CU-BA-SEM-III-Economics-III-Second Draft-converted

As the demand for a good depends upon its price, similarly consumption of a community depends upon the level of income. In other words, consumption is a function of income. The consumption function or propensity to consume relates the amount of consumption to the level of income. When the income of a community rises, consumption also rises. Keynes made it clear that there is a direct relationship between income and consumption. The functional relationship between income and consumption is called consumption or propensity to consume. Thus C= f(Y), where C is consumption, f is function and Y is National Income. According to Keynes, The psychology of the community is such that when aggregate real income increased, aggregate consumption is increased, but not so much as income. Keynes law of consumption depends on the following three aspects; 1) Increase in income and increase in consumption are not at the same proportion. Consumption is always positive but less than one. 2) An Increase in income is shared between consumption and saving. 3) Increase in income will not cause rise in consumption and saving at the same time. If the rate of increase in saving rises, the rate of increase in consumption will fall. Figure 3.1: Keynesian Linear Consumption Function 51 Source: economicdiscussions.net In a mathematical form the relationship can be expressed as, C= a+ bY CU IDOL SELF LEARNING MATERIAL (SLM)

Thus, a consumption function is generally described in terms of the equation Y= a+ bY where ‘a’ the amount of autonomous consumption and slope (b) is MPC. The rate of change in consumption due to change in income depends on MPC. The + sign indicates that as income increases, obviously consumption will also increase. Keynes also made it clear that in the short run, the consumption function is stable because consumption habits of the people are more or less stable in the short period. The income- consumption relationship can be expressed in the above diagram. The vertical axis shows the spending on consumption indicated by c and the horizontal axis shows income or output indicated by Y. The straight-line consumption function CC is expressed in terms of equation C = a+ b Y. The consumption curve CC is a short run curve. In this case, consumption takes place even when income is zero. Even when income is zero, people spend some minimum level either by gift or borrowing. 3.3 ABSOLUTE INCOME HYPOTHESIS The Absolute Income Hypothesis was put forward by John Maynard Keynes. The hypothesis is based on what Keynes called the Fundamental Psychological Law of Consumption. In the words of Keynes, \"The fundamental psychological law upon which we are entitled to depend with grate confidence both a priori from our knowledge of human nature and from the detailed facts of experience, is that men are deposed, as a rule and on the average, to increase their consumption as their in income increases, but not by as much as the increase in their income\". Thus, this hypothesis is based on following postulates. • Consumption is stable function of income. • The marginal propensity to consume (MPC) is less than 1 but greater than zero. • As income increases consumption also increases but less than proportionately. As a result, the average propensity to consume (APC) falls over time. This makes marginal propensity to consume (MPC) less than the average propensity to consume (APC). Keynes holds the view that household's current consumption expenditure depends on the current income of the household. On the basis of this fundamental argument, absolute income hypothesis builds its propositions that current consumption expenditure depends upon current and absolute level of disposable income. C =  (Y) Where, C = current consumption, Y = current disposable income. 52 CU IDOL SELF LEARNING MATERIAL (SLM)

Following are the main features of Keynesian consumption function. ▪ The real consumption expenditure is a positive function of the real current disposable income. ▪ The marginal propensity to consume (MPC) ranges between zero and 1, that is 0 < MPC < 1 (0 and 1 excluded). ▪ The marginal propensity to consume (MPC) is less than the average propensity to consume (APC). ▪ The average propensity to consume (APC) declines as income increases. Fig 3.2 Absolute Income hypothesis Source: economicsdiscussions.net 3.3.1 Criticism It’s Critical Appraisal: The quality of that principle that it forces on all element except income that pre-set the customer-behaviour. That is not described by Keynes. But the problems are that it nonrational consumption function continues with assumption. As Pro. Shapiro objected, “Now economist feels that basic consumption function is rational its mean to ignores the main principle of absolute hypothesis.” 3.4 RELATIVE INCOME HYPOTHESIS The psychologist and sociologists have acknowledged that individuals care about their status in society. Duesenberry gives careful consideration to this postulate. He explained his relative 53 CU IDOL SELF LEARNING MATERIAL (SLM)

