Macroeconomics

Definition: Macroeconomics is that specialized field of economics which focuses on the

overall economy. It works on the aggregate value of the various individual units, to determine
its more substantial impact on the whole nation. All the prominent reforms and policies are
based on this concept.

For instance; the nation’s income is computed as the per capita income, which is nothing but
the average of the total earning of all the citizens in that country.

Scope of Macroeconomics
Macroeconomics is a vital field of study for the economists, government, financial bodies and
researchers to analyze the general national issues and economic well-being of a country.

Macroeconomics widely cover two major fundamentals which are further sub-parted into
multiple topics, as explained below:

Macroeconomics Theories

Government, as we know, is the regulatory body of a nation, it considers the various aspects
which are crucial and impacts the lives of the citizens.

There are six significant theories under macroeconomics:

Economic Growth and Development: The status of a country’s economy can be evaluated
in terms of the per capita real income, as studied under macroeconomics.

Theory of National Income: It covers the various topics related to the evaluation of national
income, including the income, expenditure and budgeting.

Theory of Money: Macroeconomics analyzes the functions of the reserve bank in the
economy, the inflow and outflow of money, along with its impact on the employment level.

Theory of International Trade: It is a field of study that enlightens upon the export and
import of goods or services. In brief, it determines the impact of cross-border trade and duty
charged, on the economy.

Theory of Employment: This stream of macroeconomics helps to figures out the level of
unemployment and prevailing employment conditions in the country. Also, to know how it
affects the supply, demand , savings, consumption, expenditure behaviour.

Theory of General Price Level: The most important of all is the analysis of product pricing
and how these price levels fluctuate because of inflation or deflation.

Macroeconomics Policies

The government and the reserve bank functions together while determining the
macroeconomic policies, for the nation’s welfare and development.

The two segments of this section are as follows:

Fiscal Policy: As we know, fiscal policy is a means of meeting the deficit of income over the
expenditure; it is a form of budgetary decision under macroeconomics.

Monetary Policy: Monetary policy is framed by the reserve bank in collaboration with the
government. These policies are the measures taken to maintain economic stability and growth
in the country by regulating the various interest rates.

Importance of Macroeconomics
Why do we need to dig into macroeconomics?

The answer is macroeconomics is a vital concept that considers the whole nation and works
for the welfare of the economy.
Let us now find out its other significance:

Trade Cycle Analysis

It is beneficial for timing the economic fluctuations to avoid or be prepared for any financial
crises or adverse situations.

Economic Policies Formulation

Framing of the monetary and fiscal policies majorly depends upon the study of prevailing
macroeconomic conditions in the country.

Downsizes the Effect of Inflation and Deflation

Macroeconomics also helps the government and the financial bodies to be prepared for the
situations of economic instability.

Facilitates Material Welfare

This stream of economics gives a broader perspective of social or national issues. Therefore,
the ones who look forward to contributing to the welfare of society needs to study
macroeconomics.

Regulates Economic System

It ensures or keeps a check over the proper functioning of the country’s economy and actual
position.

Resolves Economic Issues

The analysis of macroeconomics theories and issues helps the economists and the
government to figure out the causes and possible solutions of such macro-level problems.

Economic Development
Dealing with different economic conditions by making use of macroeconomics research,
opens up the way towards the country’s growth.

Issues Related to Macroeconomics

An economist needs to deeply analyze the following problems prevailing in the society as
well as the economy while studying macroeconomics:

Issues Related to Government Policies

The business operations often lead to social costs such as pollution, soil erosion, depletion of
natural resources, endangering wildlife, etc.

To control this social cost, the government frames specific policies and regulations which act
as a hurdle for business organizations.

Issues Related to Macroeconomic Trends in the Economy

The economic conditions of a country exceedingly influence the operations of any

organization.

Various economic trends or factors affecting the business are Gross Domestic Product
(GDP), employment conditions, investment opportunities, banking, pricing policies, etc.

Issues Related to Foreign Trade

Many organizations trade (i.e. either export or imports goods from other countries) in
international markets. They are sensitive to the fluctuations in the economy of other
countries, exchange rates, prices, etc.

Such changes may even influence the economic conditions of the country, ultimately
affecting the business organizations.

Limitations of Macroeconomics

Why do some economists criticize macroeconomics?

The following shortcomings of this approach have to lead to its criticism:

 Considers Aggregates as Homogenous: The individual data may not be similar in

structure or composition. Thus, when such single figures are compiled to get an
aggregate value, it may not seem to be that useful.
 Misleading: The extensive application of the macroeconomics measures seems to be
irrelevant when aimed at 100% results.
 Fallacy of Deductive Inferences: Macroeconomics function on aggregate values.
But, the interpretation of the individual activities may not be the same as compared to
the conclusion drawn on a mass level.
 Conceptual and Statistical Complexities: When the individual data have different
units, its aggregation becomes arduous and holds no significance.
 Unnecessary Aggregate Variables: When the individual elements need to be
examined separately, the aggregate values cannot be used for the purpose.
 Neglects Individual Consumers: The concept of macroeconomics overlooks the
importance of the individual unit or consumer since the fundamental is to make use of
the aggregates.
 Too Much Generalization: The conclusion derived from the aggregation of the data,
is generally taken to be true for all the individuals.

