BCom Notes Part I Economics Consumption Function and the Multiplier

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Consumption Function and the Multiplier

Qs. What is Consumption function? How is it determined? OR

Explain the term “Prosperity to consume” Bring out the functional between Consumption and Income.

OR

Distinguish between average prosperity to consume and marginal prosperity to consume and show that A. MPC < 1 B. MPC declines as income rises and C. Prosperity to consume is generally stable.

In the Keynession System, employment depends on effective demand which in the form of consumption demand and investment demand. If demand increase for consumption of commodity the investment increase and so employment level increase. A high prosperity to consume is favorable to employment.

Meaning

Consumption function is also called prosperity to consume. Consumption means amount spent on consumption at a given level of income. Consumption function or prosperity to consume means the whole of schedule showing consumption expenditure at various level of income.

Factors Influence Consumption

These factors are

1. The real income of the individual.

2. His Past savings.

3. Rate of interest.

Income play a major role in order to influence consumption function. Past saving are very small and for specific purpose like contributions to social security (Pension etc). Rate of interest encourage some people save more to earn a higher rate of interest.

Average and Marginal Prosperity to Consumer

The r/s between income and consumption is measured by the average and marginal prosperity to consume.

APC = C / Y [Where C --> Consumption and Y --> Income]

APC is the ratio of consumption and income where

MPC = /\ C / /\Y

MPC is the rate of change in consumption to the change in income.

The normal r/s between income and consumption is such that income rises, consumption also rises, but by less than the rise in come.

Qs. Examine the meaning, working and importance of the multiplier in keynession theory of income and employment

OR

What is “Marginal Prosperity to Consume”? Show how multiplier depends on the magnitude of the MPC.

MPC shows r/s between a given rise in investing and the resulting change in income. Suppose we invest 100Rs, so we expect more than that as additional income. We spend some amount from additional income and save the rest income. Additional spending depends on their MPC. Now we suppose MPC is 3/4. Then they will spend 75 Rs and save 25 Rs. If the MPC is stable the series of consecutive expenditure becomes.

/\(income) Y = 100 + 100 x (3/4) + 100 x (3/4)2 + 100 x (3/4)3

=> /\Y = 100 [1 + (3/4) + (3/4)2 + (3/4)3 + ......]

We see that an initial primary investment of 100 Rs gives rise to an icrease of 40 Rs in the National Income. The investment Multiplier measures the r/s between an increase in income caused by a primary increase in investment

Investment Multiplier = /\Y / /\I

In our case,

Multiplier = 400/100 = 4

Multiplier is given by the following formula

Multiplier = I / I – MPC

If MPC = 4/5 than Multiplier is 5

If MPC = 9/10 than Multiplier is 10 But

If MPC = 1 than Multiplier is infinite this shows a little increase of investment will load automatically a full employment.

If MPC = 0 than Multiplier = 1 shows increase in investment is equal to increase in total income.

Limitation of the Multiplier Concept

The factors which tends to reduce multiplying effect are called “Leakage”. The various limitation of multiplier are

1. MPC Not Constant

MPC is assumed constant in keyness concept of multiplier so that mps will necessarily be constant. Keyness ignore the possibility of leakage. In dynamic economy MPC or MPS never be constant.

2. Debit Cancellation

If people use a part of new increment in income to repay their add debts instead of spending on further consumption.

3. Purchase of Old Stock and Securities

If new income is spent on buying on buying old stock, shares and securities, consumption will be less and multiplies in respect will be low.

4. Net Imports

If import is greater than export than if means outflow of funds to foreign coutries.

5. Price Inflation

If the price of goods increase mpc will automatically increase.

Instead of all above problem, Multiplier have very importance in economics and for economics policy. Its play a vital role as an instrument of income.

Qs. Distinguish between autonomous and introduced investment on what factors investment depend?

OR

What is meant by “Investment”? and what do you understand by introduce to invest. Discuss the factors which govern the inducement to invest in a capitalist economy.

In the keynessian system employment depends upon effective demand. Effective demand should be constitute of investment and consumption. Investment mean addition to stock of capital to the nation’s like building of new factories, new machines etc.

Autonomous and Induced Investment

Autonomous Investment is done by Govt. for promoting peoples welfares as under plan developed. Induced investment is made by the people as a result of change in income level or consumption.

