is true that open economy is also a partner in the faster, vibrant global growth. Despite of inherent risks with the open economy, it is worth to be followed because of the immense direct and indirect benefits associated with it. PSYCHOLOGICAL LAW OF CONSUMPTION Further, Keynes put forward a psychological law of consumption, according to which, as income increases consumption increases but not by as much as the increase in income. In other words, marginal propensity to consume is less than one. 1 > ∆C/∆Y > 0 While Keynes recognized that many subjective and objective factors including interest rate and wealth influenced the level of consumption expenditure, he emphasized that it is the current level of income on which the consumption spending of an individual and the society depends. To quote him: “The amount of aggregate consumption depends mainly on the amount of aggregate income. The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge of human nature and from the detailed facts of experience is that men (and women, too) are disposed, as a rule and on an average to increase their consumption as their income increases, but not by as much as the increase in their income” In the above statement about consumption behavior, Keynes makes three points. First, he suggests that consumption expenditure depends mainly on absolute income of the current period, that is, consumption is a positive function of the absolute level of current income. The more income in a period one has, the more is likely to be his consumption expenditure in that period. In other words in any period the rich people tend to consume more than the poor people do. Secondly, Keynes points out that consumption expenditure does not have a proportional relationship with income. According to him, as the income increases, a smaller proportion of income is consumed. The proportion of consumption to income is called average propensity to consume (APC). Thus, Keynes argues that average propensity to consume (APC) falls as income increases. The Keynes’ consumption function can be expressed in the following form: C = a + bYd 100 CU IDOL SELF LEARNING MATERIAL (SLM)
Where C is consumption expenditure and Yd is the real disposable income which equals gross national income minus taxes, a and b are constants, where a is the intercept term, that is, the amount of consumption expenditure at zero level of income. Thus, a is autonomous consumption. The parameter b is the marginal propensity to consume (MPC) which measures the increase in consumption spending in response to per unit increase in disposable income. Thus MPC = ∆C/∆Y It is evident from Fig. 6.2 and 6.3 the behaviour of consumption expenditure as perceived by Keynes implies that marginal propensity to consume (MPC) which is measured by the slope of consumption function curve CC at a point is less than average propensity to consume (APC) which is measured by the slope of the line joining a point on the consumption function curve CC to the origin (that is, MPC < APC). Fig. 6.2 National Disposable Income This is because as income rises consumption does not increase proportionately and as income falls consumption does not fall proportionately as people seek to protect their earlier consumption standards. This can be seen from Fig. 6.2 the slope of consumption function curve CC’ measuring MPC and the slopes of lines OA and OB which give the APC(i. e C/Y ) at points A and B respectively are falling whereas slope of the linear consumption function CC’ remains constant. 101 CU IDOL SELF LEARNING MATERIAL (SLM)
Fig. 6.3 In Fig. 6.3 we have shown a linear consumption function with an intercept term. In this form of linear consumption function, though marginal propensity to consume (AC/AF) is constant, average propensity to consume (C/F) is declining with the increase in income as indicated by the slopes of the lines OA and OB at levels of income F, and F2 respectively. The straight line OB drawn from the origin indicating average propensity to consume at higher income level F2 has a relatively less slope than the straight line OA drawn from the origin to point/t at lower income level Fr The decline in average propensity to consume as the income increases implies that the proportion of income that is saved increases with the increase in national income of the country. This result also follows from the studies of family budgets of various families at different income levels. The fraction of income spent on consumption by the rich families is lower than that of the poor families. In other words, the rich families save a higher proportion of their income as compared to the poor families. The assumption of diminishing average propensity to consume is a significant part of Keynesian theory of income and employment. This implies that as income increases, a progressively larger proportion of national income would be saved. Therefore, to achieve and maintain equilibrium at full-employment level of income, increasing proportion of national income is needed to be invested. If sufficient investment opportunities are not available, the economy would then run into trouble and in that case it would not be possible to maintain full-employment because aggregate demand will fall short of full-employment output. On the basis of this increasing proportion of saving with the increase in income and, consequently, the emergence of the problem of demand deficiency, some Keynesian economists based the theory of secular stagnation on the declining propensity to consume. 102 CU IDOL SELF LEARNING MATERIAL (SLM)
MPC & APC Consumption function denotes the functional relation between consumption and income. Whereas the MPC refers to the marginal increase in consumption (∆C) as a result of marginal increase in income (∆Y), APC means the ratio of total consumption to total income (C/Y): 1. We have seen above that in case of a curved consumption function, as income increase, the MPC as well as the APC both decline, but the decline in the MPC is more than the decline in MPC. In other words, both the propensities decline with an increase in income, though the decline in one (MPC) is greater than the decline in the other (APC). 2. When MPC is constant, the consumption function is linear i.e., straight line. The APC will be constant only if the consumption function passes through the origin. However, if it does not pass through the origin, APC will not be constant. 3. Sometimes the MPC and APC may be equal. It is the case when MPC is constant, that is when the consumption function is linear. Suppose income rises, and of this extra income only 80% is spent on consumption; in that case MPC will be 80% or 0.8. Since the MPC is to remain constant and if the APC also happens to be 0.8, both MPC and APC will be equal. 4. MPC is higher is case of poor communities and lower in case of rich communities. The reason is that in case of rich communities most of their basic needs have already been fulfilled and all the additional increments in income are saved (leading to higher MPS), whereas in poor communities most of their primary needs remain unfulfilled, so that additional increase in income lead to increase their consumption. That is why in backward countries like India, Pakistan, Burma and Indonesia, MPC is higher while in advanced countries like the U.S.A. and U.K. it is lower. (Sometimes MPC and APC in advanced countries assume constant value as pointed out by Prof. Hansen and broadly speaking become the cause of flattening of the C curve causing deficiency of effective demand and creating poverty amidst plenty). MPS & APS Average Propensity to Save (APS): Average propensity to save refers to the ratio of saving to the corresponding level of saving income. 103 CU IDOL SELF LEARNING MATERIAL (SLM)
APS = Saving (S)/Income (Y) If saving is Rs 30 crores at national income off 100 crores, then: S APS = S/Y =30/ 100 = 0.30, i.e. 30% of the income is saved. The estimation of APS is illustrated with the help of Table 6.4 and Fig. 6.4. Table 6.1 Average Propensity to Save Fig. 6.4 Average Prop In Table 6.4, APS = (-) 0.20 at the income of Rs 100 crores as there is negative saving of Rs 20 crores. APS = 0 at income of Rs 200 crores as saving is zero. In Fig 6.5, income is measured on the X-axis and saving is measured on the Y-axis. SS is the saving curve. APS at point A on the saving curve SS: APS = OR/OY1 Important Points about APS: 1. APS can never be 1 or more than 1: 104 CU IDOL SELF LEARNING MATERIAL (SLM)
As saving can never be equal to or more than national income. 2. APS can be 0: In Table 6.4, APS = 0 as saving are zero at the income level of Rs 200 crores. This point is known as Break-even point. 3. APS can be negative or less than 1: At income levels which are lower than the break-even point, APS can be negative as there will be disserving in the economy (shown by the shaded area in Fig. 6.5). 4. APS rises with increase in income: APS rises with increase in income because the proportion of income saved keeps on increasing. Marginal Propensity to Save (MPS): Marginal propensity to save refers to the ratio of change in saving to change in total income. Fig. 6.5 Marginal Propensity to Save (MPS): Table 6.2 Marginal Propensity to Save (MPS): 105 CU IDOL SELF LEARNING MATERIAL (SLM)
Fig. 6.6 Marginal Propensity to Save In Table 6.7 MPS = 0.20 when income increases from zero to Rs 100 Crores. Value of MPS remains constant at 0.20 throughout the saving function. Since MPS (∆S/∆Y) measures the slope of saving curve, constant value of MPS means that the saving curve is a straight line. In Fig. 7.8 MPS at point A with respect to Pint B = ∆S/∆Y = PR/ Y1Y2 MPS varies between 0 and 1 1. If the entire additional income is saved, i.e. ∆C=0, then MPS =1 2. However, if entire additional income of MPS varies between and 1. Relationship between APC and APS: The sum of APC and APS is equal to one. It can be proved as under: We know: Y = C + S Dividing both sides by Y, we get Y/Y = C/Y + S/Y APC + APS = 1 because income is either used for consumption or for saving. Relationship between MPC and MPS: The sum of MPC and MPS is equal to one. It can be proved as under: We know: ∆Y = ∆C + ∆S Dividing both sides by ∆Y, we get ∆Y/∆Y = ∆C/∆Y+∆S/∆Y 1 = MPC + MPS 106 CU IDOL SELF LEARNING MATERIAL (SLM)
