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Unit11
Structure
11.1 Introduction Objectives

ConsumptionFunctionAndInvestmentFunction

11.2 Meaningsofconsumptionfunction 11.3.1 11.3.2 11.3.3 11.3.4 Psychologicallawofconsumption Theaveragepropensitytoconsumeandthemarginalpropensitytoconsume RelationshipbetweenMPCandAPC Importanceofconsumptionfunction SelfAssessmentQuestion1 11.3 Investmentfunction 11.3.1 11.3.2 11.3.3 Typesofinvestment Determinantsofinvestment Marginalefficiencyofcapitalandbusinessexpectations SelfAssessmentQuestions2 11.4 Multiplier 11.5 Accelerator SelfAssessmentQuestions3 11.6 Summary TerminalQuestions AnswertoSAQsandTQs 11.1 Introduction An increase in income leads to an increase in the level of consumption. But the increase in consumption is not proportionate to the increase in the level of income. Consumption function explains the functional relationship that exists between income and the level of consumption. Psychologicallawofconsumption,theaveragepropensitytoconsumeandthemarginalpropensity toconsumehelpustounderstandthecommunitybehaviour. Investmentfunctionexplainstherelationshipbetweenaggregateincomeandaggregateinvestment. Varioustypesofinvestmentlikegrossinvestmentandnetinvestment,publicinvestmentandprivate
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investment, autonomous investment and induced investment, marginal efficiencyof capitaland the rate of interest as the determinants of investment give us an insight into the nature of investment activity. Multiplier is the ratio of change in income to a change in investment. Accelerator explains the increaseinthelevelofinvestmentasaconsequenceupontheincreaseinthelevelofincomeand consumption. LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing

1. Themainobjectiveofthestudyofconsumptionfunctionandinvestmentfunctionistohelpa
studenttounderstandandappreciatetheaggregativebehaviouroftheeconomyasawhole.

2. KeynesPsychologicallawofconsumptionexplainshowtheincreaseinconsumptionislessthan
proportionatetoanincreaseinincome.

3. Workingofthemultiplierexplainstheimportanceofconsumptioninincreasingthelevelof
investment.

4. Theprincipleofaccelerationexplainstheimportanceofanincreaseinthelevelofconsumption
andincomeinrealisinganacceleratedgrowthoftheeconomythroughanincreaseinthelevelof investment. Understandtheimportanceoftherateofinterestandmarginalefficiencyofcapitalin determiningthelevelofinvestment. Roleofbusinessexpectationsindeterminingmarginalefficiencyofcapitalandtherefore investment. 11.2. MeaningofConsumptionFunction Theconsumptionfunctionindicatestherelationshipbetweenconsumptionandincome.Consumption isanincreasingfunctionofincome.LordKeynesinhistheoryofIncomeandEmploymenthasgiven a very significantplace to this concept. According to him, the level ofnational output, income and employment directly depends on effective demand in an economy. Higher the level of effective demand, higher would be the level of income and employment and viceversa. Effective demand consists of consumption expenditure and investment expenditure. Consumption expenditure depends on the size of income and the consumers propensity to consume and investment

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expendituredependsonthemarginalefficiencyofcapitalandtherateofinterest.Keynessuggested ahighpropensitytoconsumetotackletheproblemofunemploymentinaneconomyandoneofthe remedialmeasuressuggestedtoovercomeunemploymentistoincreasethepropensitytoconsume. AccordingtoProf.Hanson,ThisconceptisKeynessgreatestcontributiontotheeconomistskitof toolsinourgeneration.Itisalsocalledpropensitytoconsume.Itdoesnotmeanameredesireto consume,buttheactualconsumptionthattakesplaceoutofvaryinglevelsofincome.Tounderstand the concept clearly it is necessary to distinguish between consumption and consumption function. Thetermconsumptionreferstoaparticularamountofconsumptionoutofagivenamountof income. Ontheotherhand,Consumptionfunctionreferstodifferentamountsofconsumption atdifferentlevelsof income.Itexplainsafunctionalrelationshipbetweenchangesinthelevelof consumptionasaresultofchangesinthelevelsofincome.Itindicateshowconsumptionvariesas incomechanges.ItisexpressedasC=f[Y]IfconsumptionisrepresentedbyCandIncomebyY then,thepropensitytoconsumeisC=f(Y).Itimpliesthatconsumptionisanincreasingfunctionof income. There is a direct relationship between the two. Higher the income, higher would be the consumptionandviceversa. Income(y)inRscrores 10 15 20 25 30 26 Consumption(c) 10 14 18 22

The table shows consumption as an increasing function of income, both the variables, Y and C, moveinthesamedirection.FurtherconsumptionisshowntochangebyRs.4croresforeachchange ofRs.5croresinincome.Itisassumedthatintheshortrunthepropensitytoconsumewillremain stable.Increaseinconsumptionislessthanproportionatetotheincreaseinincome. Whenwerepresentthisonadiagramwegetacurverisingupwardsbutlesssteeply,thisshowsthat theincreaseinconsumptionissmallerthantheincreaseinincome.

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Y C

Consumption C 0 Income X

Inthediagram,theYaxismeasuresconsumptionandtheXaxisrealincome.TheCCcurve representstheconsumptionfunction. 11.2.1PsychologicalLawOfConsumption In the words of Keynes Men are disposed, as a rule and on the average, to increase their consumptionastheirincomeincreases,butnotbyasmuchastheincreaseintheirincomes.Inthe shortperiod,asthelevelofincomeofthepeopleremainsthesame,thelevelofconsumptionalso remainsthesame. Generally it is observed that when income increases, consumption also increases but by a lessproportionthantheincreaseinincome. SupposethetotalincomeofthecommunityisRs10 crore and the consumption expenditure is also Rs 10 crore. In that case, there is no saving and investment.FurthertheincomeincreasestoRs.15crore.Then,consumptionalsoincreases,butnot totheextentofRs15crore.ItmayincreasetoRs14croreandRs1croreconstitutesthesavings. ThissavingscreateagapbetweenIncomeandConsumption.ThisgapisinconformitywithKeynes Psychological law of consumption, which states that, when aggregate income increases, consumption expenditure shall also increase but by a somewhat smaller amount. This law tellsusthatpeoplefailtospendonconsumptionthefullamountofincrementinincome.Asincome increases,thewantsofthepeoplegetsatisfiedandassuchwhenincomeincreasestheysavemore than what they spend. This law may be considered as a rough indication of the actual macro

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behaviorofconsumersintheshortrun.ThisisthefundamentalprincipleuponwhichtheKeynesian consumptionfunctionisbased. It is based upon his observations and conclusion derived from the study of consumption function. This law is also called the fundamental law of consumption. It consists of three inter related propositions: 1. Whentheaggregateincomeincreases,expenditureonconsumptionwillalsoincreasebutbya smalleramount. 2. Theincreasedincomeisdistributedoverbothspendingandsaving. 3. Asincomeincreases,bothconsumptionspendingandsavingwillgoup. ThesethreeprepositionsformKeynespsychologicallawofconsumption. As consumption expenditure progressively diminishes when income increases, a gap between income andexpenditurearises. Thistendency is sodeep rooted inpeopleshabits, customs,and thepsychologicalsetupthatitisdifficulttochangeintheshortrun.Hence,itisimpossibletoraise the propensity to consume of the people so as to increase the national output, income and employment.Increasingthevolumeofinvestmentinaneconomycanonlyfillupthegapbetween incomeandConsumption.

