Introduction to macro economics

Macroeconomics is an analysis of a country’s economic structure and performance and the

government’s policies in affecting its economic conditions. Economists are interested to know the
factors that contribute towards a country economic growth because if the economy progresses, it
will provide more job opportunities, goods and services and eventually raise the people’s standard
of living.

Definition

Economists define macroeconomics as a field of economics that studies the relationship between
aggregate variables such as income, purchasing power, price and money. This means
macroeconomics examines the function of the economy as a whole system, looking at how demand
and supply of products, services and resources are determined and factors that influence them.

In layman’s word: Macroeconomics is the study of the behavior of the economy as a whole

Objectives:

Broadly, the objective of macroeconomic policies is to maximize the level of national income,
providing economic growth to raise the utility and standard of living of participants in the economy.

1. Sustainability - a rate of growth which allows an increase in living standards without undue
structural and environmental difficulties.
2. Full employment - Ensuring full employment to its citizens is one of the primary goals of
any government. The best way to alleviate poverty is to provide gainful employment to the
poor. The minimization of the unemployment rate is an accepted goal of macroeconomic
policy
3. Price stability - Movements in the price level are of great concern to policy makers and
ordinary citizens. Prices determine the purchasing power of money incomes and hence have
serious implications for living standards.
Inflation: is a rise in the general (or average) level of prices in an economy.
Deflation: or a negative rate of inflation, refers to a decline in the general level of prices.
An extreme form of inflation, where prices rise by thousands of percentage points in a year,
is called ‘hyperinflation’.
4. External Balance - equilibrium in the Balance of payments without the use of artificial
constraints. That is, exports roughly equal to imports over the long run.
 5. Equitable distribution of income and wealth - a fair share of the national 'cake', more
equitable than would be in the case of an entirely free market.
6. Increasing Productivity - more output per unit of labor per hour. Also, since labor is but
one of many inputs to produce goods and services, it could also be described as output per
unit of factor inputs per hour.

Instruments of Macroeconomic Policy

What does the government do when unemployment is rising and GDP is falling, or economic
growth is declining, or the country is facing a balance-of-payment crisis?

Governments use macroeconomic policies to achieve their economic objectives. These policies
influence economic activity and thus help government attain macroeconomic goals.

Given below shows some of the objectives of governments and the instruments that can be
used to achieve those objectives.

` Macroeconomic objectives and Instruments

Objectives Instruments/ tools

High output level Low Monetary policy

Reduce unemployment rate Fiscal policy
Stable price level Exchange rate policy

Maintenance of Balance of Payments International trade policy

Steady economic growth Prices and Incomes Policies

Employment Policy

1. Monetary Policy

All modern societies use money as the medium of exchange. Since money can be exchanged for
goods and services, it can also be regarded as a financial asset – a store of value. There are various
definitions of money stock, but generally speaking, money consists of financial assets with a high
degree of liquidity (that is, money or assets that can be quickly converted into money with little
or no loss of purchasing power).
The monetary system of a country consists of those institutions that create such assets. The system
is guided and controlled by the central bank of the country. The Central Bank, commercial banks
and other institutions which deals with the financial assets like the Non-Banking Financial
Intermediaries (NBFIs) together constitute the financial system.

The monetary policy of a country is formulated and implemented by its central bank (in India, the
Reserve Bank of India). It is used to influence the total quantity of money, interest rates and total
volume of credit in the economy.

2. Fiscal Policy

Fiscal policy refers to the policy of the government with respect to its spending (or expenditure)
and mobilization of resources (an important source of revenue being taxes). Government
expenditure consists of purchases and transfer payments. Government purchases refer to
spending on goods and services such as the construction of roads and dams, salaries to public
servants, etc. Transfer payments refer to payments of money by the government to some select
groups in the form of financial assistance (e.g. payments made to the elderly or the unemployed).
Government spending has a positive effect on the overall spending in the economy and thus
influences the GDP level. Government, therefore, uses its spending as a tool to control the level
of economic activity in the country.

