Chapter 2: Consumption, Saving, and Investment
Consumption, saving, and investment are the three fundamental components that drive economic activity. The relationship between these variables determines national income, employment, and economic growth. This chapter explores the theories of consumption and saving (especially Keynes' Consumption Function), the determinants of investment, and the multiplier effect — all central to understanding how economies grow or contract.
2.1 The Consumption Function
Consumption (C) is the total expenditure by households on goods and services in a given period. It is the largest component of aggregate demand, typically accounting for 70-80% of GDP in most economies. Keynes identified consumption as the key driver of economic activity.
Keynes' Psychological Law of Consumption: "The fundamental psychological law... is that men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income." This means as income rises, consumption rises but by less — the remaining income is saved.
Keynes' Consumption Function
C = a + bY
Where: C = Total consumption expenditure, a = Autonomous consumption (consumption at zero income, a > 0), b = Marginal Propensity to Consume (MPC), where 0 < b < 1, Y = National income (disposable income)
Key Consumption Concepts
| Concept | Formula | Meaning | Numerical Example |
|---|---|---|---|
| APC (Average Propensity to Consume) | APC = C/Y | Fraction of total income spent on consumption | If Y=100, C=80, then APC = 80/100 = 0.8 |
| MPC (Marginal Propensity to Consume) | MPC = ΔC/ΔY | Fraction of additional income spent on consumption | If ΔY=100, ΔC=75, then MPC = 75/100 = 0.75 |
| Autonomous Consumption (a) | C when Y = 0 | Minimum consumption needed for survival (financed by past savings or borrowing) | If C = 20 + 0.8Y, then a = 20 |
Properties of Consumption Function
| Property | Explanation | Implication |
|---|---|---|
| C is positive at zero income | a > 0 (autonomous consumption exists) | People must consume even without income (dissaving) |
| 0 < MPC < 1 | Additional income is partly consumed, partly saved | MPC + MPS = 1 always |
| APC > MPC | Average consumption rate exceeds marginal rate | APC declines as income rises |
| APC declines with income | Rich save a larger proportion than poor | Inequality reduces total consumption in economy |
Worked Example
Given: C = 40 + 0.8Y (in NPR billions)
Calculate C, S, APC, APS, MPC, MPS when Y = 200, 300, 400
| Y | C = 40+0.8Y | S = Y-C | APC = C/Y | APS = S/Y | MPC | MPS |
|---|---|---|---|---|---|---|
| 200 | 200 | 0 | 1.00 | 0.00 | 0.8 | 0.2 |
| 300 | 280 | 20 | 0.93 | 0.07 | 0.8 | 0.2 |
| 400 | 360 | 40 | 0.90 | 0.10 | 0.8 | 0.2 |
Observations: At Y=200, C=Y (break-even point). APC falls from 1.00 to 0.90 as income rises. APS rises. MPC is constant at 0.8. MPC + MPS = 1.
2.2 The Saving Function
Saving (S) is the part of income not spent on consumption: S = Y - C. Since C = a + bY, the saving function is: S = -a + (1-b)Y = -a + sY, where s = MPS = (1-b).
Key Saving Concepts
| Concept | Formula | Meaning |
|---|---|---|
| APS | APS = S/Y | Fraction of total income saved |
| MPS | MPS = ΔS/ΔY | Fraction of additional income saved |
| Break-even Point | Y where C = Y (S = 0) | Income level where all income is consumed |
| Dissaving | S < 0 (when Y < break-even) | Consuming more than income (using past savings) |
Key Relationships: APC + APS = 1, MPC + MPS = 1. These hold true at every income level.
2.3 Other Consumption Theories
| Theory | Economist | Key Idea | Implication |
|---|---|---|---|
| Absolute Income Hypothesis | Keynes (1936) | Consumption depends on current absolute income | Short-run relationship; MPC constant; APC falls with income |
| Relative Income Hypothesis | Duesenberry (1949) | Consumption depends on relative position in income distribution and past peak income | Demonstration effect — people imitate higher-income neighbors; ratchet effect — consumption doesn't fall easily |
| Permanent Income Hypothesis | Friedman (1957) | Consumption based on expected long-term average (permanent) income, not current income | Temporary income changes don't significantly affect consumption; explains why APC is stable long-run |
| Life Cycle Hypothesis | Modigliani (1954) | People plan consumption over entire lifetime, smoothing it across earning and retirement years | Young people borrow, middle-aged save, old dissave; saving rate depends on age structure of population |
2.4 Investment Function
Investment (I) is expenditure on capital goods — machinery, buildings, equipment, and inventory — that increases the economy's productive capacity. Unlike consumption which satisfies current needs, investment creates future productive capacity and is the most volatile component of GDP.