income hypothesis in 1949 in a book title 'Income, Saving and Theory of Consumer Behaviour'. In this book Duesenberry argued the utility of an individual derived from given consumption level depends on its relative magnitude in society rather than its absolute level. Dusenberry argued that utility index of an individual is depends on the ratio of his or her consumption to weighted average of the consumption of the others. It means that utility of an individual depends both on own income and income relative to others. Relative income hypothesis shows that people/households make their decisions regarding consumption and saving based not only on absolute income but on relative income as well. As a consumer, individual considers his income as it relates to the income of other before making purchase decisions. Duesenberry, in his relative income hypothesis argued that if relative income of an individual remains same, the individual will spend the same proportion of his income on consumption as he was doing before the absolute increase in his income. In other worlds, average propensity to consume (APC) of an individual will remain same despite of the fact that his absolute income increases. Study conducted by Kuznets based on timeseries has shown that in long run average propensity to consume remains almost constant. It means in long run the community would continue to consume the same proportion of income as its income increases. So the exact difference between absolute and relative income hypothesis is as follows Keynesian absolute income hypothesis implies that as the absolute income of community increases, it will offer a smaller proportion of its income towards consumptions and as a result, APC will decline. On the contrary, relative income hypothesis implies that if the income of the community increases, and the relative distribution of income remains the same, then consumption would increase by the same proportion. Thus, the relative income hypothesis suggests that as income increases consumption function curve shifts above so that average propensity to consume remains constant. Similarly, relative income hypothesis provides slightly different explanation from absolute income hypothesis on the question of what happens when household income decreases. On the one hand absolute income hypothesis holds the view that consumption decreases when there is decrease in income. On the contrary relative income hypothesis holds the view that consumption will not decreases in proportion to income because of 'Ratchet Effect'. Ratchet Effect 54 CU IDOL SELF LEARNING MATERIAL (SLM)

When the income of individual falls, consumption does not fall as much, this is called Ratchet Effect. How this happens? This is because people are aware about position in the society they live in and they do not want to show the neighbours that they can no longer afford to maintain the previous standard of life. James Duesenberry (1949) offers slightly different explanations to conventional argument. Conventionally, if income falls, then consumption should fall. But Duesnberry rejects this view. He argues that once the consumption habits are acquired, it becomes difficult to get rid of these habits. Some of the consumption habits are formed at high income levels that are not completely abandoned when income falls. The ratchet effect arises due to household's resistance against the fall in consumption following a decrease in household income. Dusenberry argues that when absolute income increase absolute consumption also increases. But absolute income decreases, the household do not allow their consumption to fall in their income. This is because, in a long run, household gets used to certain standard of living. Therefore, when income of these households falls, consumption of these households falls less then proportionally. When consumption does not fall in proportion to the fall in income, then average propensity to consume (APC) rises and marginal propensity to consume (MPC) falls. This is called ratchet effect in consumption behaviour. For example, If the income of household increases from Rs. 10,000/- per unit of time to Rs. 11,000/-. The consumption of household would increase from Rs. 8000/- to Rs. 8800/-. In this case MPC = △ C/△ Y = 800/1000 = 0.80,APC = C/Y = 8800/1100 = 0.80 Here, MPC =APC 0.80 0.80 But when the income decreases, say to Rs.9000/-, consumption decreases less then proportionally to say, Rs. 7500. In this case MPC = 0.50, APC =0.83 Note that MPC has decreased from 0.8 to 0.5 and APC has increased from 0.8 to 0.83. 55 CU IDOL SELF LEARNING MATERIAL (SLM)

Fig 3.3 Relative Income hypothesis Source: economicdiscussions.net Figure3.3 shows the fundamental framework of relative income hypothesis by Duesenberry. OX is a horizontal axis showing income and OC is vertical axis showing level of consumption corresponding to the level of income. In this diagram, if long run consumption increases as a result of increase in income is shown as CLR. When income is OY0, aggregate consumption is OC0. As the income increases to OY1, consumption rises to OC1. This means a constant APC consequent upon a steady growth of national income. Now, let's assume that income levels fall from OY1 to OY0. In these circumstances, Dusenberry's hypothesis comes in operation and it's visible. For example, household will maintain the previous cons8umption level what they enjoyed the past peak of income levels. It means households are unwilling to reduce their consumption standards along with CLR. Consumption will not decline to OC0, but will remain at OC'1 (>OC0) at the income level OY0. At this level of income, APC will be higher than what it was at OY1 and MPC will be lower. If income rises, consumption will rise along CSR because people will maintain their consumption standard at the previous peak income. Once OY1 level of income is reached consumption will move along with CLR. The short run consumption is subject to 'the ratchet 56 CU IDOL SELF LEARNING MATERIAL (SLM)

