National income

It is defined as the total volume of all goods and services produced in a country within a given period of
time usually one year expressed in monetary units or the monetary value of all goods and services
produced in a country within a given year.

Methods or Ways of Evaluating or Measuring National income. There are three main ways by which
the expenditure method.

1.THE OUTPUT METHOD. With this method the national income is determined by summing up all values
added to production in the primary, secondary and tertiary sector of the economy.

Accounting procedure.

STEP 1.THE SUM OF VALUES ADDED TO PRODUCTION IN THE PRIMARY, SECONDARY AND TERTIARY
SECTOR

=TOTAL DOMESTIC OUTPUT (TDO)

STEP 2. TDO +RESIDUAL ERRORS – STOCK APPRECIATION (or +STOCK DEPRECIATION) –ADJUSTMENTS
FOR FINANCIAL SERVICES

=GROSS DOMESTIC PRODUCT at Factor cost (GDPfc)

STEP 3. GDPfc+NET PROPERTY INCOME FROM ABROAD

=GROSS NATIONAL PRODUCT AT FACTOR COST (GNPfc)

STEP 4. GNPfc – DEPRECIATION

=NET NATIONAL PRODUCT AT FACTOR COST (NNPfc) or the NATIONAL INCOME

2. THE INCOME METHOD. With this method the National Income is determined by summing up all
factor incomes (all the rewards) paid to the various factors of production used in producing the national
output. These include wages and salaries as well as income form self employment, rents, interest and
imputed charges for the consumption of non trading capital, profits and dividends including
undistributed profits of companies and trading surpluses of public Corporations.

Accounting procedure

Step 1.SUM OF FACTOR INCOMES

=TOTAL DOMESTIC INCOME (TDI)

STEP 2. TDI +RESIDUAL ERRORS– STOCK APPRECIATION (or +STOCK DEPRECIATION)

= GROSS DOMESTIC INCOME AT FACTOR COST (GDIfc)

Step 3. GDIfc+NET PROPERTY INCOME FROM ABROAD

=GROSS NATIONAL INCOME AT FACTOR COST (GNIfc)

STEP 4. GNIfc – DEPRECIATION

=NET NATIONAL INCOME AT FACTOR COST (NNIfc) or the NATIONAL INCOME

3. The Expenditure Method

With this method the national income is determined by summing up all final expenditures made by
firms, households and governments on goods and services. Final expenditures are summarised in the
aggregate money demand equation given as C+I+G+X-M
Where
C=Consumers expenditures on goods and services,
I = Gross Investments
G = Government Expenditures on goods and services
X =Export of goods and services
M=Import of goods and Services
Note that there are 2 main components of Gross Investments;
Firstly the addition to stocks or changes in Stocks or the Value of physical increase in stocks, which is the
accumulation of Stocks over the period; that is STOCKS OF 31st December –Stocks of 1st January.

Secondly Gross Capital Formation or gross Expenditures on fixed Capital or Gross formation of fixed
Capital.

Accounting procedure.

STEP 1. C+I+G =TOTAL DOMESTIC EXPENDITURES at Market price (TDEmp)

C+I+G+X = TOTAL FINAL EXPENDITURES AT market price (TFEmp)

C+I+G+X-M =GROSS DOMESTIC EXPENDITURES at market price (GDEmp)

STEP 2. (GDEmp) –INDIRECT TAXES +SUBSIDIES

=GROSS DOMESTIC EXPENDITURE AT factor cost (GDEfc)

STEP 3. GDEfc+NET PROPERTY INCOME FROM ABROAD

=GROSS NATIONAL EXPENDITURE AT factor cost (GNEfc)

STEP 4. GNEfc – DEPRECIATION

=NET NATIONAL EXPENDITURES AT factor cost (NNEfc) or the NATIONAL INCOME

 Problems encountered when measuring National Income.

A. Problems of the out put method.

1. The problem of double counting where the value of a product may be counted more
than once. This occurs because the output of certain sectors are used as inputs of other
sectors. The solution is to consider only the values added at each stage of the
production of a good or only the value of the final product. Eg consider the table below
showing the various stages involved in the production of a chair.

We observe that the sum of the values added is equal to the value of the final product.

Note that Adjustment for Financial Services (AFS) is to avoid double counting in the financial sector.

2. The problem of stock appreciation and Stock depreciation. Stock appreciation is the
increase in the values of stock not due to their physical increase but due to price
increase or inflation. It increases the values of Stocks unnecessarily when actually real
output has not increased. The solution is to subtract the element of stock appreciation.

Stock depreciation on the other hand is the decrease in stock values not due to their physical
decrease but due to falling prices or deflation. As such it has to be added.

