GROUP FOUR PRESENTATION

ON
ECN 220 (ACCOUNTING 200L)

NAMES

REG NO

1. EKWUEZE CHUKWUDI ONYEKURU

13/BA/AC/1225
2. OBOT DEBORAH MONDAY
12/BA/AC/1161
3. CHINWENDU EMMANUEL AHUAZA
12/BA/AC/1193
4. UDOH BENEDETTE CLEMENT
12/BA/AC/1147
5. EKONG EMEM REMIGIUS
13/BA/AC/1345
6. OKWOKWO UBONG-ABASI STEPHEN
12/BA/AC/1162
7. ABIA BASSEY ROSELYN
8. SUNDAY BLESSING ALBERT
12/BA/AC/1198
9. NKANGA AKANINYENE OKON
10.

12/BA/AC/1189
THOMPSON UDUAK IMOH
12/BA/AC/1157

12/BA/AC/1166

TABLE OF CONTENTS
CONTENTS
1.0 Consumption function and theory
1.1 Keynesian Consumption function
1.2 Relative Income hypothesis (RIH)
1.3 Permanent Income hypothesis (PIH)
1.4 Life Cycle hypothesis (LCH)
1.5 Absolute Income hypothesis (AIH)
2.0 Theory of Capital and Investment
2.1 Meaning and types of Investment
2.2 Marginal efficiency of capital
2.3 The Present Value Concept
2.4 The Interest rate
2.5 Other factors that affect inducement to invest outside
rate of interest.

1.0 CONSUMPTION FUNCTION AND THEORY:

1.1 KEYNESIAN CONSUMPTION FUNCTION:

John Maynard Keynes (1936) was the first to evolve the
concept of consumption function. According to him
consumption function or propensity to consume refers to
income consumption relationships. It is a functional relationship
between two aggregates i.e total consumption and gross
national income.
Consumption demand depends on income and propensity
to consume. Propensity to consume depends on various factors
such as price level, interest rate, stock of wealth etc. constant
in his theory of consumption. Thus with these factors being
assumed constant in the short run, Keynesian consumption
function considers consumption as a function of income. Thus
we can represent the symbolical as C = F(Y)
When C is consumption
Y is income and
F denotes functional relationship.

consumption

Graphically we can represent this consumption function below:

(C=
Y)

Fig
1.0

C2
C1

45o
0

Y1

Y2

Incom
e

Figure 1 above shows a consumption function-denotary that

consumption as a function of disposable income. Here
consumption is a linear function based on the assumption that
consumption changes by the same amount all through. The 45
line may be regarded as a zero saving line and shape and
position of the C curve indicate the division of income between

consumption and saving. It is important to note that the theory

of consumption discussed here as propounded by J.M Keynes,
according to him the main determinant of aggregate
consumption expenditure is then aggregate level of income.
This is often referred to as Absolute income Hypothesis.
In a specific form, Keynesian function can be written as
C

by

Where a and b are constant. While a is intercept term of the

consumption otherwise known as Autonomous Consumption
(Consumption of Zero level or no level of income), b stands for
the slope of the consumption function and therefore represents
marginal propensity to consume.
We can illustrate the above expression graphically:
C

Fig 2.0

As =

Y>
C

Y=

C = a +by,
= AE

AS = Aggregation supply
AE = Aggregation
expenditure

a
0

45
5

From the diagram above the region denoted by a indicates

autonomous consumption which is consumption at no level of
income thus at this point such an economy is dissaving. When
income is Zero output and hence aggregate expenditure is
Zero. The higher the level of income the greater the national
output and hence the greater the aggregate expenditure. All
these stated above is represented by the 45 line. The point
labelled E is the equilibrium level of income where AS = AE

There are some technical attributes of the consumption

function there include:
1. The Average Propensity to Consume:
The Average propensity to consume may be defined as the
ratio of consumption expenditure to any particular level of
income. Algebraically, it is expressed as
APC =
C/Y
Where

APC

Average Propensity to Consume

C =
Y =

Consumption
Income

The APC declines as income increases because the

proportion of income spent on consumption decreases.