effect'. If ratchets up following an increase in income levels, but it does not fall back downward in response to fall in income. 3.4.1 Criticisms However, the principle of Dussenberry solves the direct opposition between short period and long period study, but there are many drawbacks in that 1. No Proportional Increase in Consumption: The assumption of Relative Income principle is that income and consumption are rationally increases. But there is not always rational increment in consumption by the increment on full employment status. 2. No Direct Relation between Consumption and Income: This principle is assuming that consumption and income are directly related. But this thing is not supported on the bases of experience. Consumption is not always reducing according to business depression. Example, consumption was not reducing during business depression of 1948-49 and 1974-75. 3. Distribution of Income not unchanged: Presented principle is based on assumption that the distribution of income is approximately unchanged being change on the level of whole income. If income reorganized in more similar side with the increment in income, then the APC reduce of every persons related with poor and rich family. So, when income increase, then consumption function will not shift up from CS1 to CS2. 4. Reversible consumer Behaviour: According to Michal Ivenj, “Consumer behaviour is slowly change not fully unchanged. Then as more time expend from last maximum level, current consumption of last maximum income status will as low effected.” If we know it also that how any consumer had to spend on last maximum income status, then it is not possible to know that now how he will spend. 5. Neglect of other Factors: Present principle is bases on assumption that the change in expenditure of consumer is related with his last high-income level. This principle is weak according that it neglects the other component that affects the consumer-behaviour like updating new consumer things, changes in age-structure, urbanizations and asset holder. 6. Consumer Preferences do not Depend on other: The unreal assumption of that principle is that consumer preferences are dependent on each other according to it the expenditure of any consumer is related with the consumption structure of his rich neighbour. But it is not always. By the direct study of Prof. George Katona get that expectancy and nature are important in consumer expenditure. He says that the nature of income –expectancy and asset perception 57 CU IDOL SELF LEARNING MATERIAL (SLM)

based on the status of ambition is more affected to consumer expenditure relation in comparison to display effect. 7. Reverse Lighting Bolt Effect: Prof. Smith and Pro Jackson criticizes the Dussenberry on the bases of their experience prove that the income is recovering after depression it is no because of Ratchet effect but the consumption experience of consumer is just like ‘reverse lightning bolt effect’. It is because that consumer increases his consumption on increasing income slowly-slowly because of ‘irregular habit stability’ after depression. 3.5 PERMANENT INCOME HYPOTHESIS The Permanent Income Hypothesis was formulated by a Nobel Laureate Milton Friedman in 1957. Earlier, both absolute and relative income hypothesis related consumption to absolute and relative current income. But Milton Friedman in his book 'Theory of Consumption Function' rejected the argument of current income hypothesis and formulated a new theoretical framework to understand consumption function. This theoretical framework is known as 'Permanent Income Hypothesis'. Permanent income is the mean of all the incomes anticipated in the long run. While calculating permanent income, Friedman says that it is an income anticipated from human and non-human wealth. Income from human wealth refers to income from human capital that includes training, education, skill and intelligence. In short, income from human capital is the income earned by selling the household labour. On the other hand, income from non-human wealth means income from assets like- money, stocks, bonds, real estate and consumer durables etc. In short, this theory can be stated that it is the permanent income and not current income that determines the level of consumption expenditure. Permanent income hypothesis also provided explanations for some of the issues that rose from the empirical data regarding the relationship between average and marginal propensity to consume. 3.5.1 Concepts of Transitory Income, Transitory Expenditure and Transitory Purchase While calculating permanent income, we need to understand and distinguish between transitory income and transitory expenditure. Transitory income consists an income earned by people in the form of bonus to workers, lottery wins etc. Similarly, transitory losses consists of unpaid sick leave, temporary loss of job, non-payment of wages due to strikes and lockouts, short term fall in returns on the income earning assets etc. Similarly, there is need to understand the concept of transitory purchases along with transitory income and expenditures. 58 CU IDOL SELF LEARNING MATERIAL (SLM)

Sometime households make once in a while purchase of goods which they do not need for immediate consumption. These types of purchases are made because of attractive offers, anticipated scarcity of the commodity etc. But at the same time some routine purchases are postponed by households due to lack of funds, sudden price rise or lower prices expected in the future. The purchases that are deferred by households are treated as negative transitory purchases. The permanent income hypothesis assumes no relationship between income and transitory purchases made or postponed. While estimating permanent income of household, the transitory income is considered as an addition while transitory expenditure is considered as a loss from the permanent income. 3.5.2 Equations of Permanent Income Hypothesis While elaborating permanent income hypothesis, Dornbusch and Fischer said that Friedman has not provided a standard definition of permanent income. But certainly he has given a pragmatic approach to estimate permanent income. Further, they also said that permanent income was equal to geometrically weighted average of present and past measured income. Friedman's theory of permanent income hypothesis is very significant and has opened new areas of research on saving and consumption function. Friedman believes that every household has some conception of his future expected income that is considered to be stable. This is called permanent income. The actual income of the household may or may not coincide with permanent income. The gap between measured income and permanent income are called transitory income which may be negative or positive. Thus, we have the following identity. Ym = Y p +Ytr ………………………………… (1) It means that measured income consists of permanent income and transitory income. While defining permanent income, Friedman said that 'the effect of those factors that the unit regards as determining it's capital value of wealth; the non-human wealth, personal attributes of earners like his training, ability, personality, the attributes of the economic activities of the earners and so on. Besides, transitory component of income, on the other hand, reflects the effect of 'change' or accidental factors which causes the measured income to rise or fall temporarily. In fact, income earned through such windfall gains is temporary and consumer knows it. As a result, consumer will not base his consumption upon such transitory income. In fact, consumer would base his consumption upon what he considers as his permanent income. Algebraically, permanent income hypothesis can be written as: Cp = kY p …………………. (2) 59 CU IDOL SELF LEARNING MATERIAL (SLM)

