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Aggregate Demand and Consumption Function

Aggregate demand and Equilibrium level of output
The aggregate demand is the total amount of goods demanded in the economy.
That is, AD = C + I + G + NX.

The output is at its equilibrium level when the quantity of output produced is
equal to the quantity demanded.
That is, Y = AD = C + I + G + NX

When aggregate demand is not equal to output, there is unplanned inventory

investment or disinvestment.
That is, IU = Y – AD.

Consumption function and aggregate demand

Consumption increases with increase in income. The relation between consumption and
income is described by the consumption function.
Thus,
C = f (Y )
The complete function is C = C + c Y
This shows that consumption is an increasing function of income. There is a part of
consumption which is independent of income.

That is,

C is called autonomous consumption.

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Assume, rest other components of AD Equilibrium level of income and output.

are constant because they are
independent of income.
Thus, we write the AD function now as

AD = A + c Y
Where, A = C + I + G + NX

The AD schedule is shown in

the diagram.

The Equilibrium condition is given by, Y = A + c Y

Since, we have Y on both sides,

we can solve for the equilibrium level of income and output,
1
Y0 = A
1− c
The above equation shows the level of output as a function of the marginal propensity
to consume and autonomous spending.
Frequently, we are interested in knowing how a change in some component of
autonomous spending would change output. We can relate this through:

1
Y0 = A
1− c

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It would mean that, if MPC denoted by c is 0.5, then 1/(1-c) = 2.

So, given increase in government spending, increase the final output by 2 time, i.e., the
output gets doubled. Thus, the equilibrium level of output is higher, larger the marginal
propensity to consume, c, and higher the level of autonomous spending.

To the process of increase in autonomous spending and increase in final income or output is
called multiplier. The multiplier is the amount by which equilibrium output changes when
autonomous aggregate demand increases by 1 unit.

Multipliers & Macroeconomic equilibrium

Multiplier

To the relationship between initial increase in investment and the final

increase in aggregate income is called the ‘Investment Multiplier’ by Keynes,
and others called it ‘Income Multiplier’.

Keynes asserted that investment in a particular industry not only raises output
in that industry but also expands production in other industries, whose
product is demanded by the people employed in the former industry.

The amount of final increase in aggregate income due to a quantum of initial

increase in investment depends upon the Marginal Propensity to Consume
(MPC).

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Working of the Multiplier

Example:
Assume that i) MPC = 0.5, and ii) initial investment is Rs 20 cr.

The value of multiplier will be, k = 1/(1-MPC) = 1/ (1-0.5) = 2

Thus for an initial investment of Rs 20 Crores, the final increase in income with MPC of 0.5 is
Rs 40 Crores.

However, please note that the process of income expansion of Rs 40 crores is not all at once. The income
expansion is spread over a period of time involving several rounds of investment and consumption.

In round 1: income will increase by 20 crores

In round 2: by 10 crores (MPC = 0.5)
In round 3: by 5 crores
In round 4: by 2.5 crores
In round 5: by 1.25 crores
.
.
.

At the end, the total will add up to Rs 40 crores.

Note that multiplier process also works on reverse direction.

Mathematical Derivation of the Multiplier

The following mathematical derivation explains how the Multiplier (k) depends upon the value of MPC.

Since, multiplier is the ratio of change in income to the change in investment.

Symbolically,
Y
k = Where, k is multiplier, Y is income, I is investment
I

Or
 Y = k ( I ) .........................................(1)

Since, Y = C + I

ΔY = ΔC + ΔI

Or ΔI = ΔY – ΔC …………………………………(2)

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Now, substitute equation (2) in equation (1):

ΔY = k (ΔY- ΔC)

ΔY/k = ΔY – ΔC

1 C
Or, =1− (by dividing ΔY on both sides)
k Y

1
Or, k =
C
1−
Y

1 C
Or, k = ...............................................................(3) (Since, = MPC)
1 − MPC Y

1
Alternatively, k = (Since, MPC + MPS = 1)
MPS

Thus, if MPC = 1, k will be infinite; and if MPC = 0, k will be 1.

Impact of the Multiplier on Employment and Income

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Income tax as automatic stabilizers

While, the marginal propensity to consume out of disposable income

remains c, the marginal propensity to consume out of income should be
c(1-t), where 1 – t is the fraction of income left after taxes paid.

For example, if the marginal propensity to consume, c is 0.8 and the tax
rate is 0.25, the mpc out of disposable income, c (1-t), is 0.8 (1 – 0.25) =
0.6.
Y = A + c (1 − t ) Y
The equilibrium condition will be:
1
Y0 = A
1 − c (1 − t )
For the equilibrium level of output:

Accelerator

The acceleration principle explains the process by which an increase in the demand for
consumption goods leads to an increase in investment.

It is based on the idea that the demand for capital goods is derived from the demand for
consumer goods.

Symbolically, β = 𝛥𝐼/𝛥𝐶

Or, ΔI = β ΔC ………………………………………………(1)

Where, ΔI is net change in investment

ΔC is net change in consumption
β is Accelerator.

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Hicks version believed that demand for capital goods is not derived from consumer goods but
any direct demand for national output. Therefore, his equation is given as:

β = ΔI/ΔY Where Y is output.

Thus, the demand for capital goods or the net investment is equal to accelerator times change
in the output. For example, if increase in the output/consumption is 10 crores, given the value
of accelerator, β = 4; investment will increase by 40 crores.

Super-Multiplier
For a satisfactory explanation of income generation, economists have
combined the two concepts: multiplier and accelerator, which is called super-
multiplier.

Here, we start with the assumption that there is an initial autonomous

investment. This autonomous investment increases the final income by
multiplier(k) times. This increase in income/consumption leads to further
induced net-investment by accelerator( ) times, which in turn leads to increase
in income and consumption.

The super-multiplier is dependent on both induced consumption (i.e. MPC =

ΔC/ΔY) and induced investment (i.e. MPI = ΔI/ΔY).

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Hicks divided investment component into autonomous investment and induced investment, so that:

I = I a + i Y .................................................(1), where, i is MPI

Since, Y = C + I

or , Y = C + I
or , Y = c Y + I a + i Y sin ce, c = C / Y , and I = I a + i Y

I a = Y − c Y − i Y

I a = (1 − c − i ) Y

I a
= (1 − c − i )
Y

Y 1
=
I a 1− c − i

1
Ks = ...................................................................(2)
1− c − i
Here, K s is the sup er multiplier
c is MPC
i is MPI

From equation 2, we get:

1
Y = (I a ) .........................................................(3)
1− c − i

Which means that final increase in income is dependent on the Super-multiplier (Ks) times
the initial autonomous investment.

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Numerical example:
Assume, MPC is 0.5, MPI is 0.4 and initial investment of Rs 100 crores.
The final increase in income will be

1 1
Y = ( Rs.100 cr .) = (100 cr .) = 1000 cr
1 − 0.5 − 0.4 0 .1

Thus, a rise in initial autonomous investment of Rs. 100 crores generates the final
income of Rs 1000 crores through super-multiplier effect, whereas the simple multiplier
would have raised the final income to Rs 200 crores only, given K = 2 and initial
investment of Rs. 100 crores.