MPC + MPS = 1 because total increment in income is either used for consumption of for saving. SUMMARY • Aggregate demand tells the quantity of goods and services demanded in an economy at a given price level. In effect, the aggregate demand curve is a just like any other demand curve, but for the sum total of all goods and services in an economy. It tells the total amount that all consumers, businesses, and the government are willing to spend on goods and services at different price levels. • The aggregate demand curve can be thought of just like a demand curve for a firm. When the price level is high, aggregate demand is low; when the price level is low, aggregate demand is high. The aggregate demand curve lies in a plane consisting of the price level and income or output. It shows a downward slope with price level on the vertical axis and income or output on the horizontal axis. As such, the aggregate demand curve outlines the relationship between income or output and the price level. It is important to notice that aggregate demand is a schedule because as the price level changes, the income or output also changes. • Aggregate demand is a graphical model that illustrates the relationship between the price level and all of the spending that households, businesses, the government, and other countries are willing to do at each price level. If that sounds familiar, it should! The components of aggregate demand are identical to the components that are used to calculate real GDP using the expenditures approach: • Consumption • Investments • Government spending • Net exports. The aggregate demand (AD) curve • The AD curve is one part of a three-part model that describes something called “National Income Determination.” That’s quite a mouthful, but remember that national income is real GDP. In other words, part of what determines national income is all of the spending done by households (consumption), firms (investment), government (government spending), and the rest of the world (net exports). AD 107 CU IDOL SELF LEARNING MATERIAL (SLM)
shows the amount of that spending at various price levels. • Along the AD curve, real GDP increases and the price level decreases. In other words, AD slopes down. Changes in the price level will cause a movement along the AD curve. • There are three main reasons why we would expect real GDP to increase in response to a decrease in the price level, and vice versa: the wealth effect interest rate effect the exchange rate effect • Any change to a component of Aggregate Demand (AD) that is not in response to a change in the price level will cause AD to shift. An increase in AD would be a shift to the right. A decrease in AD would be a shift to the left. • For example, if everyone gets an unexpected bonus added to their allowance on the same day, then consumption would increase and AD would shift right. Or, imagine if a central bank increases an important interest rate. In response, firms buy less capital and other interest-sensitive spending, which decreases Investments. As a result, AD will shift to the left. If American made cars were suddenly popular in China, then exports from the U.S. would increase and AD in the U.S. would increase, shifting to the right. • The intuition behind the real wealth effect is that when the price level decreases, it takes less money to buy goods and services. The money you have is now worth more and you feel wealthier. So, in response to a decrease in the price level, real GDP will increase. More formally, this means that when households’ assets are worth more in terms of their purchasing power, they are more likely to purchase more goods and services. The opposite happens when the price level increases. • The intuition behind the interest rate effect is that when the price level decreases, you need less money in your pocket to buy stuff. The less money you need to keep on hand buying stuff, the more money you are going to keep in a bank. Banks pay interest to try to lure people to deposit their money in banks. So, if you are going to keep more money in the bank anyway, banks don’t have to offer as much interest in order to convince you; that drives interest rates down. As a result, businesses and households spend more money on investment and “big ticket” items that are interest sensitive, like X, Y, and Z. So, once again, a decrease in the price level will increase real GDP. • On the other hand, a higher price level will drive up interest rates. Remember how a higher price level would make everyone’s dollars are worth less, and they cut back on 108 CU IDOL SELF LEARNING MATERIAL (SLM)
consumption? Well, what if they didn’t want to cut back on consumption. Instead, maybe they sell off some other asset like a bond to try to get more money. The problem is, every other bondholder is also trying to sell off their bonds, so there are no buyers! Anyone who wants to issue a new bond is going to have to do something to try to attract buyers. The way to do that is to raise the interest rate that is offered. All of that excess demand for money leads to an increase in the interest rate. • Finally, the intuition behind the exchange rate effect is that a decrease in the price level in country A makes its goods cheaper to country B, so country B buys more of country A’s exports. When the price level in one country goes down, its goods are suddenly more attractive to every other country. It’s like the whole country is on sale! Since that country’s goods are suddenly cheaper, their exports go up. • Of course, as with the other explanations for the downward-sloping aggregate demand curve, the opposite will happen when the price level increases. Country A’s goods will be less attractive to Country B’s consumers and the quantity of aggregate output demanded will decrease. • One important note: in all three of these effects, the changes in the amount of AD are brought about by a change in the price level. But if wealth, interest, or exports change for some reason besides a change in the price level, this would actually represent a shift in AD, not a movement along the curve. KEY WORDS/ABBREVIATIONS • Real wage - The nominal wage adjusted for the effects of inflation • Saving ratio - The percentage of disposable income that is saved rather than spent • Nominal - Nominal means the money value of something, for example the money value ofa weekly wage unadjusted for the effects of inflation • Constant prices - Constant prices tells us that the data has been inflation adjusted LEARNING ACTIVITY 1. Diagrammatically explain the demand curve 2. State the formulae for AD 109 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT END EXERCISES (MCQS AND DESCRIPTIVE) 110 A. Descriptive Questions 1. Note on Law of consumption 2. Explain the term MPS 3. Explain the term APS 4. Explain the term MPC 5. Explain the term APC B. Multiple Choice Questions (MCQs) 1. Which of the components of not of aggregate demand? (a) Investments (b) Government expenditures (c) Net exports (d) Savings 2. An example of a government expenditure is (a) employing a public school teacher (b) a social security payment to an elderly person (c) an AFDC (Aid to Families with Dependent Children) payment (d) All of these 3. When MPC is constant, the consumption function is (a) Linear (b) Horizontal (c) Vertical CU IDOL SELF LEARNING MATERIAL (SLM)
(d) Upward sloping 4. APS is (a) 1 (b) -1 (c) 0 (d) -1 < 0 < 1 5. MPS + MPC = (a) 1 (b) 0 (c) -1 (d) Infinite Answers: 1. (d) 2. (d) 3. (a) 4. (d) 5. (a) REFERENCES • Dwivedi, D.N. (2006). Macroeconomics: Theory and Policy. New Delhi: Tata McGraw Hill. • Ray, N.C. (1980). An introduction to Macro Economics. New Delhi: The Macmillan Company of India. • Lipsey, R.G. & Chrystal, K.A. (2004). Economics. New Delhi: Oxford University Press. • Shapiro, Edward. (2009). Macroeconomic Analysis. New York: Harcourt Publishers Ltd. • Peterson, L., Jain. (2005). Managerial Economic. New Delhi: Prentice Hall of India. • Mote, V.L., Gupta G.S. (2017). Managerial Economics. New Delhi: McGraw Hill Education. 111 CU IDOL SELF LEARNING MATERIAL (SLM)
112 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 7- SAVING AND INVESTMENT 113 Structure Learning Objectives Introduction Relationship between saving and investments Types of investments Determinants of Inventory Investment Determinants of investment in an economy Multiplier concept Derivation of Investment Multiplier Algebraic Derivation of Multiplier Theory of Multiplier Calculating the Size or Value of Multiplier Two Limiting Cases of the Value of Multiplier Assumptions of Multiplier Theory Diagrammatic Representation of Multiplier Summary Key Words/Abbreviations Learning Activity Unit End Exercises (MCQs and Descriptive) References LEARNING OBJECTIVES After studying this unit, you will be able to: • Give the outline of the relation between savings & investments • Explain the Multiplier concept • List the determinants of investment CU IDOL SELF LEARNING MATERIAL (SLM)
INTRODUCTION Saving takes place when people abstain from consumption, that is, when they consume less than their income. Investment takes place when we purchase new capital equipment or other assets that make for future productivity. Investment does not mean buying stocks or bonds. Here are some important facts: For Robinson Cruse, the difference between saving and investment is a distinction without a difference. Since he does all saving and all investment, they are automatically equal. However, for the larger economy, this is not true. Investment funds come either from our own saving or from someone else's saving. The motive for saving is one of deferring your consumption to a later day. We save when we consume only part of our income now and save for retirement, a rainy day, putting children through college, the summer home, etc. The motive for investment is to make money. Investment takes place when we purchase plants or equipment, which make workers and businesses more productive in the future. Ultimately saving and investment must be equal, (subject to a couple of complications that make for nice exam questions). As you will see in a moment, you can think of saving as a supply of funds for investment and investment as a demand for funds. Three Elements of Investment: Business firms make investment in the following three ways. The basic objective is to produce saleable goods to make profit. 1. To replace existing capital: Capital goods wear out through use and have to be replaced. So, a firm has to make provision for depreciation, i.e., reduction in the value of capital goods due to their contribution to the production process. At any fixed time, there will be some investment which is needed to replace worn-out capital. 2. To expand capacity: If the amount of total (gross) new investment taking place happened to just equal the amount of depreciation, the size of the stock of capital employed would remain constant. Any excess of gross investment over depreciation represents net investment in expanded capac•ity or net capital formation. Net investment is needed to introduce new products and groups of products or to produce existing products on a much larger scale. In a period of rising demand for goods and services 114 CU IDOL SELF LEARNING MATERIAL (SLM)
