Class Summary of 3rd September 2013: CONSUMPTION

John Maynard Keynes, the globally lauded British Economist was concerned with the short-run as compared to the Classical economist whose primary regard was long-run. In his book, “The General Theory of Employment, Interest and Money”, Keynes coined an interesting term, “Animal Spirits which dealt with human emotions that drive consumer confidence. He further argued that free market forces could considerable time to adjust. In the short-run there could be long eons of underemployment. Based on psychological law Keynes also gave his insight on the fact that short-run in the times of economic depression is influenced by aggregate demand. Aggregate demand is a concept where there is full employment and all the resources are gainfully employed. It can also be stated that aggregate demand is the amount of goods and services in a particular economy that can be purchased at all possible price levels. Aggregate demand satisfies resource allocation, defining framework of economic activity and proxy for national income. Aggregate demand is often synonymous to effective demand, but this equivalence is only restricted to aggregated market for goods in general. However, effective demand is the maximum potential output that can be created. Now aggregate demand follows an aggregate demand curve which is the sum of the individual demand curves for different sector of the economy. AD= C + I + G + (X – M)
Demand Absorption External Demand

Here, AD = aggregate demand; C = Consumption; I = investment, G = Government Spending; X – M = Net Export, where, X = total exports and M = total imports CONSUMPTION

Household Final Consumption Expenditure; at least one wage earner in a household, unit of economic activity

Private Sector
Use of resources to run their day to day activities is the consumption of the private sector

Government consumes to run its day to day activities; largest sector in Government Expenditure: Defence
Bitan Banerjee

 Autonomous and Induced Consumptions: Autonomous consumption is the minimum level of consumption that would exist even if a consumer has no income. In this regard.Another intriguing concept that we came across was “Pump Priming”. Free Trade Zones. Bitan Banerjee . where the Americans aided European nations with economic support to revive after World War II in order to stalemate the spread the Soviet Communism. The term pump priming is derived from mechanical engineering paradigm dealing with the operation of older pumps. the price of money or the interest rate goes up. Since terms like. “resource”. thus it is independent of income. where an entire province named Hainan is being declared to be an SEZ. private sector spending. China has been most successful. Economic activity is at its optimum during the time of full employment where there is proper resource allocation and rightful employment. Now after the Marshall Plan comes the concept of full employment. Whereas. Since. a suction valve had to be primed with water so that the pump would start functioning properly once again. SEZs primary objectives are to facilitate export of goods and provide employments. we talked about economic despondency. or drives down. the concept of “SEZ” or “Special Economic Zone” appears automatically. are being pervasively used herein. Of all the countries that expedite SEZ. which in turn should lead to economic expansion. The theory behind crowding out assumes that governmental borrowing uses up a larger and larger proportion of the total supply of savings available for investment. Marshall Plan during the early 1930’s needs a specific mention. pump priming presumes that the economy must be primed to function properly once again. Some more concepts:  Concept of Crowding out: This is an economic concept where increased public sector spending replaces. SEZs consists of Industrial Parks. Because demand for savings increases while supply stays the same. As with these pumps. “allocations” and “investments” or in other words creating new assets. and Export Processing Zones. Induced Consumption is the consumption expenditure on households goods as well as services that alters with income making it income dependent. government spending is assumed to stimulate private spending. Conducting a business in a SEZ means that a company will receive tax incentives and the opportunity to pay lower tariffs. It is a situation where all available work force resources are being used in the most economically efficient way.

Here. ii. the less faith in the future. all these components of aggregate demand (AD) are expressed in nominal (economic value expressed in monetary terms) or real (nominal value adjusted for inflation) terms. “CONSUMPTION IS NEVER ZERO” In conclusion. motives of savings are different. vii. even Governments save a part of their income from the public sector (this when accumulated becomes gross national savings). vi. So. the notion of a circular flow (of income and expenditures) is developed to illustrate the Keynesian vision of an inherently unstable market economy. when income is subtracted by these. what we get is “savings”. Now. It should be noted that savings is a residual variable. so. Keynes identified eight different motives of savings: i. iii. Private Companies save their profits/retained earnings. Industrial Worker (Blue Collar Workers whose jobs requires manual labour) and Rural Workers. iv. Tracking income and expenditures graphically helps to conceptualize the market mechanisms that take the economy from an initial state of full-employment into deep depression and back again and then into an inflationary spiral. An interesting fact: Germany and Japan save more than any other nations.  Different segments of labours: Agricultural labour. all the variables above indicate “expenditure”. And most importantly. v. Households save. Class Summary as of September 4th 2013: Private Investment AD= C + I + G + (X – M) As discussed before. Precautionary motive Life-cycle motive Intertermporal substitution motive Improvement motive Independent motive Bequest motive Avarice motive Enterprise motive Bitan Banerjee .The more the saving. viii. decisions on the investment are not made on the basis of savings.