11.2.2TheAveragePropensitytoconsumeandTheMarginalPropensitytoConsume . 1.TheAveragePropensitytoconsume The relationship between income and consumption is measured by the average and marginal propensitytoconsume.TheAPCexplainstherelationshipbetweentotalconsumptionandtotal income. At a certain period oftime, it indicates the ratioof aggregate consumption expenditure to aggregateincome. Thus,itistheratioofconsumptiontoincomeandisexpressedasC/Y. Totalconsumption TotalIncome C Y 8000 10,000

Thus,APC=APC= APC= =0.8or80%

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SupposetheincomeofthecommunityisRs.10,000croreandconsumptionexpenditureisRs.8,000 crore,thentheAPCis8000/10,000=80%or0.8.Thus,wecanderiveAPCbydividingconsumption expenditurebythetotalincome. 2.MarginalPropensitytoconsume MPC may be defined as the incremental change in consumption as a result of a given increment in income. It refers to the ratio of the change in aggregate consumption to the change in the level of aggregate income. It may be derived by dividing an increment in consumptionbyanincrementinincome.Symbolically MPC=

DC DY

Suppose total income increases from Rs.10,000 crore to Rs. 20,000 crore and total consumption increasesfromRs8000croretoRs15,000crore,then, 7000 MPC= =0.7or70% 10,000 TechnicalcharacteristicsofMPC 1ThevalueofMPCisalwayspositivebutlessthanone. This means that when income increases, the whole income is not spent on consumption. Similarly, when income declines, consumption expenditure does not decline in the same proportion.Consumptionexpenditureneverbecomeszero. 2.MPCisgreaterthanzero. It is always positive. This means that an increase in income will lead to an increase in consumption.MPCcannotbenegative. 3.MPCgoesdownasincomeincreases. 4. MPC may rise, fall or remain constant, depending on many factors, both subjective and objective. 5.MPCofthepoorisgreaterthanthatoftherich. 6.IntheshortrunMPCisstable.

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The concept of MPC throws light on the possible division of additional income between consumption and saving. It also tells us how the extra income will be divided in the Keynesian system.Saving,intheultimateanalysisisequaltoinvestment.Inourexample,MPCis70%andas such the MPS must be30%. The reason is that the income of a community is divided between savingandspending. ThesumofMPCandMPSequals1.

11.2.3. RelationshipBetweenMPCAndAPC
TheTableshowingtheRelationshipbetweenAPC&MPC Rs.Incrores. Income 100 200 300 400 500 Consumption 100 180 240 280 300 APC 100% 90% 80% 70% 60% MPC 80% 60% 40% 20%

1.

Generallyspeaking,whenincomeincreases,APCaswellasMPCdeclinesbutthedeclinein MPCisgreaterthanAPC.

2. 3. 4. 5.

Asincomegoesdown,MPCfallsandAPCalsofallsbutataslowerrate. IfMPCisrising,theAPCwillalsoberisingalthoughataslowerrate. WhenMPCisconstant,APCmayalsoremainconstant. APC,insomecases,maybeequaltoMPC.Itisquitepossible,if50%ofincreasedincomeis consumedandtheremaining50%issaved.

6.

MPCisgenerallyhighinpoorcountrieswhencomparedtorichcountries.Inrichcountriesthe basicrequirementsaresatisfiedandtherefore,theMPCwouldbelessandMPSwouldbehigh.

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But in poor countries majority of the people have to satisfy their basic needs and hence as incomeincreasestheMPCalsoincreaseswhileMPSisgenerallylow. Factorsdeterminingconsumptionfunction Broadlyspeaking,therearetwofactors,whichinfluenceconsumptionfunctioninthelongrun.They are1.SubjectiveFactors.2.Objectivefactors. 1. Subjective factors: Subjective factors basically underlie and determine the form of the

consumptionthesubjectivefactorsareinternalorendogenousinnature. Theymainlydepend upon the personal decisions taken by the people. Keynes has listed eight main motives, which compel people to refrain from current spending. They are the motives of precaution, foresight,calculation,improvement,independence,enterprise,prideandavarice. Inadditiontothesefactors,hehasalsoaddedalistofmotives,whichleadstoconsumption.We could also draw up a corresponding list of motives to consumption such as enjoyment, shortsightedness,generosity,miscalculation,ostentationandextravaganceKeynes. II.Objectivefactors Objective factors are those, which depends on merits and facts. In this case personal factors will not come into picture. The following are some of the important objective factors, whichinfluenceconsumption. 1.Distributionofnationalincome,2.FiscalPolicy,3.Moneyincome,4.Realincome,5.Priceand wagelevel,6.Changesintastesandfashion,7.Changesinexpectations,8. Windfall (Sudden) gains and losses, 9. The level of consumer Indebtedness,10.Attitude towards thrift11.Liquid assets,12. Social and life insurances,13. Rate of interest,14. Business policies of corporations, 15emonstrationeffect,16.Changesinexpectations,and17Installmentbuying,etc. Theobjectivefactorsgenerallyremainunchangedintheshortperiod.Thus,propensitytoconsume intheshortperiodisgenerallystable.Itisbecauseofthis,Keynesplaceshisrelianceoninvestment forthepurposeofincreasingemploymentduringdepression. 11.2.4 ImportanceOfConsumptionFunction Ithasgotgreattheoreticalaswellaspracticalimportance.Allmostallcountriesoftheworldaimat removingunemploymentraisetheirnationalincomeandenjoyprosperity.Forthispurpose,apolicy

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ofplannedeconomicdevelopmentisessential.Intheformulationofthispolicyconsumptionfunction playsaveryimportantrole.