Conclusion

Macroeconomics is the basis of various economic reforms and the national decision model in
a country. However, the policies framed under this concept usually have a dual impact, i.e.,
on the society as a whole and individual citizens. Therefore, it requires a highly analytical,
logical and extraordinary approach while reaching to such interferences.
Aggregate Demand

(a) Meaning:

Aggregate demand refers to the total demand for final goods and services in the economy.

Since aggregate demand is measured by total expenditure of the community on goods and
services, therefore, aggregate demand is also defined as ‘total amount of money which all
sectors (households, firms, government) of the economy are ready to spend on purchase of
goods and services.

Alternatively, it is the total expenditure which the community intends to incur on purchase of
goods and services. Thus, aggregate demand is synonymous with aggregate expenditure in
the economy. If the total intended (i.e., ex-ante) expenditure on buying all the output is larger
than before, this shows a higher aggregate demand.

On the contrary, if the community decides to spend less on the available output, it shows a
fall in the aggregate demand. In simple words, aggregate demand is the total expenditure on
consumption and investment. It should be noted that determination of output and employment
in Keynesian framework depends mainly on the level of aggregate demand in short period.

(b) Components of AD:

Thus, the main components of aggregate demand (aggregate expenditure) in a four

sector economy are:

1. Household (or private) consumption demand. (C)

2. Private investment demand. (I)

3. Government demand for goods and services. (G)

4. Net export demand. (X-M)

Thus,

AD = C + I + G+(X-M)

Mind, all the variables represent planned (ex-ante) and not actual (ex-post).

We discuss below each of the above components:

1. Household (or Private) Consumption Demand (C):

It is defined as ‘Value of goods and services that households are able and willing to buy.’
Alternatively, it refers to ex-ante (planned) consumption expenditure to be incurred by all
households on purchase of goods and services. For instance, households’ demand for food,
clothing, housing, books, furniture, cycles, radios, TV sets, educational and medical services
will be called household consumption demand. Consumption (C) is a function (f) of
disposable income (Y), i.e., C =J(Y) (for detail refer Section 8.6).
As disposable income increases, consumption expenditure also increases but by how much?
It depends upon propensity to consume. The relationship between income and consumption is
called ‘propensity to consume’ or consumption function. Consumption function is
represented by the equation. (For details see Section 8.6)

2. Private Investment Demand (I):

This refers to planned (ex-ante) expenditure on creation of new capital assets like machines,
buildings and raw materials by private entrepreneurs. Remember, investment in Keynesian
sense does not imply purchase of existing shares or securities but means expenditures on
creation of new capital assets such as plants and equipment, inventories, construction works,
etc. that help in production. Investment is made not only to maintain present level of
production, but also to increase production capacity in future.

An economy grows through investment. Among three categories of investment, namely,

purchase of new buildings, addition to stock and investment in fixed plant or machinery, the
investment demand is focussed on last category, i.e., machinery.

The relationship between investment demand and rate of interest is called investment demand
function. There is inverse relationship between rate of interest and investment demand.
Investment is of two types—Autonomous and Induced (see Section 8.11) but all private
investment expenditure is assumed as induced investment.

What determines investment in private enterprise economy? Just as household consumption

demand depends on disposable income of households, investment demand in private
enterprise economy depends mainly on two factors, namely, MEI {Marginal Efficiency of
Investment) and Rate of Interest. In other words, the investors Judge whether the expected
rate of return on new investment is equal to or greater than or less than the market rate of
interest.

Suppose a businessman makes an additional investment by taking loan. He has to pay interest
on it which is his expenditure on new investment. Before making investment, he would
compare the interest he has to pay on loan and the profit he is expected to get on this
investment. According to Keynes, the net return expected from a new unit of investment is
called Marginal Efficiency of Investment (MEI).

Thus, three elements which are important in understanding investment are:

(i) Revenue (i.e., rate of return on new investment)

(ii) Cost (i.e., rate of interest)

(iii) Expectations (of profit)

Investment demand function:

Of the three elements which affect investment, rate of interest is the most important. The
relationship between investment demand and rate of interest is called investment demand
function. There is inverse relationship between the rate of interest and investment demand,
i.e., higher the rate of interest, the lower will be the investment demand.
3. Government Demand for Goods and Services (G):

It refers to government planned (ex-ante) expenditure on purchase of consumer and capital

goods to fulfill common needs of the society. The level of government expenditure is
determined by government policy Present-day states are by and large welfare states wherein
government participation in economic welfare of the people has increased manifold.

Government demand may be for satisfying public needs for roads, schools, hospitals, water
works, railway transport or for infrastructure (like roads, bridges, airports), maintenance of
law and order and defence from external aggression. Investment can be induced and
autonomous.

It needs to be noted that whereas investment in private sector is made with profit motive and,
therefore, called induced investment, government investment is guided by people’s welfare
motive and, therefore, called autonomous investment. Since investment expenditure is
assumed to be autonomous, graphically investment curve is a horizontal line parallel to x-axis
as shown as RI in Fig. 8.1.