Consumption

Diagrammatically, the average propensity to consume is

any one part the consumption curve as shown in the figure
below.

C
C

Fig
3.0

Incom
e
above

Point E on the consumption curve

measure the Average
propensity to consume. It pertinent to note that the APC
declines as curve flattens to the right.
2.

The Marginal Propensity to Consume:

The Marginal propensity to consume refers to the fraction of

additional disposable income that is consumed. The concept is
central to Keynesian economic analysis. The concept owes it
origin to Keynes assertion that men are disposed as a rule and
the average, to increase their consumption as their increases,
but not by as much as the psychological law of consumption

propounded by Keynes: according to which, as income

increases consumption increases in income. Hence marginal
propensity to consume is less than one.
Summary we can say that the MPC is the ratio of the
change in consumption to the change in income. It is expressed
as
MPC =

C/

Recall that marginal propensity to consume is less than

one: thus
1>

C/

Y>0

N:B The MPC is constant at all level of income this is illustrated

in the table below:
INCOME
Y

100
160
220
280

CONSUMPTIO
N
(C)
90
140
190
240

APC
C/Y

MPC
C/
Y

0.9
0.875
0.864
0.857

------0.833
0.833
0.833

Note: when income increases, the MPC falls but more than APC.
On the other hand, When income falls, the MPC rises and the
APC also rises but APC rises at a slower rate than MPC. This is
possible during the cyclical fluctuations whereas in the short
run there is no change in the MPC and MPC is less than APC. (
MPC < APC ).
MPC is for short run analysis
APC is for long run analysis
According to Keynes, there are two factors that determine
and influence the consumption function. They can be classified
as either objective or subjective factors. The subjective factors
are Endogenous (internal) to the economic system they include
Psychological characteristics of human natures, social practices
and institutions and social arrangements.

The objective factors on the other hand are exogenous:

external to the economy itself. They may therefore undergo
rapid changes and may cause marked shifts in the consumption
function: they include: the level of income, income distribution,
price level, availability of credit, fiscal policy etc.
1.2 RELATIVE INCOME HYPOTHESIS (RIH): in 1949 An
American economist James .S. Duesenberry put forward the
theory of consumer behaviour which lay stress on relative
income of an individual rather than his absolute income as a
determinant of his consumption. According to Duesenberry, the
consumption of a person does not depend on his current
income level. This theory was based on ideals that were not
considered in earlier economic analysis. These are
1. That consumption behaviour of individual was influence by
consumption behaviour of other individuals and
2. That the consumption behaviour of individuals exhibits a
ratchet effect deriving from the fact that consumption
behaviour tends to be habitual: the habitual nature connecting
that people try to maintain the standard of living they have
become used to, the fact that they may have experienced a
decline in income notwithstanding.
Duesenberry posited that an individuals consumption and
saving decision are influence by his social environment. Thus,
given a level of income, an individuals is likely to consume
more of that income if he lives in environment dominated by
the well-to-do in society than if he lives in less affluent
neighbourhood. Moreover efforts by the individual to maintain a
certain economic status in his neighbourhood means that he
spend more out of his income to maintain that status. Thus, his
consumption, rather than being related to his absolute income
level would be related to his relative income within his
neighbourhood. This makes for a constant average propensity
to consume given a relatively constant income distribution.
Hence it makes for a proportional relationship between
aggregate consumption and aggregate disposable income.
Demonstration Effect: By emphasising relative income as
a determinant of consumption, the relative income hypothesis
suggests that individuals or households try to imitate or copy
the consumption levels of their neighbours or other families in a
particular community. This is called demonstration effect or

