• https://economicoutlook.cmie.

com/kommon/
bin/sr.php?kall=wshreport&nvdt=2021090119
1420113&nvtype=INSIGHTS
• GDP (Y) is made up of four components:
• Consumption (C),
• Investment (I),
• Government purchases (G), and
• Net exports (NX).
• Each of the four components is a part of
aggregate demand (AD).
 Components of Aggregate Demand
• In a four sector economy,
• (i.e. Household Sector, Producer Sector,
Government Sector, The External Sector)
• It is given by AD = C+I+G+(X-M)
• C (Private Consumption expenditure)
• I (Private Investment expenditure)
• G (Both Government Consumption Expenditure
Government Investment Expenditure)
• X-M (Net Exports)
 Aggregate Demand
• Aggregate demand is defined as the total
level of demand in an economy.
• Demand for all goods and services in an
economy during a period of time.
• Aggregate demand is measured in terms of
expenditure on the goods and services.
• Aggregate demand is synonymous with
aggregate expenditure in the economy.
• Aggregate demand is the total expenditure on
consumption as well as investment (ex-
ante/planned).
• Determination of output and employment in
Keynesian framework depends mainly on the
level of aggregate demand in short period.
AD curve in Macroeconomics vs. Demand
Curve in Microeconomics
 AD Schedule
• A schedule depicting the total amount of
spending on domestic goods and services at
various levels of NATIONAL INCOME
 AD Curve
• AD curve shows the relationship between
price and the quantity of output (real GDP)
demanded by the households, firms and the
government.
 Consumption
 ‘Value of goods and services that households
are able and willing to buy.’ 
 It refers to ex-ante (planned) consumption
expenditure to be incurred by all households
on purchase of goods and services.
 Amount of money spent out of national
income on the purchase of goods and
services.
• https://economictimes.indiatimes.com/news/
economy/indicators/view-first-quarter-gdp-pri
nt-tells-the-story-of-waning-private-consumpti
on/articleshow/85831840.cms
• https://www.cmie.com/kommon/bin/sr.php?k
all=warticle&dt=20211011151349&msec=930
 Determinants of consumption
• Subjective factors
• Foresightedness
• Economic Independence
• Enlarged income in future
• Occupational motive
• Miserliness
• Precautionary motive
• Objective factors
• Change in money income
• Change in real income
• Change in distribution of NY
• Policy of corporate(For instance,
if corporations hold more
reserves, the dividend payments
to shareholders will be less.)
• Fiscal policy
• Change in rate of interest
• Demonstration effect
• Consumer confidence
 The Consumption Function (C)
• Functional relationship between C and Y
• Positive relationship
• Largest component of AD
• Algebraically
_
• C = C + bY or C = Ĉ + bY
• Or C = a +bY
• Where a is autonomous consumption
• b is marginal propensity to consume
Y C

0 20
50 60
100 100
150 140
• Autonomous consumption (indicated by a)
– refers to the level of consumption that does not
vary with income
• Induced consumption (indicated by b.Y)
– refers to expenditure that varies directly in income
(b = MPC)
• The slope of consumption function is equal to
b.
• Marginal propensity to consume (MPC),
indicated by b
– refers to the increase in consumption per unit
increase in income.
• MPC =Change in consumption/Change in
Income
• Δ C/ Δ Y
• Can MPC be greater than 1?
• No, Value of MPC lies between 0 to 1.
• 0<b<1
• Average propensity to consume (APC) refers
to the proportion of total income spent on
consumption.
• It is given by APC = C/Y
• Can APC be equal to 1?
• The value of APC is generally less than 1.

APC vs MPC
 Linear and non-linear consumption function

 Can consumption function be linear?

 If Yes, in what case?
 In case when MPC is constant.

 Non-linear consumption curve

 MPC does not remain constant (it goes on
falling with increase in income).
Cyclical and Secular Consumption Function

• Cyclical : Short-run
– C = a + bY
– No proportional relation between income and
consumption.
– Both APC and MPC decline, but APC>MPC
• Secular : Long-run
– C = bY
– Proportional relationship
– APC and MPC are both constant and equal
Movement and Shift in the
consumption function
 Movement along the consumption function

 Changes in
disposable personal income ca
use movements along this
curve.
 Increase in income leads to
upward movement along the
curve and vice versa.
 Shifts in the Consumption Function

• Change in consumption due to other factors other than

income
• For instance, when wealth increases due to accumulated
savings, one may feel richer to spend more on consumption.
Such cases represent factors other than income that cause
consumption to increase.
• This leads to a shift of the consumption curve.
• An increase in consumption is depicted by an ‘upward’ shift
of the consumption curve.
• And decrease in consumption is depicted by a downward shift
of the consumption curve.
 Factors affecting Shift in the Consumption Function

 Wealth
• An increase in wealth shifts the consumption function upwards
 Interest rates or availability of credit
• An increase in interest rates shifts the consumption function
downwards
 Distribution of income
• A more equal distribution of income shifts the consumption
function upwards
 Expectation of future prices or income
• Expectations on future prices or income may shift the
consumption function upwards or downwards.
Saving Function
 Savings
• Savings refer to the residual of consumption.
• The APS is given by APS = S/Y = 1 - APC
• The MPS is given by MPS = Δ S/ Δ Y = 1 – MPC
• Like APC, APS is generally less than 1,
• Though it can be zero or negative.
• Can APS be greater than one.
 Saving function
• S = f (Y)
• S= -a + sY
• S=Y–C
• S = Y – (a+ bY)
• S = Y – a – bY
• S = -a +Y (1-b)
• S = -a +sY
 Relationship between APC & APS
• APC+APS= 1
• APC = C/Y
• APS = S/Y
• Y=C+S
• APC + APS = C/Y + S/Y = C+S/Y= Y/Y = 1
 Relationship between MPC & MPS
• MPC+MPS=1
• MPC= Δ C/ Δ Y
• MPS = Δ S/ Δ Y
• Δ Y= Δ C + Δ S
• MPC + MPS = Δ C/ Δ Y + Δ S/ Δ Y =
• Δ C + Δ S/ Δ Y = Δ Y / Δ Y
• =1
 APC And MPC
• MPC is constant, APC is falling , APC > MPC
• MPC is constant, APC is falling APC = MPC
• MPC is constant, APC is rising APC < MPC
MPC is higher is case of poor communities and lower
in case of rich communities. 