Permanent consumption (Cp) equals k proportion of permanent income (Yp) Ym = Y p + Ytr …………………… (3) Measured income (Ym) equals permanent income (Yp) plus transitory income (Ytr) Cm = Cp + Ctr……………………. (4) Measured consumption (Cm) equals permanent consumption (Cp) plus transitory consumption (Ctr) R1 (YtrY p) = 0 ……………………... (5) Correlation coefficient (R1) between Ytr and Ype quals zero R2 (Ctr Cp) = 0 …………………………. (6) Correlation coefficient (R2) between Ctr and Cpe quals zero R3(Ytr Ctr) = 0 …………………………. (7) Correlation coefficient (R3) between Ytr and Ctr equals zero These equations explain permanent income hypothesis. For example-equation-1 states that permanent or planned consumption a certain proportion (k) of the permanent income. The proportionality factor k need not be a constant for it depends on demographic and ethnic factors, the interest rate and ratio of non-human wealth to permanent income. Friedman estimated permanent income on the basis of measured income data for 17 years. The formula that he used to measure the permanent income is given below. Ypt = ������Y1+ ������(1- ������) Yt-1 + ������(1- ������2) Yt-2 +…… ������(1- ������n) Yt-n----------------------------(8) Ypt = permanent income in period ������ = rate of declining weightage for the annual measured income in the past. 3.5.3 Criticisms Still there are some drawbacks in this principle 1. Correlation between Temporary Income and Consumption: its assumption of Friedman is unrealistic that in the temporary part of consumption and income are not related. The mean of that assumption that when the measure income of family is increases or decreases, then his consumption neither increase nor decrease, because accordingly he neither save nor spends. But this thing is apposite to real consumer behaviour. If any person gets immediate profit, then he did not deposit full money in bank account but he spends partly on his current saving. 60 CU IDOL SELF LEARNING MATERIAL (SLM)

Therefore, if person lost his wallet, then he will not go to bank for money for fulfil his need, but he will be ignored or cut his present consumption. 2. APC of all Income Groups not Equal: The rule of Friedman says that APC is equals to poor and rich families in long term. But this thing is against to the normal-behaviour of family. It is realistic that low-income family did not save more income as more income holder. It’s not only one reason that their income is low but it is also that they will prefer to present consumption expect to future consumption for fulfil their left need. So, the savings of low income is low relatively to their income but the savings of more income families more relatively their income. The saving level is different in normal income level and consumption also. 3. Use of Various Terms for Income and Consumption Confusing: Friedman use that words in his principle ‘Permanent’, ‘Temporary’ and ‘measured’, it untangles that principle. the perception of measured income one side improperly finds by permanent and temporary income and other side by permanent and temporary consumption improperly. 4. No Distinction between Human and Non-Human Wealth: The more deflect of permanent income principle is that Friedman did not do distinction between Human and Non-Human wealth and the experiential analysis of his principle, it is mix in one dictionary gets income by both. Despite of these deflect, in the words of Michal Ivenz, “It can be appositely says that certification is the supporter of this principle that by the replacement of Friedman the research of consumption gets new way and new side.” 3.6 LIFE CYCLE HYPOTHESIS The theory of life cycle hypothesis is associated with economist like Franco Modigliani, Richard Brumberg and Alberto Ando. Given the wealth constraint, life cycle hypothesis aims to maximize the utility function over the life span. The maximization of utility function depends upon the availability of resources. The resource pool of an individual consists of his current and discounted future earning over his life span and current net worth. Modigliani won Nobel prize in Economics in year 1985 for his work on life cycle hypothesis. This hypothesis explains the conflict between average propensity to save (APS) from cross section data and data from time series. Life cycle hypothesis assumes that an individual earns relatively low income at the beginning and at the end of his life. But the flow of income remains high during the middle of his life. The individual maintains increasing level of consumption in his entire 61 CU IDOL SELF LEARNING MATERIAL (SLM)