4. Net Exports (Exports-Imports) Demand:

Net export is the difference between export of goods and services and import of goods and
services during a given period. Net exports reflect the demand of foreign countries for our
goods and services over our demand for foreign countries’ goods and services. Thus, net
exports show expected (ex-ante) net foreign demand.

This strengthens the income, output and employment process of our economy. As against it,
imports from abroad drive out the earning of the economy and, therefore, they do not
encourage domestic output and employment.

There are many factors which influence the volume of net foreign demand such as foreign
exchange rates, terms of trade, trade policy of the importing and exporting countries, relative
prices of goods, incomes of the nations, balance of payment position, types of exchange
control, etc. Since net exports or foreign expenditure on our goods and services constitute a
small proportion of the total expenditure (or aggregate demand), this constituent of net
exports is usually ignored.
In sum, aggregate demand is the sum of the above- mentioned four types of demand
(expenditure), i.e., AD = C + 1 + G + (X-M). Since determination of income (output) and
employment is to be studied in the context of a two sector (Household and Firm) economy we
shall, therefore, include in aggregate demand (AD) only two broad components of demand
such as consumption demand (C) and investment demand (I). Put in symbols:

AD = C + I

This has been depicted in Fig. 8.1. Aggregate demand curve has been shown as sum of
consumption (C) and investment (I).

Following are noteworthy points of the diagram:

(i) AD curve has a positive slope which means when income increases, AD (expenditure)
also increases.

(ii) AD curve does not originate at point O which shows that even at zero level of income,
some minimum level of consumption (equal to OR in the Fig. 8.1) is essential.

(iii) Investment curve is a straight line parallel to X-axis because according to Keynes, level
of investment remains constant at all levels of income during short period.

Aggregate Supply and its Component

Aggregate supply is the money value of total output available in the economy for purchase
during a given period. When expressed.

In physical terms, aggregate supply refers to the total production of goods and services in an
economy. It is assumed that in short run, prices of goods do not change and elasticity of
supply is infinite.

At the given price level, output can be increased till all resources are fully employed.

If we go deep, we will find that aggregate supply is represented by national income. How?
We know that the money value of final output is distributed as rent, wages, interest and profit
among factors of production which help to produce the output. From producers’ point of
view, it is the cost of producing goods and services which they must recover from sale of
output; otherwise, they will not produce the output.

Since the sum of factor incomes (rent, wages, interest and profit) at national level is called
national income, therefore, aggregate supply (AS), output and national income are same.
Alternatively, AS = Y where Y is national income. Thus, income or total output measures the
aggregate supply of goods and services.
Aggregate Supply = Output = Income

Components:

Main components of aggregate supply are two, namely, consumption and saving. A major
portion of income is spent on consumption of goods and services and the balance is saved.
Thus, national income (Y) or aggregate supply (AS) is sum of consumption expenditure (C)
and savings (S).

Put in the form of an equation:

AS = C + S, i.e., Y = C + S

AS curve is depicted in the Fig. 8.2 Aggregate supply or national income is shown on X-axis
and total spending (Consumption + saving) on Y-axis. AS curve is artificially represented by
a 45° line from the origin why? Because every point on this line is equidistant from X-axis
and Y-axis taking same scale on both the axes, i.e., each point on this line indicates
Expenditure (AD) = Income (AS).

Thus 45° line (also called a Guide line) helps us to identify equilibrium when two variables
are to be shown graphically equal. That is why AS curve is represented by a 45° line so that
when AD curve intersects it, AD becomes equal to AS. Thus, every point on 45° line
represents AD = AS (i.e., equilibrium).

Again, 45° line implies that the sum of consumption and saving (C -I- S) is always equal to
the level of income (Y). Another point to be kept in mind is that since technology is assumed
to be constant during short period, output (or aggregate supply) can be increased only by
employing more resources, mainly labour. Thus, aggregate supply increases in direct
proportion to increase in employment.
Effective Demand

The principle of ‘effective demand’ is basic to Keynes’ analysis of income, output and
employment. Economic theory has been radically changed with the introduction of this
principle. Stated briefly, the Principle of Effective Demand tells us that in the short period, an
economy’s aggregate income and employment are determined by the level of aggregate
demand which is satisfied with aggregate supply.

Total employment depends on total demand. As employment increases, income increases. A

fundamental principle about the propensity to consume is that as the real income of the
community increases, consumption will also increase but by less than income.

Therefore, in order to have enough demand to sustain an increase in employment there must
be an increase in real investment equal to the gap between income and consumption out of
that income. In other words, employment can’t increase, unless investment increases.

We can generalize and say; a given level of income and employment cannot be maintained
unless investment is sufficient to absorb the saving out of that level of income. This is the
core of the principle of effective demand.

Meaning of Effective Demand:

Effective demand manifests itself in the spending of income. It is judged from the total
expenditure in the economy. The total demand in the economy consists of consumption goods
and investment goods, though consumption goods demand forms a major part of the total
demand.