existing capacity will be fully utilized and there will be need for fresh investment. 3. To increase efficiency: To survive in a competitive world, firms will be under constant pressure to raise productivity of resources, especially labor power. This can be achieved through process of innovation, i.e., introduction of new production processes. This is often associated with the application of new technology. In fact, the greater the pressure and scope for increased efficiency, the larger the volume of investment firms are likely to undertake if they are to survive and expand. RELATIONSHIP BETWEEN SAVING AND INVESTMENTS Incomes are generated by production and the economic system is said to be in equilibrium when all the incomes earned are returned to the income flow through spending. Keynes’ income-expenditure analysis fo•cuses on the relationship between aggregate expenditures and income. In a two-sector model, equilibrium occurs when income received equals aggre•gated desired expenditures (i.e., Y = C + I). An alternative way of describing how national income is determined is to focus on saving and investment. Here, we consider a simple situation in which all income is disposable income. This happens when we assume that taxes are zero and all of a firm’s profits are paid out as dividends. And in a simple 2-sector economy, with no government or foreign trade, we assume that there are no government savings or dis-savings, or flow of funds from abroad. This simple model system is affected by the existence of two complicating factors — saving and investment. Saving is that part of income which is not consumed and therefore not passed on in the income flow. Investment is the process of capital formation plus addition to stocks and therefore is an addition to the income flow. The main reason for the apparent paradox in the above two statements is that both terms, savings and investment, are defined differently in each statement. When Keynes stated that saving was always equal to investment, he was referred to actual or realized saving and actual or realized investment. The income obtained from the production of the national output is distributed to the various factors of production employed in the production process and so national income and national output are always and neces•sarily equal. They are merely the same thing looked at in two different ways. 115 CU IDOL SELF LEARNING MATERIAL (SLM)
The output produced will be either for current use or will be added to the country’s stock of investment goods. The income earned will either be used for consumption purposes or saved. As aggregate output and income are always equal and consumption is identical in both places, the rest of the equation must also be equal or Y = C + I and Q = GNP = C + S and if Y = Q, C + S = C + I or S = I. So, in Keynes’ simple 2-sector demand-determined model individuals can either spend their income today or save it, either to consume later or to leave as a bequest to their children. This is true by definition: Income = consumption + saving . . . (1) With no government purchases or net exports, the components of aggre•gate expenditures that firms can produce only two kinds of goods: con•sumer goods and investment goods. Thus, output Y can be broken into two components: Y = consumption + investment . . . (2) These two identities can be combined to form a new one. Since the value of national output equals national income Y = income . . . (3) We can use tire right-hand side of (1) and (2) to get: Consumption + savings = Consumption + investment . . . (4) By subtracting consumption from both sides of the equation, we get: Saving = investment . . . (5) In short, saving must equal investment. This is a simple matter of defini•tion and is known as saving-investment equality (identity). The simplest way to understand this identity is to think of firms as producing a certain amount of goods, the value of which is just equal to the income received by all individuals in the economy (here the entire sales revenue of firms is paid out as income to factor-suppliers). That portion of national income which is not spend on consumption goods is saved. On the output side, firms either sell the goods they produce or put them into inventory, for future sale. Some of the inventories business firms hold is planned (desired), because businesses require inventories to survive (i.e., because production and sales do not coincide). Some of it is unplanned (undesired) — business may be surprised by a brief recession that spoils their 116 CU IDOL SELF LEARNING MATERIAL (SLM)
sales forecasts. Both intended and unintended inventory build ups are considered investment. The goods that are not demanded by consumers are, by definition, demanded by business firms, i.e., are invested. (In fact, investment is the demand for capital goods). After all, inventory accumulation consists of goods that are produced not for current consumption but presumably for future consump•tion. The above identity (5) can now be transformed into an equation deter•mining national income, once we recognize that in equilibrium firms will cut back production if there is unintended inventory accumulation. Since firms will reduce output, in equilibrium the amount companies invest in the amount they wish to invest (including inventories), given current market conditions. (That is, in equilibrium, firms do not suffer unpleasant sur•prises). The equilibrium condition theory is that Investment = desired investment . . . (6) Now, let us switch over to the savings side of the identity (5). The Keynesian short-run consumption function tells us how much people will wish to consume at each level of income. But since saving is a residue (i.e., what is not consumed is automatically saved), the consumption function can easily be transformed into a saving function, given the level of saving at each level of income. Saving is just income minus consumption: Saving = income (Y) – consumption (c) . . . (7) Since saving must equal investment, and in equilibrium investment must equal desired investment, then in equilibrium Saving = desired investment . . . (8) The Fig. 7.1 shows a fixed level of desired investment (7). The desired investment function is horizontal because in Keynes’ model all investment is autonomous, i.e., is assumed to be independent of national income. National income equilibrium occurs at point E where the desired saving function intersects the desired investment function. 117 CU IDOL SELF LEARNING MATERIAL (SLM)
Fig. 7.1 Relationship between saving and investments Thus, in the words of Samuelson, “investment calls the tune and consumption dances to the music. Invest•ment determines output, while saving responds pre•cisely to income changes. Out-put rises or falls until planned saving has adjusted to the level of planned investment”. Therefore, we observe that ac•tual (ex-post) saving is always equal to actual (ex-post) invest•ment. But planned or desired (ex-ante) saving is equal to planned or desired (ex-ante) investment only when national income is in equilibrium. When we talk of saving and investment being equal, we are referring to the observed behavior of an economy; a study of what has actually happened or what has been realized. But the Keynesian analysis of income determination revolves around the intended nature of such variables as saving and investment. These plans to save and invest lead to changes in the income flow, with different equilibrium levels being reached. Decisions to save and invest are constantly being made by different groups of people at different times and for different reasons. So there is very little chance of these plans being equal to each other within the same time period. When any discrepancy between the plans to save and invest occurs a change in the level of income brings about a state of disequilibrium, and as income continues to change so do these plans get readjusted until a level of income is reached where planned saving and investment are once more equal to each other. It is only then that equilibrium has been attained where there is no tendency for the level of income and employment to alter. This process is facilitated by a multiplied change in income which operates both in an upward and in a downward direction. A simple numerical example may clarify the above: 118 CU IDOL SELF LEARNING MATERIAL (SLM)
Table 7.2 Relation between Saving and Investment The table gives a consumption function, from which saving plans can be obtained. Assuming that planned investment is autonomous and that all household plans are realized, an equilibrium level of income can be calcu•lated. When income is 500 the consumption schedule indicates that 400 will be consumed, leaving the remainder (100) to be saved. At this level of income autonomous planned investment is 100, thereby bringing total planned expenditure (consumption + investment) equal to the level of output (or income). With planned saving and investment being equal, the economy is in a state of equilibrium — there are no forces at work changing the level of output or income. However, at the higher level of income (600) planned saving exceeds planned investment resulting in planned expenditure failing below planned income. As the rate of production exceeds the rate of sales by 20 the level of stock will rise thereby resulting in a rise in unplanned investment. Any stock changes are regarded as changes in investment. At this stage, realized investment, made up of planned and unplanned investment, will still be equal to realized saving, but the discrepancy between the intentions of savers and investors will result in the level of income falling back until it reaches the equilibrium level of 500. An exactly opposite process will work itself out if actual income falls below its equilibrium value. If income were 400 the consumption schedule would indicate that 320 would be consumed and 80 saved. With planned investment exceeding planned saving, planned expenditure would exceed planned income resulting in a fall in the value of stocks (inventories). The fall in stocks can be regarded as unplanned disinvestment, giving a realized investment figure of (100 – 20) = 80 (which is the same as realized savings). TYPES OF INVESTMENTS 1. Business Fixed Investment: 119 CU IDOL SELF LEARNING MATERIAL (SLM)
Business fixed investment means investment in the machines, tools and equipment that businessmen buy for use in further production of goods and services. The stock of these machines or plant equipment etc. represents fixed capital. The term ‘fixed’ in it implies that expenditure made on the machines, equipment etc. continues to be used for production for a relatively long time. This is in contrast to inventory investment whose components will be either used shortly for production or sold shortly to others for further production. Business fixed investment is important in two respects. First, business fixed investment is an important component of aggregate demand and therefore plays a significant role in the determination of natural income and employment. Business fixed investment is a volatile component of aggregate demand and, as Keynes emphasized, fluctuation in levels of fixed business investment is responsible for business cycles in a free market economy. Keynes put forward a theory of investment which states that business fixed investment is determined by expected rate of profit (which he calls marginal efficiency of capital) and rate of interest. Since rate of interest in the short run is relatively sticky, it is changes in expectations about earning profits in future that cause fluctuations in business fixed investment. According to the neoclassical theory, business fixed investment is determined by the marginal product of capital on one hand and user’s cost of capital on the other. The user’s cost of capital merely depends on the price of capital goods, the interest rate and the depreciation rate. According to the neoclassical model, if marginal product of capital exceeds user’s cost of capital, firms will find it profitable to undertake fixed investment. In this model, rate of interest, which is an important component of the user cost of capital, and taxation of profits play an important role in the determination of business fixed investment. 2. Residential Investment: Residential investment refers to the expenditure which people make on constructing or buying new houses or dwelling apartments for the purpose of living or renting out to others. Residential investment varies from 3 per cent to 5 per cent of GDP in various countries. Two important features of residential investment are worth noting. First, since the average life of a housing unit is of 40 to 50 years, the stock of existing housing units at a point of time is very large as compared to the new residential investment in a year (i.e., flow of residential investment). Second, there is well developed resale market for housing units so that people 120 CU IDOL SELF LEARNING MATERIAL (SLM)
