THE DETERMINANTS OF CONSUMPTION AND PRIVATE INVESTMENT

Chapters 5 and 6 provided a simple model showing how real g.n.p. is determined by the interaction of aggregate supply and aggregate demand. In the short run, since the aggregate supply curveis essentially fixed, the level of aggregate demand (total spending by households, businesses, and governments) largely determines the level of real output and employment. In that model, consump tion spending is entirely a function of the level of g.n.p. (income), while both private investment and government spending are considered autono mous—that is, unaffected by the level of g.n.p. Thus, the simple multiplier effects in Chapter 6 depend on the partially unreal assumptions that private investment and government spending are autonomously determined, and that consumption spending is passively dependent on income re ceived.

Obviously that model is oversimplified. You may reasonably suspect that consumption spend ing is affected by factors other than income. More over, Chapter 6 did not look into the actual determinants of private investment spending, which you may safely suspect are complex. It is the purpose of this chapter to examine in more detail the determinants of consumption and pri vate investment spending.

CONSUMPTION EXPENDITURES

The Reiction of Consumption to Income

It seems intuitively reasonable to suppose that consumption expenditures depend heavily on the incomes that people receive. Careful studies have been made of what happens to aggregate consumption expenditures when aggregate disposable personal income rises and falls. As far back as our data go, they show aggregate consumption rising and falling with aggregate disposable personal income; and, of course, they show that, on the average, this same relationship holds for individual families. However, if we look at individual families one by one, we find widely varying behavior masked by the average figures.

FIG. 7-1 In the depression people spent
nearly all their disposable income on con-
sumption. During World War II they saved
a large proportion. Since then their spend-
ing.saving behavior has been quite stable.
Note that the trend line leans over o little,
showing how much consumption spending is
less than disposable income. (Source: U.S.
Department of Commerce.)

Consider first the aggregate relationships. Figure 7-1 plots the relationship between total disposable personal income and total consumption expenditures in the economy in each year from 1922 through 1966. For example, in 1960, d.p.i. (read off the bottom scale) was about $352 billion and personal consumption expenditures (read off the vertical scale) were $329 billion. For 1933, the lowest year, d.p.i. was only $45 billion while personal consumption expenditures were $46 billion, actually more than disposable personal income. People used accumulated savings and went into debt to keep themselves fed, clothed, and housed when incomes plummeted in the depression.

The line running from southwest to northeast on the chart is drawn to “fit” the dots plotted. The fact that most years fall about on the straight line shows that the relationship between disposable income and consumption spending has been a rather stable one. But the fact that some years are substantially off the line shows equally that the stable relationship has not always held. During World War II, for example, consumption spending fell far below what would normally have been expected for the high incomes received during those years.

Put in common-sense language, this evidence says that the percentage of d.p.i. spent on consumption rises as incomes fall in a depression (since people try hard not to cut back their living standards as much as their incomes fall). Conversely, when incomes rise sharply in a boom, the percentage spent on consumption falls (to around 94—96 per cent in the generally prosperous years since 1950). And under special circumstances like World War II, when many goods were unavailable and the government urged everyone to save more to avoid inflation, the consumption percentage may fall much further—down to about 75 per cent in 1943 and 1944. The fact that the “fitted” line leans over toward the right shows that the percentage relationship is not a constant one, like C = .9 (d.p.i.). Such an equation would give us a line which shows zero consumption at zero d.p.i. But we see that households in fact raised their consumption to over 100 per cent of d.p.i. in 1932, when income was well above zero.

Such analysis of historical relationships is an example of the research that provides sound empirical foundations for the models used in economic analysis, as in Chapter 6. However, we shall see in the following sections that the consumption-income relationships are in fact more complex than those shown in Fig. 7-1, and to get useful predicting relationships we need to take more factors into account.