Types of Investment
| Type | Description | Example in Nepal |
|---|---|---|
| Autonomous Investment | Independent of income level; driven by technology, innovation, government policy | Government hydropower project, NRB infrastructure investment |
| Induced Investment | Depends on level of income/output; increases when economy grows | New factory opened due to rising demand for goods |
| Gross Investment | Total new capital goods purchased | All new machinery + replacement of old |
| Net Investment | Gross investment minus depreciation | Only the additional productive capacity created |
Determinants of Investment
| Determinant | Effect on Investment | Nepal Context |
|---|---|---|
| Interest Rate | Higher rate → lower investment (cost of borrowing rises) | NRB base rate affects business loans |
| Expected Returns (MEC) | Higher expected profits → more investment | Hydropower sector attracts investment due to high returns |
| Business Confidence | Optimism → more investment; pessimism → less | Political stability encourages private investment |
| Technology | New technology creates investment opportunities | Digital banking technology drives bank IT investment |
| Government Policy | Tax incentives, subsidies encourage investment | Special Economic Zones, tax holidays for industries |
Marginal Efficiency of Capital (MEC)
MEC is the expected rate of return on an additional unit of capital. Keynes argued that investment is undertaken when MEC exceeds the interest rate. As more investment occurs, MEC declines (diminishing returns). Equilibrium investment is where MEC = rate of interest.
2.5 The Multiplier
The multiplier shows how an initial change in spending leads to a larger change in national income. Introduced by R.F. Kahn and developed by Keynes, it is central to understanding fiscal policy effectiveness.
Investment Multiplier (K): K = 1/(1-MPC) = 1/MPS
Change in Income: ΔY = K × ΔI
Multiplier Values
| MPC | MPS | Multiplier (K) | Effect of NPR 100 crore Investment |
|---|---|---|---|
| 0.5 | 0.5 | 2 | Income rises by NPR 200 crore |
| 0.75 | 0.25 | 4 | Income rises by NPR 400 crore |
| 0.8 | 0.2 | 5 | Income rises by NPR 500 crore |
| 0.9 | 0.1 | 10 | Income rises by NPR 1,000 crore |
Multiplier Process (Example)
Given: MPC = 0.8, Initial investment = NPR 100 crore
| Round | Additional Spending | Cumulative Income |
|---|---|---|
| 1 | 100.00 | 100.00 |
| 2 | 80.00 (100×0.8) | 180.00 |
| 3 | 64.00 (80×0.8) | 244.00 |
| 4 | 51.20 | 295.20 |
| ... | ... | ... |
| ∞ | → 0 | 500.00 |
Total ΔY = 100 × 1/(1-0.8) = 100 × 5 = NPR 500 crore
Assumptions and Limitations of Multiplier
| Assumption | Reality (Limitation) |
|---|---|
| MPC is constant | MPC may change at different income levels |
| No leakages except saving | Taxes, imports, and hoarding also leak spending |
| Excess capacity exists | If economy at full capacity, multiplier causes inflation not output growth |
| No time lags | Spending rounds take time; full effect may take months |
| Closed economy | Open economies like Nepal leak spending through imports |
2.6 Paradox of Thrift
The Paradox of Thrift (Keynes) states that if everyone in the economy tries to save more simultaneously, total savings in the economy may actually decline because reduced spending leads to lower income, which reduces the ability to save. This is a powerful example of the fallacy of composition — what is rational for an individual may be harmful for the economy as a whole.
How the Paradox Works
| Step | What Happens | Effect |
|---|---|---|
| 1 | People decide to save more (reduce consumption) | Aggregate demand falls |
| 2 | Firms see lower sales, reduce production | Output and income fall |
| 3 | Lower income means less ability to save | Actual saving may decrease despite higher intention |
| 4 | Multiplier effect amplifies the contraction | Economy enters recession |
Nepal Application: During COVID-19, Nepali consumers drastically cut spending and increased precautionary saving. This reduced demand for goods and services, causing businesses to close, workers to lose jobs, and the economy to contract by ~2%. The government had to step in with fiscal stimulus to restore demand.