who construct or own them can sell them in this secondary market. Residential investment depends on price of existing housing units. The higher the price of existing units, the higher will be investment in constructing and buying new housing units. The price of housing units is determined by demand for housing units which slopes downward and the supply of existing units which is a fixed quantity and its supply curve is therefore vertical straight line. In the long run demand for housing is determined by rate of population growth and formation of new households. The higher rate of population growth will lead to the increase in demand for housing units. The tendency towards two-member households has led to greater demand for housing units. Income is another important factor determining demand for houses and therefore greater residential investment. Since level of income over time fluctuates a good deal, there is strong cyclical pattern of investment in residential construction. Finally, interest is another important factor that determines demand for dwelling units. Most houses, especially in cities, are purchased by borrowing funds from banks for a long time, say 20 to 25 years. Generally, the houses purchased are mortgaged with banks or other financial institutions who provide funds for this purpose. The individuals who purchase houses on mortgage borrowing pay monthly installment of original sum borrowed plus interest. Therefore demand for housing units is highly sensitive to changes in rate of interest. Therefore, monetary policy has a substantial effect on residential investment. 3. Inventory Investment: Firms hold inventories of raw materials, semi-finished goods to be processed into final goods. The firms also hold inventories of finished goods to be sold shortly. The change in the inventories or stocks of these goods with the firms is called inventory investment. Now, why do firms hold inventories? The first motive of holding inventories is smoothing of the level of production. The firms experience temporary booms and busts in sales of their output. Instead of adjusting their production each time to match the changes in sales of the product they find cheaper to produce goods at a steady rate. With this steady rate of production when sales are low, the firms will be producing more than they are selling and therefore in these periods they will hold the extra goods produced as inventories. On the other hand, when sales are high with a steady rate of production, they will be 121 CU IDOL SELF LEARNING MATERIAL (SLM)
producing less than they sell. In such periods to meet the market demand for goods, they will take out goods from inventories to meet the demand. The second reason for holding inventories is that it is less costly for a firm to buy inputs such as raw materials less frequently in large quantities to produce goods and therefore it is required to hold inventories of raw materials and other intermediate products. Buying small quantities of the materials more frequently to produce goods is a more costly affair. The third reason for holding inventories by the firms is to avoid ‘running out of stock’ possibilities when their sales of goods are high and therefore it is profitable to sell at that time. This requires them to hold inventories of goods. 7.3.1 Determinants of Inventory Investment: The inventories of raw materials and goods depend on the level of output which a firm plans to produce. An important model that explains the inventories of raw materials and goods is the accelerator model. Though the accelerator model applies to all types of investment, it applies best in case of inventory investment. According to the accelerator model, the firms hold the total stock of inventories of raw materials and goods that is proportional to their level of output. When manufacturing firms’ level of output is high, they require to keep more inventories of materials and of goods in process of being converted into finished products. When the economy is booming, retail firms would like to hold more inventories so that the goods they are selling may not go out of stock and their customers go away disappointed. Thus, if N stands for the stock of inventories and Y for level of output, then N = βY Where β is proportion of output (Y) that the firms want to hold as inventories. Now, since inventory investment (I) means the change in stock of inventories, it can be written as follows: In = ∆N = β∆Y The accelerator model predicts that given the parameter β when output of firms increases, inventory investment will increase and when output falls, the inventory investment by firms will decline. In fact, when output of goods falls due to slackening of demand, the firms will allow the inventories to run down which implies negative inventory investment. The empirical macroeconomic studies made in United States indicated that for every dollar increase in GDP, there is 0.20 of inventory investment. That is, value of β in the accelerator model is 0.2. In quantitative terms, the accelerator model of inventory investment can be 122 CU IDOL SELF LEARNING MATERIAL (SLM)
written as In = 0.2 ∆Y 4. Autonomous Investment: By autonomous investment we mean the investment which does not change with the changes in the income level and is therefore independent of income. Keynes thought that the level of investment depends upon marginal efficiency of capital and the rate of interest. He thought changes in income level will not affect investment. This view of Keynes is based upon his preoccupation with short-run problem. He was of the opinion that changes in income level will affect investment only in the long run. Therefore, considering it as the short-run problem he treated investment as independent of the changes in the income level. In fact the distinction between autonomous investment and induced investment has been made by post-Keynesian economists. Autonomous investment refers to the investment which does not depend upon changes in the income level. This autonomous investment generally takes place in houses, roads, public undertakings and in other types of economic infrastructure such as power, transport and communication. This autonomous investment depends more on population growth and technical progress than on the level of income. Most of the investment undertaken by Government is of the autonomous nature. The investment undertaken by Government in various development projects to accelerate economic growth of the country is of autonomous type. The autonomous investment is depicted in Fig. 7.3 where it will be seen that whatever the level of national income, investment remains the same at la. Therefore the autonomous investment curve is a horizontal straight line. Fig. 7.3 Autonomous Investment 123 5. Induced Investment: Induced investment is that investment which is affected by the changes in the level of CU IDOL SELF LEARNING MATERIAL (SLM)
income. The greater the level of income, the larger will be the consumption of the community. In order to produce more consumer goods, more investment has to be made in capital goods so that greater output of consumer goods becomes possible. Keynes regarded rate of interest as a factor determining induced investment but the empirical evidence gathered so far suggests that induced investment depends more on income than on the rate of interest. Induced investment is shown in Fig. 7.4 where it will be seen that with the increase in national income, induced investment is increasing. Increase in national income implies that demand for output of goods and services increases. To produce greater output, more capital goods are required to produce them. To have more capital goods more investment has to be undertaken. This induced investment is undertaken both in fixed capital assets and in inventories. The essence of induced investment is that greater income and therefore greater aggregate demand affects the level of investment in the economy. The induced investment underlines the concept of the principle of accelerator, which is highly useful in explaining the occurrence of trade cycles. Fig. 7.4 Induced Investments DETERMINANTS OF INVESTMENT IN AN ECONOMY Investment which refers to the construction of a new capital asset like machinery or factory building is made for the purpose of earning profit. Various theories have been developed from time to time to explain the behavior of investment. Keynes believed that investment does not depend on the current level of income. It is not a function of income or its rate of change. According to Keynes, the volume of investment 124 CU IDOL SELF LEARNING MATERIAL (SLM)
depends on all other factors except national income. However, post-Keynesian economists consider income as a determinant of investment. A study of the various theories brings into focus the main influences on the level of business investment which are the following: 1. Investment and profitability: Ceteris paribus, higher profitability will improve the prospects for investment. First, the major portion of business investment in India is financed out of retained profits. So, the higher their level the more funds become available for financing investment. Secondly, increased current profits may be taken to indicate a higher return on new, future capital projects. This could induce firms invest their funds instead of lending them in the open market. According to Keynes, the volume of investment in a community depends mainly on two factors: the marginal efficiency of capital and the rate of interest on long-term loans. Both the factors are highly unstable, the former being more unstable than latter. a. Marginal Efficiency of Capital: The marginal efficiency of capital is the highest rate of return over cost expected from producing one more unit of a particular type of capital asset. Suppose that a go-down built at a cost of Rs 20,000 is expected to fetch a rental of Rs 1,200 per year. Suppose that depreciation and maintenance amount to Rs 200 per year. Then, the net income which will probably be obtained by the owner is Rs 1,000, i.e., a return 5%. If the rate of interest is 4% there will be an inducement to construct such go-downs. The marginal efficiency of this type of capital is 5%. If 5% is the highest rate of return which is expected to be secured from any type of investment, the marginal effi•ciency of capital in general in that community at that time is 5%. Investment continues as long as the marginal efficiency of capital is greater than the rate of interest. Thus, the level of investment is determined at the point where the marginal efficiency of capital is equal to the market rate of interest. b. The rate of interest: ‘the cost of investing’: The main objective of business firms in investing in plant, equipment and machinery is to make profit. If a firm is unable to make profit from its investment, it will not be able to retain a portion of its earning for expansion arid diversification. Similarly, if an investment project does not return sufficient money it will turn out unviable. 125 CU IDOL SELF LEARNING MATERIAL (SLM)