3. Taxation

Is another important instrument of fiscal policy, which affects the economy in two ways?
Changes in the tax structure have a direct impact on people’s disposable incomes (i.e. total income
‘minus’ tax payment), which in turn affects the amount they spend on goods and services and the
amount they save. An increase or decrease in private consumption and savings affects the overall
output and investment in the economy in the short as well as the long run.

Taxation also affects the prices of goods and services and factors of production. For example, if a
low tax is levied on business profits, businessmen will be encouraged to invest in capital goods,
which will spur investment and speed up economic growth
4. Exchange Rate Policy

Exchange rate policy plays an important role in international trade. The international trade of a
country is affected by its foreign exchange rate. The foreign exchange rate is the rate (or price)
at which a country's currency can be exchanged with a foreign currency. The exchange rate policy
of a country forms a part of its monetary policy.

Different countries follow different exchange rate systems. In some systems, the exchange rate is
fixed against currencies whose exchange rate is stable. In others, the exchange rate is determined
purely by supply and demand.
5. International Trade Policy
Trade policies relate to tariff and non-tariff trade regulations that limit or promote the imports and
exports of a country. The last part of the 20th century witnessed an increase in the pace of
globalization, which made many world economies highly dependent on international trade. During
the 1970s and 1980s many East-Asian countries used their trade policies strategically, to increase
economic growth.
6. Prices and Incomes Policy & Employment Policy

Prices and incomes policies are used to influence the working of the market economy. Under
this policy, government sets the prices of some goods and services, and determines the wages.
The government takes these measures to control inflation, and protect jobs in the domestic market.

Employment policies are aimed at generating employment opportunities. In India, the

government takes up projects that require huge labor force during non-agricultural seasons, when
employment in rural areas is low. Similarly, the government sometimes provides free training
facilities to unskilled labor, to make them fit for new skilled jobs.

Aggregate Demand (AD) and Aggregate Supply (AS)

Aggregate demand (AD)

‘Aggregate demand refers to collective behavior of all buyers in a marketplace. In other words, it
is the relationship between various quantities of output that all people together will buy at various
price levels in a defined period. Therefore, it illustrates the total demand for all goods and services
rather than the demand for a single product. The relationship between average prices and real
output in terms of quantity per year is shown in Figure below. The aggregate demand curve slopes
downward because of real balance effect, foreign trade effect and interest rate effect.

Aggregate Demand

Real balances effect: The most apparent reason for downward slope of AD curve is that a
decrease in the prices of goods and services makes the rupee more valuable. Suppose you have
Rs. 1000. How much can you buy with this money? It will depend on the current price level. At
the current price level, you can buy goods and services worth Rs. 1000. But, how much can you
buy if prices rise? Rs 1000 will not get you the same amount of goods and services. The real
value of money is measured by how much goods and services can be bought with one rupee.

Suppose the price level increases by 25% in a year. What will happen to real value of your money?
At the end of the year, the real value of your money will be = (money at the beginning of the
year)/ (1+ (percentage increase/100))

= Rest 1000/ (1+0.25)

= Rs 800

So, the purchasing power of your money has decreased in the given year. Or, at the end of the
year, you won't be able to buy the same amount of goods and services that you would have bought
at the beginning of the year.
However, a decrease in the price level will have opposite effect. It means that the money is worth
more when prices fall. So, you will be able to buy more goods and services without any increase
in income level.

Thus, real balances effects cause an inverse relationship between real output and price level i.e.,
aggregate demand curve is downward sloping.

Foreign trade effect: Changes in imports and exports are also responsible for downward slope
of AD curve. Consumers now have a choice of buying either domestic or foreign goods. The
relative price in two countries is the decisive factor. If the average prices of goods that are
produced in India are rising, Indians may buy more imported goods. Similarly, if the prices fall in
India, they may buy more goods that are produced in India.