1.ItinvalidatesSayslawofmarkets. Saylawofmarketswhichisthefundamentalbasisofclassicaltheoryofincomeandemployment, statesthatSupplycreatesitsowndemand.Asaresult,thereisnopossibilityofoverproduction andunemployment.Consumptionfunctiontellsusthattheentireincreaseinadditionalincomeisnot spent on consumption goods. Hence, according to Keynes, supply instead of creating its own demand very often exceeds it and creates a glut of goods leading directly to over production and massunemployment. 2.Ithighlightstheimportanceofinvestmentinemploymenttheory. According to Keynes, in order to increase the volume of employment, both consumption and investment must be stepped up. But consumption function in the short run remains more or less constantandassuchitmaybetakenasgiven.Hence,investmentplaysacrucialroleindetermining thelevelofemployment. 3.Ithelpstoexplaintheturningpointsofthebusinesscycle. During the boom period, though income increases, consumption expenditure fails to match the increased incomes. Hence, saving increasesdemanddeclinesand ultimately theslumpdevelops. Similarly, during the period of slump, income contracts, people fail to reduce their expenditure on consumptiontothefullextentofthedecreaseinincomes.Thistendencyultimatelyleadstoboom. 4.IthelpstoexplainthedecliningtendencyofMEC Inrichadvancednations,theMPCislessthanone.Hence,MECshowsadecliningtrend.Thisis becauseasincomeincreases,expenditurefallssavingrisesdemanddeclinesproductionmovesin the downward direction profits fall leading to a decline in MEC. Hence, investment declines and economicgrowthdeclines. 5.Ithelpstoexplaintheconceptofsecularstagnation Generallyspeaking,theMPCislowandMPSishighinmostoftheindustrializednations.Thegap between income and consumption continues to raise necessitating increase in investment. As propensitytoconsumeisstable,propensitytosavealsotendstobestable.Ontheotherhand,it
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becomes less and less with the lapse of time. The economy may sooner or latter reach a stage where it finds itself unable to utilize fully and effectively its savings for the task of promoting full employment.KeynescallssuchasituationasSecularStagnation. 6.IthelpstofindoutthevalueofMultiplier Thevalueofmultiplierisderivedfromconsumptionfunction. 1 K= Thishelpsustounderstandtheprocessofmultiplication. 1MPC SincetheMPCislessthanunity,theincreaseinnationalincomeisnotinproportiontoinvestment. Themagnifyingeffectofmultiplierdeclinesduetofallinconsumptionexpenditureinaneconomy. 7.Ithelpstoexplaintheconceptofunderemploymentequilibrium. As MPC is less than one, the consumersfail to spendon consumption thefull increased income. Effective demand becomes inadequate to bring about full employment equilibrium. Thus, the economyremainsatunderemploymentequilibrium. 8 Itupholdsthestateintervention.

Sinceoverproductionandunemploymentarepossibleowingtothedeficiencyofconsumption,the economycannotbeaselfadjustingsystembyitself.Hence,stateinterventionisamust. Thus, consumption function helps us to analyze the process of income generation, expansion in employment opportunities, need for the state intervention and a very high level of investment to maintainthenationalincomeandemployment. SelfAssessmentQuestions1 1Therelationshipbetweenconsumptionandincomeiscalled_____________. 2.__________istheratioofchangeintotalconsumptiontochangeintotalincome. 3.Twogroupoffactorthataffectconsumptionfunctionare________and______.

11.3. InvestmentFunction Investment is the second important component of effective demand. In Keynesian economics, the term investment has a different meaning. In the ordinary language, it refers to financial

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investment.Itmeanspurchaseofstocks,shares,debentures,bondsetc.Inthiscase,thereis only transfer of rights or titles from one person to another. It is an investment by one and disinvestmentbyanotherandassuchthevaluetransactionmutuallycancelsouteachother.They donotaddanythingtothetotalstockofcapitalofthenation. Investment, according to Keynes, refers to real investment. It implies creation of new capital assets or additions to the existing stock of productive assets. It refers to that part of the aggregateincome,whichisusedforthecreationofnewstructures,newcapitalequipments, machinesetcthathelpintheproductionoffinalgoodsandservicesinaneconomy.Creation ofincomeearningassetsiscalledinvestment.Thus,investmentmustgenerateincomeinthe economy. In the words of Joan Robinson, By investment, is meant an addition to capital, such investmentoccurswhenanewhouseisbuiltoranewfactoryisbuilt.Investmentmeansmakingan addition to the stock of goods in existence. These activities necessitate the employment of more laborandthusresultinanincreaseinnationalincomeandemployment.Investmentisnotastock but a flow, a variable because it highlights on the additions to the existing stock of capital. The productiveabilityofaneconomyismeasuredintermsofitsstockofcapitalanditscapacitytoaddto theexistingstockofcapital.Hence,itisacrucialfactorintheeconomicdevelopmentofanynation.

11.3.1.TypesOfInvestment Keynesspeaksof5typesofinvestment. 1. PrivateInvestment. Itismadebyprivateentrepreneursonthepurchaseofdifferentcapitalassetslikemachinery,plants, constructionofhousesandfactories,offices,shops,etc. ItisinfluencedbyMECandinterestrate. It is profit elastic. Profit motive isthe basisfor private investment. Privateentrepreneurs would takeuponlythoseprojects,whichyieldquickresultsandgenerallyhavesmallgestationperiod. 2.Publicinvestment. ItisundertakenbythepublicauthoritieslikeCentral,StateandLocalauthorities.Itismadeon building up of infrastructure of the economy, public utilities and on social goods. For example expenditure on basic industries, defense industries, construction of multi purpose river valley projects,etc.Inthiscasethebasiccriterionandmottoissocialnetgain,socialwelfareandnot profit motive. The principle of maximum social advantage would govern public expenditure. It is influencedbysocialandpoliticalconsiderationsalso.
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3.ForeignInvestment. Itconsistsofexcessofexportsovertheimportsofacountry.Itdependsuponmanyfactors suchaspropensitytoexportofagivencountry,foreignerscapacitytoimport,pricesofexportsand imports,statetradingandotherfactors. 4. Inducedinvestment

Y
I Investment

Income

Itisanothernameforprivateinvestment.Investment,whichvarieswiththechangesinthelevel ofnationalincome,iscalledinducedinvestment.Whennationalincomeincreases,theaggregate demandandlevelofconsumptionofthecommunityalsoincreases.Inordertomeetthisincreased demand,investmenthastobesteppedupincapitalgoodssectorwhichfinallyleadstoincreasein theproductionofconsumptiongoodsTherefore,wecansaythatinducedinvestmentisincome elastici.e.,itincreasesasincomeincreasesandviceversa. Thus, it is sensitive to changes in income and isgoverned by profit motive. The shape ofthe inducedinvestmentcurvehasbeenshownasrisingupwardstotheright.Thismeansthatasincome increases,investmentalsoincreasesandviceversa. 5.AutonomousInvestment Itisanothernameforpublicinvestment. Theinvestment,whichisindependentofthelevelof income,iscalledasautonomousinvestment.Suchinvestmentsdonotvarywiththelevelof

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income.Thereforeitiscalledincomeinelastic.Itdoesnotdependonchangesinthelevelofincome, consumption,rateofinterestorexpectedprofit.

I Investment

X Income

Autonomousinvestmentdependsuponpopulationgrowth,technologicalprogress,discoveryofnew resourcesetcforexampleexpenditureonpublicbuildings,transportandcommunications,defense, publicutilities,watersupply,generationofelectricityetcareconsideredasautonomousinvestment. Itisguidedbysocialwelfareratherthanprofitmotive. The investment curve is perfectly elastic. And as such it indicates that though income changes, investmentmoreorlessremainsconstant. Thereareafewotherconceptsofinvestment.Theyareasfollows 1. GrossInvestment: Grossinvestmentreferstothetotalrealinvestmentoranadditiontocapitalstockofthecountry. 2. Replacement Investment: A part of gross investment that is used for replacing the old capital equipmentsiscalledreplacementinvestment. 3. Net investment: The net investment is equal to the gross investment minus replacement investment. Hence, Net Investment = Gross investment capital consumption or replacement investment. 4.Exanteinvestment:Theinvestmentthatisintendedorexpectedorplannedisknownasexante investment.

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5.Expostinvestment:Theactualorrealizedinvestmentisknownasexpostinvestment.

