Consumption Function and Investment Function.pptx

Consumption Function

1. Consumption Function Prof. Nithin Kumar S Assistant Professor Department of Economics J.S.S Banashankari Arts, Commerce And Shantikumar Gubbi Science College Vidyagiri, Dharwad - 580004

2. Introduction 'Consumption function' explains the functional relationship between consumption (C) and income (Y). According to Kurihara , consumption function is a "functional relationship between two aggregates. i.e., total consumption and gross national income ". Prof. Nithin Kumar S 2

3. Consumption function is also called propensity to consume. It is represented as C = f (Y) C = Consumption Y = Income Other determinants of consumption being constant an increase in income increases the consumption and a decrease in income decreases the consumption . Prof. Nithin Kumar S 3

4. APC and MPC The consumption function has two technical attributes- Average Propensity to Consume and Marginal Propensity to Consume. Prof. Nithin Kumar S 4

5. Average Propensity to Consume [APC ] It refers to the total amount of consumption expenditure out of the given total income at a particular period. According to Kurihara , "The average propensity to consume may be defined as the ratio of consumption expenditure to any particular level of income " Prof. Nithin Kumar S 5

6. APC is found by dividing the consumption expenditure [C] by income [Y] APC = C ÷ Y . Suppose that the aggregate income of nation is Rs . 80000 crores and its aggregate consumption expenditure is Rs . 60000 crores . Then APC=C÷Y or = or 0.75   Prof. Nithin Kumar S 6

7. Y=1 and the APC is always less than one [APC<1] because a portion of the income is saved. In the above example, the residue remained after consumption is savings. Average propensity to save [APS] is found either by subtracting APC from income [APS =Y-APS] or by dividing the savings by income. [APS=S/Y] APS should be less than one, because, Y=APC+APS Y=1 so APC is < and APS is also <1 . Prof. Nithin Kumar S 7

8. Marginal Propensity to Consume [MPC]: It refers to the additional consumption out of given additional income. Kurihara defines it as "the ratio of change in consumption to the change in income or as the rate of change in the average propensity to consume as income changes". Prof. Nithin Kumar S 8

9. MPC is obtained by dividing the change in consumption [∆C] by change in income (∆Y). MPC = ∆C/∆Y. If the additional income is Rs.5000 crores and additional consumption expenditure is Rs.3000 crores then MPC = ∆C/ ∆Y or = or 0.6 The remaining portion of the additional income is called the marginal propensity to save additional savings [MPS]. The marginal propensity to save can be derived from the formula MPS = ∆S/∆Y or 1-MPC   Prof. Nithin Kumar S 9

10. Consumption Function Prof. Nithin Kumar S 10

11. The 45° line Y [CY] is unity line where income and consumption are equal at all levels. Linear consumption curve C is based on the assumption that consumption changes by the same amount throughout. In other words, the MPC is the same at all levels of income. Consumption is the increasing function of income . Prof. Nithin Kumar S 11

12. At point E consumption is equal to income. At E entire income is pent on consumption. A rise in income to YF2 increases the consumption to OC2. The increase in consumption [CC2] is less than the increase in income [YFYF2]. CC2<YFYF2 . Points RS show the savings. Thus the consumption function measures both the amounts of consumption and savings simultaneously . Prof. Nithin Kumar S 12

13. Keynes has given more importance to MPC in his analysis. The value of MPC is assumed to be positive and less than one as the increased income is not entirely spent on consumption. The MPC is helpful in three ways: Prof. Nithin Kumar S 13

14. In explaining the possibility of general over production or underemployment equilibrium. In explaining necessity of filling the gap between income and consumption and In finding out the multiplier effect . Prof. Nithin Kumar S 14

15. Psychological Law of Consumption Consumption function is based on the Keynesian psychological law of consumption. The psychological law explains human tendency to spend less on consumption [or to save more] when income increases Prof. Nithin Kumar S 15

16. Propositions An increase of income will be divided in some proportion between consumption expenditure and savings. As the income increases, both the consumption expenditure and the savings will go up. In other words, increased income neither decreases the consumption expenditure nor the savings. When the aggregate income increases the aggregate consumption expenditure also increases, but by a somewhat smaller amount. In other words with an increase in income the consumption expenditure also increases, but less than proportionately . Prof. Nithin Kumar S 16

