary gap, which is caused by an increase in aggregate demand. In this case, it is assumed that demand attempts to push the economy beyond the previous possible income, which results in inflation.

In either situation, the economy is not well stable, and the government has to intervene to create the bridge. It may employ fiscal and monetary policies, like raising spending during recessions and lowering it during the boom. In either case, it returns demand to the same level as potential output. We already know that aggregate consumption is equal to total spending, economy-wide, or domestic products, for which reason economic experts also call it the total planned expenditure. In which case, aggregate demand can be calculated as the sum of its for aspects; consumer spending, investment spending, government spending, and spending on the exports (without imports).

Consumption spending

When individuals and households spend on any type of goods and service, it is referred to as consumption expenditure. There are different types of goods in this case, which include durable and non-durable. Durables and things that last longer can be used over an extended period, like cars, houses, and furniture. Non-durable, on the other hand, are perishables; things like groceries, which can be consumed once and they are done. Services are defined as intangible goods, which consumers pay for, like healthcare and entertainment.

According to Keynes, there are three factors the determine consumption.

Disposable income

For many people across the world, their spending is determined by how much they take home. It referred to left-over or disposable income, usually what remains after tax cuts. Consumers will buy only what they need based on this.

Expected future income

Also, many consumers follow their expectations about future earnings to determine how they spend now. In words, if a consumer feels optimistic about what they are like to get in the near future, they may spend more now, which increases aggregate demand. But when they hear news about recession and potential trouble in the economic cycle, they may be compelled to pull back,


People consume according to what they have or own. When they get more wealth, they may want to consume more of their income while saving less. At a time when the US stock market dramatically surged in the 1990s, the rates of saving went low, perhaps because there was more wealth, so people found less need to save. Also, people may spend beyond their income when they think their wealth is increasing. They do it through borrowing. During the Great Depression that started March 2008 to March 2009, consumers felt less certain about their future; hence there was an increased rate of saving and reduced consumption.

Keynes when on to state that there is a combination of many other factors that affect how people save and spend. Incase household preference falls in favor of consumption more than saving; then, aggregate demand is most likely to shift to the right.

Investment Expenditure

When consumers or firms spend on capital goods, it is said to be investment expenditure. This spending is divided into four categories: firms’ durable equipment/software, now nonresidential houses, inventory changes, and residential buildings. The last is related to consumers, whereas the rest fit in firms. Keynes treats investment with a focus on the role of expectations about the future, in making business decisions. For instance, a business may need to invest in physical assets – like machinery, or in services, like skills or research. In this case, the firm will have to consider the future benefits from the investment before making the decision.

There is no better way of understanding investment expectations than through future profits. When there is a chance of economic growth, a firm may want to expand its reach on the market. There is also the issue of interest rate, which take a significant position in how a business determines their investment needs. Companies need to need financing to buy critical items, just like individuals.

There are many other factors that go into profitability and investment decisions. A better example is when there is a decline in energy prices. In this case, a business that uses energy as the main input source stands to benefit more. Also, investments look more attractive when governments offer an incentive like tax code, that make investment easy.

Keynes further holds that business investment plays a crucial role in aggregate demand. When the markets are favorable for firms, they produce more, and consumers buy at lower prices.

Government spending

Spending by federal, state, and local governments is another component that determines aggregate demand. It is also true, even the US, which is through to be a market economy, the government still as a vital role in economic growth and development. The government offers public services, like difference, infrastructure, and education. Also, Keynes acknowledges that government budges an incredible tool for motivating aggregate demand. Government spending can, therefore, stimulate aggregate spending, or reduce by less spending, which may extend into influencing consumption and investment spending through lowered or raised tax rates.

In conclusion, Keynes commended that government policies can be of great help during extreme situations like a deep recession. Only governments have the power and resources to fuel aggregate demand. It can help cushion consumers against certain effects of such times.

Net exports

Product manufactured locally but sold abroad are referred to as net exports, whereas imports are produced abroad but sold locally. Export spending is categorized under aggregate demand influence because it features in domestic goods and services. Exports increase aggregate demands, while import spending reduces it. Changes in relative growth rates between partner trading nations and relative pricing structures with these countries can cause changes in export and import demand.

The level of demand for exports depends on the economy of the purchasing nation. When there is a recession in Canada and Japan, for instance, the heart is felt in the US because these are its major importers. Also, exports and imports and are influenced by price shifts in domestic and international markets.


- Consumption, investment, governmentConsumption and Investment, and net exports as the four factors that influence aggregated consumption.

- Consumption and investment can change based on a number of factors.

- Governments play a vital in economic growth aggregate demand.

Author: James Hamilton

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