Topic 3: Consumption, Capital Accumulation and Growth


You should now understand three basic points: 1) that the output produced in an economy is the flow of returns off its aggregate capital stock; 2) that income is the amount of that output flow left after a sufficient portion has been diverted to replace capital stock that depreciated or wore out during the period; and 3) that income is therefore the amount that can be consumed while maintaining the capital stock and the economy's ability to produce income in the future constant.

Investment is the flow of additions to the capital stock during the period. The allowance for depreciation is often called replacement investment---the amount that must be added to the capital stock to replace the part that depreciated during the period. If the rest of output is consumed, the capital stock will be the same at the beginning of next period as it was at the beginning of this period. And next period's output and income will be the same as this period's output and income (assuming that depreciation is the same).

Suppose that people decide to consume less than their incomes. Then more will be added to the capital stock than necessary to maintain it intact. The capital stock will grow from this year to next and next year's income will be higher than this year's income. This net addition to the capital stock from this year to next is called net investment. Net investment plus the allowance for depreciation is called gross investment As was noted in the previous topic, the difference between gross and net investment is depreciation.

Aggregate income can therefore be broken down into two parts---consumption and net investment---according to whether it is consumed or added to the capital stock. This relationship can be stated in terms of the simple equation.

1.       Y = C + I

where C is the level of aggregate consumption, Y is the level of income and I is the level of net investment. It should be noted here that we are lumping together privately produced and government produced consumption and investment into single aggregates.

The level of gross investment equals net investment plus depreciation:

2.       Ig = I + D

where Ig is the level of gross investment and D is the allowance for depreciation.

Output thus equals the sum of consumption and gross investment and can be expressed as

3.       X = Y + D = C + I + D = C + Ig

where X is the level of output.

The public's choice as to the division of income between consumption and net investment is the fundamental factor determining how fast income will grow from period to period. If aggregate consumption is less than aggregate income, and net investment is therefore positive, the capital stock and income will grow through time. If aggregate consumption is greater than aggregate income, the capital stock and the income generated by it will decline as time passes. Most industrial countries have experienced substantial growth in output and income over the past 150 years. This could not have occurred without growth of the capital stock over that period. And the growth of the capital stock could not have occurred unless consumption was consistently less than income.

It must be remembered that we are defining the stock of capital very broadly here to include knowledge and technology as well as natural resources, human skills, buildings, machinery and inventories. The growth of knowledge and technology is often referred to as technological change. While some technical advances occur by accident, most of the important ones require investment of human and physical capital services. Those capital services have to be diverted from producing consumer goods in order to be used in the production of knowledge and technology.

An understanding of why some economies grow and others do not thus requires an understanding of why some societies consume less than their income while others consume all of it.

Two other conditions for growth of income, as we usually think of it, to occur should also be mentioned briefly, although these details belong in a more advanced discussion. First, for income per person to grow the economy's capital stock must grow faster than its population. So to understand why people in some parts of the world get richer as time passes while those in other places do not, we also have to understand why the population grows slower in some places than in others.

The second additional condition for growth to occur is that newly added capital stock must make the same contribution to output as did the capital stock previously in place. In other words, income that is diverted from consumption into investment must not be wasted or improperly allocated among the different types of capital. For example, knowledge and technology must expand appropriately in relation to other kinds of capital.

It's time for the test. Make sure you have thought through the questions and arrived at your own answers before looking at the answers provided.

Question 1
Question 2
Question 3

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