17. A ssumptions The present psychological and institutional complex remains unchanged. The conditions of the economy are normal The existence of a laissez faire capitalist economy . The law explains the tendency of people who fail to spend on consumption the full amount of an increment of income. Prof. Nithin Kumar S 17

18. Psychological Law of Consumption Prof. Nithin Kumar S 18

19. In the above figure, line Y shows income and line C the consumption. At E they are in equilibrium. Above E the gap between consumption and income goes on increasing. At higher income the ratio of savings will be more. It is a human tendency to save more when income increases . Prof. Nithin Kumar S 19

20. Implication of Psychological Law The psychological law has some important implications. Important among them are the following: Invalidates Say's law Repudiates laissez faire Existence of under employment equilibrium Highlights the importance of investment Declining tendency of MEC Possibility of Underinvestment Income generation Economic fluctuations Prof. Nithin Kumar S 20

21. 1. Invalidates Say's law It invalidates Say's law of markets by showing the possibility of overproductions. It shows how the supply fails to create its own demand. Psychological law clearly shows that a gap exists between income and consumption when the former increases. This is under-consumption or over production gap leading to unemployment . Prof. Nithin Kumar S 21

22. 2. Repudiates laissez faire It repudiates the laissez faire policy and stresses the need for government intervention. State intervention arises in the economy to avert general overproduction and unemployment through macroeconomic policies . Prof. Nithin Kumar S 22

23. 3. Existence of under employment equilibrium Psychological law explains the logic behind the assumption of under employment equilibrium. Consumers do not spend the full increment of their income on consumption. This results in the deficiency in aggregate demand. So the point of effective demand which determines equilibrium level of employment is of underemployment equilibrium. Prof. Nithin Kumar S 23

24. 4. Highlights the importance of investment Psychological law highlights the importance of investment. Investment is of crucial importance in filling the gap between income and consumption. Inadequacy of investment is responsible for unemployment. Keynes law highlights the significance of investment in solving unemployment . Prof. Nithin Kumar S 24

25. 5. Declining tendency of MEC It points out the declining tendency of marginal efficiency of capital in a laissez faire economy. Under consumption [gap between income and consumption] decreases the demand for consumer goods. Reduction in the production brings down the demand for capital goods. Ultimately the marginal efficiency of capital declines. Decline in the MEC implies a fall in the expected rate of profits and business expectations . Prof. Nithin Kumar S 25

26. 6. Possibility of Underinvestment It pinpoints the dangers of existence of permanent over saving or under consumption gap in the capitalist economy. The gap between income and consumption widens when people become rich. Increased income increases the savings. Richness results in over savings or under investment. Under investment is responsible for the secular stagnation of a capitalist economy . Prof. Nithin Kumar S 26

27. 7. Income generation Psychological law explains the unique nature of income generation in an economy. The process of income generation is explained by multiplier theory. The multiplier is a tool to find out the impact of investment on income. Since people do not spend their full increment of income on consumption the MPC is always less than one. The value of multiplier is derived from the MPC. [ K=1-1/MPC]. The higher the MPC higher in income generation . Prof. Nithin Kumar S 27

28. 8. Economic fluctuations Psychological law explains the turning point of a business cycle. A business cycle is characterized by two phases, boom and depression. The downturn starts before the economy reaches the full depression level because the fall in consumption is less than the fall in the income Prof. Nithin Kumar S 28

29. Determinants of Consumption Function Subjective Factors Individual Motives Motive of Precaution Business Motives Objective Factors Prof. Nithin Kumar S 29

30. I. Subjective Factors Individual Motives Motive of Precaution Motive of foresight Motive of Calculation Motive of Improvement Motive of Independence Motive of Speculation Motive of Pride Motive of Avarice Prof. Nithin Kumar S 30

31. Business Motives Motive of Enterprise Motive of Liquidity Motive of Progress Motive of Financial Prudence Prof. Nithin Kumar S 31

32. II. Objective Factors Windfall gains and losses Wage level Fiscal policy Changes in expectations Interest rate Corporate policies Liquid assets The distribution of income Forced savings Consumption imitations Prof. Nithin Kumar S 32