Consumption goes on increasing with increase in income and employment. At various levels
of income there are corresponding levels of demand but all levels of demand are not
effective. Only that level of demand is effective which is fully met with the forthcoming
supply so that entrepreneurs neither have a tendency to reduce nor to expand production.

Effective Demand is the demand for the output as a whole; in other words, out of the various
levels of demand, the one which is brought in equilibrium with supply in the economy is
called effective demand. It was this theory of effective demand which remained neglected for
more than 100 years and came into prominence with the appearance of Keynes’ General
Theory.

Keynes was interested in the problem of how much people intended to spend at different
levels of income and employment, as it was this intended spending that determined the level
of consumption and investment. Keynes’s view was that people’s intentions to spend were
translated into aggregate demand. Should aggregate demand, said Keynes, fall below income
businessmen expect to receive, there will be cut backs on production of goods resulting in
unemployment. On the opposite, should aggregate demand exceed expectations, production
will be stimulated.

In any community, effective demand represents the money actually spent by- people on
goods and services. The money which the entrepreneurs receive is paid to the factors of
production in the form of wages, rent, interest and profit. As such, effective demand (actual
expenditure) equals national income which is the sum of the income receipts of all members
of the community.

It also represents the value of the output of the community because the total value of the
national output is just the same thing as the receipts of the entrepreneurs from selling goods.
Further, all output is either consumption goods or investment goods; we can therefore say
that effective demand is equal to national expenditure on consumption plus investment goods.

Thus, effective demand (ED) = national income (Y) = value of national output = Expenditure
on consumption goods (C) + expenditure on investment goods (I).

Therefore, ED = Y = C + I= 0 = Employment.

Importance of the Concept of Effective Demand:

The principle of effective demand occupies an integral position in the Keynesian theory of
employment. The general theory has the basic observation that total demand determines total
employment. A deficiency of effective demand causes unemployment.

With the help of the concept of effective demand that Say’s Law of Markets has been
repudiated. The concept of effective demand has established beyond doubt that whatever is
produced is not automatically consumed nor is the income spent at a rate which will keep the
factors of production fully employed.

Secondly, an analysis of effective demand also shows the inherent contradictions in Pigou’s
plea that wage cuts will remove unemployment. In Keynes’ view, as level of employment
depends upon the level of effective demand, wage cuts may or may not increase employment.

Thirdly, the Principle of Effective Demand could explain as to how and why a depression
could come to stay. Keynes explained that Effective demand consists of consumption and
investment.As employment increases, income also increases leading to a rise in consumption
but by less than the rise in income. Thus, consumption lags behind and becomes the chief
reason of the gap that comes to exist between total income and total expenditure therefore, in
order to maintain effective demand at earlier (or original) level, real investment, equal to the
gap between income and consumption, must be made. In other words, employment cannot
expand unless investment expands. Therein has the all most importance of the principle of
effective demand. It makes clear that investment rules the roost.

Fourthly, it puts the spotlight on the demand side. In contrast to the classical emphasis on the
supply side, Keynes placed major emphasis on demand side and traced fluctuations in
employment to changes in demand. The theory of effective demand makes clear how and
why aggregate demand becomes deficient in a capitalist economy and how deficiency of
effective demand generates depression.

Determinants of Effective Demand:

For an understanding of Keynes’ theory of employment and how an equilibrium level of

employment is established in the economy, we must know its determinants the aggregate
demand function and the aggregate supply function and their inter-relationship.
1. Aggregate Demand Function, and

2. Aggregate Supply Function.

Consumption Function

Concept of Consumption Function:

As the demand for a good depends upon its price, similarly consumption of a community
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.

When the income of a community rises, consumption also rises. How much consumption
rises in response to a given increase in income depends upon the marginal propensity to
consume. It should be borne in mind that the consumption function is the whole schedule
which describes the amounts of consumption at various levels of income. We give in Table
9.1 such a schedule of consumption function.

Consumption function should be carefully distinguished from the amount of consumption. By

consumption function is meant the whole schedule which shows consumption at various
levels of income, whereas amount of consumption means the amount consumed at a specific
level of income.

The schedule described above reflects the consumption function of a community i. e., it
indicates how the consumption changes in response to the change in income. In the
consumption schedule given in Table 9.1 it will be seen that at the level of income equal to
Rs. 1200 crores, the amount of consumption is Rs. 1090 crores.

As the national income increases to Rs. 1500 crores, the amount of consumption rises to Rs.
1300 crore, consumption function remaining the same. Thus, with a given consumption
function, amount of consumption is different at different levels of income.

The above schedule of consumption function reveals an important fact that when income
rises, consumption also rises but not as much as the income. This fact about consumption
function was emphasized by Keynes, who first of all evolved the concept of consumption
function.

The reason why consumption rises less than income is that a part of the increment in income
is saved. Therefore, we see that when income increases from Rs. 1000 crores to Rs. 1100
crores, the amount of consumption rises from Rs. 950 crores to 1020 crores. Thus, with the
increase in income by Rs. 100 crores, consumption rises by Rs. 70 crores; the remaining Rs.
30 crores are saved. Similarly, when income rises from Rs. 1100 crores to Rs. 1200 crores,
the amount of consumption increases from Rs. 1020 crores to Rs. 1090 crores.