3. The problem of self produced and self or auto consumed goods and services. These are
goods and services which are produced and consumed without passing through the
market circuit as such they are not recorded. For example the services of house wifes,
house servants, farm to mouth gardening, undertaking personal repairs etc. The
solution is to make estimates of these outputs and include in the national income.
4. The problem of the black economy ( Hidden or underground economy). These are those
income generating activities which are not recorded mainly because they are illegal and
or due to tax evasion. Examples include prostitution, arm robbery, drug trafficking,
gambling etc. Where it is difficult to evaluate these outputs, estimates have to be made
and included in the national income.
5. Difficulties in estimating the output of the public sector. This is because public goods
and services do not have market prices. The solution is to evaluate them from their
 factor cost. That is, sum up all factor incomes paid to the various factors of production
engaged in providing the public good.
6. Some of the output consist of imported materials as such care should be taken to
ensure that these materials are not included.
B. Problems of the income method.
1. Double counting of income should be avoided. Only final incomes should be included.
2. Personal incomes in the Form of transfer payments like pension and family allowance,
unemployment allowance, students grants and scholarships etc should not be included.
These are payments made to citizens for no corresponding work done.
3. Income from self employment should be included as part of wages. Also imputed
charges for the consumption of non trading capital should be included as part of
interest. These are charges on capital which is no used directly in trading by the firm.
Also trading surpluses of companies and undisturbed profits of Companies should be
considered as part of profits.
4. Note should also be taken of income generated from the black economy. And the non
monitories economic activities.
5. Incomes may increase due to stock appreciation or reduce due to stock depreciation as
such it should be treated accordingly.
C. Problems of the expenditure method.
1. Double counting of expenditures should be avoided. Only final expenditures should be
included.
2. Expenditures are always recorded at market price and as such they must be converted
to their corresponding factor cost. This is done by subtracting indirect taxes and adding
subsidies. Indirect takes are t subtracted since they increase market prices while
subsidies are added since they reduce market prices.
D. General problems.
1. Inadequate information concerning the NI of a country. This is due to the inaccessibility
of certain areas. Statisticians cannot go to some remote areas to collect the
information. The solution is to improve on the transport and communication net work.
2. Lack of well trained statisticians especially in less developed countries to collect the
information. The solution is to educate and train the statisticians.
3. Ignorance and illiteracy. Some people refuse to provide information about their
production activities because of ignorance and illiteracy and or due to tax evasion. The
solution is to educate

People on the importance of collecting NI statistics.

4. The is a tendency for statisticians to make errors and omissions during the collection of
the statistics. The solution is that statisticians include the residual error item to correct
for any errors and omissions. However for convenience reasons, it is limited only to the
output and income method.
 5. Some of the income comes from property held abroad while some property income
tends to move to abroad. The solution is to obtain the net property income from abroad
by subtracting the income to abroad from the income from abroad (property income
from abroad – property income to abroad) and add to the domestic product to obtain
the national product.
6. The is the tendency for materials and equipment produced to face wear and tear that is
to depreciate. A country is said to be living on its capital if its capital stock is facing wear
and tear and is not replaced. This is also known as capital consumption. The solution is
to subtract the element of depreciation from the gross product to obtain the net
product.

Importance or use of national income statistics (why do countries measure their national
income)

1. It is used for measuring changes in living standards. If the national income of a country
increases from one period to another, every thing being equal, it will imply that it’s living
standards have increased, since more goods and services would have been produced.
2. It is use for international comparison. That is for comparing living standards and the level of
development amongst nations. If country A has a higher national income than country B, every
thing being equal, it will imply that living standards are higher in country A than in country B or
country A is more developed than B. However care should be taken when using national income
for measuring changes in living standard or for making international comparison because it may
not necessarily be true.
3. It is used for economic forecasting and prevision. When the national income of a country is
steadily rising from one period to another, it will indicate that the country may eventually
experience a boom. If it is steadily falling, it may indicate a depression around the corner. As
such the government should start taking corrective measures.
4. It is used for taxation purpose. The tax structure of a country depends on its national income.
Generally, if the national income is increasing, taxes can be increased and vice versa. Those
sectors that contribute more to the National income will be taxed more.
5. It is used for economic planning. The short, medium and long term development plans of the
government depends on its national income. The government cannot carry out effective
planning without knowing its income or what it is producing.
6. It is used as a basis for determining the flow of foreign aid from donor to recipient countries.
Generally countries with low national income receive more foreign aid than those with high
national income.
7. It is used to determine the amount of contribution or quota each country has to make to some
international organizations like the IMF, world bank etc. Countries with high national income
contribute more to these organizations than those with low national income

Criticism for using national income in measuring changes in living standards or for making
international comparison.
NB: Even though a country may have a high national income, it may not necessarily mean that its living
standard is high or that it is more developed than another country for the following reasons.

1. A country may have a high national income but it is accompanied by a rising population. As such
it’s living standards may be low. The population may be rising faster than the national income,
making the per capita income to instead decline. On the other hand a country with a low
national income but with a low or falling population may end up with a higher standard of living
since its per capita income may be higher.
2. The level of prices or inflation also matters. A country can have a high national income but it is
due to rising prices or inflation, since national income is measured in monetary terms. As such
the living standards will be low compared to another country with a low national income which
has been as a result of falling prices. That is why it is even most appropriate to compare
countries using but the real per capita income where adjustments for inflation have been made.
3. The composition of the GNP is also important. A country may have a high national income but it
is composed mostly of military expenditures or heavy capital equipment. As such the living
standards will be low compared to another country with a low national income but which is
composed of mostly consumers goods.
4. The distribution of the GNP is also important. A country may have a high national income but it
is not evenly distributed amongst its citizens. The income may be concentrated only in the
hands of the few rich. As such the living standards will be low compared to another country
with a low national income but which is more evenly distributed amongst its citizens.
5. The time taken to produce the national income is also important. Some countries have very
high national income because their citizens have spent much time for work in producing the
national income with little or no time for leisure. As such the living standards will be low
compared to another country with a low national income but with much time for leisure.
6. The volume of externalities should also be taken into consideration. Some countries have very
high national income but it is accompanied with heavy social cost like air water and land
pollution due to heavy industrial activities. As such the living standards will be low compared to
another country with a low national income but with a lesser volume of these social cost.
7. The quality of the output is also important. Some countries have very high national income but
the GNP is of low quality. For example China. Other countries have high national income with
high quality products. E.g. most European countries, making their living standards to be much
higher.
8. Some countries have high national income but most of the income is used to fight against
natural disasters like extreme cold, earthquakes floods etc. Their living standards will not
necessarily be high compared to other countries with low national income where these natural
disasters are absent.
9. The method of calculating and computing the statistics is also relevant. Some countries have
high national income because they have been able to include some of the underground and non
monitories economic activities. E.g. in most European countries nowadays, the activities of
prostitutes are included. It is the sex industry which falls under the tertiary sector. In other
countries, these same activities are not included making their GNP to be low.
Importance or use of national income statistics (why do countries measure their national income)