Interest rate effect: Changes in price level affect the demand for loans which in turn, affect the
interest rates. When price levels are lower, the demand for loans will also be lower. And due to
lower demand for loans, interest rates will fall. When money is available at a cheaper rate, it
encourages people to borrow more and make loan – financed purchases. So, it can be said that
when price levels are lower, people buy more. Again, this is an inverse relationship between price
and quantity.
Aggregate supply (AS)

Aggregate supply is the real value of output producers are willing and able to bring to market at
alternative price levels (ceteris paribus). The slope of the curve is always positively upward as
shown in Figure below.Upward slope of AS curve reflects profits and costs effects

Aggregate Supply

Profit effect: Producers produce goods and services to earn profits. They can earn profits only
when their selling prices are higher than their costs of production. Therefore, changing the price
level will affect the profitability of the producers. When prices of goods and services fall, profits
also fall. In the short run, the costs in terms of rent, interest payments, negotiated wages, etc. are
fixed.

When output prices fall, these costs will remain the same and the producer’s profit will be reduced.
Producers respond to this situation by reducing the rate of output.

Similarly, when output prices increase, profit margins will also increase because in the short run,
the costs will remain constant. When profit margins increase, producers try to produce and sell
more goods and services. So, the rate of output increases in case of an increase in price levels.
This is reflected in the upward slope of the aggregate supply curve.

Cost effects: Another reason for the upward slope of the aggregate supply curve is cost. As
explained earlier, the profit of a producer increases when the price level increases because some
costs remain constant in the short run. But not all costs remain constant. They may have to pay
overtime wages to increase their output. If the supply of inputs is limited, it may also lead to an
increase in cost. These cost pressures increase when the rate of output increases. As time passes,
the costs that were initially constant will also move upward. Therefore, the cost of producing
goods and services will increase. In such cases, producers will increase the output only when the
prices of the output increases at least at the rate cost of production is increasing.

NATIONAL INCOME

National income and national product play a significant role in measuring the level of economic
activity in an economy. Just as the accounting statement of a firm provides information on the
flow of revenues and expenses to reveal the firm's performance, the national income provides
information on the economy as a whole. It helps in answering the questions like what is level of
output produced in an year and how effectively it has been used, how much income has been
generated in the marketplace, etc. National income helps us in understanding how the economy
works and how it is performing. It also helps in understanding how output relates to income and
how government taxes, subsidies, expenditures, etc. affect the economic outcome.

Concepts of National Income:

There are a number of concepts pertaining to national income. They are:
1. Gross National Income (GNP)
2. Net National Income (NNP)
3. Gross Domestic Product (GDP)
4. Personal Income
5. Disposable Personal Income
6. per Capita Income

1. Gross National Income:

GNP is the total measure of the flow of goods and services at market value resulting from current
production during a year in a country, including net income from abroad, GNP includes four types
of final goods and services: (1) Consumer’s goods and services to satisfy the immediate wants of
the people. (2) Gross Private Domestic Investment in capital goods consisting of fixed capital
formation, residential construction and inventories of finished and unfinished goods.(3) goods and
services produced by the government and (4) net exports of goods and services that is, the difference
between value of exports and imports of goods and services, known as net income from abroad
2. Net National Income (NNP):
GNP includes the value of total output of consumption and investment goods. But the process of
production uses up a certain amount of fixed capital. Some fixed equipment wears out, its other
components are damaged or destroyed and still others are rendered obsolete through technological
changes. All this process is termed as depreciation or capital consumption allowance. In order
to arrive at NNP, we deduct depreciation from GNP. The word ‘net’ refers to the exclusion of that
part of total output which represents depreciation. So, NNP = GNP- Depreciation.