Here also, as a result of increase in income by Rs. 100, the amount of consumption has risen
by Rs. 70 crores and the remaining Rs. 30 crores have been saved. The same applies to
further increases in income and consumption. We shall see later that Keynes based his theory
of multiplier on the proposition that consumption increases less than the increase in income
and this theory of multiplier occupies an important place in macroeconomics.

Consumption demand depends on income and propensity to consume. Propensity to consume

depends on various factors such as price level, interest rate, stock of wealth and several
subjective factors. Since Keynes was concerned with short-run consumption function he
assumed price level, interest rate, stock of wealth etc. constant in his theory of consumption.
Thus with these factors being assumed constant in the short run, Keynesian consumption
function considers consumption as a function of income. Thus

C = f (Y)

In a specific form, Keynesian function can be written as:

C = a + bY

where a and b are constants. While a is intercept term of the consumption function, b stands
for the slope of the consumption function and therefore represents marginal propensity to
consume.

Keynesian consumption function has been depicted by CC curve in Fig. 9.1 in which along
the Y-axis national income is measured and along the K-axis the amount of consumption is
measured. In Figure 9.1 a line OZ making 45° angle with the X-axis has been drawn. Because
line OZ makes 45° angle with the X-axis every point on it is equidistant from both the X-axis
and T-axis. Therefore, if consumption function curve coincides with 45° line OZ it would
imply that the amount of consumption is equal to the income at every level of income.

In this case, with the increase in income, consumption would also increase by the same
amount. In actual practice consumption increases less than the increase in income. Therefore,
in actual practice the curve depicting the consumption function will deviate from the 45° line.
If we represent the above consumption schedule by a curve, we would get the propensity to
consume curve such as CC in Fig. 9.1.

It is evident from this figure that the consumption function curve CC deviates from the 45°
line OZ. At lower levels of income, the consumption function curve CC lies above the OZ
line, signifying that at these lower levels of income consumption is greater than the income. It
is so because at lower levels of income; a nation may draw upon its accumulated savings to
maintain its consumption standard or it may borrow from others.

As income increases, consumption also increases and at the income level OY0, consumption
is equal to income. Beyond this, with the increase in income, consumption increases but less
than the increase in income and therefore, consumption function curve CC lies below the 45°
line OZ beyond Y0.

An important point to be noted here is that beyond the level of income OY0, the gap between
consumption and income is widening. The difference between consumption and income
represents savings. Therefore, with the increase in income, saving gap widens and, as we
shall see later, this has a significant implication in macroeconomics.

It is useful to point out here that when the consumption function of a community changes, the
whole consumption function curve changes or shifts. When propensity to consume increases,
it means that at various levels of income more is consumed than before. Therefore, as a result
of increase in propensity to consume of the community, the whole consumption function
curve shifts upward as has been shown by the upper curve C’C in Fig. 9.2. On the contrary,
when the propensity to consume of the community decreases, the whole consumption
function curve shifts downward signifying that at various levels of income, less is consumed
than before.

Important Features of Keynes’ Consumption Function:

In macroeconomics, Keynes’s consumption function plays a highly important role. Therefore,

it is essential to state its important features.

The following are the important features of Keynes’s consumption function:

1. First, absolute level of current income is the important factor that determines consumption
of the community. Increase in national income causes an increase in consumption. On the
other hand, classical economists thought that it was rate of interest that primarily determined
saving and consumption of the community.

A rise in rate of interest induces the people to save more and thus to reduce their level of
consumption. According to Keynes, though rate of interest is one of the factors that determine
consumption of the community, he did not consider it a very important determinant of it. By
considering level of current income as the most important factor determining consumption
and saving, Keynes made a significant contribution to the macroeconomic theory.

2. The second important feature of Keynes’ consumption function is that marginal propensity
to consume is less than one but greater than zero (0 < MPC < 1). The feature of Keynes’s
consumption function that marginal propensity to consume is less than one is known as
Keynes’s Psychological Law of Consumption. According to this law, as income increases,
consumption increases but not as much as the increase in income.

3. In Keynes’ consumption function, namely, C = a + bY, as income increases, average

propensity to consume (APC) falls. Keynes was of the view that rich people relatively save a
higher proportion of their income so that at higher levels of income average propensity to
consume (APC), that is, proportion of total consumption to national income falls as national
income rises.

4. Another important feature of consumption function as put forward by Keynes is that it

remains stable in the short run. Consumption function, according to Keynes, depends on
various institutional factors such as distribution of income and wealth and psychological
factors such as willingness to save.

Since there cannot be much changes in these institutional and psychological factors,
consumption function remains stable in the short run, that is, it does not shift upward or
downward. Therefore, Keynes in his theory, explains the determination of income and
employment in the short run by considering that the consumption function is stable.

Savings Function

Saving is that part of income which is not spent on current consumption. The relationship
between saving and income is called saving function.Simply put, saving function (or
propensity to save) relates the level of saving to the level of income. It is the desire or
tendency of the households to save at a given level of income. Thus, saving (S) is a function
(f) of income (Y).