1. It is used for measuring changes in living standards. If the national income of a country
increases from one period to another, every thing being equal, it will imply that it’s living
standards have increased, since more goods and services would have been produced.
2. It is use for international comparison. That is for comparing living standards and the level of
development amongst nations. If country A has a higher national income than country B, every
thing being equal, it will imply that living standards are higher in country A than in country B or
country A is more developed than B. However care should be taken when using national income
for measuring changes in living standard or for making international comparison because it may
not necessarily be true.
3. It is used for economic forecasting and prevision. When the national income of a country is
steadily rising from one period to another, it will indicate that the country may eventually
experience a boom. If it is steadily falling, it may indicate a depression around the corner. As
such the government should start taking corrective measures.
4. It is used for taxation purpose. The tax structure of a country depends on its national income.
Generally, if the national income is increasing, taxes can be increased and vice versa. Those
sectors that contribute more to the National income will be taxed more.
5. It is used for economic planning. The short, medium and long term development plans of the
government depends on its national income. The government cannot carry out effective
planning without knowing its income or what it is producing.
6. It is used as a basis for determining the flow of foreign aid from donor to recipient countries.
Generally countries with low national income receive more foreign aid than those with high
national income.
7. It is used to determine the amount of contribution or quota each country has to make to some
international organizations like the IMF, world bank etc. Countries with high national income
contribute more to these organizations than those with low national income.

Criticism for using national income in measuring changes in living standards or for making
international comparison.

Even though a country may have a high national income, it may not necessarily mean that its living
standard is high or that it is more developed than another country for the following reasons.

1. A country may have a high national income but it is accompanied by a rising population. As such
it’s living standards may be low. The population may be rising faster than the national income,
making the per capita income to instead decline. On the other hand a country with a low
national income but with a low or falling population may end up with a higher standard of living
since its per capita income may be higher.
2. The level of prices or inflation also matters. A country can have a high national income but it is
due to rising prices or inflation, since national income is measured in monetary terms. As such
the living standards will be low compared to another country with a low national income which
 has been as a result of falling prices. That is why it is even most appropriate to compare
countries using but the real per capita income where adjustments for inflation have been made.
3. The composition of the GNP is also important. A country may have a high national income but it
is composed mostly of military expenditures or heavy capital equipment. As such the living
standards will be low compared to another country with a low national income but which is
composed of mostly consumers goods.
4. The distribution of the GNP is also important. A country may have a high national income but it
is not evenly distributed amongst its citizens. The income may be concentrated only in the
hands of the few rich. As such the living standards will be low compared to another country
with a low national income but which is more evenly distributed amongst its citizens.
5. The time taken to produce the national income is also important. Some countries have very
high national income because their citizens have spent much time for work in producing the
national income with little or no time for leisure. As such the living standards will be low
compared to another country with a low national income but with much time for leisure.
6. The volume of externalities should also be taken into consideration. Some countries have very
high national income but it is accompanied with heavy social cost like air water and land
pollution due to heavy industrial activities. As such the living standards will be low compared to
another country with a low national income but with a lesser volume of these social cost.
7. Quality of the output is also important. Some countries have very high national income but the
GNP is of low quality. For example China. Other countries have high national income with high
quality products. E.g. most European countries, making their living standards to be much
higher.
8. Some countries have high national income but most of the income is used to fight against
natural disasters like extreme cold, earthquakes floods etc. Their living standards will not
necessarily be high compared to other countries with low national income where these natural
disasters are absent.
9. The method of calculating and computing the statistics is also relevant. Some countries have
high national income because they have been able to include some of the underground and non
monitories economic activities. E.g. in most European countries nowadays, the activities of
prostitutes are included. It is the sex industry which falls under the tertiary sector. In other
countries, these same activities are not included making their GNP to be low.

NOMINAL AND REAL NATIONAL INCOME

Nominal National income is the National Income measured at current prices. It measures the national
income from one year to another based on the current prices of each year. It is the therefore the
national income where no adjustments for inflation have been made.

Real National Income is the national income measured at constant prices. It measures the National
Income from one year to another assuming that prices are constant. It is therefore the National Income
where adjustments for inflation has been made.

The Nominal National Income can be converted to the Real National Income using the formula
Real National Income=Nominal National Income X 100
Price index 1

THE CIRCULAR FLOW OF INCOME

It is the continuous flow of income from firms to households and vice versa. The national income is in a
continuous flow moving from firms to household and vice versa as shown.