• Significance of MPC
Break-even Point (relationship between consumption
function and saving function)
Why should rising MPS be cause of worry when
it is a sign of rising GDP in the economy?
Investment (I)
• In ordinary language investment refers to
purchase of shares, stocks, bonds and
securities existing in the stock market. This is
called as financial investment.
• In Keynesian sense investment refers to real
investment which adds to capital equipment.
Therefore investment includes new plant and
equipment, construction of public works like
dams, roads, buildings etc., net foreign
investment, inventories, stocks and shares of
new companies.
 Investment (I)
 Planned (ex-ante) expenditure on creation
of new capital assets like machines, buildings
and raw materials by private entrepreneurs.
 the act of acquiring fixed capital assets and
accumulating stocks and inventories.
 the process of adding capital goods in an
economy.
 Types of investment
• Investment can be classified in to two types
– Autonomous
– Induced
 Autonomous investment
• Independent of the level of income.
• Income inelastic.
• Not affected by changes in demand, but it in
turn influences demand.
• Influenced by factors like
– innovations,
– inventions,
– growth of population,
– labor force, and research,
– social and legal institutions,
– weather changes
– war.
 Induced investment
• Investment that is induced by changes in
income and profit
• income elastic
• varies directly with NY.
• Induced investment is a function of income I =
f(Y)
• All private investment expenditure is assumed
as induced investment.
 Induced investment may be again divided
into:
• Average propensity to invest (API)
• The average propensity to invest refers to the ratio
of investment to income.
• i.e., I/Y.
• Marginal propensity to invest (MPI)
• Whereas, the marginal propensity to invest refers
to ratio of change in investment to the change in
income.
• i.e. ΔI/ΔY.
What determines investment in
private enterprise economy? 
 Investment function
• Functional relation between investment and
its various determinants
• I = f (y, r)
• There is inverse relationship between rate of
interest and investment demand. 
 Determinants of Induced Investment

• Cost of capital asset,

• Expected rate of return from it during its life
time (Prospective yield)
• Market rate of interest
The Marginal Efficiency of Capital (MEC)
is determined by two important factors
• Supply price of the capital asset
– (The supply price of the capital asset is defined as
the price at which the new capital asset is supplied
or replaced.)
• Prospective yields from capital asset
– (expected revenues from the sale of output
created by the asset during its life time minus
variable costs)
• Py= Q1+Q2+Q3+………+Qn
• Py = Prospective yield
• Q1, Q2, ….Qn = Net revenue received in the
respective years
• MEC > r
• If MEC is greater than market rate of interest,
it is profitable to undertake the project.
• MEC < r
• If MEC is less than the market rate of interest,
it is less profitable to undertake the project.
 Measures to stimulate Induced Investment

• Reduce interest rates and taxes

• Increase in government expenditure
• Price- Support policy
R and MEC MEC

INVESTMENT
What determines the level of
investment in an economy?
 Factors influencing investment
• Technological advance and innovation
– Changes in technology shifts the MEI rightward
• The price level (cost )
– The lower the cost of capital goods, the higher the rate of
investments.
• Availability of finance
• Rate of change of income
– As the income increases at an increasing rate, investments
will increase as well.
• Territorial expansion
• Expectations
• Government policies
– Government policies (e.g. pioneer statuses, tax
holidays) generally work to increase investments
– Ease of doing business
• Increase in population
• Competition in market
• Business confidence
– A higher business confidence (affected by many
things) will increase investments.
 Government Spending
• Government consumption expenditure
• Government investment expenditure
 Net Exports
• X-M
• Exports - Imports
 Slope of AD
• https://www.thoughtco.com/the-slope-of-the-
aggregate-demand-curve-1146834
 Why is the Aggregate-Demand Curve
Downward Sloping?
• Real wealth effect – When prices go down, purchasing
power goes up. Consequently, consumption goes up
• Interest rate effect – When price levels go down, demand
for money goes down leading to a fall in interest rates.
This means the cost of borrowing is lowered, increasing
demand and subsequently, firms’ level of investment.
• International substitution effect – When export prices go
down, foreigners buy more. Likewise, when import prices
are relatively higher, imports are substituted by domestic
products.
Shift in Aggregate Demand
Shift of the AD curve versus Movement along the AD curve
 Shift in AD
• Due to Change in C, I, G, NX
 Shifts in AD Curve
• Shifts of the AD curve may be effected by a change in any of the
following
• Real Wealth
• When real wealth increases, demand increases. AD shifts right.
• Interest rates
• When interest rates go down, price levels go down. Consumers are
more likely to purchase now (as the opportunity cost of investment
is lower). AD shifts right
• Inflation
• If there is an expected change in prices in the future, consumers will
tend to purchase now. AD shifts right.
 Shifts in AD Curve (Contd..)
• Income abroad
• When income from abroad increases, demand for
exports increases. AD shifts right.
• Exchange rates
• As local currency appreciates, there in an increase in
imports and a decrease in exports. AD shifts left
• Expectations
• The expectations of fall in price lead to increase in
demand, AD shifts right