The decision to make investment in a project (such as setting up of a paper mill) will depend on the relation•ship between the anticipated rate of return and the expected rate of interest over the life of the project, which measures the cost of financing the project. If the expected (estimated) rate of return (profit) on a project were 20% then having to pay 22% interest for investment funds would lead to a loss — the project would not be economically viable. At an anticipated rate of interest of 15%, however, the same project would become viable. As J.E. Meade put it, “A greater amount of fixed capital should be invested so long as the annual interest on the capital plus the annual cost of repair, depreciation, etc. is less than the price of any additional output expected from the investment”. The same rule would apply for investment financed out of a firm’s own funds. In this case, the rate of interest measures the opportunity cost of employing these funds in alternative uses. In fact, the rate of interest influences investments, because it represents the cost ofborrowing. The profit from an investment is equal to the total revenue obtained from it minus the expenses, of which interest is a part. The entrepreneur expects a certain net yield from an investment and if the rate of interest is high the net yield is reduced. Hence, a high rate of interest will cut out a number of investments and the total volume of investments will beless. Conversely, a low rate of interest will make some investments attractive and the volume of investments will increase. Increase of investment is desirable because it increases income and employment. Keynes, therefore, recommended that central banks should follow cheap money policy, i.e., a policy of reducing the rate of interest. This will encourage business people to invest more. Moreover, movement in interest rates can also influence investments by providing an indicator of likely future economic conditions. Rising interest rates may be a signal of government action to restrain the growth of demand — which could have an adverse effect on firms’ sales and returns. At a fixed point of time, there will exist a range of potential investment projects over the economy, some expected to yield higher rates of return (in terms of profit), some lower costs and others possibly a loss. Ceteris paribus, the lower the anticipated rate of interest, the larger will be the number of viable projects and hence the higher the level of total investment under•taken. At the same time, the profitability of marginal investment — what Keynes calls the marginal efficiency of capital — will also decline as Fig. 7.5 shows. So long as MEC exceeds the rate of interest (r) new investment will take place and once MEC is equated to r no further 126 CU IDOL SELF LEARNING MATERIAL (SLM)
in•vestment will occur, as indicated by point E. Fig. 7.5 Determinants of investment in an economy As Keynes has pointed out, “The amount of current invest-ment depends on the in-ducement to invest and the inducement to investment, in its turn, depends on the relation between the schedule of marginal efficiency of capital and the interest rates on loans of varying maturities and risks”. However, it is a matter of great surprise that most study show little connection between investment and rates of interest. Investment appears to be very interest-elastic. One explanation seems to be that investment is actually relatively interest- inelastic but other factors, which influence investment, tend to neutralize this effect. MULTIPLIER CONCEPT The theory of multiplier occupies an important place in the modern theory of income and employment. The concept of multiplier was first of all developed by F.A. Kahn in the early 1930s. But Keynes later further refined it. F.A. Kahn developed the concept of multiplier with reference to the increase in employment, direct as well as indirect, as a result of initial increase in investment and employment. Keynes, however, propounded the concept of multiplier with reference to the increase in total income, direct as well as indirect, as a result of original increase in investment and income. Therefore, whereas Kahn’s multiplier is known as ’employment multiplier’, Keynes’s multiplier is known as investment or income multiplier. The essence of multiplier is that total increase in income, output or employment is manifold the original increase in investment. For example, if investment equal to Rs. 100 crores is made, then the income will not rise by Rs. 100 crores only but a multiple of it. 127 CU IDOL SELF LEARNING MATERIAL (SLM)
If as a result of the investment of Rs. 100 crores, the national income increases by Rs. 300 crores, multiplier is equal to 3. If as a result of investment of Rs. 100 crores, total national income increases by Rs. 400 crores, multiplier is 4. The multiplier is, therefore, the ratio of increment in income to the increment in investment. If ΔI stands for increment in investment and AY stands for the resultant increase in income, then multiplier is equal to the ratio of increment in income (By) to the increment in investment (ΔI). Therefore k = ΔY/ΔI where k stands for multiplier. Now, the question is why the increase in income is many times more than the initial increase in investment. It is easy to explain this. Suppose Government undertakes investment expenditure equal to Rs. 100 crores on some public works, say the construction of rural roads. For this Gov•ernment will pay wages to the laborer’s engaged, prices for the materials to the suppliers and remunerations to other factors who make contribution to the work of road- building. The total cost will amount to Rs. 100 crores. This will increase incomes of the people equal to Rs. 100 crores. But this is not all. The people who receive Rs. 100 crores will spend a good part of them on consumer goods. Suppose marginal propensity to consume of the people is 4/5 or 80%. Then out of Rs. 100 crores they will spend Rs. 80 crores on consumer goods, which would increase incomes of those people who supply consumer goods equal to Rs. 80 crores. But those who receive these Rs. 80 crores will also in turn spend these incomes, depending upon their marginal propensity to consume. If their marginal propensity to consume is also 4/5, then they will spend Rs. 64 crores on consumer goods. Thus, this will further increase incomes of some other people equal to Rs. 64 crores. In this way, the chain of consumption expenditure would continue and the income of the people will go on increasing. But every additional increase in income will be progressively less since a part of the income received will be saved. Thus, we see that the income will not increase by only Rs. 100 cores, which was initially invested in the construction of roads, but by many time more. Derivation of Investment Multiplier: How much increase in national income will take place as a result of an initial increase in investment can be expressed in the following mathematical form: Increase in income Or 128 CU IDOL SELF LEARNING MATERIAL (SLM)
ΔY = 100 + 100 x 4/5 + 100(4/5)2 + 100(4/5)3 + 100(4/5)4 = 100[1 + (4/5) + (4/5)2 + (4/5)3 + (4/5)4] But the above series is one of geometric progression. Therefore, increase in income (ΔY) = 100 1/1-4/5 = 100 X 1/1/5 = 100 x 5 = 500 It is thus clear that if the marginal propensity to consume is 4/5, the investment of Rs. 100 cores leads to the increase in the national income by Rs. 500 crores. Therefore, multiplier here is equal to 5. We can express this in a general formula. If ΔY stands for increase in income, ΔI stands for increase in investment and MPC for marginal propensity to consume, we can write the equation (i) above as follows: ΔY = ΔI 1/1-MPC ΔY/ΔI = 1/1-MPC ΔY/ΔI measures the size of the multiplier. Therefore, Size of multiplier or k = 1/1-MPC It is clear from above that the size of multiplier depends upon the marginal propensity to consume of the community. The multiplier is the reciprocal of one minus marginal propensity to consume. However, we can express multiplier in a simpler form. As we know that saving is equal to income minus consumption, one minus marginal propensity to consume will be equal to marginal propensity to save, that is, 1 – MPC = MPS. Therefore, multiplier is equal to 1/1 – MPC = 1/MPS Algebraic Derivation of Multiplier: The multiplier can be derived algebraically as follows: Writing the equation for the equilibrium level of income we have Y=C+I As in the multiplier analysis we are concerned with changes in income induced by changes in investment, rewriting the equation (1) in terms of changes in the variables we have 129 CU IDOL SELF LEARNING MATERIAL (SLM)
ΔY = ΔC + ΔI In the simple Keynesian model of income determination, change in investment is considered to be autonomous or independent of changes in income while changes in consumption are function of changes in income. In the consumption function, C = a + bY Where a is a constant term, b is marginal propensity to consume which is also assumed to remain constant. Therefore, change in consumption can occur only if there is change in income. Thus Theory of Multiplier ΔC = bΔY Substituting (3) into (2) we have ΔY = bΔY + ΔI ΔY – bΔY = ΔI ΔY (1 – b) = ΔI Or ΔY = 1/1-b ΔI ΔY/ΔI = 1/1 -b As b stands for marginal propensity to consume ΔY/ΔI = 1/1 – MPC = 1/MPS This is the same formula of multiplier as obtained earlier. Note that the value of multiplier ΔY/ΔI will remain constant as long as marginal propensity to consume remains the same. Calculating the Size or Value of Multiplier: It follows from above that the size or value of multiplier is the reciprocal of marginal propensity to save. Therefore, we can obtain the value of multiplier if we know the marginal propensity to consume or the marginal propensity to save of the community. Given the size of multiplier form the net increase in investment, we can find out the total increment in income that will occur as a result of investment. If the marginal propensity to consume of a community is equal to 2/3, we can find out the size of multiplier as under: 130 CU IDOL SELF LEARNING MATERIAL (SLM)