3, Gross Domestic Product:

Income generated by the factors of production within the county from its own resources is called
domestic income or domestic product. Gross domestic product includes:
1. Wages and salaries
2. Rents, including imputed house rents
3. Interest
4. Dividends
5. Undistributed corporate profits including surpluses of public sector undertakings
6. Mixed incomes consisting of profits of unincorporated firms, self-employed persons,
partnerships etc. and
7. Direct taxes
Since gross domestic product or income does not include income earned from abroad, it can also
be shown as:
Domestic Income = National Income – Net Income from Abroad
Thus the difference between domestic income and national income is the net income earned from
abroad may be positive or negative. If exports exceed imports, net income from abroad is
positive. In this case national income is greater than domestic income. On the other hand, when
inputs exceed exports, net income earned from abroad is negative and domestic income is greater
than national income.
4. Personal Income:
Personal income is the total income received by the individuals of a country from all sources before
direct taxes in one year. The entire national income will not be available for
consumption. National income is different from personal income. In order to arrive at personal
income several deductions are to be made. For example, corporations have to pay income-tax from
the corporate profits before declaring dividends. Likewise a part of the corporate profits available
for distribution is reduced. Similarly salaried persons and wage earners pay a certain percentage of
their income towards social security contribution. To that extent income available to the employees
and workers is reduced. Against this, the government may give social security benefits such as
unemployment allowances, old age pensions etc. These payments are called transfer payments are
called transfer payments. These are to be added to arrive at personal income. Therefore.
Personal Income = National Income – Corporate income taxes – undistributed corporate profits-
social security contributions + transfer payments.
5. Disposable personal income:
Disposable income or personal disposable income means the actual income which can be spent on
consumption by individuals and families. The whole of the personal income cannot be spent on
consumption, because it is the income that accrues before direct taxes have actually been
paid. Therefore, in order to obtain the disposable income, direct taxes are deducted from personal
income. Thus:
Disposable income = personal income – direct taxes
But the whole of the disposable income is not spent on consumption and a spent on consumption
and a part of it is saved. Thus,
Disposable income = consumption expenditure + savings expenditure.
6. Per capita income:
The average income of the people of a country in a particular year is called per capita income for
that year. This concept also refers to the measurement of income at current prices and at constant
prices. For instance, in order to find out the per capita income at current prices, the national income
of a country is divided by the population of the country in that year.
Per capita Income = National income÷ population
This concept enables us to know the average income and the standard of living of the people. But it
is not very reliable, because in every country due to unequal distribution of national income a major
portion of it goes to the richer sections of the society and thus income received by the common man
is lower than the per capita income.
Methods of measuring National income:
In preparing the national income estimate it is necessary to add the values of all final goods and
services produced and exchanged during a year. Thus whatever is produced is either used for
consumption or saving. There are three methods of estimating national income. They are:
1. The census of products method
2. The census of income method
3. The expenditure method
1. The census of products method:
This is also called inventory or output method. Under this method, the value of aggregate
production of final goods and services in an economy in a year is considered. The economy is
divided into different sectors such as agriculture, mining, manufacturing, small enterprises,
commerce, transport, communication and services etc. Then the gross product is found out by
adding the net values of all production that has taken place in these sectors during a year. The
aggregate of all these is called the gross national product at market price. While calculating the
gross national product under this method, care must be taken to avoid double
counting. Computation of national income of a country through output method

Output method or product method Rs. (Crores)

Agriculture, forestry and fishing 300
Construction 200
Distributive Trades 500
Gas, Electricity and finance 100
Insurance, banking and finance 300
Manufacturing 500
Mining and quarrying 200
Public administration and defense 250
Public health and education 250
Others 200
Total Domestic Product 2800