2.7 Comprehensive Worked Example: Complete Income Determination with Multiplier
Given: C = 200 + 0.75Y, I = 300 (autonomous)
(a) Find Equilibrium Income:
Y = C + I = 200 + 0.75Y + 300
Y - 0.75Y = 500
0.25Y = 500
Y = 2,000
(b) At Equilibrium:
C = 200 + 0.75(2000) = 200 + 1500 = 1,700
S = Y - C = 2000 - 1700 = 300 (= I, confirming equilibrium ✓)
(c) Break-even Income:
At break-even, C = Y: Y = 200 + 0.75Y → 0.25Y = 200 → Y = 800
(d) Multiplier:
K = 1/(1-MPC) = 1/(1-0.75) = 1/0.25 = 4
(e) If Investment increases by 100:
ΔY = K × ΔI = 4 × 100 = 400
New Y = 2000 + 400 = 2,400
New C = 200 + 0.75(2400) = 2,000
New S = 2400 - 2000 = 400 (= new I of 400 ✓)
(f) Complete Income-Expenditure Schedule:
| Y | C=200+0.75Y | S=Y-C | I | AD=C+I | AD vs Y |
|---|---|---|---|---|---|
| 500 | 575 | -75 | 300 | 875 | AD > Y (expand) |
| 1,000 | 950 | 50 | 300 | 1,250 | AD > Y (expand) |
| 1,500 | 1,325 | 175 | 300 | 1,625 | AD > Y (expand) |
| 2,000 | 1,700 | 300 | 300 | 2,000 | AD = Y (equilibrium) |
| 2,500 | 2,075 | 425 | 300 | 2,375 | AD < Y (contract) |
2.8 Investment and Nepal's Economy
| Investment Type | Nepal Status | Key Issues | Policy Measures |
|---|---|---|---|
| Public Investment | ~25% of budget allocated to capital expenditure | Low execution rate (often <60% spent) | Improve procurement, build institutional capacity |
| Private Domestic | Growing but concentrated in real estate and trading | Limited manufacturing investment; high cost of doing business | Tax incentives, Special Economic Zones, reduce bureaucracy |
| Foreign Direct Investment | Very low relative to GDP (<1%) | Political instability, regulatory complexity, small market | Investment Board Nepal, one-stop service, bilateral treaties |
| Remittance-Funded | Remittances mostly consumed, not invested | Lack of investment channels, financial literacy | Diaspora bonds, remittance-linked savings schemes |
2.9 The Accelerator Principle
The accelerator principle states that investment is a function of the rate of change of output, not the level. A small change in consumption can cause a proportionally larger change in investment. Combined with the multiplier, the accelerator-multiplier interaction explains business cycle fluctuations.
| Year | Output | Change in Output | Capital Needed (ratio 3:1) | Net Investment |
|---|---|---|---|---|
| 1 | 1,000 | — | 3,000 | — |
| 2 | 1,100 | +100 | 3,300 | 300 |
| 3 | 1,250 | +150 | 3,750 | 450 |
| 4 | 1,350 | +100 | 4,050 | 300 |
| 5 | 1,350 | 0 | 4,050 | 0 |
Key insight: Even though output stays the same in Year 5, investment drops to zero because there is no CHANGE in output. This shows why investment is much more volatile than consumption.
Practice Questions
Short Answer:
1. State Keynes' Psychological Law of Consumption. Explain MPC and APC.
2. Derive the saving function from the consumption function C = 50 + 0.75Y.
3. Differentiate between autonomous and induced investment.
4. Explain the concept of Marginal Efficiency of Capital (MEC).
5. What is the multiplier? Derive the multiplier formula.
Long Answer:
6. Given C = 100 + 0.8Y, calculate C, S, APC, APS for Y = 500, 1000, 1500, 2000. Plot the consumption and saving functions. Find the break-even income. (15 marks)
7. Compare and contrast Keynes' Absolute Income Hypothesis, Friedman's Permanent Income Hypothesis, and Modigliani's Life Cycle Hypothesis. (15 marks)
8. Explain the working of the investment multiplier with a numerical example. Discuss its assumptions and limitations in the context of Nepal's economy. (15 marks)
9. "Investment is the most volatile component of aggregate demand." Discuss the determinants of investment with reference to Nepal. (15 marks)
10. If MPC = 0.75 and government increases spending by NPR 200 crore, calculate the total change in national income. Show the multiplier process for the first 5 rounds. (15 marks)
Exam Tips: ✓ ALWAYS show numerical calculations — formulas alone don't get full marks ✓ Know APC+APS=1 and MPC+MPS=1 — frequently tested ✓ Draw consumption and saving function graphs when asked ✓ Multiplier problems require step-by-step rounds ✓ Relate MEC to interest rate for investment decisions