Multiplier, k = 1/1-MPC 1/1-2/3 = 1/1/2 = 3 Likewise, if the marginal propensity to consume is equal to ½ or 0.5, thenthe multiplier: 1/1-1/2 = 1/1/2 = 2 Two Limiting Cases of the Value of Multiplier: There are two limiting cases of the multiplier. One limiting case occurs when the marginal propensity to consume is equal to one, that is, when the whole of the increment in income is consumed and nothing is saved. In this case, the size of multiplier will be equal to infinity, that is, a small increase in investment will bring about a very large increase in income and employment so that full employment is reached and even the process goes beyond that. “In such circumstances, the Government would need to employ only one road builder to raise income indefinitely, causing first full employment and then a limitless spiral of inflation.” However, this is unlikely to occur since marginal propensity to consume in the real world is less than one. The other limiting case occurs when marginal propensity to consume is equal to zero, that is, when nothing out of the increment in income is consumed, and the whole incre•ment in income is saved. In this case, the value of the multiplier will be equal to one. That is, in this case, the increment in income will be equal to the original increase in investment and not a multiple of it. But in actual practice the marginal propensity to consume is less than one but more than zero (1 > ΔC/ΔY > 0). Therefore, the value of the multiplier is greater than one but less than infinity. Assumptions of Multiplier Theory: In our above explanation of multiplier, we have made many simplifying assumptions. First, we have assumed that the marginal propensity to consume remains constant throughout as the income increases in various rounds of consumption expenditure. However, the marginal propen•sity to consume may differ in various rounds of consumption expenditure. But this constancy of marginal propensity to consume is a realistic assumption, since all available empirical evi•dence shows that marginal propensity to consume is very stable in the short run. Secondly, we have assumed that there is a net increase in investment in a period and no further indirect effects on investment in that period occur or if they occur, they have been taken into account so that there is a given net increase in investment. Further, we have assumed that there is no any time-lag between the increase in investment and the resultant increment in income. That is, increment in income takes place 131 CU IDOL SELF LEARNING MATERIAL (SLM)
instantaneously as a result of increment in investment. J.M. Keynes ignored the time-lag in the process of income generation and therefore his multiplier is also called instantaneous multiplier. In recent years, the importance of time lag has been recognized and concept of dynamic multiplier has been developed on that basis. But in an ele•mentary study as the present one the time lags will be ignored as was done by Keynes. Another important assumption in the theory of multiplier is that excess capacity exists in the consumer goods industries so that when the demand for them increases, more amounts of consumer goods can be produced to meet this demand. If there is no excess capacity in consumer goods industries, the increase in demand as a result of some original increase in investment will bring about rise in prices rather than increases in real income, output and employment. Keynes’s multiplier was evolved in the context of advanced capitalist economies which were in grip of depression and in times of depression and there did exist excess capacity in the consumer goods industries due to lack of aggregate demand. The Keynesian multiplier effect is very small in developing countries like India since there is not much excess capacity in consumer goods industries. In our above analysis of the multiplier process we have taken a closed economy, that is, we have not taken into account imports and exports. If ours were an open economy, then a part of the increment in consumption expenditure would have been made on imports of goods from abroad. This would have caused increment in income in foreign countries rather than within the country. This will reduce the value of the multiplier. Imports are important leakage from the multiplier process and we have ignored them in our above analysis for the purpose of simplicity. It is worth noting that multiplier not only works in money terms but also in real terms. In other words, multiple increments in income as a result of a given net increase in investment do not only take place in money terms but also in terms of real output, that is, in terms of goods and services. When incomes increase as a result of investment and these increments in income are spent on consumer goods, the output of consumer goods is increased to meet the extra demand brought about by increased incomes. Therefore, real income or output, increases by the same amount as the increment in money incomes, since the prices of goods have been assumed to be constant. Of course, we have assumed, as has been mentioned above, that there exists excess productive capacity in the consumer goods industries so that when the demand for consumer goods increases, their production can be easily increased to meet this demand. However, if due to some bottlenecks 132 CU IDOL SELF LEARNING MATERIAL (SLM)
output of goods cannot be increased in response to increasing demand, prices will rise and as result the real multiplier effect will be small. Diagrammatic Representation of Multiplier: We have already explained that the level of national income is determined by the equilib•rium between aggregate demand and aggregate supply. In other words, the level of national income is fixed at the level where C + I curve intersects the 45° income curve. With such a diagram we can explain the multiplier. The mul•tiplier is illustrated in Fig. 7.6. In this figure C represents marginal propensity to consume. Marginal propensity to consume has been here assumed to be equal to 1/2 i.e., 0.5. Therefore, the slope of the curve C of marginal propensity to consume curve C has been taken to be equal to 0.5. C + I represents ag•gregate demand curve. It will be seen from Fig. 7.6 that the aggregate demand curve C + I which intersects the 45° line at point E so that the level of income equal to OY1 is determined. Fig. 7.6 National Income If investment increases by the amount EH we can then find out how much increment in income will occur as a result of this. As a consequence of increase in investment by EH, the aggregate demand curve shifts upward to the new position C + I’. This new aggregate demand curve C + I’ intersects the 45° income line at point F so that the equilibrium level of income increases to OY2. Hence as a result of net increase in investment equal to EH, the income has increased by Y1Y2. It will be seen from the figure that Y1Y2 is greater than EH. On measuring, it will be found that Y1Y2 is twice the length of EH. This is as it is expected because the marginal propensity to consume is here equal to 1/2 and therefore the size of multiplier will be equal to 2. 133 CU IDOL SELF LEARNING MATERIAL (SLM)
The multiplier can be illus•trated through saving-investment diagram also. In a previous chap•ter we explained the determination of national income also through saving the investment. Therefore, the multiplier can also be ex•plained with the help of saving- investment diagram, as has been shown in Fig. 7.7. In this figure SS is the saving curve indicating that as the level of income in•creases, the community plans to save more. II is the investment curve showing the level of investment planned to be undertaken by the investors in the community. Fig 7.7 saving- investment diagram The investment has been taken to be a constant amount and autonomous of changes in income. This investment level 01 has been determined by marginal efficiency of capital and the rate of interest. Investment being autonomous of income means that it does not change with the level of income. Keynes treated investment as autonomous of income and we will here follow him. It will be seen from Fig. 7.7 that saving and investment curves intersect at point E, that is, planned saving and planned investment are in equilib•rium at the level of income OY1. Thus, with the given saving and investment curves level of income equal to OY1 is determined. Now suppose that there is an increase in investment by the amount II’. With this increase in investment, the investment curve shifts to the new dotted position I’I’. This new investment curves I’I’ intersects the saving curve at point F and a new equilibrium as reached at the level of income OY2. A glance at the Fig. 7.7 will reveal that the increase in income Y1 Y2 is twice the increase in investment by II’. Thus multiplier is here equal to [K=1/0.5=2]. 134 CU IDOL SELF LEARNING MATERIAL (SLM)
SUMMARY • Before we embark on a journey towards financial independence, let us first understand the basics of savings and investments. A disciplined investor creates a balance between the two. • Saving is the process of parking hard cash in extremely safe and liquid securities. The primary aim should be capital preservation and the secondary goal getting some returns, if possible. This can include savings accounts and certificate of deposits among others. • Investing is the process of using money/capital to generate a safe and acceptable return over a time-period. An investment can include real estate, gold coins, stocks, mutual funds and small business to name a few. • Saving is setting aside money you don’t spend now for emergencies or for a future purchase. It’s money you want to be able to access quickly, with little or no risk, and with the least amount of taxes. Financial institutions offer a number of different savings options. • Investing is buying assets such as stocks, bonds, mutual funds or real estate with the expectation that your investment will make money for you. Investments usually are selected to achieve long-term goals. Generally speaking, investments can be categorized as income investments or growth investments. • Saving means different things to different people. To some it means putting money in the bank. To others it means buying stocks or contributing to a pension plan. But to economists, saving means only one thing—consuming less in the present in order to consume more in the future. • An easy way to understand the economist’s view of saving—and its importance for economic growth—is to consider an economy in which there is a single commodity, say, corn. The amount of corn on hand at any point in time can either be consumed (literally gobbled up) or saved. Any corn that is saved is immediately planted (invested), yielding more corn in the future. Hence, saving adds to the stock of corn in the ground, or in economic jargon, the stock of capital. The greater the stock of capital, the greater the amount of future corn, which can, in turn, either be consumed or saved. • Although in general parlance investment may connote many types of economic activity, economists normally use the term to describe the purchase of durable goods 135 CU IDOL SELF LEARNING MATERIAL (SLM)