2. The census of income method:

This method approaches the national income from the distribution side. The incomes accruing to
all the factors of production during the process of production are aggregated together. This is called
national income at factor cost. National income is calculated by adding the following:
1. Wages and salaries
2. Social security
3. Earning of self-employed or professional income
4. Dividends
5. Undistributed profits
6. Interest
7. Rent
8. Profits of public sector enterprises and
9. Subsidies and transfer payments have to be deducted. All unpaid services are to be
excluded. Financial investments in the form of equity shares, sales of old property etc. are to be
excluded. Direct tax revenue to the government should be subtracted from the total
income. Government subsidies should be deducted. In India the national income committee is
using this method in calculating national income.
The expenditure method:
Expenditure method arrives at national income by adding up, all expenditure made on goods and
services during a year. Income can be spent on consumer goods or capital goods. Again,
expenditure can be made by private individuals and households or by government and business
enterprises. Further, people of foreign countries spend on the goods and services which a country
exports to them. Similarly people of a country spend on imports of goods and services from other
countries. We add up the following types of expenditure by households, government and by
productive enterprises to obtain national income.
1. Expenditure on consumer goods and services by individuals and households. This is called final
private consumption expenditure and is denoted by ’C’.
2. Government expenditure on goods and services to satisfy collective wants. This is called
government’s final consumption expenditure and is denoted ‘G’.
3. The expenditure by productive enterprises on capital goods and inventories or stocks. This is
called gross domestic capital formation, which, is denoted by ‘I'. Gross domestic capital formation
is divided into two parts.
a. Gross fixed capital formation.
b. Addition to the stocks or inventories of goods.
4. The expenditure made by foreigners on goods and services of a country exported to other
countries, which are called exports and are denoted by ‘x’. We deduct from exports ‘x’ the
expenditure by people, enterprises and government of a country on imports (M) of goods and
services from other countries. That is, we have to estimate net exports (that is exports- imports) or
(x-m)
Thus we add up the above four types C+G+I+(x-m) to get final expenditure on gross domestic
product. On deducting consumption of fixed capital, we get net domestic product.
Circular Flow of Income in a Four Sector Economy
In today's globalized business scenario, all countries have trade relations with other countries. If
a country import goods from another country, the amount spent on imported goods by households
is received by factors of production in the exporting country. This may not be in the interests of
the importing country as this expenditure by households will not help in the creation of national
income. For example, if an Indian customer prefers a foreign brand of jewelry instead of an Indian
one, the income of the factors producing jewelry abroad will go up, while the income level in
India will fall. Therefore, imports invariably cause an outflow of income from the circular flow
of income.
National income, output, and expenditure are generated by the activities of the two most vital parts
of an economy, its households and firms, as they engage in mutually beneficial exchange. Income
(Y) in an economy flows from one part to another whenever a transaction takes place. New
spending (C) generates new income (Y), which generates further new spending (C), and further
new income (Y), and so on. Spending and income continue to circulate around the macro economy
in what is referred to as the circular flow of income.

The circular flow of income forms the basis for all models of the macro-economy, and
understanding the circular flow process is key to explaining how national income, output and
expenditure is created over time.

If a country exports to another country, income flows into the country for the factors of production
and the residents of the exporting country do not incur the expenditure. The country's income is
increased by the amount of exports and circular flow of income also goes up. Therefore, exports
cause inflows of income into the circular flow of income. The Circular flow of income in a four
sector economy is shown in Figure

Circular Flow of money

The Circular Flow of income

Households

The primary economic function of households is to supply domestic firms with needed factors of
production - land, human capital, real capital and enterprise. The factors are supplied by factor
owners in return for a reward. Landis supplied by landowners, human capital by
labour, real capital by capital owners (capitalists) and enterprise is provided by
entrepreneurs. Entrepreneurs combine the other three factors, and bear the risks associated with
production.

Firms

The function of firms is to supply private goods and services to domestic households and firms, and
to households and firms abroad. To do this they use factors and pay for their services.

Factor incomes

Factors of production earn an income which contributes to national income. Land receives rent,
human capital receives a wage, real capital receives a rate of return, and enterprise receives a profit.
Members of households pay for goods and services they consume with the income they receive
from selling their factor in the relevant market.

Production function

The simple production function states that output (Q) is a function (f) of: (is determined by) the
factor inputs, land (L), labor (La), and capital (K), i.e.