33. Measures to increase Consumption Function Even distribution of income Suitable wage policy Social security measures Easy credit facilities Urbanization Transport system Publicity Government policy Prof. Nithin Kumar S 33

34. Uses of Consumption Function Measures the changes Shows the necessity of investment : Provides multiplier Shows over production gap Prof. Nithin Kumar S 34

35. Keynes thus highlights the importance of consumption in an economy through consumption function. As a macro economic tool it shows the necessity of government intervention in filling the gap between income and consumption . Prof. Nithin Kumar S 35

36. INVESTMENT FUNCTION

37. Introduction Investment function explains the functional relationship between income and investment [I= f (Y)]. According to Keynes consumption and investment are the major components of effective demand. In short run consumption is more or less stable. So Keynes gives more importance to investment as the major determinant of employment . Prof. Nithin Kumar S 37

38. Autonomous and Induced Investments Keynes distinguishes between two types of investments: Autonomous Investment And Induced Investment. Autonomous Investment is income inelastic whereas induced investment is income elastic . Prof. Nithin Kumar S 38

39. Public investments which are expected to pay for themselves over a long period are autonomous investments. Investment not motivated by profit is autonomous investment . Autonomous investments are neither influenced by marginal efficiency of capital nor by rate of interest. Investment in economic and social overheads like construction of buildings dams, canals, bridges, roads, railways, schools, hospitals etc. are the autonomous investments . Prof. Nithin Kumar S 39

40. Induced investment is income elastic. Investment motivated by profit is induced investment. It is a function of income [II = f (Y)]. It is influenced by marginal efficiency of capital and rate of interest. It is income or profit motivated. The ratio of investment to income is called the average propensity to invest [AP=I/Y]. The ratio of change in investment to the change in income is the marginal propensity to invest [MPI = ΔΙ/ΔΥ ]. Prof. Nithin Kumar S 40

41. Autonomous and Induced Investment Prof. Nithin Kumar S 41

42. ‘II’ represents the induced investment. It increases with the rise in income. It decreases with a fall in income. Al represents autonomous investment. At all levels of income it remains constant. Induced investment is income elastic. Autonomous investment is income inelastic . Prof. Nithin Kumar S 42

43. Determinants of Investment Function Investment, according to Keynes, is determined by the marginal efficiency of capital and the rate of interest. Marginal efficiency of capital [MEC] exercises greater influence on the volume of investment . Prof. Nithin Kumar S 43

44. Marginal Efficiency of Capital [MEC ] MEC was first employed in economic theory by the American economist Irving Fisher. Later Keynes popularizes it in macro economic analysis. According to Dillard, "The marginal efficiency of a particular type of capital asset is the highest rate of return over cost expected from an additional or marginal unit of that type of asset " Prof. Nithin Kumar S 44

45. MEC is the highest rate of return over cost expected from producing an additional unit of the most profitable capital asset. MEC is determined by supply price of capital assets and prospective yield from capital assets. Prof. Nithin Kumar S 45

46. The MEC of an asset is the rate at which the prospective yield expected from that asset is to be discounted if it is to be equal to the price of the asset. In other words- Supply price = Discounted prospective yield. Symbolically , Cr = + + + Cr = supply price or replacement cost of new capital asset Q1, Q2, Q3, Qn = series of prospective annual yield from capital asset r = rate of discount or marginal efficiency of capital   Prof. Nithin Kumar S 46

47. The MEC falls when the investment increases because of the declining prospective yields and rising supply price. The MEC falls because of two reasons Rising investment results in a larger supply of goods which decrease the prices. A decrease in the prices will lower the prospective yield. Increases in investment raises the demand for capital assets. The cost of production of these capital assets goes on rising because of diminishing returns . The relationship between investment and MEC is shown in the following Figure Prof. Nithin Kumar S 47

48. Prof. Nithin Kumar S 48

49. The MEC curve, like a typical demand curve is downward sloping. The downward slope illustrates the inverse relationship existing between investment and MEC. The supply price of an asset rises when more and more investment takes place in the asset. When the supply price rises but prospective yields fall then naturally the MEC will fall. Hence the MEC curve slopes downwards to right . Prof. Nithin Kumar S 49