Duesenberry effect. Two things fellows from this, First, the

average propensity to consume does not fall. This is because of
incomes of all families increase in the same proportion,
distribution of relative income would remain unchanged and
therefore the proportion of consumption expenditure to income
which depends on relative income will remain constant.
Secondly, a family with a given income would devote more
of his income to consumption if it is living in a community in
which that income is regarded as relatively low because of the
working of demonstration effect. On the other hand, a family
will spend a lower proportion of its income if it is living in a
community in which that income is considered as relatively
high because of demonstration effect will not be present in the
case. For example, family with a given income say N500,000
per month spend a larger proportion of their income on
consumption if they live in urban areas. The higher proportion
to consume of families living in urban areas is due to the
working of demonstration effect where families with relatively
higher income reside whose higher consumption standards
tempt others in lower income brackets to consume more.
Duesenberry explains the social character of consumption
pattern to mean the tendency in human beings not only to
keep up with the Jenses but also to surpass the Jenses.
Ratchet effect: in this regard, Duesenberry argued that people
having become used to standard of living find it difficult to
lower some even in the face of declining income. The second
part of Duesenberry theory in the past part peak of income
hypothesis while explains the short-run fluctuation in the
consumption function and refutes the Keynesian assumption
that consumption function relative are reversible. Here, once
people reach a particular peak income level and become
accustomed to this standard of living. They are not prepared to
reduce their consumption pattern during a recession.
Duesenberrys hypothesis are combined together into this
form
Ct / Yt = a - b Yt/Yo
Where C and Y are consumption and income respectively.
(t) Refers to current period
(o) Refers to the previous peak
(a) Is a constant relating to the positive autonomous
consumption at#

(b) Is the consumption function.

In the above equation, the consumption function ratio in the
current period ( Ct/Yt ) is regarded a function of ( Yt/Yo ) or
the ratio of current income to the previous peak in income.
GRAPHICAL ILLUSTRATION.
The graph below illustrates Duesenberrys explanation of
proportional / non-proportional relationship of consumption
and disposable income.

LRCF
C
z

C2

SRCF
2
SRCF1

C1
Co

y
e

Y
long
0

Y1

The line LRCF is the

run consumption function, passing
through the origin and therefore without an intercept
guarantees the equality of MPC and APC. But the SRCFs are
down to reflect the short run cyclical fluctuations which account
for the drifts in the short run consumption functions. Thus given
an while level of income Y0 consumption will initially be on the
LRCF at point Y. This coincides with point Co on the vertical axis.
A rise in income to Y1 will make an increase in consumption.
But the movement will be along the short-run consumption
function to point b. if the increase in income for Y0 to Y1 is
persistent, the ratchet effect will hold and consumption will
move up to point Z along the LRCF. This means an increase in
consumption from C1 to C2 on the vertical axis. However, if
consumers were to experience a decline in income to Y2,
consumption would rather decline along the LRCF to point e fall
along the SRCF, to point C. this is because consumption is still
influence by his previous peak.
The RIH suggest the

following behavioural relationship between the APC and MPC

depending on the direction of the change in income.
a) If income is growing at a constant rate, APC would be
constant with MPC equalling APC.
b) If current income falls below a previous income level,
the APC would be greater than the MPC.
c) If income is rising but lags behind a previous income
level the APC would be declining while the MPC would
be rising but would nevertheless be less than the APC.
d) If income is rising and it is above a previous level, the
APC would be constant but would ensure the equality
between MPC and APC.

DEFECTS OF THE RIH

A major defect of the RIH was its emphasis on the
habitual behaviour and the demonstration effect arguments as
the factors underlying consumption with the utility
maximization assumption of the consumer as well as the
rational behavioural assumption of consumers.
1.3. THE PERMANENT INCOME HYPOTHESIS. (PIH)
The permanent income hypothesis is found in Milton Friedmans
famous study titled A theory of the consumption function
published in 1957. According to Friedmans, permanent income
is the amount a consumer unit could consume (or believes
that it could) while maintaining wealth intact. While
permanent consumption is the value of the services that it is
planned to consume during the period in question.
The permanent income hypothesis states that the ratio of
the permanent consumption to permanent income is constant
regardless of the level of permanent income.
To friedman, the average propensities to consume may
depend upon such factors as the ratio of interest, the ratio of
non-human wealth to permanent income, the ages of members
and the number of members in the consumers unit, the extent
of income variability, etc. Notwithstanding the influence which
these factors may exert on the individual consumer units
consumption, the value of the consumption-income ratio is
independent of the level of permanent income. The permanent