There are 2 main types of flow

1.Real flows. House holds supply factors of production to firms. Firms convert these factors of
production into goods and services which are consumed by the households.
2. Monetary flows. When households supply factors of production, they are rewarded with factor
incomes like wages interest rents and profits. They use these factor incomes to make payments for the
goods and services.

TYPES OF ECONOMY, THEIR CIRCULAR FLOW AND EQUILIBRIUM INCOME

1.THE TWO SECTOR SPEND THRIFT ECONOMY. This is an economy where all what is produced is
consumed. There are no injections and there are no withdrawals or Leakages. The diagram represents
the summary of the circular flow as shown.

An injection is any addition of income into the circular flow. That is any increase in the income of
Households which is not coming from the spendings of firms or any increase in the income of firms
which is not coming from household spendings. For example when firms borrow from banks to carry out
investments or when Government carry out expenditures in the economy through firms or when firms
generate revenue from exportation. Therefore typical injections are Autonomous Investments,
Government Spendings and Exports.
A Withdrawal or Leakage is any income which is not passed back into the Circular flow. For example
when household save their incomes in banks or when they pay taxes to the government or when
households import goods from other countries. therefore typical leakages are Savings, Taxes and
Imports.

Determination of the equilibrium income. The equilibrium income is defined as that income level
where there is no tendency for the income to rise or fall. It can be determined in two ways that is the
Aggregate money demand approach and the injection withdrawal approach.

The Aggregate Money Demand (ADM) Approach. With this approach, for National Income to be at
equilibrium, it must be equal to the AMD. That is; Y=AMD. AMD refers to total purchasing power or
spendings in an economy.

If income (Y) is greater than AMD, it implies that the output by the firms in the economy is greater than
the global demand or purchasing power of the citizens. Firms are producing but the citizen’s purchasing
power is not sufficient enough to absorb the output. The tendency will be that the firms will want to
contract production. As such the national output or income will have the tendency of falling and it will
not be at equilibrium.

income (Y) is lesser than AMD, it implies that the output by the firms in the economy is lesser than the
global demand or purchasing power of the citizens. The output by the firms in the economy is not
sufficient enough to satisfy the total demand or purchasing power of the citizens. The tendency will be
for the firms to expand production. As such the national income will have the tendency of rising and will
still not be at equilibrium.
The income will only be at equilibrium when it is equal to the AMD and the is no tendency for the
Income to rise or Fall.

The injection withdrawal approach. With this approach, for the national income to be at equilibrium,
the sum of injections must be equal to the sum of withdrawals. That is; Sum of J=Sum of W

If the sum of injections is greater than the sum of withdrawals, it means the addition of income into the
circular flow is greater than the income withdrawn out of the circular flow. As such the income of the
system will have the tendency of rising and will not be at equilibrium.

If the sum of Withdrawals is greater than the sum ofInjections, it means the income which is withdrawn
from the circular flow is greater than the income which is added into the circular flow. As such the
income of the system will have the tendency of falling and will still not be at equilibrium.
The income will only be at equilibrium when the sum of Injections is equal to the sum of Withdrawals
and the is no tendency for the Income to rise or Fall.

Note that since in the 2 sector spend thrift economy all what is produced (Y) is consumed (C) that is Y=C
it implies the income equal the aggregate demand and hence the economy is at equilibrium following
the AMD approach.
Also since there are no injections and there are no Withdrawals, it implies the economy is at equilibrium
following the injection withdrawal approach.
2.THE TWO SECTOR FRUGAL ECONOMY. This is similar to the two sector spend thrift economy but in
addition, there are financial institutions or banks where household save and firms borrow to carry out
investments. The circular flow diagram is shown below.

Since there are 2 components of spending or AMD that is consumption (C) and Investments (I), it implies
at equilibrium, with the AMD approach,
Y=C+I
With the injection withdrawal approach, since the is only one injection Investments (I) and only one
leakage Savings (S), it implies at equilibrium,
I=S
3. THE THREE SECTOR GOVERNED ECONOMY. This is similar to the 2 sector frugal economy but in
addition, government activity is introduced into the system where households are taxed and the
government carry out expenditures in the economy through firms as shown.

At equilibrium, with the AMD approach, Y=C+I+G

With the injection withdrawal approach, I+G=S+T
4. THE FOUR SECTOR OPENED ECONOMY. This is similar to the three sector governed economy but in
addition the economy is now opened up to international trade with the rest of the world where firms
export (X) and households Import (M) as shown.
At equilibrium, with the AMD approach, Y=C+I+G+X-M
With the injection Withdrawal approach, I+G+X =S+T+M

GRAPHICAL REPRESENTATION OF THE EQUILIBRIUM INCOME.

The equilibrium income can be represented graphically using the AMD approach and the injection
withdrawal approach.
With the AMD approach, a graph of income on the X-axis and AMD on the Y-axis is plotted. A 45 degree
line is included. This is a line showing equality between income and AMD. Where the AMD curve cuts
the 45 degree line, the equilibrium income is attained because at this point the income equal the AMD
as shown.

Assume a 2 sector economy where AMD IS C+I and there is only one injection I and only one leakage S.
Clearly the equilibrium income is Ye where the AMD curve (C+I) cuts the 45 degree line because at this
point the income will be exactly equal to the AMD.

If the full employment output was at Yf1, the income OYf1 or BYf1 will be lesser than the AMD AYf1. This
creates an INFLATIONARY GAP given by the distance AB which is defined as the amount by which AMD
exceeds national output or income at full employment. An Inflationary gap tends to exist because prices
will have the tendency of rising since aggregate demand is greater than aggregate supply or National
output. Also the income will have the tendency of rising and will not be at equilibrium.