life. But the present value of his total consumption would not exceed the present value of total income during his life time. The life cycle hypothesis also observes that in order to avoid the fluctuations in income, people save their income especially during the high income and dissave during the time of low income. If the probability of future income increases, consumption also increases. The life cycle hypothesis also suggests that an individual is a net borrower at the earlier stage of his life. During the middle of his life, individual save more and also puts aside a sum for his retirement. In the later years, a person will dissave and consumer more than his income. In life cycle hypothesis individual smoothen out the consumption pattern in the lifetime and this process has independent of current level of income. Life cycle hypothesis states that early stage of life of an individual, consumption expenditure is likely to exceed income. Because individual may purchase a new home to start his family life at eh initial stage of his career. In order to support these consumption need, individual is likely to borrow from future. In the mid-career life, individual's income increases. Individual is in a position to repay and of his past borrowing and also begins to save for her/ his retirement. At the stage of retirement, consumption expenditure may decline but decline in income is more drastic. At the retirement stage of life, the individual is dis-saver. While highlighting the pattern of consumption behaviour of an individual, the life cycle hypothesis emphasises on three factors, viz.: 1. Availability of resources to the individual. 2. Rate of return on his capital 3. The age of an individual The availability of resources with an individual consists of individuals existing net wealth and the present value of all current and future labour income. Consumer is rational; this is one of the crucial assumptions of life cycle hypothesis. In order to maximize the total utility over life time, a rational consumer plans his/her consumption on the basis of resources, allocation of income and consumption. 3.6.1 Postulates of Life Cycle Hypothesis Total consumption of an individual is determined by current physical and financial wealth and life -time labour of an individual. The consumption expenditure of an individual depends upon life time income and stock of wealth. Life-time consumption pattern of an individual remains more or less stable. There is no relationship between current income and current consumption. The postulate No. 1 & 2 will pave the way for life-time consumption. 62 CU IDOL SELF LEARNING MATERIAL (SLM)

C = aWR + cYL .............................................(1) Where, WR = real wealth, YL= labour income, a = mpc wealth income, and c= mpc labour income. Now let's assume that an individual starts working at the age of B, and this individual wants to live for N years with his retirement age at R. Therefore, his working life equals R-B years. Let's also assume that: 1. Individual has no uncertainty about his longevity, employment and health condition. 2. He earns no interest on his accumulated savings. 3. He does not consume his total labour income 4. Prices remain constant. Taking in to considerations of the following assumptions, the lifetime income is estimated as follows: Lifetime income = YL (R - B) Where, YL = annual labour income, and R-B = number of working years. Assuming R-B = EL to the earning life, we may redefine lifetime labour income as lifetime income = YL X EL. Life-cycle hypothesis states that an individual plans his lifetime consumption in such as way that his lifetime consumption equals his lifetime income. Here the term 'lifetime' means working life = N -B. Given the individual's expected life of N years and his planned constant (annual) consumption (C), the consumption hypothesis can be written as C X N = YL X EL……………………………… (2) Let's divide both the sides by N, we get the lifetime consumption (C) as XYL N EL C = .............................................(3) Equation (3) reveals that not only a fraction of labour income is consumed annually and the rest is saved and accumulated. We will return to the savings aspects shorts. 3.6.2 Criticisms There are some limits of life cycle principle. 1. Plan for Lifetime Consumption Unrealistic: It is the statement of Ando-Modigliani is that consumer planed for the consumption of his throughout life; it is unrealistic because consumer focuses more on present consumption rather than future consumption which is uncertain. 2. Consumption not Directly Related to Assets: Life-cycle principle already consider that consumption is directly related to assets of person. As assets increases as their consumption increases and consumption decreases on the decrement of assets. It is also necessary because it may be that person reduces his consumption for increase the asset. 63 CU IDOL SELF LEARNING MATERIAL (SLM)

3. Consumption Dependent on Attitude towards Life: Consumption depends on the view point of the life of person. Being given the same income and asset, one person can more consume expect of other. 4. Consumer not Rational and Knowledgeable: This landscape is depending on that hypothesis that consumer is full prudent and he has full knowledge about his income and life. It realistic to being rational and prudent of any consumer. 5.Many Variables: This principle is depending on many variables like current income, future anticipated labour income, value of assets and life. It is very hard to assume it. So it is unrealistic. Despite these things, life-cycle principle is great from those all Theories, that are already described, because there are involve only assets as variable within consumption function, and it also clear that thing that why MPC < APC in short duration and APC remain constant. 3.7 AVERAGE PROPENSITY TO CONSUME The average propensity to consume can be referred to as the percentage of income spent on goods and services by an individual. IT is the ratio of consumption to income. It is arrived at by dividing the total amount spent on household consumption by the total disposable income. An increase in the average propensity to consume denotes a high demand for goods and services. An increase or decrease in the average propensity to consume also determines the propensity to save. The opposite of the average propensity to consume is the average propensity to save. It can be expressed as, ������������������ = ������/������ For example, if total income is Rs.1000, consumption is 500, then APC = 500/1000 =0.5 A tendency of incremental savings has a negative effect on the average propensity to consume. High-income households have a less average propensity to save. However, in the case of a fresh earner, an increase in income has an incremental effect on the average propensity to 64 CU IDOL SELF LEARNING MATERIAL (SLM)

