Determinants of

Consumption

According to the absolute income hypothesis, disposable income is directly related to consumption.
As disposable income increases, consumption increases as well. However, there are other influences
on consumption as well.

For example, according to Dusenbery people in the low and middle income group imitate people in
the high income group. For example, poor people will buy luxury items which rich people buy even if
they are poorer. This is called the demonstration effect. On the other hand, if someone’s income is
relatively high compared to others, a large part of income will not be spent. Thus, the MPC of the
rich will be lower than that of the poor.

In the same way according to the ‘permanent income’ hypothesis, consumption does not depend on
current disposable income but on permanent or expected income. According to this theory if there is
a transitory increase in income people will not adjust their consumption plans upwards. Similarly, if
there is a fall in income below their permanent income people will not reduce their consumption
drastically.

Permanent income refers to the present value of the expected flow of income from existing stock of
human and non-human wealth over a long period of time. Human wealth refers to wages and salaries
whereas non-human wealth refers to income from bonds, stocks, shares and property

Non income determinants of consumption

The consumption level of each individual is affected by a large number of factors such as the price
level, fiscal policy, the rate of interest, windfall gains, expectation, the distribution of income, tastes
and attitudes and age of consumer durables.

The price level influences a large part of the consumption of the public. When the price level or rate
of inflation rises, real income falls causing a fall in the level of consumption. This is called the real
balance effect. However, an indirect relationship between consumption and the price level does not
always exist. For example, if the increase in price is associated with an increase in quality
consumption will not necessarily fall. Similarly, the consumption of goods having snob appeal will
vary directly with the price level.

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Fiscal policy is another important factor influencing the level of consumption. By raising the rate of
tax such as excise duties and VAT consumption can be reduced. Increases in the rate of direct taxes
as well as the introduction of new direct taxes will reduce consumption. On the other hand, the
subsidisation of goods and services raising consumption. Policies such as rationing, and price
controls can also be used to reduce consumption. Under the welfare state the government provides
many social security benefits which increase the level of consumption.

The government can use rate of interest to influence consumption. By raising rate of interest
consumers are motivated to save more reducing consumption. An increase in the rate of interest
means an increased in cost of borrowing. As borrowing falls, consumption also falls. Similarly, the
opportunity cost of consumption when the rate of interest rises is higher. This is because higher
interest can be obtained by sacrificing consumption.

Increases in share prices leads to windfall gains and hence increases in consumption. The size and
nature of assets also influences consumption. The larger the size of financial assets and the higher
the liquidity the assets the higher is consumption.

Expectations also cause consumption to fluctuate. For example, if people expect prices to increase,
they will increase their current consumption.

Normally the poor has a higher MPC then the rich. Thus, a more equal distribution of income will
increase the volume of consumption. This is because the poor will spend a larger part of the increase
in income compared to the rich.

Investment

Investment can have different meaning when viewed from different angles. For the households,
investment may assume the form of buying of shares, bonds or debentures. However, according to
economists, investment refers to the net addition to the stock of physical capital and work in
progress. Any act of spending which raises aggregate demand and adds to the level of income and
employment is investment. It is the process of adding to the stocks of real productive assets or
productive capacity. Investment is also commonly known as the gross domestic fixed capital
formation comprises of three elements namely

 New construction such as houses, factories…

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  Producer durables such as machinery and equipment
 Changes in business stocks or inventories i.e physical increase in the amount of goods
produced but unsold.

The purchase of shares and bonds which are paper assets is a mere transfer of ownership. However,
paper assets held abroad is investment.

Types of investment
Investment may be conceived in terms of gross and net investment. Gross investment includes
depreciation. It refers to the total amount of investment made in the country over a specified period
of time. On the other hand, net investment refers to the real increase in a country’s productive
potential. Net investment is gross investment after adjusting for the depreciation or capital
consumption. Depreciation is the amount of investment necessary to replace that part of the
economy’s existing capital stock that is used up in producing this year’s output. It is the loss in
productive capacity due to wear and tear, the passage of time and technical obsolescence.
Net investment = Gross investment – Depreciation
Investment may also be conceived in terms of ex-ante or ex-post. Ex-ante investment means
planned or anticipated or intended investment. However ex-post investment refers to realised or
actual investment.