50. The investors compare the MEC with rate of interest while undertaking investment. Investment will increase if the MEC is higher than the rate of interest. On the other hand, investment will decrease if the MEC is lower than interest rate. Investment increases so long as the MEC is higher than rate of interest. Investment stops when the MEC and rate interest become equal . The relationship between MEC and rate of interest shown in the following Figure Prof. Nithin Kumar S 50

51. Prof. Nithin Kumar S 51

52. A fall in the interest rate from r2 to r1 brings about an increase in investment which is equal to 11 and 12. At a lower rate of interest more is the investment. But at a higher interest rate less is the investment. Thus MEC is inversely related to rate of interest . Prof. Nithin Kumar S 52

53. MEC is determined by various factors. They are grouped into Endogenous and Exogenous factors Prof. Nithin Kumar S 53

54. Endogenous factors affecting MEC Nature of Demand Changes in Income Changes in liquid assets Capital Stock Expectations Prof. Nithin Kumar S 54

55. 1. Nature of Demand MEC increases if the demand for a product is expected to rise. Increase in MEC increase the investment. On the other hand MEC decreases if the demand for the product is expected to fall. Decrease in MEC decreases the investment. Similar is the effect of price on investment. An increase in price enhances the investment by affecting favorably on MEC. A decrease in price has exactly the opposite effect. Prof. Nithin Kumar S 55

56. 2. Changes in Income An increase in income affects favorably on MEC by increasing the demand. A decrease in income affects unfavorably on MEC by decreasing the demand. Changes in income changes the investment by changing the MEC. A raise in income will have favourable effects on investment and vice versa . Prof. Nithin Kumar S 56

57. 3. Changes in liquid assets The inducement to invest in high when the investors possess more liquid assets. This is true in the case of those firms which keep large reserve funds and undistributed profits. Lack of liquid assets makes investment by the firm or investor very difficult . Prof. Nithin Kumar S 57

58. 4. Capital Stock If the existing stock of capital goods is large MEC will decrease and investment will fall. Similarly if there is idle capacity in the existing stock of capital assets investment will not take place. Capital stock and MEC are inversely related. More is the capital stock less is the MEC and investment. Less is the capital stock; more is the MEC and investment . Prof. Nithin Kumar S 58

59. 5. Expectations MEC also depends on expectations and attitude. Waves of optimism raise the MEC and investment. On the contrary, MEC is depressed by the waves of pessimism. Prof. Nithin Kumar S 59

60. Exogenous factors affecting MEC Population Inventions and Innovations Sale prospects Tax policy Other factors Prof. Nithin Kumar S 60

61. 1. P opulation Rapidly growing population extends the demand for goods and services. Increased demand increases both the MEC and investments. A declining population contracts the demand for goods and services. Decreased demand decreases the MEC as well as investments . Prof. Nithin Kumar S 61

62. 2. Inventions and Innovations Inventions and Innovations raise the MEC. If inventions and new technologies reduce the costs, the MEC will rise. Ultimately the inducement to invest will be affected favorably. Inventions and innovations lead to increased economic activities by creating dynamic changes in the economy. On the other hand absence of inventions and innovations will lead the economy into static conditions. In a static state MEC is the lowest. So the inducement to invest will be totally absent . Prof. Nithin Kumar S 62

63. 3. Sale prospects The MEC will be high if the sale prospects of a new product are high and costs are less. This will increase the inducement to invest. The MEC will be low if the sale prospects of a new product are low and costs are high. This will discourage new investments . Prof. Nithin Kumar S 63

64. 4. Tax policy MEC is favorably affected if the government levies less direct and indirect taxes. Decreased direct taxes will increase the inducement to invest. A decrease in the commodity taxes will increase the demand. Both influence the MEC favorably. On the other hand a progressive direct tax will curtail the inducement to invest. An increase in the indirect taxes will curtail the consumption. Both affect the MEC unfavorably. Prof. Nithin Kumar S 64

65. 5. Other factors Fear of nationalization and protection to public sector will decrease the private investments. A non interventionist policy provision of the private credit facilities and improved infrastructural facilities to private sector will enhance the MEC. These favourable factors increase the private investments . Prof. Nithin Kumar S 65

