Question

Households make four kinds of economic decisions (textbook, pp. 4–5). Consider two households, one with children aged 6 and 8, and the other with “children” aged 26 and 28, that are otherwise identical. Using the four economic decision categories (Consumption and saving decisions, investment decisions, financing decisions, risk-management decisions), discuss how these households’ financial decisions would be similar and how they would be different.

Answer 1

INCOME:

Income is a flow of wealth (goods and services) over a period of time. If income rises, more goods and services are enjoyed. But, to enjoy goods, they must be produced. A nation's Income, then, is basically the same as its output over a period. Thus national income is the total money value of all goods and services produced by the country during the year. The flow of national Income begins when production units combine capital and labour and turn out goods and services called as Gross National Product. At the same time, the production units which produce goods and services, distribute money incomes to all who help in production in the form of wages, rent, interest and profit. This is called as Gross National Income which refers to the total earnings of all factor units.Three kinds of national income estimates can be constructed which bring out clearly the different aspects of the national economy;

1. National income as net aggregate output

2.. National Income as sum of distributive shares.

3. National income as aggregate value of final products.

CONSUMPTION:

Consumption refers to the expenditure of the community on the purchase of consumer goods and services at different level of income. Every household spends a part of its income on consumption and, sometimes, has to spend all its income only on consumption. According to Keynes, the level of consumption will change with a change in the level of income. In Keynesian analysis, a major determinant of consumption is the level of disposable income with the households. Past savings may sometimes be used whenever the current income is not sufficient or when a costly and durable commodity like a car or a refrigerator is to be purchased. But normally, past savings may not be available for current expenditure in the case of most households. In a modern economy, most of the savings of middle class people consist of insurance policies, contribution to provident fund and social security fund, etc., all of which or most of which are not available for current use. A high rate of interest may induce some people to increase their savings and thus, restrict their consumption. According to classical thinkers, saving is a positive function of the rate of interest and therefore, consumption is a negative function of the rate of interest. Keynes does not accept this idea by stating that a high rate of interest may not induce the rich to save more, because their income is so high that they are saving automatically. The middle class income group saves irrespective of the rate of interest for the sake of future security; and the vast majority of the low-income groups may not be able to save at all (for, their income is too low). Ultimately, it is the level of income which determines consumption.

In mathematical terms, C = F (Y). Where: C = Consumption ,Y = Income.

SAVING:

The relevance of saving as an important source of the supply of capital for investment has been made an extensively explored term of discussion among the economists throughout the world particularly due to shortage of capital and the chronic state of economic stagnation in the developing countries. Economists have established the functional relationship between income and savings. But the empirical works on the determinants of saving have failed to throw conclusive evidence. The concept of saving plays an important role in economic analysis. Saving is defined as the difference between income and consumption. During pre-independence period in India, people spent most of their income on consumption and only a small amount of income was left in the form of saving. As a result, saving rate was very low, especially in the rural sector. In India, since the attainment of independence in 1947, the major objective of the government policy has been the promotion of saving and capital formation as they are the primary instruments of economic growth. Increase in the savings serves increased Investment, for Increasing income and again savings for economic growth. This process may continue till saving, investment ratio to income would get stabilized and there would be steady and self-sustained increases in national income and economic welfare. The rapid development of the western economies was the result of an increasing rate of investment which was made possible by way of proportionate rise in the rate of saving. Saving is therefore, the key factor in achieving a high rate of investment.

INVESTMENT:

Investment means a person's commitment of funds towards his future life. It is an economic activity. It refers to acquisition of income i.e. diversification of money towards investment and there by increasing productivity of a nation. It is related to funds invested in various securities, consisting of Government and semi-government securities, loans, debentures and shares of companies and represents legal claims of various securities such as shares, debentures, bonds etc, and assets of special nature. Investments are freely bought and sold in the stock exchange through brokers and banks, who charge a small amount of commission for their services. It means the use of money to earn more money by way of interest, dividend or capital appreciation. The dynamics of economic growth provides various opportunities for investors to invest their money in different types of securities. Well planned investment alone can ensure regular income, capital appreciation and can be used to meet the financial requirements of the investors.The important concepts of investment are explained below:

a) Economic Investment: It means the net addition to the capital stock of the society which consists of goods and services that are used in the production of other goods and services. Addition to the capital stock means an increase in buildings, plants, equipments and inventories over the amount of goods and services that existed.

b) Commitment Investment: It refers to money commitment to satisfy personal desires. In this concept, no rate of return is involved in such investment and capital growth is not expected.

c) Financial Investment: Financial investment involves the investment of funds in various assets, such as stock, bonds, real estate, mortgages etc. Investment is the employment of funds with the aim of achieving additional income or a growth in value. It involves the commitment of resources which have been saved or put away from current consumption with the hope of benefits that will accrue in future. It involves long term commitment of funds and waiting for a reward in the future. The term financial investment is often used by investors to differentiate between the pseudo-investment concept of the consumer and the real investment of the businessman. Semantics aside, there is still a difference between an "Investment" in a ticket on a horse and the construction of a new plant, between the pawning of a watch and the planting of a field of corn. Some investments are simply transactions among people while others involve nature. The latter are "real" investments whereas, the former are "financial" investments.

EQUALITY OF SAVINGS AND INVESTMENTS AND RATE OF INTEREST:

Keynes does not accept the classical statement that the equality of S and I is brought about by the rate of interest. According to him, S and I are not sensitive to changes in the rate of interest. For instance, the rich will save automatically even if the rate of interest is zero; the middle income group will save for security and safety of the future, whatever be the rate of interest, and the low income groups do not have the capacity to save, even if the rate of interest is quite high. In other words, saving is related to levels of income rather than to the rate of interest. ^^ At the same time, as Keynes points out, investment is not affected by high or low rates of interest but depends upon the profitability of fresh investment or the anticipation of investors about the profitability of new investment. He, therefore, argues that S and I are not related to or dependent on the rate of interest but instead both depend upon the level of income in the country.^'* Hence, according to Keynesian analysis of income and employment, three basic concepts are: consumption, saving and investment.