Investment can be classified in terms of autonomous (ab) and induced (by) investment. Autonomous
investment means investment which does not vary with the level of income and is exogenously
determined. Autonomous investment is income inelastic and is mainly undertaken by the
government in the form of housing, roads and improving infrastructure. For private investment to
take place, autonomous investment is essential.

Induced investment is investment which is income elastic that is investment which varies with the
level of income, that is, investment which is brought about by a factor which is endogenous to or
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within the theory. Therefore, the higher the level of income/GDP the higher is the induced
investment. Total investment is therefore the sum of induced and autonomous investment.

Investment may be physical as well as human capital. Investment in human capital refers to
expenditure in education and training of workers. Investment in physical capital refers to investment
in factories, stocks of raw materials, offices…which will help to produce other goods and services.

Factors influencing planned investment

1. Marginal efficiency of capital and the rate of interest
The MEC shows the relationship between the rate of interest and the desired stock of capital

The marginal efficiency of capital is also called the expected rate of return on capital or internal rate
of return. It is the profitability of capital assets. It may be defined as the highest rate of return over
cost expected from marginal or additional unit of a capital asset. Any person would consider both
the marginal efficiency of capital and the rate of interest before investing. If the expected rate of
return on capital is greater than the rate of interest, it would be profitable for the person to invest.
However, if the rate of interest is higher than the marginal efficiency of capital, the person would not
invest but prefer to lend since the interest received would be higher than profits from investment.
Consider the table below
M.E.C Rate of Interest Effect on investment
4 4 Neutral
5 4 Favourable
4 5 Unfavourable

The marginal efficiency of capital curve is downwards sloping indicating that more is invested at
lower rate of interest than at higher interest rates.

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A fall in interest rate from r to r 1 causes MEC to rise and hence the level of investment rise from m to
m1.

Normally a fall in ROI is expected to lead to a fall in cost of borrowing and therefore investment
should increase. However, in his General Theory, Keynes found that investment is not much
responsive to low ROI. Recent studies in U.S have proved that ROI is almost as insignificant variable
affecting investment activity. Thus, between the MEC and ROI the MEC is a more important factor.

2. Cost of capital goods

An increase in the price of capital goods will reduce the MEC of an investment project. This is more
relevant if firms cannot pass on the increase in cost to consumers. Consequently, an increase in cost
of obtaining capital goods will reduce the volume of planned investment. The investment curve will
shift to the left.

3. Pump priming
The days of laissez faire capitalism are over. Government action is necessary not only to stabilise but
also to promote private investment with a view to increase employment. It refers to the type of
government expenditure which is designed to stimulate private investment and achieve full
employment for example socially useful projects such as the construction of business parks, roads,
railways, dams, canals, hydro-electric works etc… which provide the necessary infrastructure for
private investment. The provision of these services increases private investment in the economy.
Public investment made in sufficient quantities should be able to stimulate the economy during a
recession. However, pump priming requires expenditure on social overhead capital or infrastructure
be financed by borrowing or incurring a budget deficit but not by taxation.

4. Political and social stability

Investment also depends on political and social stability of a country. Investment where there is
political and social instability is synonymous to losses. The level of investment in countries such as
Nigeria (47th) and Somalia (53rd) is low because of poor stability index. Remarkable increase in
investment occurs in countries where stability exists.

5. Rate of technological innovation

Any economy where technology improves rapidly experiences magnified level of investment. When
technology improves, firms must invest in these capital goods featuring the latest technology

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otherwise they may have a competitive disadvantage compared to its rivals. Technological
improvement will make new capital equipment more productive than previous equipment. This will
increase the rate of return and motivate firms to invest more. This causes the investment curve to
shift upwards.