by households, businesses, and governments. Private (nongovernmental) investment is commonly divided into three broad categories: residential investment, which accounts for about a quarter of all private investment (25.7 percent in 1990); nonresidential, or business, fixed investment, which accounts for most of the remainder; and inventory investment, which is small but volatile. Indeed, inventory investment is often negative (it was in 1990, and in three years during the eighties). Business fixed investment, in turn, is composed of equipment and nonresidential structures. Equipment now makes up over three-quarters of business investment. KEY WORDS/ABBREVIATIONS • Market capitalization: The market cap of a company is figured by multiplying its current share price by the number of shares outstanding. The largest companies have market caps in the billions. • Money Market: A money market account is an interest-bearing account that will usually pay a higher interest rate than a bank savings account would. • Personal Investment Strategy: This is exactly what it sounds like: your personal approach and strategy to investments. There's no single right way to invest. Learn about how investingworks. Then define and execute your personal strategy. LEARNING ACTIVITY 1. If disposal income is $400 billion, autonomous consumption is $60 billion, and MPC is 0.8, what is the level of saving? 2. Using a real-life example explain the concept of savings & investments UNIT END EXERCISES (MCQS AND DESCRIPTIVE) A. Descriptive Questions 1. Note on Multiplier effect 2. Explain different types of investments 136 CU IDOL SELF LEARNING MATERIAL (SLM)
3. What are the determinants of investment in an economy 4. Explain the relationship between savings &investments 5. Algebraically derive a multiplier B. Multiple Choice Questions (MCQs) 1. means investment in the machines, tools and equipment that businessmen buy for use in further production of goods and services. (a) Business investments (b) Residential investments (c) Inventory investments (d) Induced investments 2. we mean the investment which does not change with the changes in the income level and is therefore independent of income. (a) Business investments (b) Residential investments (c) Autonomous investments (d) Induced investments 3. Autonomous investment curve is a (a) Horizontal (b) Vertical (c) Linear (d) Fluctuating 4. is that investment which is affected by the changes in the level of income. (a) Business investments (b) Residential investments 137 CU IDOL SELF LEARNING MATERIAL (SLM)
(c) Autonomous investments (d) Induced investments 5. The concept of multiplier was first of all developed by (a) F.A. Kahn (b) Keynes (c) Schumpeter (d)Both (a) & (b) Answers: 1. (a) 2. (c) 3. (a) 4. (d) 5. (a) REFERENCES • Dwivedi, D.N. (2006). Macroeconomics: Theory and Policy. New Delhi: Tata McGraw Hill. • Ray, N.C. (1980). An introduction to Macro Economics. New Delhi: The Macmillan Company of India. • Lipsey, R.G. & Chrystal, K.A. (2004). Economics. New Delhi: Oxford University Press. • Shapiro, Edward. (2009). Macroeconomic Analysis. New York: Harcourt Publishers Ltd. • Peterson, L., Jain. (2005). Managerial Economic. New Delhi: Prentice Hall of India. • Mote, V.L., Gupta G.S. (2017). Managerial Economics. New Delhi: McGraw Hill Education. 138 CU IDOL SELF LEARNING MATERIAL (SLM)
• 139 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 8- EQUILIBRIUM Structure Learning Objectives Introduction Concept of full and underemployment Full Employment Underemployment Types of unemployment Types of Underemployment Causes of Underemployment Effects of Underemployment Problems of excess demand and deficit demand & measures to correct them Reasons for Deficient Demand Impact of Deficient Demand Problems Due to Deficient Demand Excess Demand Summary Key Words/Abbreviations Learning Activity Unit End Exercises (MCQs and Descriptive) References LEARNING OBJECTIVES After studying this unit, you will be able to: • Explain the concepts of employment & unemployment • Describe the various types of unemployment prevailing • Give details of the problems of excess & deficit demand & various measures to solve them 140 CU IDOL SELF LEARNING MATERIAL (SLM)
INTRODUCTION An economy that operates above its full employment equilibrium means it produces goods and services at a higher rate than its potential or long-run average levels as measured by its GDP. The amount by which the current real GDP is greater than the historic average is called an inflationary gap. When the market is in equilibrium, there is no excess supply in the short run. So, everything is in harmony. But an overly active economy creates more demand for goods and services. This increase in demand pushes both prices and wages upward as companies increase production to meet that demand. Companies can only ramp up production only so much before hitting capacity constraints. Therefore, increases in supply will be finite. Economists see this as a cautionary period as this results in a situation where too much money chases too few goods. This creates inflationary pressures in the economy—something that isn’t sustainable for long periods. CONCEPT OF FULL AND UNDEREMPLOYMENT Full Employment Full employment refers to a situation in which every able-bodied person who is willing to work at the prevailing rate of wages is, in fact, employed. Alternatively, it is a situation when there is no involuntary unemployment. That is why full employment is also defined as a situation where there is no involuntary unemployment. It needs to be noted that although full employment means a situation where all resources in the economy land, labour, capital, etc.—are fully employed but for simplifying meaning of full employment is restricted to labour market only, i.e., a situation where all able bodied persons who are willing to work at the prevailing wage rate find jobs. Every economy in the world aims at achieving the level of full employment equilibrium where all its available resources are fully and efficiently employed because it leads to maximum level of output. This is conceptual meaning of the term ‘full employment’. In practice, the concept of full employment generally refers to full employment of labour force of a country. Thus, when the entire labour force of a country is fully employed, it is termed as situation of full emplo5mient. Ke5mes defines it differently. According to him, when an increase in 141 CU IDOL SELF LEARNING MATERIAL (SLM)
aggregate demand does not result in an increase in level of output and employment, it shows state of full employment. In reality, full employment never exists because it is always possible to find some people unwilling to do any productive work though they may be fit physically and mentally. Also, some people remain temporarily without jobs over short period when they try to change employment from one job to another (called frictional unemployment) or when new machines are introduced or when a plant may break down (called structural unemployment). Thus, frictional, structural and voluntary unemployment can co-exist within the state of full emplo3mient. In short, full employment does not stand for zero unemployment. A certain percentage of unemployment, say, up to 3%, is inevitable due to frictional and technological unemployment although there is no consensus among economists on this point. Classical economists and Keynes view full employment in different ways. According to Classical, full employment is a situation where there is no involuntary unemployment. But according to Keynes, full employment indicates that level of employment where increase in aggregate demand does not lead to increase in level of output and employment. Underemployment Formula 8.1 Underemployment Underemployment is divided into three common categories, as follows: • Skilled workers in low-income jobs • Skilled workers in jobs that don’t fully utilize their skills • Part-time workers who would rather work full-time TYPES OF UNEMPLOYMENT Unemployment is a term referring to individuals who are employable and seeking a job but are unable to find a job. Furthermore, it is those people in the workforce or pool of people who are available for work that does not have an appropriate job. Usually measured by the unemployment rate, which is dividing the number of unemployed people by the total number of people in the workforce, unemployment serves as one of the indicators of an economy’s 142 CU IDOL SELF LEARNING MATERIAL (SLM)
status. The term “unemployment” can be tricky and often confusing, but it certainly includes people who are waiting to return to a job after being discharged. However, it does not anymore encompass individuals who have stopped looking for a job in the past four weeks due to various reasons such as leaving work to pursue higher education, retirement, disability, and personal issues. Even people who are not actively seeking a job anywhere but actually want to find one are not considered unemployed. Interestingly, people who have not looked for a job in the past four weeks but have been actively seeking one in the last 12 months are put into a category called the “marginally attached to the labor force.” Within this category is another category called “discouraged workers,” which refers to people who have lost all their hope of finding a job. The too many details and exclusions mentioned above make a lot of people believe that unemployment is vague and that the rate does not fully represent the actual number of people who are unemployed. So, it is a good idea to also look at the term “employment,” which the Bureau of Labor Statistics (BLS) describes as individuals aged 16 and above who have recently put hours into work in the past week, paid or otherwise, because of self-employment. Types of unemployment There are basically four types of unemployment: (1) demand deficient, (2) frictional, (3) structural, and (4) voluntary unemployment. 1. Demand deficient unemployment This is the biggest cause of unemployment that happens especially during a recession. When there is a reduction in the demand for the company’s products or services, they will most likely cut back on their production, making it unnecessary to retain a wide workforce within the organization. In effect, workers are laid off. 2. Frictional unemployment Frictional unemployment refers to workers who are in between jobs. An example is a worker who recently quit or was fired and is looking for a job in an economy that is not experiencing a recession. It is not an unhealthy thing because it is usually caused by workers looking for a job that is most suitable to their skills. 3. Structural unemployment Structural unemployment happens when the skills set of a worker does not match the skills demands of the jobs available or if the worker cannot reach the geographical location of a job. An example is a teaching job that requires relocation to China, but the worker cannot 143 CU IDOL SELF LEARNING MATERIAL (SLM)