consume. Low-income families have a higher propensity to consume. They tend to spend most of their monthly earnings on essential goods and services. The average propensity to consume and the savings ratio are expressed as a percentage of the total disposable income. Consumer spending helps in boosting the economy. When there is a high demand for the supply of goods, more goods are purchased, more people are employed, and more business are open. When people have a tendency to save, it can negatively affect the economy as people purchase fewer goods and services. It indicates that there is a low demand for goods and services, resulting in fewer jobs, and increased business closures. Ideally, the sum of the average propensity to consume and the average propensity to save is equivalent to one. This is due to the fact that households use all income for either saving or consumption. Contrary to the average propensity to consume, the APS is calculated as the percentage of total income used for saving rather than spending on goods and services. The average propensity to consume could also be calculated by subtracting the APS from 1. The APS is also known as the savings ratio, and it is usually expressed as a percentage of total household disposable income (income minus taxes). 3.8 MARGINAL PROPENSITY TO CONSUME The marginal propensity to consume (MPC) measures the proportion of extra income that is spent on consumption. The marginal propensity to consume is the ratio of the change in consumption to change in disposable income. In other words, MPC is the rate of change in propensity to consume. MPC = change in consumption/ change in income Or MPC = △ C/△ Y Where △C- Change in consumption and △Y- Change in Income. The slope of the consumption function or any other straight line is measured by dividing the vertical change by horizontal change. The symbol ‘△’ represents the change. Or slope can also be calculated as Slope = vertical change/ horizontal change 65 CU IDOL SELF LEARNING MATERIAL (SLM)

The propensity to consume is assumed to be stable in the short run. Therefore, out of the given income how much will be spent depends on the slope of the curve. The MPC will invariably be between 0 and 1. The below diagram explains the MPC: Figure 3.2: Marginal Propensity to consume Source: www.economicshelp.org 3.9 SAVING FUNCTION The portion of the income not spent on consumption is called saving. Saving is nothing but consumption that is forgone. If saving rises, consumption will fall. According to Keynes, the level of saving in the economy depends basically on income. The relationship between saving and income is termed as ‘Saving function’. It is mathematically expressed as follows: S = -a + bY Where S- Saving, -a -dis-savings, and Y- Income. Marginal Propensity to Save (MPS) is the ratio of change in saving to change in income. Thus is the rate of change in the propensity to save. The marginal propensity to save (MPS) = the amount of extra income that is saved. MPS = △S / △Y Where △S- Change in saving and △Y – Change in Income. 66 CU IDOL SELF LEARNING MATERIAL (SLM)

With increase in income; if MPC tends to fall, MPS will tend to rise. If MPC remains constant, MPS also will remain constant. Thus income consists of consumption and savings. Hence Y = C+ S Or MPC+ MPS =1 MPS= 1- MPC MPC= 1- MPS 3.10 OTHER DETERMINANTS OF CONSUMPTION Though income is the most important factor that has the greatest influence on consumption, there are other factors which influence the Propensity to Consume. They are as follows: i) Real Income: Real income is the basic factor which determines community’s propensity to consume. When real income of the community increases, consumption expenditure also increases but by a smaller amount. The consumption function shifts upward. (ii) Distribution of wealth: If there is unequal distribution of wealth in a country, the consumption function will also be unequal. People with low income group have high propensity to consume and rich people low propensity to consume. An equal distribution of wealth raises the propensity to consume. (iii) Expectation Change in Price: If people expect prices are going to rise in near future, they hasten to spend large sum out of a given income just after the promulgation of first Martial Law in our country. So we can say that when prices are expected to be high in future, the propensity to consume increases or the consumption function shifts upward. When they are expected to be low, the propensity to consume decreases or the consumption function shifts downward. (iv) Changes in Fiscal Policy: Taxes also play an important part in influencing the propensity to consume. If the nature of taxes is such that they directly affect the poor people and reduce their income, then the propensity to consume is high and if rich persons are not taxed at a progressive rate and they accumulate more wealth, then the propensity to consume is low. (v) Change in the Rate of Interest: A change in the rate of interest exercises influence on the propensity to consume. When the interest rate is raised, it generally induces people to decrease expenditure and save more for lending purposes. On the other hand, when the interest 67 CU IDOL SELF LEARNING MATERIAL (SLM)