Q = f (L, La, K)

Injections and withdrawals

The circular flow will adjust following new injections into it or new withdrawals from it. An
injection of new spending will increase the flow. A net injection relates to the overall effect of
injections in relation to withdrawals following a change in an economic variable.
Savings and investment

The simple circular flow is, therefore, adjusted to take into account withdrawals and injections.
Households may choose to save (S) some of their income (Y) rather than spend it (C), and this
reduces the circular flow of income. Marginal decisions to save reduce the flow of income in the
economy because saving is a withdrawal out of the circular flow. However, firms also purchase
capital goods, such as machinery, from other firms, and this spending is an injection into the circular
flow. This process, called investment (I), occurs because existing machinery wears out and because
firms may wish to increase their capacity to produce.

The public sector

In a mixed economy with a government, the simple model must be adjusted to include the public
sector. Therefore, as well as save, households are also likely to pay taxes (T) to the government
(G), and further income is withdrawn out of the circular flow of income.

Government injects income back into the economy by spending (G) on public and merit goods like
defence and policing, education, and healthcare, and also on support for the poor and those unable
to work.

International trade

Finally, the model must be adjusted to include international trade. Countries that trade are called
‘open’ economies, the households of an open economy will spend some of their income on goods
from abroad, called imports (M), and this is withdrawn from the circular flow. Foreign consumers
and firms will, however, also wish to buy domestic products, called exports (X), and this is an
injection into the circular flow.

Consumption Function
A consumption function is a functional statement of relationship between consumption expenditure
and its determinants. Although, consumption expenditure of households depends on a number of
factors such as income, wealth, rate of interest, expected future income, life style, age, sex etc;
income is the primary determinant of consumption. Given this dictum, the consumption function
or propensity to consume refers to the income consumption relationship. As the demand for a
commodity depends upon its price, consumption of a commodity depends upon the level of income.
In other words, consumption is a function of income. The consumption function relates the amount
of consumption to the level of income. It is the functional relationship between two aggregates, that
is, total consumption and the gross national income.
Symbolically, the consumption function can be represented as C = f (Y), where, ‗C‘ is the
consumption, ‗Y‘ is income and ‗f‘ if the functional relationship. Thus, the consumption function
indicates a functional relationship between C and Y, where C is the dependent variable and Y is the
independent variable. That is, C is determined by Y. This relationship is based on the ceteris paribus
assumption. As such only income consumption relationship is considered and all other possible
influences on consumption such as wealth, rate of interest, expectations about future income, life
style, age and sex etc are held constant.

Determinants of the consumption function

By the determinants of consumption we mean the factors that influence the shape, position and
slope of the consumption function. Keynes categorized consumption‘s non-income determinants
into two broad groups but speculated that these non-income determinants were of minimum
significance in explaining short run consumption. The two broad groups are

I. Subjective factors

II. Objective factors

Subjective factors primarily include the psychological attitude of the people towards
consumption. They are psychological characteristics of human nature, social practices and
institutional and social arrangements. Objective factors include changes in price level, fiscal policy,
rate of interest, expectations, wealth etc which undergo rapid changes and can cause marked shifts
in consumption function. The subjective and objective factors are explained below.

I .Subjective factors
As stated above, the subjective factors are the psychological characteristics of human nature,
social practices and institutions, especially behavioral patterns of business firms and social
arrangements affecting the distribution of income. According to Keynes, these subjective factors,
though not alterable, are unlikely to undergo a material change over a short period of time except
in abnormal circumstances.