Concept of Marginal Efficiency of Capital (MEC)

It has very importance in macro economics. When ever an enterprise makes a certain investment in his business, he first looks into the marginal efficiency of capital. What return he is going to certain from the given investment.

MEC is the expected rate of profit of a new capital asset.

Lets suppose, we invest 10,000 Rs on purchase of new machine. The net return of this machine is expected to Rs. 1000 per annum, The MEC will be

1000/10000 x 100 = 10%

Show the ratio of expected annual return.

Factors On Which Investment Depends.

Investment depends on

1. MEC

2. Rate of Interest

1. MEC

The MEC is the expected annual rate of return on an additional unit of a capital good.

According to Keynels

The MEC is the rate of discount which makes the present value of the prospective field from the Capital asset equal to its supply price.

MEC is -vely shoped.

2. Rate of Interest

As the investment increases the rate of interest also increase so MEC decline.

Factors Effecting MEC

MEC is influenced by shortrun as well as long run factors. These are

A. Short Run Factors

i. Demand for the Product.

ii. Liquid Assets.

iii. Sudden changes in income.

iv. Current rate of investment.

B. Long Run Factors

i. Rate of Growth of Population

ii. Technological Development

iii. Rate of Taxes.

Qs. What is “Effective Demand”? How it influence the determination of level of employment and income in an economy? Discuss

OR

Explain the Keynessian Theory of Income and Employment.

According to Keynessian employment is a function of income, the greater the level of national income the volume of employment keeping other factors constant in short run.

i.e. Capital, Technology, Quality of Labor are constant.

So in the absence of changes in these constant the total output of goods and services cannot be expanded without increasing employment. The level of both income and employment depends on the Aggregate Demand and Aggregate Supply. The intersection of Aggregate Demand curve and Aggregate supply curve shows equilibrium level of income and employment.

Keynessian emphasize on Aggregate Demand (AD) which is depends upon the total expenditure of the consumer on consumption goods and of enterprise on investment goods. Consumption depends upon the size of the consumer income and prosperity to consume investment demand is determined by the MPC and the rate of interest. It depends upon fixture expectations of enterprise regarding the future yields from the goods.

Investment Demand = Distance between C and C + I

C + I —> Aggregate Demands

E —> Shows the Equilibrium level of income and employment

OY —> level of income at Equilibrium point E.

Equilibrium Not Necessary at Full Employment

It is clear that this equilibrium E between AS and AD may not be achieved at full employment and income. The equilibrium will established at full employment income only when investment demand is sufficiently large to fill the saving gap between the income and consumption correspondence to full employment.

Qs. When Aggregate Demand equals Aggregate Supply or Saving equals investment equilibrium level of national income is determined? Prove.

OR

Equilibrium level of national income is determined by the intersection of savings and investment schedules. Discuss

Equilibrium level of income and employment is established at that level at which AD = AS. It has also been seen that AD = AS when the investment spending is equal to then amount savings.

If Income Investment < Saving

It means AD would not be sufficient to take the AS of output of the market so bringing reduction in output income and employment at level in which investment spending.

If Given Level of Income Intended Investment < Intended Savings

The enterprise will not be able to sell the entire output at given prices. So they intend to reduce output so the level of income and employment will reduced.

Qs. According to Keyness, Saving-Investment Equality is a basic condition of equilibrium. Discuss

OR

Are Saving and investment in an economy always equal? If not how can this condition be brought about

OR

What do you mean by Saving and Investment?

Investment

According to Keyness Theory,

Investment means not addition to the stock of capital goods like machinery, equipment, factories etc.

It also include Inventories that why term Investment is different from Capital.

Saving

Saving means that amount which a man saves out of income after his expenditure so, saving means the income which is not consumed.

Saving and Investment Equality

A controversial question always in mind that is Saving and Investment are equal? According to Keyness

No, but it only possible when they reach in equilibrium position.

According to Keyness

The national Income is derived from the production and Scale of A. Consumer’s good and B. Investment goods.

i.e. Income = Consumption + Investment

=> Y = C + I …… i

Another look at income is

Income = Consumption + Saving

Y = C + S …… ii

So,

By comparing these two eq. we get

C + S = C + I

=> SC saving > I (investment)

Are Savings and Investment Always Equal

According to Keyness Economics,

They must be always equal But we got that is not happen always.

By realizing all of there we get realized or actual saving and investment always equal but intended or expected savings and investment may differ. But it also equal at equilibrium level of income.