rate is reduced, it usually encourages expenditure as lending then becomes less attractive. So we conclude that an increase in the rate of interest generally reduces propensity to consume or shifts the consumption function downward and a fall in the rate of interest usually helps to the increase of propensity to consume or shifts the consumption function upward. (vi) Availability of Goods: Propensity to consume is also affected by the availability of consumption goods. If the goods are available in abundance, then the propensity to consume increases. If they are scarce and are priced very high, then the propensity to consume will decline. (vii) Credit Facilities: cheap credit facilities are available in the country, the consumption function will move upward. (viii) Higher Living Standard: If the real income of the people increases in the country and people adopt the use of new produce like television, washing machines, refrigerators, care, etc., etc., the consumption function is high. (ix) Stock of Liquid Assets: If the consumer has greater amounts of liquid assets; there will be more desire for the households to spend out of disposable income. The consumption function shifts upward and vice versa. (x) Consumer Indebtedness: In case the consumer is heavily indebted and they pay bigger monthly instalments to replay the dept, then propensity to consume is low or the consumption function shifts downward and vice versa. (xi) Windfall Gains: If there are unexpected gains due to stock market boom in the economy, it tends to shift the consumption function upward. They are windfall gains. The unexpected losses in the stock market lead to the downward shifting of the consumption curve. (xii) Demographic Factors: The consumption function is also influenced by demographic factors like size of family, occupations, place of residence etc. Persons living in cities, for instance, spend more than those living in rural areas. (xiii) Attitude Towards Saving: If a community is consumption oriented, there will be less saving in the country. The consumption function shifts upward. In case, people save more and spend less, then the consumption function will shift downward. (ix) Demonstration Effect: If people are easily influenced by advertisements on radio and television and seeing pattern of living of the rich neighbours, the level of total consumption will go up. 68 CU IDOL SELF LEARNING MATERIAL (SLM)

3.11 SUMMARY • Consumption function is the relationship between income and consumption. • The proportion of income spent on actual consumption at different levels of income is called Propensity to consume. • The rate of increase in consumption will be less than the rate of increase in income. • Even when income is zero, People will spend minimum level of amount either by gift or borrowing. • Average Propensity to consume is calculated by dividing the total amount spent on consumption by the total National Income. • The APS is also known as Savings ratio. • Marginal Propensity to Consume is the ratio of change in Propensity to consume. • Consumption function relates the amount of consumption to level of income. • The relationship between savings and income is called saving relationship. • The ratio of change in saving to change in income is called Marginal Propensity to Save. • MPC + MPS = 1 3.12 KEYWORDS • MPC- Marginal Propensity to Consume • MPS- Marginal Propensity to Save • C- Consumption • Y- National Income • S- Savings 3.13 LEARNING ACTIVITY 1. Find out the Income and consumption of the people living in your area and find the MPC. ___________________________________________________________________________ ___________________________________________________________________________ 2. Find out the Income and savings of your family and find whether savings is more than consumption. ___________________________________________________________________________ ___________________________________________________________________________ 69 CU IDOL SELF LEARNING MATERIAL (SLM)

3.14 UNIT END QUESTIONS 70 A. Descriptive Questions Short Questions 1. Define the term consumption function. 2. What is autonomous consumption? 3. What are the three aspects of consumption function? 4. Define saving function. 5. What is Average consumption function. Long Questions 1. Describe the consumption function with diagram. 2. Describe the Average Propensity to Consume. 3. Describe the Marginal Propensity to Consume with diagram 4. What is saving function and explain MPS. 5. What are the determinants of consumption other than income? B. Multiple Choice Questions. 1. The relationship between income and consumption is _____ a. Indirect b. Direct c. No relationship d. None of these 2. The rate of increase in consumption is ____ than the rate of increase in income. a. Less b. More c. Equal d. None of these 3. ______ is the rate of change in propensity to consume. a. MPS b. C c. MPC CU IDOL SELF LEARNING MATERIAL (SLM)