If the full employment output was at Yf2, the income OYf2 or CYf2 will be greater than the AMD DYf2.
This creates a DEFLATIONARY GAP given by the distance CD which is defined as the amount by which
national output or income exceeds AMD at full employment. A Deflationary gap tends to exist because
prices will have the tendency of falling since aggregate supply or National output is greater than
aggregate demand. Also the income will have the tendency of falling and will not be at equilibrium.

Beneath this, the graph of injection investment (I) and withdrawal savings (S) is plotted. The equilibrium
income is equally attained where the injection (I) equal the withdrawal (S).
At Yf1, injection (I) is greater than withdrawal (S) as such the income will have the tendency of rising and
will not be at equilibrium. This equally creates an INFLATIONARY GAP given by the distance A’B’, which
can also be defined as the amount by which Injections exceed Withdrawals at full employment.
At Yf2, Withdrawals (S) is greater than Injections (I) as such the income will have the tendency of falling
and will still not be at equilibrium. This equally creates a DEFLATIONARY GAP given by the distance C’D’
which can also be defined as the amount by which Withdrawals exceed Injections at full Employment

CONSUMPTION
It is the usage of commodities for the satisfaction of human wants. Consumption spendings are
spendings carried out by households on consumer goods and services, both durable and non durable.
The propensities to Consume
Marginal propensity to consume. It is the change in consumption resulting from a given change in
income or the proportion of additional income which is consumed.

MPC=Change in Consumption =C2-C1

Change in Income Y2-Y1

The Average propensity to consume. It is the fraction of income which is spent on consumption.

APC=Consumption =C
Income Y

THE CONSUMPTION FUNCTION. The typical consumption function is written as

C=aY+Co where a is the MPC, Y is Income , Co is autonomous Consumption and aY is induced
consumption.
According to the Keynesian, Consumption is made up of two components; that is autonomous
consumption and induced consumption. Induced consumption is consumption which depends on
income while Autonomous consumption is consumption which does not depend on income. Even if
income is zero; that is even if an economy is not producing, its consumption will not be zero. Such
autonomous consumption is possible due to de-savings or deepening into past savings, through
borrowing and through foreign aid.

Change in consumption and a shift of the consumption function. A change in consumption is a

movement along the same consumption function or curve and it is due to changes in income.

When income increases from Y1 to Y2, Consumption increases from C1 to C2, and when income falls from
Y2 to Y1, Consumption falls from C2 toC1.

A shift of the consumption function is a complete displacement of the whole consumption function or
curve either upward which represents an increase in consumption or downward which is a decrease in
consumption. It is not due to changes in income but it is due to changes in those factors influencing
consumption.

Even at the same income level Y*, Consumption can increase from C* to C1 or can reduce from C* to C2.

Factors influencing consumption (Determinants of Consumption)

Even though the main determinant of consumption is the level of income, there are other factors that
affect consumption even if income does not change which include
1. The level of disposable income. Disposable income is income left after subtracting direct taxes but
including transfer payments. When direct taxes are reduced or when transfer payments like pension,
family allowance etc are increased, disposable will increase which will increase consumption. When
direct taxes are increased or when transfer payments are reduced, disposable income will increase
which increase consumption.
2.The distribution of income. If income is more evenly distributed amongst the citizens, the impact on
consumption will be greater than if it is concentrated in the hands of a few rich. Generally, the poor or
low income earners tend to have a greater propensity to consume than the rich or high income earners.
That is poor people tend to spend a greater proportion of their income on consumption than the rich.
Therefore if income is evenly distributed to benefit the poorer mass, consumption will be greater than if
the income is mostly in the hands of the few rich.
3. The availability of credit facilities. When credit facilities like hire purchase, credit sales etc are
available, consumption tends to increase especially for durable consumer goods like cars ,TV, etc. in
most developed countries, consumption tends to be high for such durable commodities since they have
a lot of credit facilities.
4. The distribution of wealth. This affects consumption in the same way as income distribution. If wealth
is more evenly distributed amongst the citizens, the impact on consumption will be greater than if the
wealth is concentrated in the hands of a few rich.
5.The rate of interest. If interest rates are low, people will be encouraged to take loans from banks
which will increase consumption. If interest rates are high, people are discouraged to take loans which
will reduce consumption.
6. The spending habit of the community. In spend thrift societies consumption tends to be high. But in
thrifty societies where people consider savings as a good moral habit, consumption tends to be low.
7. Expectation of future price changes. When people are expecting a general rise in future price level
they tend to increase their consumption because they want to avoid the higher prices in future. When
they are expecting a fall in the general price level, consumption tends to reduce because people want to
wait for the prices to eventually fall before they can buy.
8. Changes in population size and structure. Generally when population size increases, global
consumption tend to increase and vice versa. Changes in population structure also affects consumption.
Generally a youthful population has a greater effect on consumption than an ageing population.

SAVINGS
Savings is that part of income which is not consumed but is kept aside for future use.
The propensities to save.
The marginal propensity to save. It is the change in savings resulting from a change in income or the
proportion of additional income which is saved.

MPS=Change in savings = S2-S1

Change in income Y2-Y1

Average propensity to Save. It is the fraction or proportion of income which is saved.

