Consumption and Investment Functions

7/28/2019 Consumption and Investment Functions

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Theory of Income andEmployment


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Economics Concerns

- Economic Growth

-Unemployment

Inflation

-Current Account Balance

Real National Income

Price Level

International

Transactions


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Aggregate Demand

Private Consumption

Investments

Government Expenditure

Net Exports


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Aggregate Supply

Production Function

Demand and Supply of factors of

production

technology


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Current Account Balance

Sum of net exports of goods and

services

Net income from aborad


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CLASSICAL ECONOMISTS

The classical economist held the view that, andeconomy based on laissez faire principles, is always inthe state if equilibrium at full employment

Free market mechanism ensures optimum allocation ofresources

Actual output equals potential output. There is neitherunderemployment noroverproduction

Wherever there is a deviation from an equilibriumsituation, the invisible hands of demand and supplycome into operations and brings the economy back toequilibrium

Role of money is only to facilitate transactions. It doesnot play any significant role in determination of outputand employment.

The level of output and employment are determined bythe availability ofreal resources i.e. labour and capital


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Says law of Market

Supply Creates its ownDemand

Barter Economy

Monetary Economy

No UnemploymentWage Cut Strategy


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Keynes Theory

Income, Effective Demand and Employment

Income

Consumption

MPC

Investment

Rate of InterestMEC

Supply of MoneyLiquidity Preference

Supply Price

Or CostProspective

Yield


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Theories of Aggregate

Consumption

Relationship between aggregate consumption

expenditure and the level of Income1. Absolute Income Theory of Consumption

2. Relative Income Theory of Consumption

3. Permanent Income Theory of Consumption4. Life- cycle Theory of Consumption


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Keynesian Consumption Function

(Absolute Income Theory)

Consumption function is relationship between

disposable income (Y) and consumption expenditure

(C) Consumption Function C = f (Y)

Consumption expenditure is positive function of

Income

men are disposed, as a rule and on average, toincrease their consumption as their income

increases, but not by as much as the increase in their

income

C/ Y is Positive but less than unity


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MARGINAL PROPENSITYTO CONSUME (MPC)

MPC refers to the relationship between marginal

income and marginal consumptionAs income increases, people tends to consume a

decreasing proportion of the marginal income

Keynesian theory of consumption produces a non-

linear consumption function MPC and APC

C = a + b Y

Disposable Income

C = f (Y)Consumption

Expenditure

0 Y

C


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Saving Function

Relationship between Savings and

Income S = f (Y)

Y = C + S

S = Y C

S = Y (a + b Y)

S = - a + (1 b) Y


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RELATIVE INCOME THEORY (DUSENBERRY)

A household having a relatively lower income

and living in community of higher incomes tend

to spend a higher proportion of its income than

the household with higher incomes.

Demonstration effect The Rachet Effects in Consumption behaviour :

when absolute income increases, absolute

consumption increases. But when absolute

income decreases, the household do not allowtheir consumption to fall in proportion to the fall

in their incomes


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PERMANENT INCOME HYPOTHESIS

Milton Friedman

It is the permanent income and not the current

income which decides the level of output.

Permanent income, defined broadly, is the mean ofall the income anticipated in the long run

In the long run transitory income gains and losses

are assumed to cancel out


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LIFE CYCLETHEORYOF CONSUMPTION

Ando and Modiglini

Individuals consumption in any time period

depends on (i) resources available to the individual

(ii) the rate of return on his capital and (iii) the age

of the individual

A rational consumer plans consumption on the

basis of all his resources and allocates his income

to consumption over time so that he maximizes his

total utility over his life time


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Investment

Investment in the theory of income and

employment means and addition to the

nations physical stock of capital likebuilding of new factories, new

machinery, as well as addition to the

stock of finished goods Investment means net addition to the

stock of capital over a period of time


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Investment

Purchase and sale of securities

Gross and Net investments

Planned (ex-ante) and Actual (ex-post)

investments

Public and Private investments

Autonomous investments

Induced investments


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Factors Affecting Investments

Marginal Efficiency of Capital

Rate of Interest

Excess capacity

Technological progress


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Marginal Efficiency of Capital

Marginal Efficiency of Investment is thehighest expected rate of profit which is likelyto be had by a marginal increase in the rateof investment

It is perspective yield and not actual yield Marginal efficiency of capital is the rate at

which prospective yields of an assetdiscounted so as to make it just equal to the

supply price of or replacement cost of theasset

Cr = R1 + R2 + R3 + . Rn

(1+r) (1+r)2 (1+r)3 (1+r)n


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Diminishing Marginal Efficiency of Capital

The marginal efficiency of capital fallsas investment increases because

(i)installation of larger machine leads toreduction in their perspective returns(ii)price of machine will go up as theirdemand increases

Marginal efficiency of investment islikely to be a curve falling from left toright


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Investment

Rate of

Interest

O

MEC

Y

X

Given marginalefficiency of capital, the

investment will depend

on the prevailing rate of

interests

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Consumption and Investment Functions