66. Rate of Interest Rate of interest in the second determinant of investment function. Keynes treats the rate of interest as the reward for parting with hard cash or liquidity. According to him interest is determined by demand for and supply of money . Prof. Nithin Kumar S 66

67. Supply of money It is the important determinant to rate to interest. The monetary authority determines the money supply. Supply of money is constant in the short run. So it has virtually no role to play in the determination of rate of interest . Prof. Nithin Kumar S 67

68. Demand for money Demand for money arises due to liquidity preference. It refers to the desire of the people to hold cash. If the desire to hold cash is intense the liquidity preference is high. If the desire to hold cash becomes weaker the liquidity preference is less. Liquidity preference is interest elastic. More is the liquidity preference when the interest is less. Less is the liquidity preference when the interest rate is high. Prof. Nithin Kumar S 68

69. The desire to hold cash arises from three motives Transaction motive Precautionary motive Speculative motive Prof. Nithin Kumar S 69

70. Transaction motive It is the liquidity preferred to carry out daily transactions. The liquidity preference for transaction motive is determined by the level of national income, level of employment and general price level. An increase in all these three variables increase the total volume of money needed for transactions and vice versa . Prof. Nithin Kumar S 70

71. Precautionary motive It is the money required by the people to meet the unforeseen contingencies of future. A person always keeps a portion of their income against risks and uncertainties like sickness old age and business losses Prof. Nithin Kumar S 71

72. Speculative motive It is the money demanded by the people to reap the advantages of uncertainties in the stock market. The psychology of the speculators and their anticipations are the determinants of speculative demand for money Prof. Nithin Kumar S 72

73. The rate of interest increases with an increase in the liquidity preference and falls with a decrease in it. Supply being constant, the liquidity preference deter mines the rate of interest Prof. Nithin Kumar S 73

74. Prof. Nithin Kumar S 74

75. In the above figure SS is the supply of money. Supply being constant in the short run the supply curve is a horizontal straight line in shape. LP downward sloping curve represents the demand for money. Rate of interest decreases with a fall in the demand for money [LP ]. Prof. Nithin Kumar S 75

76. Keynes has not attached much importance to rate of interest as a determinant of investment. He has focused all attention on MEC as the true determinant of inducement to invest . Prof. Nithin Kumar S 76

77. Measures to increase Investments Tax Reductions Interest rate Reductions Pump Priming Price stability Encouraging Competition Promotion of Research Prof. Nithin Kumar S 77

78. 1. Tax Reductions A favourable fiscal policy increases the inducement to invest. Tax concessions, tax reduction, tax holidays etc. will stimulate the private investment Prof. Nithin Kumar S 78

79. 2. Interest rate Reductions A reduction in the rate of interest will increase the inducement to invest in some sectors of the economy. Reduction in the interest rate results in the availability of cheap credit. Some investors may be encouraged to invest by the reduction in the rate of interest . Prof. Nithin Kumar S 79

80. 3. Pump Priming It refers to the government expenditure which takes the form of socially useful projects such as the construction of roads railways, bridges, dams canals, hydro electricity projects etc., Pump priming is virtually the autonomous investment. It stimulates the private investment and creates new employment opportunities . Prof. Nithin Kumar S 80

81. 4. Price stability Private investment can be stimulated by maintaining price stability in the economy. The government has to maintain price stability by reducing the market uncertainties. To stabilize the price several measures have to be taken. Price support policy is one among them. Under this policy the government fixes the minimum price. The government may also make bulk purchases and distribute the products. Price stability creates a sense of security among private investors and encourages private investment . Prof. Nithin Kumar S 81

82. 5. Encouraging Competition Conditions of competitions are favourable for induced investments. Prevalence of monopoly practices discourages the private investment. So the government has to create a competitive atmosphere to enhance the private investments. Prof. Nithin Kumar S 82

83. 6. Promotion of Research Research and development activities create a dynamic atmosphere conducive for investment in the economy. Scientific and technological advancements will open up new investment opportunities. Prof. Nithin Kumar S 83

84. Conclusion It is the responsibility of the government to ensure that the total investment in the economy is adequate. Public investment would supplement private investment in a period when the latter is inadequate. The government should reduce public investment in a period on inflation. It should enhance public investment during deflation. Timely public investment programmes are required to get rid to depression quickly . Prof. Nithin Kumar S 84