6. Reduction in Taxation
Taxes on profits reduce MEC and therefore they represent a disincentive to further expand.
Economists such as Hansen advocates drastic reduction in corporate income taxes during recession
to stimulate private investment. This is why in Mauritius holders of Pioneer Certificates are partly or
completely exempted from paying corporation taxes. Similarly, the ‘double tax agreement’ with
member countries avoids investors from paying double taxes and hence increases foreign
investment in Mauritius.

7. Reduction in wage level

Some economists advocate a reduction in wage bill as a measure to stimulate private investment.
Such economists believe that an increase in money wage lead to a reduction wage bill and hence the
demand for cash balances by a firm will fall, leading to a fall in ROI. However, investment is generally
interest inelastic and consequently this measure is not effective. On the other hand, Keynesians
believe that a wage cut is nullified by a fall in effective demand. It is on account of this that
Keynesian such as Hansen, Klein and Harris are opposed to ‘monkeying’ with money wages. They are
inclined to let money wages remain stable instead of subjecting them to general cut.

8. Price support facilities

Instability in prices leads to instability in the level of investment. Therefore, price stability is
important. The government has to intervene to buy and sell essential goods and services in the
market for example by running a buffer stock scheme. In times of shortages it releases stocks and in
times of surplus it should buy. In this way prices remain stable.

9. Increased consumer demand

Investment causes productive capacity to increase and therefore if demand remain constant there is
no reason to make additional investment. Only if demand rises the level of investment will rise.

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 10. Expectations
This is also referred to as ‘animal spirit’. Investment depends on the mood of businessmen. For
example, if they are optimist then investment rises. Expectations are important since businessmen
cannot see into the future to be able to judge the profitability of a scheme with 100% accuracy and
they cannot also tell how future circumstances may change. Thus, they form expectations about
their plans relying on available information.

11. The accelerator (see notes)

12. Other measures

According to Professor Klein authorities should remove monopoly in certain markets since they tend
to suppress further innovations. Thus, existence of a monopoly will cause the level of private
investment to fall. In the way new scientific research should be conducted by non-profit institution.
For example, universities and government scientific institutions should carry such research since any
discoveries will be made known to the public by such institutions.

Importance of investment
Investment is one of the most important macroeconomic aggregate in an economy. Keynes regards
the investment function as the strategic variable which must be tackled skilfully for the purpose of
increasing employment.

Investment is a major constituent of aggregate demand influencing the level of economic activity
significantly. When investment is made aggregate demand rises and via the multiplier the level of
income and employment increase manifold. It is also true that through the reverse multiplier
process a fall in investment cause national income to fall by a magnified rate. For instance, if the
multiplier is 5 and investment increases by Rs1 million, then the level of income and employment
will rise by Rs5 million. Consider the diagram given below. An increase in investment by ∆I will
increase the level of income and employment from Y to Y1

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Any economy is affected by leakages such as saving, taxation and imports and investment is
important to counter them. If investment is not made in sufficient quantities the level of aggregate
demand will fall.

It has been found that unless investment is made, a country’s productive capacity declines by
depreciation. Thus, investment is fundamental not only to maintain productive capacity but also to
improve it. As such employment is generated since it pushes the LRAS curve outwards. Investment is
also essential for economic growth and development as it generates capital formation. With rising
investment productive capacity rises and so does LRAS

Investment is also necessary for research and innovation. Given the rise in competition firms are
bound to invest in research and development so as to be more competitive and to reduce costs.

The ‘crowding out’ effect

It is the possibility that an increase in one form of spending causes another form to fall. In this case
an increase in government investment will reduce the level of private investment. Normally money
supply is fixed. If the government finances its investment by borrowing from the banking system,
this will cause an increase in the demand for loanable funds. As a result, the rate of interest rises.
This increase in the rate of interest will increase the cost of borrowing implying a fall in the
profitability of investment plans. Thus, private investors will be demotivated to invest. Private
investors are also discouraged to invest if the government raises taxes on incomes and profits to
finance its investment. In this situation too, the rate of interest is increased. Hence it is said that
public investment drives out private investment.

The difference between planned and actual investment

It is important to note that planned investment spending rather than actual investment spending is
the component of aggregate expenditure.