A. Individual motives
Under the psychological characteristics of human nature, Keynes list out eight motives that
make people to undertake less consumption spending or more saving. They are
i. People save because they want to provide for unforeseen contingencies (precaution)
ii. They want to provide for expected future needs (foresight)
iii. People save from current income so as to use accumulated savings for investment which
increase their future income (calculation)
iv. People are motivated to save so that they can accumulate large wealth and improve the
standard of living (improvement)
v. People save to enjoy a sense of independence and power to do things (independence)
vi. People save so that they can use them for speculative purposes (enterprise)
vii. People save for the sake of leaving a good fortune for their heirs and children (pride)
viii. People save because of their miserly instinct and habits (miserliness)
B. Business motives
Subjective factors also lead business firms to save from their incomes. Keynes have listed four
motives for saving on the part of business firms.
i. Enterprise: many business firms desire to save a part of their current income so that they can
make investment in new enterprises and carryout expansion in future.

ii. Liquidity: business firms are induced to save so that they can face contingencies in future.
If they have good amount of liquid wealth in their hands, they would be able to meet
emergencies and difficulties successfully.

iii. Successful management: many managers of business firms are motivated to save to secure
large incomes and to show successful management.

iv. Financial prudence: business forms desire to save to provide adequate financial resources
against depreciation in plant and machinery, to repay their debts

II. Objective factors

The subjective factors explained above remain constant during short run and keep
consumption function stable. But the objective factors undergo rapid changes and causes shifts in
the consumption function. Objective factors which influence consumption are explained below.
(i) Changes in the general price level
The general price level is an important factor which influences the consumption of a
community. When general price level increases, the consumption function shifts downwards
because rise in price level cause fall in real value of the people‘s money balances. Similarly, fall in
price level cause an upward shift in the consumption function.
(ii) Change in wage rate
If wage rate rises, the consumption function shifts upwards. The workers, having high MPC,
spend more out of their increased income. However, if the rise in wage rate is accompanied by a
more than proportionate rise in price level, the real wage rate will fall. This tends to shift
consumption function downward.
(iii) Fiscal policy
Changes in fiscal policy, especially taxation policy affects the consumption function. Heavy
commodity taxation adversely affects the consumption function. Likewise, when government
reduces taxes, consumption of the people increases. At the same time, increased public expenditure
on welfare programmes tends to shift the consumption function upward.
(iv) Rate of interest
Substantial changes in the market rate of interest may influence the consumption function
indirectly. It is generally believed that higher rate of interest induces people to save more and this
results in reducing their propensity to consume. But, this is not true in the case of all the people.
Some individuals, who want a certain fixed income in future might consume more and save less
when rate of interest goes up, as they can obtain the given fixed income with lesser savings.

(v) Windfall gains and losses

Unexpected changes in the stock market leading to gains or losses tend to shift the
consumption function upward or downward. When the prices of shares go up, the shareholders
begin to think themselves better off and it causes an upward shift in their consumption function.
On the other hand, when the prices of share go down, the shareholders have to suffer sudden losses
and tend to reduce their consumption.
(vi) Changes in expectations
Changes in expectations also affect the propensity to consume. When people expect war in
the near future and expect prices to go up, they will try to spend more to meet the needs of current
period. This shifts the consumption function upward. On the contrary, if the prices are expected to
fall in future, people would buy only essential goods. It will lead to a fall in consumption demand
and to a downward shift in consumption function.

(vii) Income distribution

Distribution of income and wealth in the society also determines the shape of consumption
function. If the national income is more unequally distributed, the lower will be the propensity to
consume. This is because propensity to consume of the rich is relatively less as compared to that of
poor. If inequalities are reduced, the consumption function will shift upward because with the
increase in income of the poor, their consumption expenditure will increase more than the reduction
in the expenditure of the rich.
Investment Function:

 Investment is business spending on newly produced capital goods. Capital goods may be
fixed, as in plant and equipment, or variable, as in inventories or working capital (raw
materials, semi-finished goods, and supplies).

 The investment function is negatively sloped with respect to interest rates. More investment
occurs when interest rates are lower and less investment occurs when interest rates are
higher. Lower interest rates make all capital projects more profitable and higher interest
rates make all capital projects less profitable. Businesses buy more profitable capital before
they buy less profitable capital. So, as interest rates decrease, investment increases and as
interest rates increase, investment decreases.