income hypothesis can be set forth in terms of the following

equations.
CP

( i, w, u ) Yp

Yp

Yi

Cp

Yi

b ( Yp, YT ) = O
b ( Cp, CT ) = O
b ( YT,

CT ) = O

Where:
Y = measured or observed disposable income
C = measured or observed consumption
Yp= permanent income
YT= transitory income
CP= permanent consumption
CT= transitory consumption
K = proportionality constant between permanent
consumption and permanent income
I = rate of interest
W = ratio of non-human wealth to permanent income
U = propensity of the consumer unit to add to
consumption rather than to wealth. The most important factors
which determine the value of U are the number ages of family
members in the consumer unit and consumption i.e the extent
of income variability and
b = the correlation coefficient term.

Given the above assertion, Friedman gives a series

assumptions concerning the relationships between permanent
of transitory component of income and consumption.

1. There is no correlation between transitory and permanent

incomes
2. There is no correlation between permanent and transitory
consumption.
3. There is no correlation between transitory consumption
and transitory income.
4. Only difference in permanent income affects consumption
systematically.
DEFECTS OF PIH
A major defect of the PIH is the elusive nature of the key
variables in the hypothesis. These variables are permanent
income and consumption. Being elusive these key concepts are
difficult to isolate and utilize for statistical testing of the
hypothesis. Past experiences and expectations determine a
households permanent income. Yet experience and
expectations changes overtime, such changes equally bringing
about changes in permanent income. This it is difficult to obtain
a measure of permanent income. It is needed this, the
unobservability of the permanent income variable that stands
put as the sore thumb in the PIH.

1.4

LIFE CYCLE HYPOTHESIS LCH:

The life cycle hypothesis was formulated by Ando and
Modigliani. According to this theory, consumption is a function
of lifetime expected income of the consumer. The consumption
of the individual consumer depends on the resources available
to him, the rate of return on capital, the spending plan, and the
age at which the plan is made. The LCH posits that individuals
wish to spread lifetime income such that they would enjoy a
pattern of consumption that is optimal over their lifetime. This
behaviour is consistent with the behaviour of individual income
over their life cycle which in the early years is usually low and
largely obtainable from labour services in the later years.
Labour income is usually higher with this higher labour income
being augmented by some return on wealth. However, labour
income drops to zero on retirement and any consumption after
retirement will be financed from accumulated wealth.
To Modigliani and Ando, age is a crucial variable in
determining the relationship of consumption and wealth over

their life time, individuals experiences low income in the initial

earning years, rising income in the middle of his career and
again low at retirement.
Ando and Modigliani specification of the LCH took the
following mathematical form:
C1 = ao ylt a2 yet a3 w t
Where C1 is consumption in year t,
Yt l= is labour income at time t,
Yte= is expected labour income at time t,
Wt= is wealth at time t.
The coefficients are the respective marginal propensities.
The graph below can be used to explain the life cycle
hypothesis.

Graph of the life cycle Hypothesis.

Y = income
curve

C,
Y

Savin
g
Dissavi
ng

C
Yo Dissavi
0

Youn T1
g

Lifetim
Middle
age

T2
T3
Retireme
nt

In the diagram above, the consumption level of the individual

throughout his lifetime is somewhat or slightly increasing, as
shown by the CC curve.
The Yo Y Y1 curve shows the individual consumers income
stream during his lifetime T. during the early period of his life,
represented by T, he borrows C Yo B amount of money to keep
his consumption level CB. Which is almost constant in the
middle of the years of his life represented by T 1 T2, he saves
BSY amount to repay his dept and for the future. In the last

years of his life represented by T2 T3 he dissaves S C1 Y1

amount.
DEFECTS OF THE LCH:
Like the PIH, the LCH cannot be subjected to rigors of
empirical testing because of the unobservable nature of one of
its key explanatory variables viz. the expected labour income in
this regard; John Muellbaeur for example has argued that the
inability to observed life cycle income has protected the
hypothesis from serious testing and possibility of rejection.