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Changes in inventories are included as part of investment spending. Assume that the amount
businesses plan to spend on machinery and office buildings is equal to the amount they actually
spend but the amount businesses plan to spend on inventories may be different from the amount
they actually spend.

For example, Master Printing may print 1.5 million copies of the latest John Grisham novel, expecting
to sell them all. If it succeeds in selling all copies, inventories will be unchanged. However, if it sells
only 1.2 million copies it will have an unplanned increase in inventories. Hence changes in
inventories depends on sales which firms cannot always accurately predict.

It can therefore be concluded that actual investment spending will be greater than planned
investment spending when there is an unplanned increase in unplanned inventories. Actual
investment spending will be less than planned investment spending when there is an unplanned
decrease in inventories. Actual investment will be equal to planned investment only when there is
no unplanned change in inventories.
This relationship may be expressed as
Actual investment = planned investment + Changes in inventories

The Accelerator
The theory of the accelerator was developed by Albert Aflation and refined by J.M Clark. The
rationale of the profit theory is that the behaviour of realised profits guides businessmen in judging
future profits. Thus, higher current profits promise higher future profits. Consequently, businessmen
are motivated to acquire additional capital goods to produce more goods.

The accelerator theory denies that the level of profits plays this strategic role. Its rationale is that the
incentive to acquire more capital goods arises not because the current profit record is favourable
but because increases in demand are putting pressure on firm’s productive capacity. An increase in
productive capacity requires an expansion of the capital stock, which in turn calls for higher rate of
investment. Accordingly, the rate of investment spending depends on the rate of change in the level
of output/income. The acceleration principle states that the demand for capital goods varies directly
with the change in the level of output. The accelerator theory relates investment to changes in
national income.

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The extent of change in the demand for capital goods depends on the capital-output ratio(ΔK/ΔY),
durability of capital stock and the change in the level of output. It should be noted that changes in
the level of output depends on the level of aggregate demand. Thus, the accelerator can be refined
as the multiple increases in investment to a given increase in demand. The accelerator can be found
by the following formula
V = I / Y
Assumptions
1. All resources must be fully utilised i.e there should not be excess capacity.
2. Firms increase capital stock in response to any increase in demand without any
consideration of the type of demand.
3. There should be a fixed capital output ratio and the impact of technological improvements is
ruled out.
4. The supply curve of capital goods is perfectly elastic. In other words, supply of capital goods
can be increased indefinitely.
5. Capital goods are perfectly divisible.
Illustration 1 assume the capital output ratio to be 5:1
Year Annual Sales Change in sales Required capital Net investment (Increase in
(millions) (millions) stock (millions) required capital stock) (millions)
1 10 0 50 0
2 10 0 50 0
3 11 1 55 5
4 13 2 65 10
5 16 3 80 15
6 19 3 95 15
7 22 3 110 15
8 24 2 120 10
9 25 1 125 5
10 25 0 125 0

From the table given above it can be seen that as annual sales (a proxy for aggregate demand)
increases there is a corresponding increase in the required capital stock which represent investment.
For example, when sales increase from 10m to 11m in year 3, there is a net increase in the amount
of capital stock by 5m. Similarly, for any given increase in sales, required capital rises by 5 times

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which is the capital-output ratio. Note that if the value of the accelerator exceeds one the required
increase in aggregate capital stock will exceed the increase in the demand for the final output.