Symbolically, S = f (Y)

Two noteworthy features of saving function are:

(i) Saving can be negative (-) at zero or low level of income and (ii) As Income increases,
savings also increase but more than the increase in income

Thus , saving is residual income of households that is left after consumption.

Algebraically:

S = Y-C

Saving function equation:

As saving function is corollary of consumption function, we can derive the corresponding

saving function from consumption function equation C = C + bY by substituting it in the
equation S = Y – C as shown below.

Where C = Autonomous consumption (- C represents dissaving which is needed to finance

autonomous consumption. Clearly, at zero level of income, amount of autonomous
consumption = Amount of dissaving.), b = MPC (so that 1 – b represents MPS, i.e.. Marginal
propensity to save), Y = Income.
For example, the saving equation S = – 30 + (1- 0.75) Y means – 30 is dissaving (or
autonomous saving that needs to take place to finance autonomous consumption). As income
increases, 0.25 (= 1 – 0.75) or 25% of additional income is saved.

Relationship between Income and Saving:

(i) There is direct relationship between income and saving, i.e., if income increases, saving
also increases but by less than increase in income. It means as income increases, proportion
of income saved increases (because proportion of income consumed decreases).

(ii) At lower level of income, saving is negative. In the initial stages when there is very low
level of income, consumption expenditure is more than income leading to negative saving
[i.e., dissaving). For instance, if income is, say, Rs 5,000 and consumption expenditure is, say
6,000, then saving will be negative, i.e., -1000 (= 5000 – 6000). It is called dissaving. Here
average propensity to save is negative.

APS = -1000/5000 = -0.2.

Saving Function Curve:

A diagrammatic representation of relationship between income and savings level gives the
saving function curve. In Fig. 8.6 saving function curve is a straight line because slope of
saving is constant.

The curve slopes upward which depicts direct relationship between income and saving. The
savings functions line SS cuts the income line at point B which is called Break-even point
because at this point consumption expenditure is equal to income (or savings are zero).

To the left of break-even point, savings are negative (-) indicating consumption being more
than income whereas to the right of break-even point, savings are positive (-K) indicating
consumption expenditure being less than income. The shaded area reflects dissaving which is
equal to the area of autonomous consumption shown as – C in Fig. 8.6.

Investment Function

The level of income, output and employment in an economy depends upon effective demand,
which in turn, depends upon expenditures on consumption goods and investment goods (Y =
C + I).
Consumption depends upon the propensity to consume, which, we have learnt, in more or
less stable in the short period and is less than unity. Greater reliance, therefore, has to be
placed on the other constituent (investment) of income.

Out of the two components (consumption and investment) of income, consumption being
stable, fluctuations in effective demand (income) are to be traced through fluctuations in
investment. Investment, thus, comes to play a strategic role in determining the level of
income, output and employment at a time.

We can establish the importance of investment in another way also. In order to maintain an
equilibrium level of income (Y = C + I), consumption expenditures plus investment
expenditures must equal the total income (Y); but according to Psychological Law of
Consumption given by Keynes, as income increases consumption also increases but by less
than the increment in income. This means that a part of the increment in income is not spent
but saved.

The savings must be invested to bridge the gap between an increase in income and
consumption. If this gap is not plugged by an increase in investment expenditures, the result
would be an unintended increase in the stocks of goods (inventories), which in turn, would
lead to depression and mass unemployment. Hence, investment rules the roost. In Keynesian
economics investment means real investment i.e., investment in the building of new
machines, new factory buildings, roads, bridges and other forms of productive capital stock
of the community, including increase in inventories.

It does not include the purchase of existing stocks, shares and securities, which constitute
merely an exchange of money from one person to another. Such an investment is merely
financial investment and does not affect the level of employment in an economy. An
investment is termed real investment only when it leads to a increase in the demand for
human and physical resources, resulting in an increase in their employment. Investment is a
flow variable and its counterpart is stock variable called capital.

Types of Investment:

Investment may be private investment or public investment, it may be induced or

autonomous. Induced investment is that investment which changes with a change in income,
that is why it is called income, elastic. In a free enterprise capitalist economy, investments are
induced by profit motive. Such investment is very responsive to changes in income, i.e.,
induced investment increases as income increases. The shape of the induced investment
curve, therefore, is upward sloping, indicating a rise in investment as a result of rise in
income.

According to Hicks, investment is of two types, induced as described above and

autonomous— it is independent of variations in output. Explaining autonomous investment,
Hicks remarks: “Public investment, investment which occurs in direct response to inventions
and much of the long range investment (as Mr. Harrod calls it) which is only expected to pay
for itself over a long period, all of these can be regarded as autonomous investments.”

Autonomous investment is not sensitive to changes in income. In other words, it is

independent of income changes and is not guided or induced by profit motive only.
Autonomous investments are made primarily by the Government and are not based on
considerations of profit.

Autonomous investments are a peculiar feature of a war or a planned economy, for example,
expenditures on arms and equipment to strengthen the defence of India may be called
autonomous investment as it is incurred irrespective of the level of income or profits. Prof.
Hansen maintained that autonomous investment is generally associated with such factors as
introduction of new production techniques, products, development of new resources or
growth of population.