1.5

ABSOLUTE INCOME HYPOTHESIS

The absolute income hypothesis was propounded by John

Maynard Keynes and it states that when income increases,
consumption also increases but by less than the increase in
income and vice versa. This means that income consumption
relationship is non-proportional. This hypothesis was tested by
James Tobin and Arthur Smithies in separate studies and came
to the conclusion that the short-run relationship between
consumption and income is non-proportional, but the time
series data show the long-run relationship to be proportional.
Their explanation is based on the following factors.
1. Consequent upon an increase in their accumulated wealth,
households have tended to spend a larger fraction of their
income on consumption causing an upload shift in the
aggregate consumption function.
2. A charge in age composition in favour of the old people in the
population.
3. The unit reduction of new consumer grods regarded as
essentials by the typical household also causes an upward
shift in the consumption function.

Cons umption

The absolute income hypothesis can be expressed

diagrammatically below:
Y
CL
CS2
B

CS1
A

Incom
e

In the fig above, Ci is the long-run consumption function

which shows the proportional relationship between end income
as we move along the long-run curve. For instant, the APC and
the MPC are equal at point A and B on this curve. CS 1 and CS2
are short-run consumption functions. However, due to the
factors mentioned above, they tend to drift upward from point
A to point B along the long-run consumption function C L.
The great advantage of this hypothesis is that if lays tress
on factors other than income which affect the consumers
behaviour.
However as pointed out by Shapiro more and more
economists now feel that the basic consumption function is
proportional, which amounts to a rejection of the major tenet of
the absolute income hypothesis.

2.1 THEORY OF CAPITAL AND INVESTMENT.

2.2 MEANING:
Investment in ordinary usage refers to buying of shares, stocks,
bonds and securities which already exist in the stock market.
This is however financial investments it involves the transfer of
existing assets and does not affect aggregate spending.
When referring to Keynes assertion, investment means
real investment which adds capital equipment. It includes
building of roads, construction of dams, buildings etc.
To Joan Robinson By investment is meant an addition to
capital, such occurs when a new house is built or a new
factory is built.
Investment means making an addition to capital.

 Capital in the other hand refers to real assets like factories,

plants, equipment and inventories of finished and semifinished goods.
In more precise term INVESTMENT is the production or
acquisition of real capital assets during any period of time.
Capital and investment are therefore related to each other
through net investment. Due to depreciation and
obsolescence, some capital stock to wear out. When this is
deducted from gross investment, it forms net investment. If
gross investment equals depreciation net investment is
zero investment.
TYPES OF INVESTMEMT
After Keynes two types of investment have been established,
I.
II.

Induced investment
Autonomous investment
1. Induced investment

This is investment that is profit or income motivated. Factors

like prices, wages and interest charges which affect profits,
influence induced investment. Similarly demand also influences
it.

The relationship between investment and income can be

expressed functionally as; I = f(Y). it is income elastic: this
means as income increases investment also increases.
11

INDUCED
INVESTMENT
13

F.g
7.0

Investment
12

Y1

Incom

The diagram above shows induced investment, the vertical

and horizontal axis measure investment and income
respectively. At OY1 level of income, investment is O. when
income rises to Oy3, investment also increases to I3 Y3. A drop in
income level from OY3 to OY2 causes a drop in investment level
from I3Y3 to I2 Y2.
Induced investment may be further divided into
i. Average propensity to invest and
ii. Marginal propensity b invest.
I. Average propensity to invest:
This is the ratio of influence to income. It can be expressed
symbolically as 1/Y, where 1 is investment and Y is income with
reference to fig 7.0 above, average propensity to invest at OY 3
income level for instant is I3 Y3/ OY3.
II.

The marginal propensity to invest:

This is the ratio of change in investment to the change in

income, i.e 1/ Y of the figure 7.0 above is considered;
1/

=13 a/Y2 Y3

2. Autonomous investment;
Autonomous investment is independent of the level of income
and is thus income inelastic. Other factors known as exogenous
factors such as innovations, inventions, growth of population,
researches, etc influence this level of investment. It is however
not influence by changes in the level of demand. Rather it
influences demand.
Diagrammatically it is shown below

I2

Fig
8.0

II

Investment
I
1

II
Income

The diagram above explains the fact that investment is income

inelastic. It is represented by a line parallel to the horizontally
axis. It indicates that all level of income, investment remains
constant. an upward shift of the investment curve to 1
indicates an increased steady flow of investment at a constant
rate O12 at all levels of income for purposes of income
determine, the autonomous investment curve is superimposed
on the C curve in a 45o line diagram.