11.3.2.DeterminantsOfInvestment Investmentdecisionstakenbytheentrepreneursdependuponanumberoffactorslikeinterestrate, level of uncertainty, political environment, rate of growth of population, level of existing stock of capital,thenecessityofnewproducts,investorslevelofincome,levelofinventionsandinnovations, level of Consumers demand, availability of capital and liquid assets of the investors, government policyetc. Itisnecessarytonotethatinvestmentismorevolatileandunpredictable.Itishighlyunstablein the short run because thefactors determining it are highly complex anduncertain intheir nature. Theabovementionedfactorsnodoubtgenerallyaffectthevolumeofinvestment.However,themost important inducement to invest is the consideration of the profit. The profitability of investment dependsmainlyontwofactors1.MarginalEfficiencyofcapital(MEC)and2.InterestRate(IR).It relatestothecostbenefitanalysis.Thebusinessmanwhileinvestingcapitalhastocalculatethecost ofborrowingandtheexpectedrateofprofitsfromit.

11.3.3 MarginalEffeciencyOfCapitalAndBusinessExpectations
MarginalEfficiencyofCapital It refers to productivity of capital. It may be defined as the highest rate of return over cost accruing from an additional unit of capitalasset. Also it refers to the yield expected from a newunitofcapital.TheMECinitsturndependsontwoimportantfactors. 1.Prospectiveyieldfromthecapitalassetand 2.Thesupplypriceofthecapitalasset.

TheMECistheratioofthesetwofactors.Theprospectiveyieldofacapitalassetmeansthe totalnetreturnsexpectedfromtheassetoveritslifetime.Afterdeductingthevariablecostslike costofrawmaterials,wages,etcfromthemarginalrevenueproductivityofcapital,aninvestorcan estimatetheprospectiveincome(expectedannualreturnsandnottheactualreturns)fromthecapital asset.Alongwithithealsohastoconsiderthesupplypriceorreplacementcostofthecapitalasset.

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Supplypriceofacapitalassetisthecostofproducingabrandnewassetofthatkind,notthe supply price of an existing asset. It is the actual amount of money spent by an investor while purchasingnewmachineryorerectinganewfactory. TheMECofaparticulartypeofassetmeanswhataninvestorexpectstoearnfromanadditionalunit of it compared with what it costs him. To be more specific, MEC is the rate of discount, which will make the present value of the capital assets equal to their future value (prospective yield) in their lifetime.Supplyprice=discountedprospectiveyield. TheMECcanbecalculatedwiththehelpofthefollowingformula. QIQ2Q3Qn Cr= (1+r)1 (1+r)2
3 (1+r)

(1+r)n

IntheaboveformulaCrrepresentsSupplypriceorreplacementcostofthenewcapitalasset.Q1, Q2, Q3 indicate the prospective yields in the various years 1 2 3 and n. represents the rateof discountwhichwillmakethepresentvalueoftheseriesoftheannualreturnsjustequaltothesupply priceofcapitalasset.Thus,rdenotestherateofdiscountorMEC. We can illustrate the meaning of MEC as a rate of discount by means of a simple arithmetical example.Suppose,thesupplypriceofacapitalassetisRs.3000/andtheassetwillbecomeuseless aftertwoyears.FurthersupposethatcapitalassetisexpectedtoyieldRs.1100/attheendofone year and Rs.2420/ at the end of 2 years. Now, it is obvious that the rate of discount of 10% will equatethefutureyieldsoftheassetwithitscurrentsupplyprice.At10%discountratethepresent value of Rs1100/ discounted for one year plus Rs.2420/ discounted for 2 years amounts to an aggregatesumofRs.3000/whichisaspointedoutabovethesupplypriceofthecapitalasset.The abovementionedformulacanbeusedtoexplainthesamepoint. 1100 + 2420
2 (1+0.1)

Cr =

Q1+ (1+r)1

Q2 (1+r)2

3000=

1 (1+0.1)

Rs.1100 +Rs.2420 =1100+2420

3000=

[1.10]

[1.10]2

1.1

1.21

3000= Rs.1000+Rs.2000

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Inthiscase,thediscountedprospectiveyieldisequaltothecurrentsupplypriceofthecapitalasset. Iftheexpectedrateofyieldisgreaterthanthesupplyprice,thenonlyitbecomesprofitabletoinvest andotherwisenot. notethat WhenMEC > IR,theeffectoninvestmentisfavorable. WhenMEC < IR,theeffectoninvestmentisadverse. WhenMEC=IR,theeffectoninvestmentisneutral. Generally speaking, the MEC of a capital falls as investment increase. We can give the following reasonsforthis. 1. The prospective yields of the asset will fall as more and more units of it are produced. This happensbecauseasmoreassetsareproduced,theywillcompetewitheachothertomeetthe demandfortheproductandconsequently,theirgeneralearningswilldecline. 2. Theoperationofthelawofdiminishingmarginalreturns. 3. Higherinvestmentscreatehigherdemandforcapitalassetsleadingtoanincreaseinsupplyprice of capital assets. Consequently, the total production cost rises. Thus, MEC declines with an increase in investment either as a result of decreasing prospective yield or increasing supply priceofcapitalasset. 4. Higher investment results in higher production, reduction in per unit cost, lower price for the productsandlowerearningsfromthesales. ThevolumeofinducedinvestmentdependsonMECandIR.Itisnecessaryto

Thus,theMECfallsasinvestmentincreasesbecausecostsgoupandearningsfall.ThefallinMEC willbedifferentatdifferentlevelsofinvestment.TheMECcurveslopedownwardsfromlefttoright. Thistendencycanbeexplainedwiththehelpofthefollowingexample.

TheIRin %p.a 13% 11% 9%

Volumeofinvestment inCrores 5000 7000 9000

MECofcapital in%p.a 13% 11% 9%

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7% 5% 3%

11000 13000 15000

7% 5% 3%

OntheOXaxis,werepresentdifferentamountsofinvestmentandonOYaxis,werepresentMEC andIR.TheMEcurveindicatestheMEC.Itcanbeseenthatasinvestmentincreases,theMEcurve slopedownward. It is clear that ifthe current IR 9 %, then the entrepreneurs will invest Rs9000/ becauseatthispointtheMECisalso9%.MEC=IR.IftheIRfallsto7%,thentheentrepreneurswill investRs11000/.ThisisbecausetheMECisalso7%atthispoint. Y

IR

11 9 E O 70009000 Investment

MEC
Y

TheMECrepresentsaninvestorsreturnandtheIRishiscost.Obviously,thereturnoncapitalmust beequaltoitscost.Thus,theMECandIRarecloselyrelatedtoeachotherandtheymovetogether. We can conclude that given a MEC curve, the investment will depend on the existing IR in the market.