 The elasticity of the investment function determines how effective a change in interest’s
rates is in stimulating investment. The more elastic, the more responsive spending is to small
changes in the interest rate. The less elastic, the less responsive spending is to even large
changes in the interest rate.

 Shifts of the investment function are caused by income and expectations. When income
increases, businesses run out of excess capacity and must buy more plant and equipment to
accommodate more production demanded by more spending from higher income. When
income decreases, businesses cut back on production, produce less output with more excess
capacity, and decrease spending on plant and equipment.

Multiplier & Accelerator Effects

Multiplier process and the accelerator effect, both of which help to explain how we move from
one stage of an economic cycle to another

Multiplier Effects

What is the multiplier process?

 An initial change in aggregate demand can have a much greater final impact on equilibrium
national income
 This is known as the multiplier effect
 It comes about because injections of new demand for goods and services into the circular
flow of income stimulate further rounds of spending – in other words “one person’s
spending is another’s income”
 This can lead to a bigger eventual effect on output and employment

Definition

It is the number of times a rise in national income exceeds the rise in injections of demand that
caused it
Examples of the multiplier effect at work

 Consider a $300 million increase in capital investment – for example created when an
overseas company decides to build a new production plant in the UK
 This may set off a chain reaction of increases in expenditures. Firms who produce the capital
goods and construction businesses who win contracts to build the new factory will see an
increase in their incomes and profits
 If they and their employees in turn, collectively spend about 3/5 of that additional income,
then $180m will be added to the incomes of others.

At this point, total income has grown by ($300m + (0.6 x $300m).

The sum will continue to increase as the producers of the additional goods and services realize an
increase in their incomes, of which they in turn spend 60% on even more goods and services.

The increase in total income will then be ($300m + (0.6 x $300m) + (0.6 x $180m).

Each time, the extra spending and income is a fraction of the previous addition to the circular flow.

Factors that affect the value of the multiplier effect

 The higher is the propensity to consume domestically produced goods and services, the
greater is the multiplier effect. The government can influence the size of the multiplier
through changes in direct taxes. For example, a cut in the rate of income tax will increase
the amount of extra income that can be spent on further goods and services
 Another factor affecting the size of the multiplier effect is the propensity to purchase
imports. If, out of extra income, people spend their money on imports, this demand is not
passed on in the form of fresh spending on domestically produced output. It leaks away from
the circular flow of income and spending, reducing the size of the multiplier.

The multiplier process also requires that there is sufficient spare capacity for extra output to be
produced.

If short-run aggregate supply is inelastic, the full multiplier effect is unlikely to occur, because
increases in AD will lead to higher prices rather than a full increase in real national output. In
contrast, when SRAS is perfectly elastic a rise in aggregate demand causes a large increase in
national output.

In short – the multiplier effect will be larger when

1. The propensity to spend extra income on domestic goods and services is high
2. The marginal rate of tax on extra income is low
3. The propensity to spend extra income rather than save is high
4. Consumer confidence is high (this affects willingness to spend gains in income)
5. Businesses in the economy have the capacity to expand production to meet increases in
demand
The Accelerator Effect

 The accelerator effect is when an increase in national income results in a proportionately

larger rise in investment
 Consider an industry where demand is rising at a strong pace. Firms will respond to growing
demand by expanding production and making fuller use of their existing productive
capacity. They may also choose to meet higher demand by running down their stocks of
finished products.
 At some point – and if they feel that the higher level of demand will be sustained – they
may choose to increase spending on capital goods such as plant and machinery, factories
and new technology in order to increase their capacity. If this investment goes beyond what
is needed simply to replace worn out, fully depreciated machinery, then the capital stock of
the business will become larger.
 In this sense, the demand for capital goods is being driven by the demand for the products
that the firm is supplying to the market. This gives rise to the accelerator effect - the principle
states that a given change in demand for consumer goods will cause a greater percentage
change in demand for capital goods.