If we consider an institution buying an air conditioner. it is either for investment or meant for business. Now.Economists like Browing. That is why. An increase in income encourages higher investment. Here a question can be asked. if depositors are given better prospects are willing to save. So. in fact they are perishables). what is the desirable level of saving? It should be always remembered that savings is nothing but deferred consumption. raw materials etc. investment can be phrased as “the purchase of assets that are not consumed today. Now. the term “white goods” pops up automatically. in an economic jargon. but are used to create wealth in the future”. but durables as well: foods are bought for consumption only. Lusardi and Katona also identified many other motives behind savings. Again. so it will be taxed higher. they are procured with a purpose of consumption alone (not just goods. But the most common motives for savings are precautionary motives and when external borrowing is costly. it will be bought for consumption and not for resale. Even if a firm chooses to use its own funds in an investment. if a household buys an air conditioner. As per Economics. hence. the discussion is on “investments”. Investment has got different notions in the fields of Economics and Finance. whereas a higher interest rate may discourage investment as it becomes more costly to borrow money. how do the private investors weigh their options of investment? The answer lies within the following premises:  What to borrow for? (Machinery. We save because we want to consume and to make more money out of our savings in the future.)  What I need to invest?  When do I get it from?  Is there a market value of the product? (market analysis)  Any opportunity costs? (cost of current activity versus return of future activity) Since. the interest rate represents an opportunity cost of investing those funds rather than lending out that amount of money for interest. it is not a white good. so Bitan Banerjee . Savings is a function of the rate of interest S= f (i) Interest in future is more than the value that consumption gives us today. white goods are consumer resources purchased with no intention of resale. Economic history plays an important role in savings as well. but they are generally not durable.

Keynesian Model Bitan Banerjee . Thus. TFP is strongly correlated with output and hours worked. Marginal Efficiency of Capital (MEC): Keynes defines marginal efficiency of capital as “the rate of discount which makes the present value of the prospective yield from the capital asset equal to its supply price”. it acts as a variable which accounts for effects in total output not caused by traditionally measured inputs of labour and capital. A comparison of these rates with the going rate of interest may be used to indicate the profitability of investment. we all have covered the following concepts and theories: 1.  An acumen to do business  Not always because there is money/subsidies  After deciding to do business the subsidies might act as incentives to keep the business motivated Some Interesting Facts: Marginal Efficiency of Investment (MEI): Expected rates of return on investment as additional units of investment are made under specified conditions and over a stated period of time. Overall. TFP plays a critical role on economic fluctuations. Moving along. “tradability” is the factor on which the classification of white goods rests upon. Incremental Capital Output Ratio (ICOR): It is the rate at which marginal productivity increases. Animal Spirits 2. economic growth and cross-country per capita income differences. there are certain reasons for either business or investments. Glossary In these two will be a white good. At business cycle frequencies. The measure is used predominantly in determining a country's level of production efficiency. The rate of return is computed as the rate at which the expected stream of future earnings from an investment project must be discounted to make their present value equal to the cost of the project. i.e. a higher ICOR value is not preferred because it indicates that the entity's production is inefficient. ICOR = Annual Investment ÷ Annual Increase in GDP Total Factor Productivity (TFP): It is the portion of output not explained by the amount of inputs used in production.

Autonomous & Induced Consumption 12. Marginal Efficiency of Capital (MEC) 22. Consumption 6. Special Economic Zones (SEZs) 10.3. Incremental Capital Output Ratio (ICOR) 24. Labour Segmentation 13. Concept of “CONSUMPTION CAN NEVER BE ZERO” 14. Marginal Efficiency of Investment (MEI) 23. Consumption as a function of Income 15. Pump Priming 8. Savings as a function of interest 18. Marshall Plan 9. Total Factor Productivity (TFP) Bitan Banerjee . White Goods 20. Motives of Savings 17. Effective Demand 5. Tradability 21. Private Sector & Government) 7. Investments 19. Savings 16. Concept of Crowding Out 11. Types of Consumption (Household. Aggregate Demand 4.