APS=Savings =S
Income Y
Factors influencing savings
1.The level of income. When level is high, savings will be high but when income levels are low, savings
tend to be low.
2.The rate of interest. When interest rates on savings are high, people are encouraged to save but when
interest on savings are low, people are discouraged to save.
3. The availability of savings institutions. When savings institutions such as banks, Njangi houses etc. are
available, savings tend to increase and vice versa.
4. The level of taxes. Governments policies on taxes tend to affect people’s savings. When the
government increase direct taxes the disposable income of the citizens will fall which will reduce
savings. When direct taxes are reduced, disposable income increase which increase savings. High
indirect taxes also increase expenditures making people to have less for savings and vice versa.
5. The spending habit of the community. In thrifty societies where savings is considered as a good moral
habit, savings tend to be high. But in spend thrift societies, savings are generally low.
6. The purpose of the savings. When people have a particular objective to achieve in future like to
purchase a Car or to further their education, they tend to increase their savings irrespective of their level
of income.
7. Contractual savings. A greater volume of savings are on contractual bases. Such savings are not
influenced by interest rates or income levels. For example savings on life insurance policies.
8. political stability also affects savings. If a country is politically stable and people are generally
optimistic about the economy, they will be encouraged to save.
9. The population structure. Savings will be higher for an ageing population than for a young population.
Also the government can increase or mobilize savings by instituting compulsory savings schemes.

INVESTMENTS.
It is the creation of capital or the process of adding to our existing stock of capital.

TYPES OF INVESTMENTS.
1. Addition to stocks or value of physical increase in stocks. It is the accumulation of stocks over the
period; that is, stocks of 31st December minus stocks of 1st January. The stocks of goods produced by a
firm constitute part of the firm’s investment. It is the most volatile aspect of investment since it can
easily increase and can easily decrease.
2. Investments in Plants and Equipment. This refers to the purchase of machines, and equipment such as
tractors, generators, computers etc. This type of investment is highly subjected to depreciation since
machines and equipment have the tendency to wear and tear over time.
3. Investments in building and construction. This refers to investments in building and construction of
houses, factories, warehouse etc.
4. Replacement investment. This is investments to replace worn out capital.
5. Public investments. This refers to all forms of investments carried out by the public sector such as
construction of roads, bridges, schools hospitals, public administrative buildings etc. The main aim of
public investments is not to maximize profits but it is to maximize the socio economic welfare of the
citizens by providing goods and services at moderate prices.
Public investments should be distinguished from private investments which refers to all forms of
investments carried out by the private sector. The aim of private investments is to maximize profits.
7. Portfolio investments. This is investments in the purchase of bonds and securities.
Keynes considers investments mainly in terms of portfolio investments. It is different
from real investments like plants and equipment, building and construction etc.

Investment Ex-ante and Investment Ex-post.

Ex-ante investments refers to planned investments. This is the investments that enterprise and planners
in the economy wish to make at the start of a period. Ex-post investments is the investment which firms
end up realising at the end of the period. It includes both the planned and unplanned investments like
unsold stocks of goods that accumulate at the end of the year.

FACTORS INFLUENCING INVESTMENTS.

1. The level of income. This is one of the most important factors influencing investments. Investments
which depends on income is known as induced investments and its working is explained by the
accelerator principle. In summary when income increases, the demand for consumer goods and services
increases. As a result, entrepreneurs producing the consumer goods will be motivated to carry out more
investments.
2. Expected profitability. This is the most important factor influencing private investments. When the
profits which the entrepreneur hopes to earn over the life span of the investment project is very high,
he will be motivated to carry out the investments. But if the expected profits are low, he will be
discouraged.
3. The nature of demand. If the demand for the product of the investment is high and permanent the
entrepreneur will be motivated to carry out the investments. But if it is temporal or short lived or very
low, he will be discouraged.
4. Government policies on taxation. When the government impose high taxes on investors, they will be
discouraged to carry out investments, but when taxes are reduced, they will be motivated to invest. Also
a favorable investment code in a country will encourage investors and vice versa.
5. The rate of interest. Interest is the price or cost of capital. When interest rates are high, firms will be
discouraged to borrow to carry out investments but when interest rates are low they are motivated to
borrow and Carry out investments.
6. The growth of population. This increases investments in two ways. Firstly increase in population will
lead to increase in the demand for goods and services which will motivate the entrepreneurs to carry
out more investments. Secondly, population growth increases investments in building and construction
of houses since more people will need accommodation.
7. The rate of depreciation. This influences replacement investment. When equipment and machines are
depreciating too fast, the will be the need for more replacement investment to be carried out to replace
the worn out capital.
8. Political stability. When a country is socially and politically stable, it will encourage investors especially
foreigners to invest. But if the is a high degree of political stability, people will be discourage to invest.

The Relationship Between Income Consumption And Savings.

The relationship in a 2 sector economy. In a 2 sector economy, part of the income is consumed and part
is saved therefore Income equal Consumption plus Savings at all levels of income; that is
Y=C+S at all income levels.
At equilibrium, we know that Y=C+I also
Therefore at equilibrium C+S=C+I which implies I=S, which satisfies the injection withdrawal condition.
Also since part of the income is consumed and part is saved, it implies
MPC+MPS =1. Also APC+APC +1
From this relationship, the savings function can be easily deduced.
Y=C+S
S=Y-C. C=aY +Co
S=Y-(aY+Co)
S-Y-aY-Co
S=(1-a)Y-Co
S=bY-So where 1-a=b and So =Co.