secure a work visa due to certain visa restrictions. It can also happen when there is a technological change in the organization, such as workflow automation. 4. Voluntary unemployment Voluntary unemployment happens when a worker decides to leave a job because it is no longer financially fulfilling. An example is a worker whose take-home pay is less than his or her cost of living. Causes of unemployment Unemployment is caused by various reasons that come from both the demand side, or employer, and the supply side, or the worker. From the demand side, it may be caused by high interest rates, global recession, and financial crisis. From the supply side, frictional unemployment and structural employment play a great role. Effects The impact of unemployment can be felt by both the workers and the national economy and can create a ripple effect. Unemployment causes workers to suffer financial difficulties that may lead to emotional destruction. When it happens, consumer spending, which is one of an economy’s key drivers of growth, goes down, leading to a recession or even a depression when left unaddressed. Unemployment results in lowered purchasing power, which, in turn, causes lowered profits for businesses and leads to budget cuts and workforce reductions. It creates a cycle that goes on and on and on. Everyone loses in the end. Long-term unemployment vs. Short-term unemployment Unemployment that lasts longer than 27 weeks even if the individual has sought employment in the last four weeks is called long-term unemployment. Its effects are far worse than short- term unemployment for obvious reasons, and the following are noted as some of its effects. • A huge 56% of the long-term unemployed reported a decrease in their income. • It seems that financial problems are not the only effects of long-term unemployment as 46% of those in such a state reported experiencing strained family relationships. The figure is relatively higher than the 39% percent who weren’t unemployed for as long. • Another 43% of the long-term unemployed reported a significant effect on their 144 CU IDOL SELF LEARNING MATERIAL (SLM)
ability to achieve their career goals. • Sadly, long-term unemployment led to 38% of these individuals to lose their self- respect and 24% to seek professional help. PROBLEMS OF EXCESS DEMAND AND DEFICIT DEMAND & MEASURES TO CORRECT THEM Deficient demand refers to the situation when aggregate demand (AD) is less than the aggregate supply (AS) corresponding to full employment level of output in the economy. The situation of deficient demand arises when planned aggregate expenditure falls short of aggregate supply at the full employment level. It gives rise to deflationary gap. Deflationary gap is the gap by which actual aggregate demand falls short of aggregate demand required to establish full employment equilibrium. It may be noted that during deficient demand, equilibrium is determined at a level less than full employment equilibrium. It leads to underemployment equilibrium. In this situation, there exists involuntary unemployment. Reasons for Deficient Demand: A. Deficient Demand and Deflationary Gap The reasons for occurrence of deficient demand are almost opposite to the reasons for excess demand. The main causes for deficient demand are: 1. Decrease in Propensity to consume: A decrease in consumption expenditure, due to fall in the propensity to consume, leads to deficient demand in the economy. 2. Increase in taxes: AD may also fall due to imposition of higher taxes. It leads to decrease in disposable income and, as a result, the economy suffers from deficient demand. 3. Decrease in Government Expenditure: When government reduces its demand for goods and services due to fall in public expenditure, it leads to deficient demand. 4. Fall in Investment expenditure: 145 CU IDOL SELF LEARNING MATERIAL (SLM)
Increase in the rate of interest or fall in the expected returns lead to decrease in the investment expenditure. It reduces the AD and gives rise to deficient demand. 5. Rise in Imports: When international prices are comparatively less than the domestic prices, then it may lead to a rise in imports, implying a cut in the aggregate demand. 6. Fall in Exports: Exports may fall due to comparatively higher prices of domestic goods or due to increase in the exchange rate for domestic currency. This will lead to deficient demand. Impact of Deficient Demand: Deficient demand creates many difficulties in the economy due to its deflationary nature. Generally, deficient demand adversely affects the level of output, employment and price level in the economy. 1. Effect on Output: Due to lack of sufficient aggregate demand, there will be an increase in the inventory stock. It will force the firms to plan for lesser production for the subsequent period. As a result, planned output will fall. 2. Effect on Employment: Deficient demand causes involuntary unemployment in the economy due to fall in the planned output. 3. Effect on General Price Level: Deficient demand causes the general prices to fall due to lack of demand for goods and services in the economy. Problems Due to Deficient Demand In case of deficient demand in an economy, AD < AS. It means all the goods and services produced in an economy cannot be sold at existing price levels. The inventory of producers starts increasing and profits start shrinking with fall in price levels. This results in low income or output and under employment in an economy. Thus, deficient demand causes deflation and under employment. The economy gets trapped in low income equilibrium. Excess Demand 146 CU IDOL SELF LEARNING MATERIAL (SLM)
The situation of an economy, when Aggregate Demand is more than the Aggregate Supply corresponding to full employment, it is termed as excess demand situation. Excess demand —> AD > AS, corresponding to full employment level of output or income. Measures to Control Excess Demand and Deficient Demand Some of the important measures used to control excess demand and deficient demand are as follows: 1. Change in Government Spending 2. Change in Availability of Credit. The problems of excess demand and deficient demand occur when the current aggregate demand is more or less than the aggregate demand required for full employment equilibrium. These problems can be solved by bringing a change in the level of aggregate demand in the economy. There are number of measures to control excess and deficient demand. However, the scope of syllabus restricts the study to two main measures: 1. Change in Government Spending: Government spending is an important component of aggregate demand. This measure is a part of Fiscal Policy and is termed as ‘Expenditure Policy’ of the Government. Government spends huge amount on public works like construction of roads, flyovers, buildings, railway lines, etc. Changes in such expenditure directly affect the level of AD in the economy and help to control the situations of excess and deficient demand. For other measures of Fiscal Policy, please refer Power Booster. 2. Change in Availability of Credit: The Reserve Bank of India (RBI) is empowered to regulate the availability of credit and money supply in the economy through its ‘Monetary Policy’. It is policy of central bank to control money supply and credit creation in the economy. Monetary policy helps to control the situations of excess and deficient demand through its following instruments: (i) Quantitative Instruments: These instruments aim to influence the total volume of credit incirculation. Major instruments or measures are: (a) Bank Rate, (b) Open Market Operation, and (c) Legal reserve requirements. 147 CU IDOL SELF LEARNING MATERIAL (SLM)
(ii) Qualitative Instruments: These instruments aim to regulate the direction of credit. Major qualitative instruments or measures are: (a) Margin requirements, (b) Moral suasion (c) `Selective credit controls SUMMARY • Unemployment is a serious social and economic issue that results in a tremendous impact on everything but is often overlooked. A stronger system of assessing unemployment should be put in place in order to determine its causes and how to address it better. • Youthful workers in the labor force tend to experience more underemployment as a result of switching jobs and moving into and out of the labor force. Many public policies can also discourage the creation of employment, such as a high minimum wages, high unemployment benefits, and a low opportunity cost associated with terminating workers. • Employment is the primary source of income for a person and hence, it the source of economic growth. It is considered a lagging economic indicator. High underemployment suggests a low GDP and low demand for labor. • A country’s economic performance is measured using three key indicators, one of which is the unemployment rate. When adults who are willing and able to work cannot find a job, it may be a sign that an economy is producing less than it could. On the other hand, unemployment is also a natural phenomenon that even healthy economies experience. While the official unemployment rate is helpful in representing the state of a nation’s workforce, it does have some shortcomings that should be considered, such as excluding discouraged workers. • There are three types of unemployment that economists describe: frictional, structural, and cyclical. During recessions and expansions, the amount of cyclical unemployment changes. Cyclical unemployment is closely related to the business cycle, and causes the deviations of the current rate of unemployment away from the natural rate of unemployment. 148 CU IDOL SELF LEARNING MATERIAL (SLM)
KEY WORDS/ABBREVIATIONS • Cost-of-Living Adjustment (COLA) – A frequently used provision of labor contracts that grants wage increases based on changes in the consumer price index; often referred to in negotiations as the \"escalator clause.\" • Covered Employment – Those jobs covered by an unemployment compensation program are considered covered employment. Presently, those jobs for which coverage is not required in Nevada include most agricultural workers; employees of religious organizations; railroad workers; elected state and local government officials; federal government employees; military personnel; student workers at universities, interns, and student nurses; self-employed workers; sole proprietors and their immediate families. • Cyclical Unemployment – Unemployment that is caused by periodic declines in business activity that gives rise to inadequate demand for workers in the economy. • Full Employment – A state of the economy in which all people who wants to work can find employment without much difficulty at prevailing rates of pay. Some unemployment, both voluntary and involuntary, is not incompatible with full employment, since allowances must be made for frictional and seasonal factors that are always present to some degree. • Full-Time Employment – Generally includes people who worked 35 hours or more during the survey week (week of the month that includes the 12th). Persons who worked between one and 34 hours are designated as working part-time. LEARNING ACTIVITY 1. If a person is ready to work at the prevailing wage rate in the market, but he is unable to find the work, then what type of unemployment would it be called? Give reasons 2. If new computers are being installed in a company and some employees are fired from the job due to lack of computer knowledge then what kind of unemployment will it be called? Give reasons UNIT END EXERCISES (MCQS AND DESCRIPTIVE) A. Descriptive Questions 149 CU IDOL SELF LEARNING MATERIAL (SLM)
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