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DETERMINANTSOFMEC SeveralfactorsthataffectMECaregivenbelow. 1.Shortrunfactors: Expectationofincreaseddemand,higherMECleadstolargerinvestmentand viceversa. 2.CostandPrice: Iftheproductioncostsareexpectedtodeclineandmarketpricestogoupin

future,MECwillbehighleadingtoariseininvestmentandviceversa. 3.HigherPropensitytoconsumeleadingtoariseinMECencourageshigherinvestment. 4.Changesinincome: AnincreaseinincomewillsimulateinvestmentandMECwhileadeclineinthelevelofincomes willdiscourageinvestment. 5.Currentstateofexpectations: If the current rates of returns are high, the MEC is bound to be high for new projects of investmentandviceversa.Thisisbecausethefutureexpectationstoaverygreatextentdepend onthecurrentrateofearnings. 6.Stateofbusinessconfidence: During the period of optimism (boom) the MEC will be generally high and during period of pessimism(depression),itwillbegenerallyless. IILongrunfactors. 1.Rateofgrowthofpopulation: Inacapitalisteconomy,ahighrateofpopulationgrowthleadstoanincreaseinMECbecauseit leadstoanincreaseinthedemandforbothconsumptionandinvestmentgoods.Onthecontrary, adeclineinthepopulationgrowthdepressesMEC. 2.Developmentofnewareas: Development activities in the new fields like transport and communications, generation of electricity,constructionofirrigationprojects,portsetcwouldleadtoariseinMEC.

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3.Technologicalprogress: Technological progress would lead to the development and use of highly sophisticated and latest machines, equipments and instruments. This will add to the productive capacity of the economy leadingtoanincreaseinMEC. 4.Productivecapacityofexistingcapitalequipments: Underutilisedexistingcapitalassetsmaybefullyutilizedifthedemandforgoodsincreasesinthe economy.InthatcasetheMECofthesameassetwilldefinitelyrise. 5.Therateofcurrentinvestment: Ifthecurrentrateofinvestmentisalreadyhigh,therewouldbelittlescopeforfurtherinvestmentand assuchtheMECdeclines. Thus,severalfactorsbothintheshortrunandinthelongrunaffecttheMECofacapitalasset. Thus,severalmeasuresaretobetakentostimulateprivateinvestmentinaneconomy. IntheKeynesiantheory,investmentisaveryimportantandstrategicvariable.Inordertoincrease the volume of national output, income and to tackle the problem of unemployment, the remedial measure suggested by Lord Keynes is to raise the level of investment in an economy. In this connectionProf. Dillard remarks Afundamental principle isthat as the incomeof the community increases, consumption also increase but by less than the increase in income. Hence, in order to have sufficient demand to sustain an increase in employment, there must be increase in real investment equal to the gap between income and consumption out of income. In other words, employmentcannotincreaseunlessinvestmentincreases. RoleofBusinessExpectationsinDeterminingMEC Business expectations play a vital role in determining MEC and therefore investment. Level of incomeandemploymentinaneconomyaredeterminedbytwofactors,viz.,Propensitytoconsume andinducementtoinvest.Ofthesetwopropensitytoconsumeismoreorlessstable,fluctuationsin incomeandemployment,therefore,dependmainlyontheinducementtoinvest.Theinducementto investinturndependsontherateofinterestandthemarginalefficiencyofcapital.Sincetherateof interestisrelativelystableorsticky,fluctuationsininvestmentdependprimarilyuponthechangesin theMEC.TherearetwodeterminantsoftheMEC,thecostofthecapitalassetandtherateofreturn fromtheasset.
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UncertaintyintheprospectiveyieldorbusinessexpectationscausesinstabilityinMEC.Asbusiness expectations change, the volume of investment changes and this causes changes in business activityandemployment. Expectations regarding the prospective yield of capital assets are of two types:Short term expectations(b)Longtermexpectations. Shorttermexpectationsarebasedontheexistingstockofcapitalandtheintensityofconsumers demandforthegoodswhichareknownandremainmoreorlessstable. On the other hand, long term expectations relate to future changes in the size of the stock of capitalassetsandaboutchangesinthelevelofaggregatedemandwhichareuncertain.Thusthe long term expectations are highly unstable, but are more important in explaining fluctuations in investmentandemployment. Thelongtermexpectationsareinfluencedbythefollowingfactors:

1. ThestateofconfidenceHowcertainandconfidentarebusinessmenwithregardtothefuture
change.

2. StockexchangevaluationThevalueattachedtoitbythedealersinstockexchange. 3. IrrevocabledecisionsDecisionsmadebyboldanddynamicentrepreneurs. 4. Elements of instability Frequent changes in the assessment of the prospects of various
investmentshaveintroducedlotofchangesintheinvestmentactivity.

5. Link with investments Stock exchange dealings influence new investments by establishing
linksbetweenthenewinvestmentsandthepresentinvestments.

6. BehaviourofinvestorsSincethereismassvaluationofassetsonthestockexchange,there
arealternatingwavesofpessimismandoptimism. Apart from these political events like war, elections etc. also influence the prospective yield of the capitalassets. Thus investmentdecisionsare made in anuncertainatmosphere, basedon businessexpectations withregardtothemarginalefficiencyofcapital.

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SelfAssessmentQuestions2

1. Investmentmadebygovernmentanddepartmentalundertakingsiscalled______investment. 2. Depreciationispartof____________________. 3. ________investmentdoesnotdependonthechangesinthenationalincome. 4. ________varieswiththechangesinthelevelofnationalincome 11.4. Multiplier

MeaningandworkingofMultiplier Prof. Kahn developed the concept of Multiplier with reference to employment. Lord Keynes, on the lines of employment multiplier, developed an Investment Multiplier. It is derived from the conceptofmarginalpropensitytoconsumeandreferstotheeffectsofchangesininvestmentoutlays onaggregateincomethroughconsumptionexpenditure.Ithasacquiredgreatersignificanceinrecent years to explain the process of income generation in an economy when the volume of investment changes. There are various types of Multiplier such as Income multiplier, investment multiplier, employment multiplierandforeigntrademultiplieretc. Keynes investment multiplier is based on The fundamental psychological law of Consumption. It states that as income increases, consumption also increases but less than proportionately. Consequently, the consumption demand in the short run remains constant and it cannot be increased. The alternative to increase the output is to increase the volume of investment. Even thoughconsumptionfunctionisamajordeterminantofaggregatedemand,itisnottheprimeinitiator ofchangesinincomeandoutput.Thechangesinthevolumeofinvestmentwillbringaboutchanges inthelevelofincomeandoutput.Howchangesinincomeareaffectedcanbeunderstoodwiththe helpofinvestmentmultiplier. Multiplier may be defined as a ratio of change in income to a change in investment. It expresses the relationship between an initial increment in investment and the final increment in income.Itshowsbyhowmanytimestheeffectofaninitialchangeininvestmentismultiplied bycausingchangesinconsumptionandfinallyintheaggregateincome.Changeininvestment generallygivesrisetochangeinincomebyamultipleamount.Wheneveranadditionalinvestmentis

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made in the economy, it increases the aggregate income not only by an amount equal to the additionalinvestmentbutbysomewhatgreaterthanthat.Thelogicissimple.Theoriginalinvestment increases income not only in the industry where investment is made but also in certain other industries whose products are demanded by men employed in investment goods industries. For example,ifanincreaseininvestmentofRs.5LakhscausesanincreaseinincomeofRs.25Lakhs, thenthemultiplierwouldbe5.IftheincreaseinincomeisRs.30Lakhs,thenthemultiplierwouldbe 6.Algebraically,thisrelationshipcanbeexpressedas