Determinant of investment:
While making investment decisions certain factor are
taken into consideration. These include: the cost of capital, the
expected rate of return from it during its influence, and the
market rate of interest. Keynes sums up these factors in his
concept of marginal efficiency of capital (MEC).
2.2 Marginal efficiency of capital:
This is the highest rate of return expected from an additional
unit of a capital asset over its cost. To Kurihara, it is the ratio
between the prospective yield of additional capital-goods and
their supply prices. The prospective yield in the aggregate net
return from an asset during its life time, while the supply price
is the cost of producing this asset. Keynes relates the
prospective yield of a capital asset to its supply price ad defines
the MEC an equal to the rate of discount which would make
the present value of the series of annuities given by the returns
expected from the capital asset during its life just equal to its
supply price. Symbolically, this can be expressed
SP = R1/(1=i) + R2/(1+i)2

+.. Rn/(1+i)n

Where; SP is the supply price or cost of the capital asset,

R1, R2. And Rn are the prospective yields or the series of
expected annual returns from the capital asset in the years 1,
2.. and n.

i is the rate of discount which makes the capital asset exactly

equal to the present value of the expected yield from it.
Thus i is the MEC or the rate of discount which equates
the two sides of the equation.
2.3 THE PRESENT VALUE CONCEPT:
The net present value (NPV) method is one the discount
cash flow (DCF) technique that explicitly take into account both
the time value of money and also the total profitability over a
projects life. Its underlying premise is that cash flow arising at
diferrent periods differ in value and are comparable only when
their equivalent present value is found. The method aims at
investment proposal using any acceptable hurdle rate. The cost
of capital is usually used as the appropriate discount rate. NPV
is concerned with liquidity.
The discount formula to calculate the future value of a
future sum of money at the end of n time period is
PV = FV ( 1/(1+i)n)
PV = period value
FV = future value
i

= interest rate or discount rate

= number of years
The decision rule of the NPV method is given as
i.

II.4

For independent project;

If NPV > 0 : Accept project, but
If NPV < 0 : Reject the project
THE INTEREST RATE:

The interest rate play a major role in influencing investment

decision rate is seen as the cost of borrowing.
The argument is that since interest rate is the cost of
borrowing, the higher the interest rate, the more costly it is to
borrow, and as borrowing becomes more costly, businessmen
are likely to reduce borrowing. It is assumed that borrowing
makes funds available for investment. Therefore as borrowing

reduces, due to the high interest rates, investment will fall. In a

similar manner, the lower the interest rate the cheaper it is to
borrow, and this will lead to more investment spending
assuming that other factors are held constant.
FACTORS OTHER THAN THE RATE OF INTEREST
AFFECTING INDUCEMENT TO INVEST.
There are number of factors other than the rate of interest
which affect the inducement to interest. They are the following:
1. Element of uncertainty:
To Keynes, the MEC is more volatile than the rate of interest.
This is because business expectations affect the prospective
yield of capital assets. The yield of capital may change quickly
and drastically in response to the general mood of the business
community, rumors, technical developments etc. Due to
uncertainty, investment projects usually have a short-pay-off
period. Capital assets become obsolete earlier than their
expected life due to rapid technological developments.
2. Level of income:
If the level of income rises in the economy through rise money
wage rates and other factor prices, the demand for goods will
rise which one in turn, raise the inducement to invest
contrastically the inducement to invest will fall the lowering of
income levels.
3. Existing stock of capital goods:
If the existing stock of capital goods is large, it would
discourage potential investors from entering into the making of
goods. Again, the induced investment will take place if there is
excess or idle capacity in the existing stock of capital assets. In
a situation the existing stock of machines is working to its full
capacity, there would be an increase in the demand for goods
manufactured.