Induced investment is undertaken specially to produce large output. The curve of autonomous
investment is represented by a straight line running from left to right and parallel to the
horizontal income axis. The distinction between induced and autonomous investment is
shown in Fig. 18.1.

Gross Investment and Net Investment:

Investment, as we have seen which is in the nature of How of expenditures, during a given
time period, on view fixed capital goods or is in the nature of an addition to the stock of raw
materials and unsold consumer goods is called gross investment. However, replacement of
investment denotes to the expenditures incurred to maintain the stock of capital, in an
economy, intact. This type of expenditure is undertaken to offset the depreciation, wear and
tear and obsolescence in the existing productive capacity. Net investment is, thus, the excess
of gross investment over the replacement investment. The term net investment is, therefore,
sometimes used for capital formation also.

Symbolically:

Ig = In + Ir

where Ig is the gross investment, In the net investment and Ir the replacement investment also
called capital consumption. It is the variations in the In which causes fluctuations in Y, O and
E both in the short-run and in the long-run. If during a period Ig> Ir, it means that In is
positive and the stock of capital is increasing equal to In thereby leading to an increase in the
capacity to produce. If Ir > Ig, then In is negative and the stock of capital may decrease having
unfavourable effects on the productive capacity. If, however, Ig = Ir, then In = O and it means
that the economy is just making good the loss in capacity to produce on account of
obsolescence and depreciation.
It may not be out of place to mention that net investment may also include expenditures on
new durable consumer goods besides the expenditure on new capital goods. Therefore, in a
sense, it would be more appropriate to define net investment as the net addition to the stock
of capital including the producer and durable consumer goods. Capital here means
accumulation in the stock of plant and equipment held by business units. It is therefore, clear
that for economic growth, that is, if the economy is to grow over time its capital stock must
also grow.

Determinants of Investment:

Private investment (induced investment) depends upon the marginal efficiency of capital and
the rate of interest. The marginal efficiency of capital, in turn, depends upon future
expectations which fluctuate violently. Hence, private investment becomes highly capricious
and is very low, when in fact, it should be very high.

Prospective entrepreneurs keep on comparing the marginal efficiency of capital with the rate
of interest and decide to invest only when the former is higher than the later. There will be no
investment if the rate of interest is higher than the MEC. (In other words, if profit
expectations are not very bright); that is the reason why investments fall to low levels during
depression period, despite the fact that all types of encouragements are given to private
investors to invest more.

Classical economists regarded investment as dependent on the rate of interest; this to them
was an important lever by which investment in the system was regulated. This is why they
relied too heavily on the rate of interest to control fluctuations. They always held that by
manipulating the rate of interest, stability in the economic system could be restored. Until the
Great Depression of the 1930s.

Keynes also adhered to this view and believed in the efficacy of the rate of interest in solving
the problem of cyclical fluctuations. But later on, he realized its weaknesses and stopped
giving it undue importance as cyclical stabilizer. Keynes realized that investment depended
more on the psychological factors like the marginal efficiency of capital and not on the rate of
interest; as such, it was relegated to the background. It is, no doubt, true that the marginal
efficiency of capital has become the chief determinant of investment yet the influence of
interest cannot be ignored as both go to determine it.

The significant role of public investment, also called the autonomous investment, which the
Government may incur to save the economy from falling further to lower income levels,
comes to the forefront. In the nature of the case, public investment is independent of the
profit motive. Since a steady investment is essential for the investment multiplier to have
positive effect on income, output and employment, during depression, motives other than
profit are necessary to guide more investment— a function which is fulfilled only by public
investment. Further, the amount of public investment cannot only be controlled but is capable
of expansion to such an extent to make the investment multiplier work with greater force than
would otherwise be possible.

Moreover, the government can prevent it from leaking out of the spending stream, as well as
is capable of timing it, so as to let the multiplier have its full and free play. There is no reason
why public investment should not be wealth- creating as well as employment-generating and
why its adverse tertiary effects (if any) cannot be offset as a result of the beneficial effects of
multiplier on private consumption. Hence, the importance of public investment. It, therefore,
becomes necessary to analyze the various measures which stimulate investment.

Investment Multiplier

Investment increases productive capacity which, in turn, raises the level of output,
employment and income.

When investment increases by a certain amount, aggregate income increases by a multiple of

that investment.

This multiple is called multiplier. Investment multiplier shows a relationship between initial
increment in investment and the resulting increment in national income.

It is a measure of change in national income caused by change in investment. Thus, it

explains the relationship between increase in investment and the resultant increase in income.
For example, if an increase in investment of Rs 50 crore causes an increase in national
income of Rs 300 crore, then value of multiplier would be 6 (= 300 ÷ 50).

This equals increase in income divided by increase in investment. The implication of K = 6 is

that for any level of change in investment in the economy income will change 6 times of
investment amount. Multiplier (K), thus, is the ratio of increase in national income (∆Y) due
to an increase in investment (∆I). Put in symbols:

K = ∆y/∆I or ∆Y = K x ∆I

Where K = Investment multiplier, ∆Y = change in income, ∆I = change in investment.