Change[D]inincome

K=

Change[D]ininvestment

25 K==5 5

Where delta standsfor change or increase, Kfor multiplier and Y for income and Ifor Investment respectively. ThesizeofthemultiplierisdirectlyderivedfromthesizeofMPC.HighertheMPC,higherwouldbe the size of multiplier and viceversa. The multiplier is equal tothe reciprocal of 1 minus MPC. The formulatocalculatethesizeofthemultiplierisasfollows. 1 K= 1MPC. follows. K=1= 1MPC 1= 1 2/3 1=3 11/3 IfweknowthesizeoftheMPC,thevalueofthemultiplier canbeeasilyfoundout.IfMPCis2/3,thenmultiplierwouldbeas

WeknowthatMPC+MPS=1.IfwedeductMPCfrom1wegetMPS.Hence,theaboveequation canbeexpressedinthefollowingmanner. K= 1 MPS

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IftheMPCis9/10,deducting9/10from1,weget1/10.ThisistheMPS.Thereciprocalof1/ 10is10,whichisthevalueofmultiplier.Inshort,themultiplieristhereciprocaloftheMPS, whichisalwaysequalto1minustheMPC. Fromtheaboveexplanation,itisclearthat 1.HigherthevalueofMPC,higherwouldbethevalueofKandviceversa. 2.WhenMPS=0andMPC=1,thentherewillbea100percentincreaseinincomeeverytimeorthe multipliereffectwillbecontinuous. 3.WhenMPS=1andMPC=0,thenwhatisearnedwillbesavedandthevalueofmultiplierwillbe equalto0. WORKINGOFTHEMULTIPLIERANDTHEPROCESSOFINCOMEGENERATION: Theprocessofincomegenerationthroughtheworkingofthemultipliercanbeexpressedinthe followingmanner. ASSUMPTIONS:

1.MPC=orK=2. 2.AninvestmentofRs10croreswillgenerateanincomeofRs20crores.

Periodor Rounds

Investmentin Crore(Rs)

Changein Incomein Crore(Rs)

1 2 3 4 5 6

10 10 10 10 10 10 Total

10 05 2.50 1.25 0.62 0.31 20

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Themultiplierprocessisbasedontheprinciplethatonemansexpenditureisanothermansincome. IfMPCofoneindividualishigh,theincomeofanothermanisalsohigh.Fromtheabovetableitis clear that as we move from one round to another, the initial investment gives rise to a dwindling seriesofsuccessiveincrementsinincomebecauseMPCisgenerallylessthanone. Assumptions:

1.MPC=2/3orMPS=1/3orK=3. 2.OriginalinvestmentisRs30crores. 3.AdditionalinvestmentisRs10crores. Asthemultiplieris3,theadditionalinvestmentofRs.10croresleadstoanincreaseintheincomeof thecommunitytoRs.30crores.Thiscanbeunderstoodwiththehelpofthefollowingdiagram. In the diagram above, QR representsoriginal investmentof Rs30 Crores. SS is the saving curve, which intersects the investment curve at the point M, which indicates the original income of the community at Rs 130 Crores. Q1R1 is the new investment line, which indicates an additional investmentofRs10Crores.ThenewinvestmentCurveQ1R1intersectsthesamesavingcurveat M1.Atthisnewequilibriumpoint,theincomeofthecommunityisRs160Crores.Itisclearthatasa result of an additional investment of Rs 10 crores, income has gone up by 3 times (From Rs 130 crorestoRs160crores).

Y Q` Saving&Investment M`

S R`

130

Income

160

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ASSUMPTIONSANDLIMITAIONSOFTHEMULTIPLER: 1. Availabilityofconsumergoods: Multiplierworkssatisfactorilyifthevolumeofgoodsandservicesonwhichtheadditionalincome may be spent are available in plenty. Otherwise, people are unable to spend their income on them.Consequently,MPCfallsleadingtoadeclineinthevalueofK. 2. MaintenanceofInvestment: InordertorealizethefullvalueofK,itisnecessarythatthevariousincrementsininvestmentbe repeatedatregularintervals.Incase,itisnotdone,itwillnotbepossibletoraisetheincometo themultiplierlevel. 3. NetIncreaseinInvestment: In order to get the full value of K, there should be a net increase in investment. Increase in investmentinonesectoroftheeconomyshouldnotbeneutralizedbydecreaseininvestmentin anothersectorofeconomy.Otherwise,theworkingofthemultiplierisobstructed. 4. NochangeinsizeofMPC: In the process of income generation, there should not be any change in the value of MPC. If thereisanychangeinthesizeofMPC,thenthevalueofKalsochanges. 5. Noinvestmentfrominducedconsumption. In the multiplier theory we analyze only the impact of investment on consumption. But the reverse,viz.,acceleratoristotallyignored.Iftheacceleratorisallowedtooperateandeffectsof inducedconsumptiononinvestmentarealsotakenintoaccount,thenthevalueofthemultiplier would be far greater and would also be achieved at an earlier stage in the process of income generation. 6. Notimegapbetweensuccessiveexpenditureonconsumption. Ifthereisagapbetweenreceiptofincomeandexpenditureevenintheshortrun,thefullvalueof theKcannotberealizedbecauseasMPCfalls,thesizeoftheKalsodeclines.

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7. Existenceofaclosedeconomy. If there is trade between different countries,thevalue of K maybe restricted bytheamount of excess of importsover exports. A partofthe total money will go out of the country ifthereare importsandtothatextentthevalueoftheKdeclines. 8. Existenceoflessthanfullemploymentcondition. Iftheeconomyisworkingatfullemploymentlevel,inthatcasethereisnoscopeforincreasein output,incomeandemploymenteventhoughinvestmentincreases. 9. Itisbasedonnumberofassumptions. These assumptions maynot befound in practice. Consequently, the actual multiplier may be greatlyrestrictedandwillbedifferentfromtheidealmultiplier. 10. Nodirectrelationbetweeninvestmentandincome: According to Prof. Hazilitt, there is no precise, predeterminable or mechanical relationship betweensocialincome,consumption,investmentandextentofemployment. 11. Keynesmultiplierisastaticconcept: Itshowstheprocessofincomepropagationfromonepointofequilibriumtoanotherandthattoo under static conditions. It gives little insight into the actual process by which the economy achievesanewequilibrium.

PREREQUSITECONDITIONSFORTHEWORKINGOFTHEMULTIPLIER 1. Existenceofinvoluntaryunemployment. National output, income and expenditure can be increased by additional investment only when thereisinvoluntaryunemploymentconditioninaneconomy.Otherwise,therewillbenoscopefor expansioninemploymentevenifinvestmentincreases. 2. ExistenceofanIndustrialEconomy. Multiplier can freely operate in an industrial economy rather than in an agricultural economy becausethedemandforindustrialgoodsisrelativelystablethanthatofagriculturalgoodsandas suchtheMPCandthevalueofKwillbehigh. 3. Existenceofexcesscapacityinconsumergoodsindustries.