Limitations of the acceleration principles

The principle of acceleration has come in for a good deal of criticism in recent years. For example, it
has been pointed out by Kaldor that we cannot assume a constant value of the accelerator
throughout the trade cycle, that is, it is not true that an increase in output or income by an amount
must always give rise to a multiple increase in investment.
1. The theory of the accelerator assumes that there is no excess capacity. However, firms do
have excess capacity and therefore production can be increased without any increases in the
level of investment. Production can also be increased if producers have recourse to extra
shift work. Similarly, the firm may have excess stocks which can be used to meet rising
demand instead of investing.
2. Normally investors will not increase investment if demand is of temporary nature. Other
measures such as overtime will be used to meet the increase in demand. Similarly, the
willingness of firms to invest will depend on their confidence in future demand. Firms will
not rush out and spend large amounts of money on machines that will last for many years if
it quite likely that demand will fall back again the following year.
3. The accelerator principle provides an explanation for induced investment but cannot explain
replacement investment and investment in research and development.
4. It is assumed that the capital-output ratio is constant and that technological advancements
are ruled out. However, the capital output ratio can change due to technological
improvements.
5. The theory also assumes that there is no ceiling for investment that is the supply curve of
capital goods is perfectly elastic. No matter how quickly demand increases necessary capital
is easily available and spare capacity exists in the capital making industries. However, it takes
a certain period of time to produce capital goods. Consequently, the supply curve cannot be
perfectly elastic. Thus, investment is not also responsive to increases in demand. There is a
time lag.
6. It is assumed that capital goods are perfectly divisible
7. Firms may make their investment plans a long time in advance and may be unable to change
them quickly.
8. Machines do not as a rule suddenly wear out. A firm could thus delay replacing machines
and keep the old ones for a bit longer if it was uncertain about its future level of demand.

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However, in spite of the above limitations of acceleration principle, it points out an important force
which causes economic fluctuations in the economy. Economists like Samuelson, Hicks and
Dusenberg have shown how accelerator combined with multiplier provides an adequate and
satisfactory theory of business cycles that occur in free market economies.

Why the accelerator model considers induced investment rather than autonomous/replacement
investment?
When there is no change in income and hence no change in consumption, the only investment
needed is a relatively small amount of replacement investment for machines that are wearing out or
have become obsolete. When income and consumption increase, however, there will be new
investment in order to increase production capacity. This is called induced investment (Ii). Once this
has taken place, investment will fall back to mere replacement investment (Ir) unless there is a
further rise in income and consumption.
Thus, induced investment depends on changes in national (ΔY)
Ii = vΔY,
where v is the amount by which induced investment depends on changes in national income, and is
known as the accelerator coefficient. Thus, if a £1 million rise in national income caused the level of
induced investment to be £2 million, the accelerator coefficient would be 2.

Inflationary and deflationary gap

In Keynesian analysis, it is assumed that there is a maximum level of national output and hence a
maximum amount of real income that can be obtained at time. This level of output is known as the
full employment level of national income. Full employment national income refers to national
income at which there is no deficiency of aggregate demand. Thus, there is no unemployment.
However, in practice certain form of unemployment such as frictional, seasonal and structural may
exist.

Keynes argues that the point of effective demand (Ye) that is the equilibrium level of income must
not necessarily be the point of full employment (Yf). In fact, the point of effective demand can be
before or after the point of full employment as illustrated below.

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From the diagram above it is deduced that the point of equilibrium Y e differs from the point of full
employment Yf. The point of equilibrium is below the point of full employment implying that not all
resources are being used. Thus, unemployment occurs in the economy. The deflationary gap is the
amount by which aggregate demand must be increased to push the equilibrium level of income to
the full employment level. The deflationary gap is given by the distance AB and CD. It is important to
note that the deflationary gap is less than the amount by which Y e falls short of Yf.

The unemployment that occurs, result from a deficiency in aggregate demand. Keynesians proposed
inflationary fiscal and monetary policies to close the deflationary gap. Government expenditures can
be increased and also the rate of interest and cash reserve ratio can be reduced.

Inflationary gap represents the amount by which aggregate demand must be decreased to reduce
the equilibrium level of income to full employment level. In other words, it is the excess of national
income expenditure over full employment national income. From the diagram above the economy is
in equilibrium at point Ye and it is operating at full employment at Y f. Consequently, expenditure
exceeds income by GH at Yf which represents the inflationary gap. Similarly, injections exceed
withdrawals by GH.

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The inflationary gap representing excess demand, will force the general price level upwards if left
uncontrolled. Thus, appropriate deflationary fiscal and monetary polices should be used to combat
inflationary pressures. Such policies may include increases in direct taxes, reduction in government
spending, increases in the rate of interest and cash ratio and selling of government T-bills.

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