Macro Economic Variables

Income
Consumption
Saving
Investment
Saving – Investment Equality
Employment
 National Income
• Various Concepts of National Income have already
been covered.
• Few things to specifically remember while studying
Income and Employment Determination.
• Income is always denoted by “Y”
• Talk about equilibrium income.
• What is equilibrium income?
• Classical Economists believed that economy always
operates at full employment level of income and is
always in equilibrium.
• Any disequilibrium will be temporary and economy will
automatically return to full employment level of
income.
• Keynes talks about Effective Demand while
referring to equilibrium in the economy.
• Effective Demand will correspond to the point
where AD equals AS, hence equilibrium income.
• This equilibrium can be below or above full
employment level of income.
• Classical Economists give no role to the Govt. in
restoring equilibrium in the economy, while
Keynes pleads for an active role of Govt.
• Income as viewed from supply side
– Y= AS = C + S (Inventories)
• Income as viewed from demand side
– Y= AD = C + I (Rise in Inventories)
• So Equilibrium Level of Income will be
C+S=C+I Hence S=I
• Both the Classical and Keynesian Schools of
thought believe in this Saving – Investment
Equality but they take different routes for
achieving this equality.
• Classical Economists believe that this equality
is brought about by Interest Rate.
• Keynesians believe that this equality is
brought about by Income.
Classical Keynesian
• S = f(r ) Positive R/S • S = f (Y) Positive R/s

• I = f (r ) Negative R/S • I = f (Y) Positive R/S

 Saving Investment Equality:
Loanable Funds Theory
• Loanable funds refers to all income that
people have chosen to save and lend out,
rather than use for their own consumption.
• Saving is the Supply of Loanable Funds
• Savings is a positive(Direct) function of
Interest rate
+
• 𝑆 = 𝑓(𝑟)
• As Interest rate increase, people save more.
• Saving Function is represented by the
positively sloped line on Graph.
 Loanable Funds Theory. . .
• Investment is the Demand for Loanable Funds
• Investment is expenditure made by firms on new capital
goods.
• Firms borrow from the banks and financial institutions at a
fixed rate of interest.
• As rate of Interest rises, firms tend to borrow less, hence
Investment expenditure falls.
• So Investment is an inverse(negative) function of interest
rate.
• 𝐼 = 𝑓(𝑟)−
• Hence Investment is represented by downward sloping line
on graph.
 Market for Loanable Funds...
Interest Rate

Supply of Loanable Funds (Saving)

5%

Demand For Loanable Funds

(Investment)

0 $1,200 Loanable Funds (in billions

of dollars)
 Government Policies That Affect Saving and
Investment
• Taxes and saving
– Increase in Direct Taxes reduces Disposable Income and
hence savings.
• Taxes and investment
– Increase in Indirect Taxes increases prices, causing fall
in demand and hence affects output.
– Increase in Direct Taxes reduces profits
• Government budget deficits
– Crowding out of Private Investment
 An Increase in the Supply of Loanable Funds...
Interest Supply, S1 S2
Rate

5% 1. Tax incentives for

saving increase the
supply of loanable
4% funds...

2. ...which reduces Demand

the equilibrium
interest rate...

0 $1,200 $1,600 Loanable Funds

(in billions of dollars)

3. ...and raises the equilibrium quantity of loanable funds.

 An Increase in the Demand for Loanable
Funds...
Interest
Rate Supply
1. An investment tax
6% credit increases the
demand for loanable
funds...
5%
2. ...which
raises the D2
equilibrium
interest rate... Demand, D1

0 $1,200 $1,400 Loanable Funds

3. ...and raises the equilibrium (in billions of dollars)
quantity of loanable funds.
 Government Budget Deficits and Surpluses

• When the government spends more than it

receives in tax revenues, the short fall is called the
budget deficit.
– For 2003, the budget deficit is $307 billion
• The accumulation of past budget deficits is called
the government debt.
– For 2003, the total debt is 6.7 trillion.
 Government Budget Deficits and Surpluses

• Government borrowing to finance its budget

deficit reduces the supply of loanable funds
available to finance investment by households
and firms.
• This fall in investment is referred to as crowding
out.
 Thedeficit borrowing crowds out private
borrowers who are trying to finance investments.
 The Effect of a Government Budget Deficit...