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A high level of investment will succeed in utilizing the unutilized and under utilized excess capacitytotheextentpossible.Thisleadstothecreationofmoreemployment. 4. Existenceofelasticsupplyofotherfactorinputsinthemarket. Ahigherinvestmentwouldresultinhigheroutput,incomeandemploymentonlywhentheother supplementalfactorinputsareavailableinabundance. LEAKAGESINTHEMULTIPLIER Income not spent on consumption is called leakage in the cumulative income stream. This leakageobstructstheincreaseinoutputandincome.Theseleakageswillariseonaccountofthe followingreasons. 1. Savings: Higherthelevelofsavings,thelowerwouldbethevalueofKandviceversa. 2. Accumulationofidlecashbalances: If people keep more idle cash balances with them, then the MPC declines and the value of K declines. 3. Debtcancellations: Ifpeopleuseapartoftheirincometorepaytheirolddebts,thenthecurrentMPCdeclinesand thevalueofKalsodeclines.

4. Purchaseofoldsharesandstocks: A part of the income may be spent on buying old stocks, shares and other securities in the market.ThiswouldleadtoadeclineincurrentMPCandadeclineinthevalueofKalso. 5. Imports: PaymentsonimportswouldreducedomesticconsumptionleadingtoadeclineinthevalueofK. 6. Priceinflation: Inflation would reduce the purchasing power of thepeopleand consequently the MPC and the valueoftheKalso.

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7. Taxes: Highertaxeswouldreducetheincomesofthepeople,MPCandalsothevalueofK. 8. Corporatesavings: Undistributedprofitsofjointstockcompanieswouldreducetheincomesoftheshareholders,their MPCandthusthevalueoftheK. If all these leakages are properly plugged in the income stream, the effect of multiplier in the process of income generation would be higher, taking the economy towards full employment level. PRATICALIMPORTANCEOFTHEMULTIPLIER 1. It is a major tool of macro economic theory focusing attention on investment as the significant elementinincreasingthelevelofemployment. 2. ItsummarizestheworkingoftheentireKeynesianmodel. 3. Itdescribeshowincomeisgeneratedinaneconomicsystemlikestonecausingripplesinalake. 4. Itisavaluableguidetopublicinvestmentpolicy. 5. Itishelpfulforframingasuitablefullemploymentpolicy. 6. It has great practical significance in formulating anticyclical policy to smoothen business fluctuations in an economy. Thus, it is necessary for the study of trade cycle, its trends and control. 7. According to Prof. Samuelson, the multiplier theory explains why an easy money policy is ineffectiveanddeficitspendingiseffectiveduringtheperiodofdepression. 8. Forincreasingtheincomeandemployment,investmentshouldbestartedinasectorwherethe multipliermaybegreater. 9. It is used for explaining expansion in different fields of economic activities. For example credit multiplier,budgetmultiplieretc. 10. It upholds the Government intervention, active participation and macro economic management relatingtoincome,outputandemploymentetc.

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11. Ithelpstounderstandhowequalitybetweensavingandinvestmentisbroughtabout.Anincrease in investment leads to increase in income. Consequently, saving also increases and becomes equaltoinvestment. 12. It emphasizes the significance of deficit financing. Increase in public expenditure by creating deficit budget help in creating income and employment multiple times the initial increase in expenditure. Thus, the concept of multiplier has not only brought about a revolution in economic theory but also inframing various economic policies. Keynes regards it asa pathbreaking contribution to economictheory.

11.5Accelerator
Theprincipleofacceleratororaccelerationisanotherimportanttoolofeconomicanalysis.Itis older than multiplier. The accelerator dates back to 1914 or even before. It is associated with the nameofProf.J.M.Clark,anAmericaneconomistwhowasmainlyresponsibleforpopularizingitin 1917 Multiplier and accelerator are the two parallel concepts. The multiplier concept is inadequate to explain the process of income generation in a complete manner. It shows the effectof investment only on consumption expenditure and how the increase in investment will bring about increase in national income through multiplier effect. In short, multiplier explains the effects of investment on consumption and how the volume of consumption depends on the volume of investment. The multiplierfailstoanalyzetheeffectofincreaseinconsumptiononinvestment.Inordertoknowhow consumptionaffectsthevolumeofinvestment,wehavetostudytheconceptofaccelerator Acceleratorshowstheeffectofchangesinconsumptiononinducedinvestmentandtellsus how the volume of investment depends on the level of consumption. The combined action of bothmultiplierandacceleratorwillclearlyexplainhowtheaggregatenationalincomeincreasesasa resultofincreaseinthevolumeofinvestmentinaneconomy.Whenincomesofthepeopleincrease, purchasing power and the demand for consumption goods increase. In order to produce more consumptiongoods, morecapitalgoodsare required. This leads toan increase in thedemandfor investmentincapitalgoodsindustries.Thus,ariseinincomeleadstoariseinducedinvestmentin capital goods industries. For e.g.,anexpenditure of Rs.4 crores on consumption goods industries, leads to an investment of Rs.12 crores in capital goods industries, then, we can say that the
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accelerator is 3. Production of consumer goods requires a particular amount of capital goods. Therefore, the accelerator is generally more than one. In order to produce consumption goods sometimes,morecapitalisnotnecessaryandsometimes,evenitisnotrequiredatallbecausethe existingstockofcapitalgoodsbecomesufficient.Hence,acceleratormaybelessthanoneorzero. Accelerator is called as Magnification of derived demand because investment depends on employment. Inordertounderstandtheeffectofaccelerator,itisnecessarytoknowtheaccelerationcoefficient. Theratiobetweenthenetchangeinconsumptionexpenditureandtheinducedinvestmentiscalled AccelerationCoefficient.Symbolically, a= D I/ D Cwhere, astandsforaccelerationcoefficient D I=netchangeininvestmentexpenditure DC=netchangeinconsumptionexpenditure. The working of the accelerator can be explained with the following imaginary example. Let us suppose that in order to produce 1000 units of consumer goods, 100 machines are required. The capital output ratio in this case is 1:10. Further suppose that the working life of a machine is 10 years and after 10 years the machine has to be replaced. It implies that every year 10 machines havetobereplacedinordertomaintaintheconstantflowof1000unitsofconsumergoods.Hence, theaccelerationcoefficientinthiscaseis1.Hence,theannualdemandformachineswillbe10.This iscalledReplacementDemand. Now let us suppose that the demand for consumer goods goes up by 10%. Consequently, more machinesarerequirednowtomeettheincreaseddemandforconsumergoods.Nowwerequire10% or10newmachines.(10%of100machinesare10.Hence,thetotaldemandformachineswillnow be20.Itmeansa100%increaseinthedemandformachines(10forreplacementandanother10for meetingtheincreaseddemand).Theinvestmentincapitalgoodsindustryhasdoubled,becausein ourexamplethevalueoftheacceleratoris10.

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AccelerationeffectsonInvestment Consumption Goods 1000 1000 Capital Goods Investment neededfor Induced Investment Nil 10 Total Investment 10 20 %changein Total Investment 100

Period

Required replacement 100 110 10 10

0 1

Fromthetableitisclearthata10%increaseindemandforconsumptiongoodshasresultedina 100%increaseintotalinvestmentoutlay,asacceleratorisone.