Graphical representation of the relationship

At Yo, income equal consumption hence savings is 0. At Y1, Consumption is greater than income by the
distance AB following the 45 degree line hence savings is negative given by the distance A’B’.
At Y2, Income is greater than consumption by the distance CD following the 45 degree line hence
savings is positive given by the distance C’D’.
The relationship in a three sector economy. In a three sector economy, part of the income is consumed,
part is saved and part is taxed. Therefore Income equal Consumption plus Savings plus Taxes at all levels
of income; that is
Y=C+S+T at all levels of income.
Note that at equilibrium, Y=C+I+G also
Therefore at equilibrium C+I+G=C+S+T
This implies I+G=S+T which satisfies the injection withdrawal equilibrium.
The relationship in a four sector economy. In a four sector economy, part of the income is still
consumed, part is saved and part is taxed. Therefore Income equal Consumption plus Savings plus Taxes
at all levels of income; that is
Y=C+S+T at all levels of income.
At equilibrium, Y=C+I+G+X-M
Therefore at equilibrium C+I+G+X-M=C+S+T
It implies I+G+X-M=S+T which implies I+G+X=S+T+M which satisfies the injection withdrawal
equilibrium.

CHANGES IN THE EQUILIBRIUM INCOME

This can be brought about by changes in the components of AMD. Assume a two sector economy where
AMD is C+I and there is only one Injection Investment (I) and one Leakage Savings (S).

The initial equilibrium income is Ye where the AMD curve (C+I) cuts the 45 degree line and where I=S.
An increase in Investments from I to I’ will shift the AMD Curve upward from C+I to C+I’. This causes the
equilibrium income to increase from Ye to Ye’. We observe that the increase in income is far greater
than the increase in investments. This is due to the action of the multiplier.

THE MULTIPLIER
It is the process which explains how small changes in spending causes a more than proportionate change
in income. Any initial injection in an economy such as investments or government spendings tends to
generate a series of spending with the overall effect on income being far greater than the initial
spendings. The multiplier coefficient is the coefficient by which we multiply the change in investment to
bring about the change in income that is; ϪY=KϪI where k is the multiplier.
To explain the multiplier, we assume the following
-the economy is a two sector closed economy and is not affected by foreign influence
-the economy exhibits a constant propensity to consume
-the economy is operating below full employment; that is there are idle resources to expand output if
expenditures or demand increases.
Injections are autonomous while withdrawals are induced.
-households positively reacts to changes in income same as output.
Suppose that the MPC is constant at 0.75 and there is an initial injection of 100 million into the economy
worth investment spendings. The firm that receives this initial investment spending will experience a
rise in their income by the 100 million. With the MPC constant at 0.75, this firm will proceed to spend
0.75 of this income to buy goods and services from other firms such as its raw materials, payment of
workers etc. The firms receiving this second round of spendings will therefore experience a rise in their
income by 0.75 of the 100 million. With the constant propensity to consume of 0.75, they to will
proceed to spend 0.75 of this income to buy goods and services from other firms. Therefore the firms
receiving this new round of spendings will therefore experience a rise in their income by 0.75 of 0.75 of
the 100 million. These other firms receiving this new round of spendings will also proceed to spend 0.75
of this income to buy goods and services from other firms and the process goes on and on. The series of
spendings or income that will be generated is given as

ϪY=100+0.75(100)+0.75(100)(100)+0.75(100)(100)(100)+………
ϪY=100+0.75(100)+0.75(100)2+0.75(100)3 +………+0.75(100)∞

This is the sum to infinity of a convergent geometric series which is given as

ϪY=1st term
1-common ratio
ϪY=100 =100 =1 X100 =4X100=400 million
1-0.75 0.25 0.25

Clearly the multiplier value is 4 which is 1

0.25

Since 0.75 is the mpc it implies the multiplier is

 1 = 1
1-MPC MPS
Since Savings is the only leakage in a two sector economy, it implies the general formula for the
multiplier is

K= 1
Marginal rates of leakages

Therefore in

Two sector k= 1
MPS

Three sector K= 1
MPS+MRT

Four sector K = 1
MPS+MRT+MPS

THE PARADOX OF THRIFT

Its states that under certain circumstances, an attempt to increase the level of savings may instead lead
to a fall in total savings. For an individual who attempts to increase his savings, he will end up realizing
an increase in his total savings but for the society as a whole, an attempt to increase the level of savings
will instead lead to a fall in total savings. This is because savings is a leakage with a negative multiplier
effect on income. An attempt to increase savings actually means a reduction in Consumption. When
Consumption falls, firms will contract output leading to a fall in income, when income falls , it becomes
difficult to save out of the reduce income as such savings falls.
The paradox is explained based on the following assumptions
-the economy is closed
-the is only one leakage which is savings
-the economy operates below full capacity
-savings are not re injected into the economy as investments
-the economy is depressed such that increasing savings does not make more funds available for
investments.
The paradox can be explained when investment is autonomous and when investment is induced.
Autonomous investments is investment which does not depend on income as shown.
The initial equilibrium income is Ye where I =S. An attempt to increase savings will push the savings
curve upward from SS to S’S’. This causes the equilibrium income to fall from Ye to Ye’, due to the
negative multiplier effect which savings have on income. But since investments is autonomous ie it does
not depend on income, the fall in income leaves savings unchanged and at equilibrium since savings
must be equal to investments, savings remain unchanged. In this case, an attempt to increase savings
leaves savings unchanged.