Investment multiplier indicates the multiplying effect of investment on income.

Remember, the value of multiplier determines the rate of growth in the economy A higher
value of multiplier will attain a higher level of income and growth.

Working of Multiplier:

This can be further clarified with the help of an example. Mind, multiplier works through
consumption. How? The concept of multiplier is based on the assumption that expenditure of
one person is another person’s income, e.g., expenditure of A is income of B; B’s expenditure
is income of C; C’s expenditure is income of D and so on until spending becomes zero.

Suppose, government invests Rs 100 crore in establishment of a fertilizer factory .The first
impact of this new investment will be that the income of employees engaged in this factory
will go up by Rs 100 crore. If their marginal propensity to consume (MPC) is 3/4th or 75%,
they will spend Rs 75 crore (3/4th of 100) on new consumption goods.

This is not the end of the story. The producers of these goods will have an extra income of Rs
75 crore. If MPC of producers is also 3/4th, they in their turn will spend Rs 56.25 crore (3/4 of
75). So, this process will go on, with each round of expenditure being 3/4th of the previous
round and in this way the production and national income will go on increasing round after
round. The process of increase in income stops when change in income becomes equal to
change in saving.

The process of working of multiplier is further illustrated in the following table. This is based
on the assumption that initial increase in investment = Rs 100 crore and MPC = 75% (or
3/4th).

The above table clearly shows that Initial increase in investment of Rs 100 crore has resulted
in an increase of additional income of Rs 400 crore, i.e., the resultant increase in income is
multiple of initial increase in investment.

Thus, in this case Multiplier (K) = 400/100 = 4 or K = ∆Y/∆I. Keeping in view the
significance of concept of investment multiplier, Keynes suggested that in the situations of
unemployment and depression, government should Increase volume of its investment in
public utility works to give quick start to economy.

(b) Relationship of K with MPC and MPS:

Since multiplier indicates the effects of change in investment (∆I) on change in income (∆Y),
therefore, K = ∆Y/∆I = ∆Y/∆Y/∆C. By dividing by ∆Y

Clearly value of Y depends on the values of MPC and MPS.

Symbolically:

K = 1/1-MPC = 1/MPS

(i) There is direct relationship between K and MFC. If MPC is high, K will also be high but if
MPC is low, K will also be small as proved in the following examples.
has gone up from 4 to 5. Thus, K varies directly with value of MPC. In short, higher the value
of MPC, higher will be the value of multiplier. Lower the value of MPC, lower will be the
value of multiplier (K).

(ii) There is inverse relationship between K and MPS. If MPS is high, K will be low but if
MPS is low, K will be high as proved in the following examples.

Minimum and Maximum Value of Multiplier:

Value of K depends upon value of MPC or MPS. We know that MPC cannot be negative, it
can be at the most zero (minimum value) and maximum value can be 1.

(i) Minimum value of multiplier is 1 because minimum value of MPC can be zero.

(ii) Maximum value of multiplier may be – (infinity) because maximum value of MPC can be
1.

Symbolically: K = 1/1-MPC = 1/1-1 = 1/0 = Infinity (∞)

Between these two extremes (1 and infinity), value of multiplier varies depending upon value
of MPC.
Equilibrium Income Determination

The theory of determination of national income is concerned with finding out the equilibrium
level of national income, i.e., the level of national income at which the purchasing and
production plans of the economy are synchronised. This occurs at the point of the intersection
of the aggregate demand (C + I) schedule and the aggregate supply (C + S) schedule. This is
shown by point A in Fig. 3.

Income levels above point G cannot be maintained because total spending is insufficient to
buy up all the output being produced. Business firms find themselves with unsold stocks and
are thus forced to cut back production. In contrast, at income levels below point E aggregate
expenditure exceeds available output. Now, business firms find that they can sell their entire
output. So, they are encouraged to produce more to meet the additional demand that exists.

National income equilibrium is also reached at the point where total injections exactly equal
leakages. In a closed economy without government, the only injection is autonomous
investment and the only leakage is saving.

Thus, the leakages-injections approach to national income determination also goes by the
name saving-investment approach. In the circular flow of national income model, income –
consumption + leakages = C + S and spending (expenditure) = consumption + injections = C
+ I.

See Fig. 3. Here, equilibrium is achieved where leakages = injections, i.e., point £ which is
the same as point E in the income and expenditure schedules in Fig. 1. If leakages exceed
injections then total expenditure will fall, resulting in a contraction of income and output.
Conversely, if injections exceeds leakages, then total expenditure will rise, resulting in an
increase in income and output. Only when injections and leakages are equal national income
and output will remain the same.
The equilibrium level of national income will change if there is a shift in the aggregate
expenditure schedule. For example, if aggregate demand rises from AE1 to AE2 due to an
increase in investment spending, there will be an increase in the equilibrium level of national
income from YE to YF.

Alternatively, the equilibrium level of national income will change if there is a shift in either
the leakages or injections schedules. For example, an increase in investment spending will
shift the investment demand schedule upward from I1 to I2, resulting to an increase in the
equilibrium level of income from Y1 to Y2 as shown in Fig. 4.