Y S E2 I 13 E1 Q E II I 0 Multiplier Effect 13 II

14 Savings&Investment

14

12

12 AcceleratorEffect

Q Income

Q1

Q2

Theworkingoftheacceleratorcanbeexplainedwiththehelpofthefollowingdiagram. In the diagram, SS and II represent saving and investment curves. E indicates the original equilibriumpositionwhereSandImeeteachother.OQistheoriginalequilibriumincome.

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NowinvestmentincreasesfromI2toI4.Consequently,theNationalIncomeincreasesfromOQ to OQ2. The jump in income is Q to Q2. If the increase in investment from I2 to I4 had been purelypublicinvestment,thentheentireincreaseinincomeQtoQ2wouldhavebeenduetoonly the multiplier effect. But Q to Q1 increase in national income is due to the multiplier effect becauseincreaseininvestmentfromI2toI3ispublicinvestment. IncreaseinNationalIncomefromQ1toQ2isduetotheaccelerationeffectbecauseincreasein investmentfromI3toI4isduetoinducedinvestment.Thetotalmultiplierandacceleratoreffect on income is measured by QQ2 (QQ1 due to multiplier effect and Q1 Q2 due to acceleration effect).

Limitationsofaccelerator 1.Thereshouldbenoexcesscapacityincapitalgoodsindustries.Ifthereisexcesscapacityinthat case,additionalproductionofconsumergoodsdoesnotrequireadditionalcapitalgoods. 2.Ifthereisexcessivenumberofmachines,inthatcasethereisnoneedforfurtherinvestmentin capitalgoodsindustries. 3.Ifthedemandforconsumptiongoodsispurelytemporaryinnatureinthatcaseproducerswillnot makeanyadditionalinvestmentincapitalgoodsindustries.Ontheotherhand,theymakeuseof existingmachinesmoreintensively. 4.Inmanycases,investmentsmadeincapitalgoodsindustriesdonotawaitchangesorincreasein consumption,e.g.,investmentinpublicsectorindustries. 5.Ifadequatefinancialresourcesarenotforthcomingtocapitalgoodsindustries,inthatcaseinspite ofincreaseinconsumption,productionofcapitalgoodscannotbeincreased. 6.Itisalwayswrongonourparttoexpectconstantratiobetweenproductionofconsumergoodsand capitalgoods. Inallthesecases,thevalueoftheacceleratormaynotbefullyrealized. PracticalImportance 1. Itexplainstheprocessofincomegenerationmoreclearlyasittakesintoaccountoftheeffectof consumptiononinvestment. 2. Itexplainswhyfluctuationsinincomeandemploymentoccurratherviolently.
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3. Ittellsuswhycapitalgoodsindustriesfluctuatemuchmorethanconsumptiongoodsindustries. 4. It helps in understanding of the different phases of business cycles very clearly. But acceleratorlefttoit,cannotcompletelyexplaintheentirecausefortradecycles.

SelfAssessmentQuestions3 1Theratioofchangeinnationalincomeresultingfromachangeinautonomousinvestmentiscalled _________________. 2.WhenMPC=1multiplerwillbe___________. 3.__________showstheeffectsofconsumptiononinvestmentwhereas__________showsthe effectofinvestmentonconsumption. 4.Acceleratoriscalledas____________________.

11.6Summary
MacroeconomicconceptsofConsumptionfunction,Investmentfunction,Multiplier,Acceleratoretc. explain vividly the functioning of an economy. Consumption function refers to the schedule of propensitytoconsumeatvariouslevelsofincome.Thepsychologicallawofconsumptionstatesthat consumptiontendstorisewithincome,butlessproportionately.Averagepropensitytoconsumeis theratioofconsumptiontoincomeandisexpressedasC/Y.Marginalpropensitytoconsumeisthe ratioofthechangeinconsumptiontothechangeinthelevelofincome.Andisexpressedasdelta C/deltaY.Consumptionfunctionisdeterminedbyanumberofsubjectiveandobjectivefactors.The concept explains the obstacles in the attainment of full employment equilibrium. It explains the turning points of the business cycles, declining tendency of MEC, secular stagnation, underemployment equilibrium and upholds the importance of state intervention and increased investmentinthegenerationofemploymentandincome.Thevalueofthemultiplierisderivedfrom consumptionfunction. Investment refers to real investment denoting an addition to real capital assets as well as to the wealth of the society. There are various kinds of investment like Private investment, Public investment,Foreign,Induced,Autonomous,Gross.Net,etc.Investmentisdeterminedbyanumberof

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factors like the rate of interest, Marginal efficiency of Capital, Level of uncertainty, political environment, rate of growthof population, level of existing stock of capital, inventions, consumers demandetc.Investmentishighlyunstableintheshortrun.Inducementtoinvestmainlydependson therateofinterestandthemarginalefficiencyofcapital. TheMECdependson(a)theprospectiveyieldsi.e.,expectedprofitabilityofthecapitalassets,and (b) the replacement cost of these assets. Business expectations play a very important role in determiningMECandthereforeinvestment. Multiplieristheratioofchangeinincometoagivenchangeininvestment.Thereareanumberof limitations to the working of the multiplier and it presupposes the existence of involuntary unemployment, industrial economy, excess capacity in consumer goods industry etc. A number of Leakages like savings, imports,taxesetc. obstruct the increase in output and income. Itdescribes howincomeisgeneratedinaneconomicsystemlikestonecausingripplesinalake.Itisavaluable guidetopublicinvestmentpolicy. Acceleratorexplainstheeffectofincreaseinconsumptiononthedemandforcapitalgoodsandthe relatedinvestment.Accelerationdependsonthecapitaloutputratioandthedurabilityofthecapital assets.Itexplainstheprocessofincomegenerationmoreclearlyasittakesintoaccounttheeffectof consumptiononinvestment.

TerminalQuestions 1. whatisconsumptionfunction?DistinguishbetweenAPCandMPC. 2. Statethepsychologicallawofconsumption.Explainthevariousfactorsthataffect consumptionfunctionanditsimportance. 3. Whatisinvestmentfunction,discussthevariousfactorsthatdeterminetheinvestment function. 4. WhatisMarginaleffeciencyofCapital?ExplainthefactordeterminingMEC 5. Discusstheworkingofthemultiplierandexplainthevariousleakagesinmultiplier. 6. Discusstheconceptofacceleratorandexplainitsworkingandwhatareitsuses.

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AnswerSelfAssessmentQuestions SelfAssessmentQuestions1 1. ConsumptionFunction. 2. MarginalPropensitytoconsume. 3. SubjectiveandObjectivefactors. SelfAssessmentQuestions2.

1. Public 2. Grossinvestment. 3. Autonomous 4. InducedInvestment

SelfAssessmentQuestion3 1.Multipler 2.Infinite 3.MultiplerAccelerator 4.Magnificationofderiveddemand. AnswertoTerminalQuestions 1. Refertounit11.2 2. Refertounit11.2to11.2.3 3. Refertounit11.3 4. Refertounit11.3 5. Refertounit11.4 6. Refertounit11.5

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