The paradox is clearly seen when investment is induced. Induced investment is investment which
depends on income as shown.

The initial equilibrium income is Ye where I=S. An attempt to increase savings will push the savings curve
upwards from SS to S’S’. This causes the equilibrium income to fall from Ye to Ye’ due to the negative
multiplier effect which savings have on income. Since investments depend on income, the fall in income
causes investments to fall from I to I’ and at equilibrium since savings must be equal to investments,
savings falls from S to S’. In this case an attempt to increase savings actually leads to a fall in total
savings.

THE ACCELERATOR PRINCIPLE.

The principle explains how small changes in income cause a more than proportionate change in
investments. When income increases, the demand for consumer goods and services will increase. This in
turn provokes entrepreneurs to carry out more investments. For example if income increases, it will
increase the demand for Ice Cream. This in turn will make entrepreneurs to buy more machines to
produce the Ice cream. The principle therefore explains how small changes in demand in one sector of
the economy that is the consumer goods sector is magnified and spread to other sectors, that is the
capital goods sector. The accelerator coefficient is the coefficient by which we multiply the change in
income to bring about the change in investment.
that is ϪI=βϪY where β is the accelerator coefficient.
To explain the principle, we assume the following
-the Consumer goods industries should be operating at full capacity because if they operate with excess
capacity, then they will simple use the idle resources to increase output as such the will be no need for
any additional investments.
-the Capital goods industries should be operating with excess capacity because if they operate at full
capacity, they will be unable to increase the supply of the capital when needed. As such the price of
capital may instead increase which will discourage the investors.
-the workers of the consumer goods industries should not be made to work over time since over time
work can be used to increase output without necessarily increasing or carrying out more investments.
-the increase in demand should be permanent because if it is temporal or short lived, it will not motivate
the investors to carry out the investments.
-firms maintain a constant capital output ratio; that is the ratio of the capital stock to the output
remains constant.
-firms carry out a constant replacement investment yearly.
For example, suppose that a firm has a Capital output ratio of 2:1. That is, it takes 2000frs worth of
capital to produce 1000 frs worth of output. Also the firm carries out a constant replacement
investment yearly of 2000 frs. The table below shows how changes in income or demand affects the
firms total investments.

year Ϫ in Income Existing Required Net Replacement Total

Ϫ in demand Capital Capital Investment Investment Investment
Ϫ in investment (mfrs) (mfrs) (mfrs) (mfrs) (mfrs)
(mfrs)
1 10000 20000 20000 - 2000 2000
2 12000 20000 24000 4000 2000 6000
3 13000 24000 26000 2000 2000 4000
4 13500 26000 27000 1000 2000 3000
5 13800 27000 27600 600 2000 2600
6 14000 27600 28000 400 2000 2400
7 14000 28000 28000 0 2000 2000
8 13000 28000 26000 -2000 2000 0

In year 1, the firm’s existing capital equal the required capital of 20000 hence there is no need for any
net or additional investment and with the constant replacement investment of 2000 ,total investment in
year 1 is 2000.
In year 2, the firm needs to increase its output to 12000 due to increase in income or demand. This new
output now requires a capital of 24000 since the capital output ratio is 2:1. As such there is the need for
a net or additional investment of 4000 and with the constant replacement investment of 2000, total
investment in year 2 is 6000; that is Net plus Replacement Investment.
In year 3, the firm needs to increase its output to 13000 due to increase in income or demand. This new
output level now requires a capital of 26000, but the existing capital is the capital stock that was built in
year 2 which is 24000. As such there is the need for a Net or additional investment of 2000 and with the
constant replacement investment of 2000, total investment in year 3 is 4000 that is net plus
replacement and so on.
The percentage changes in income and the percentage changes in total investments can be used to
explain the accelerator at work. For example from year 1 to year 2, income increase by 20% that is

12000-10000 X100 =20%. This causes total investment to increase by 200%; that is
 10000
6000-4000 X100 =200%.
4000

From year 2 to year 3, the percentage increase in output drops from 20% to 8.3%;

that is 13000-12000 X100 =8.3%.

12000
This causes a deceleration effect on investments with total investments falling by -33.3%.

This shows that small changes in income cause more than magnified changes in total investments
revealing the accelerator at work. The accelerator coefficient is the coefficient by which we multiply the
changes in income to bring about the changes in investments; that is ϪI=βϪY where β is the accelerator
coefficient.
Therefore β=ϪI =I2-I1
ϪY Y2-Y1
For example the accelerator coefficient from Y1 to Y2

Β =6000-2000 =4000 =2
12000-10000 2000

The oscillator.
It is the chain reaction between the multiplier and the accelerator. The multiplier and the accelerator do
not act in isolation. There is a chain reaction between the two. When small changes in investments
causes more than proportionate change in income through the multiplier, the change in income in turn
causes a more than proportionate change in investment through the accelerator. This chain reaction is
known as the Oscillator and it can be used to explain trade cycles. For example during a Boom, a small
cut in investments will bring about a more than proportionate fall in income through the multiplier. The
fall in income will in turn cause a more than proportionate fall in investments through the accelerator.
This chain reaction continues until the economy eventually reaches a Slump. From a Slump, any small
increase in income or investments will propagate a series of such chain reactions upward until the
economy eventually recovers back to a boom.
Note that apart from the Oscillator, trade cycles can also be caused by
-an outburst of technology
-an unexpected increase in money supply
-unexpected changes in export and import prices (External shocks).