Interest S2
Rate Supply, S1

6% 1. A budget deficit
decreases the supply of
loanable funds...
5%

2. ...which raises
the equilibrium
interest rate... Demand

0 $800 $1,200 Loanable Funds

(in billions of dollars)
3. ...and reduces the equilibrium quantity
of loanable funds.
 Consumption
• Consumption is expenditure on final goods and
services by household to satisfy their wants.
• Largest component of National Expenditure.
• Depends on Disposable Income
• 𝐶 = 𝑓 𝑌 𝑃𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝑅𝑒𝑙𝑎𝑡𝑖𝑜𝑛𝑠ℎ𝑖𝑝
• As Income Increases Consumption Also
Increases.
• 𝐶 = 𝐶𝑎 + 𝑐𝑌
• C is Total Consumption
• 𝐶𝑎 is component of Total Consumption that is
independent of Income. It shows the level of
consumption even when income is zero.
• 𝑐𝑌 is the component that varies with changes
in income.
• “c” in the term "𝑐𝑌“ shows the rate of change
in consumption due to change in income.
• “c” is the Marginal Propensity to Consume
(MPC)
 MPC
• MPC shows the proportion of additional income
that will be consumed.
∆𝐶
• 𝑀𝑃𝐶 =
∆𝑌
• e.g. if a person receives an increment in income,
value of MPC will determine how much of the
increased income will be consumed.
• MPC value of 0.8 depicts that 80% of the
increased income will be consumed, & rest is
saved.
• The value of MPC can range between 0 (nothing
is consumed) and 1 (everything is consumed)
• 0 ≤ 𝑀𝑃𝐶 ≤ 1
 APC
• Average Propensity to Consume shows how much a
person consumes of his income, on average.
• It is ratio of Total Consumption to Total Income.
• 𝐴𝑃𝐶 = 𝐶/𝑌
• Initially APC is large (APC >1) meaning person
consumes more than what is earned. Savings are
negative. APC starts to fall as income rises.
• APC = 1 shows person is consuming the whole of his
income. NO Savings.
• APC < 1 shows person has now started saving a part of
his income.
 Saving
• Part of Income that is not consumed is known as
saving.
• As we Know Y= C + S
• So Saving (S) = Y – C
• Saving is also a positive function of Income. i.e.
𝑆=𝑓 𝑌
• 𝑆 = −𝑆𝑎 + 𝑠𝑌
• Where −𝑆𝑎 is autonomous savings. In other
words, it is level of saving when income is zero.
• It is negative because even when income is
zero, there is subsistence consumption, hence
consumption out of past saving. It is referred
to as “dissaving”. (Y < C)
• Therefore saving line would start from
negative Y-axis.
• As income begins to rise, consumption also
increases but at slower pace and hence a
point is reached when his saving is zero. (Y= C)
• Finally savings become positive when income
becomes greater then Consumption. (Y > C)
 MPS
• The term “𝑠𝑌” shows the portion of saving that is
positively influenced by income.
• “s” determines the rate of change in Savings due
to change in Income.
• “s” is therefore referred to as Marginal Propensity
to Save.
• MPS shows the proportion of income that will be
saved. It is defined as the ratio of change in
savings to change in income.
• 𝑀𝑃𝑆 = ∆𝑆Τ∆𝑌
• If value of MPS is 0.2 it means 20 % of
increased income will be saved.
• Value of MPS also ranges between zero and
one, Just like MPC.
• 0 ≤ 𝑀𝑃𝑆 ≤ 1
• MPS value of 0 represents nothing is saved,
while MPS equal to 1 means all the income is
saved.
• MPC and MPS are related by following
expression:
𝑀𝑃𝐶 + 𝑀𝑃𝑆 = 1
 APS
• APS just as APC shows the average propensity to
save.
• It is defined as ratio of total saving to total
income.
A𝑃𝑆 = 𝑆Τ𝑌
• As income rises the propensity to save increases,
so APS value increases as income increases.
• Relationship between APC and APS:
APC + APS = 1
 MPC = 0.8, MPS = 0.2
APC Falls and APS Rises Progressively
Income( Consumption MPC APC = C/Y Saving (S) MPS APS = S/Y
Y) (C )
0 100 -- -- -100 -- --
100 180 0.8 1.8 -80 0.2 -0.8
200 260 0.8 1.3 -60 0.2 -0.3
300 340 0.8 1.13 -40 0.2 -0.133
400 420 0.8 1.05 -20 0.2 -0.05
500 500 0.8 1 0 0.2 0
600 580 0.8 0.97 20 0.2 0.03
700 660 0.8 0.94 40 0.2 0.057
800 740 0.8 0.92 60 0.2 0.075
900 820 0.8 0.91 80 0.2 0.088
1000 900 0.8 0.9 100 0.2 0.1
 45°
C/S
45° Guide line C = Ca + cY
equalizes values
On X & Y axis.

S = Sa + sY

0 Y
 Investment
• Expenditure on new capital goods in known as
investment.
 Marginal Efficiency of Capital
• Expected rate of return from any investment.
• As future is uncertain so entrepreneurs want
to earn maximum profit from any investment
 Classical Economics

Classical Theory of Income and

Employment
 Classical Economics
• Classical Economics is a school of thought
in economics that flourished, primarily in Britain,
in the late 18th and early-to-mid 19th century.
• Main Thinkers:
– Adam Smith
– Jean-Baptiste Say
– David Ricardo
– Thomas Robert Malthus
– John Stuart Mill.
 Basic Principles of Classical Economics
• Following are the main principles of Classical
Economics:
– Laissez Faire Economy and Invisible Hand
– Economy always operates at Full Employment level.
– General Over Production and Unemployment is not
possible
– Prices and Wages are Flexible
– Inflation is always a monetary phenomenon
– Saving – Investment equality is caused by Interest Rate ( r )
– Treated Money as Medium of Exchange only (Transaction
Purpose )
 Theory of Income & Employment
• There is not a single theory that can be regarded
as Theory of Income and Employment
• Following theories propounded by different
economists at different times are collectively
referred to as Classical Theory of Income and
Employment.
– Say’s Law of Markets
– AC Pigou’s Explanation of Labour Market
– Fishers Quantity Theory of Money
 Says Law of Markets
• JB Say’s famous quote “Supply creates its own
demand” forms the basis of classical theory of
income and employment.
• Whatever is produced in a free economy
automatically creates its own demand.
• No concept of overproduction and economy
always operates at full employment.
• If the production capacity is doubled,