d. Y 4. _____ is consumption that is forgone. a. National Income b. Propensity to consume c. Slope d. Savings 5. MPC + MPS =_____ a. 1 b. 0 c. Infinity d. 2 Answers 3-c, 4-d, 5-a 1- b, 2-a, 3.15 REFERENCES Reference books • Baird, C.W. (1977). Elements of Macro Economics, London: West Publishing Company. • Dernburg, T.F.& McDougal, D.M. (1983). Macro Economics. New York: McGraw Hill. • Gardner Ackley, G. (1985). Macro-Economic Theory. New York: McMillan. • Ghuman, R.S. (1998). Antar-RashtriyaArthVigyan, Patiala: Punjabi University. • Harvey, J.&Johnson, M. (1971). Introduction to Macro Economics, London: McMillan Textbooks • Jain, T.R. (1997). Macro Economics, New Delhi: V.K. Publications. • Jhingan, M.L. (2003). Macro-Economic Theory, New Delhi: Varinda Publishers. • Sharma, O.P. (2003). Macro Economics, Patiala: Punjabi University. • Vaish, M.C. (2008). Macro-Economic Theory. New Delhi: Oxford University Press. Websites 71 CU IDOL SELF LEARNING MATERIAL (SLM)

• Economictimes.indiatimes.com • Theinvestorsbook.com 72 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-4 CONSUMPTION AND INVESTMENT 73 FUNCTIONS Structure 4.0 Learning Objectives 4.1 Introduction 4.2 Multiplier 4.2.1 Static Multiplier 4.2.2 Dynamic Multiplier 4.2.3 Principle of Acceleration 4.2.4 Importance of Multiplier 4.2.5 Leakages in working of Multiplier 4.3 Investment 4.3.1 Meaning 4.3.2 Gross Investment vs Net Investment 4.3.3 Induced investment vs Autonomous Investment 4.3.4 Planned and Unplanned Investment 4.3.5 Financial and Real Investment 4.3.6 Public and Private Investment 4.4 Determinants of Investment 4.5 Marginal Efficiency of Capital 4.6 Rate of Interest 4.7 Marginal Efficiency of Investment 4.8 Relation between MEC, Interest rate and MEI 4.9 Summary 4.10 Keywords 4.11 Learning Activity CU IDOL SELF LEARNING MATERIAL (SLM)

4.12 Unit End Questions 4.13 References 4.0 LEARNING OBJECTIVIES After studying this unit, students will be able to: • Explain the meaning of Multiplier. • Describe the types of Multiplier. • Analyse the meaning of Investment function. • Outline the factors that determine the investment function. • State the meaning of marginal efficiency of capital and distinguish MEC and MEI • Discuss the relation between MEC, Rate of Interest and MEI 4.1 INTRODUCTION An economy can reach equilibrium without government intervention, with government intervention, and with trade. Consumption is important to determine the aggregate demand in an economy. According to the Engel's Law, the amount spent on food and other necessities falls as the income rises. A country's consumption expenditures rise as incomes rise. The Keynesian theory explains how consumption and investment can help the economy reach equilibrium. Savings and investment can also help the economy reach an equilibrium. An increase in savings leads to a decrease in national product whereas an increase in investment demand leads to an increase in national product. When savings equal investments, the economy reaches its equilibrium point. Keynes believed that government intervention can reduce the level of unemployment. When the economy has high unemployment levels, the government can take fiscal measures to reduce unemployment. Government can increase aggregate demand during recessions by increasing its spending or decreasing the tax rate. An increase in aggregate demand will have a multiplier effect on the economy. Government spending will create employment opportunities in the economy and this in turn will increase the disposable income and consumption in the economy. Government has to increase taxes to fund the spending. However, an increase in taxes will reduce the purchasing power of the people and consumption will suffer. Thus, during a recession, government spending should increase without an increase in taxes. Government can increase spending during recessions by borrowing. 74 CU IDOL SELF LEARNING MATERIAL (SLM)

During period of high inflation, government has to reduce spending. The inflationary gap can be reduced by imposing higher taxes. Imposition of higher taxes reduces the disposable income of the people and consequently consumption. Taxes can be imposed in two forms: lumpsum and proportional. 4.2 MULTIPLIER The concept of ‘Multiplier’ occupies an important place in Keynesian theory of income, output and employment. Keynes borrowed the idea of multiplier from R.F. Kahn who explained the effect of an increase in investment on employment. Keynes explained the relationship of a small increase in investment to final increase in income. According to J.M. Keynes, employment depends upon effective demand, which further, depends upon consumption and investment (Y = C + I). Consumption function (propensity to consume) is stable in the short period and marginal propensity to consume is less than one. Therefore, all the increase in income does not go to increase consumption at the rate at which income increases. As a result, a gap is created between incomes(output) and consumption which must be filled up by making additional investment. Keynes believed that the initial increase in investment will increase the final income by many times. Thus, investment multiplier shows the relationship between an initial increase in investment and final increase in aggregate income. In other words, it is the ratio expressing quantitative relationship between the final increase in national income and the increase in investment which induces the rise in income. Arithmetically, ∆Y = K.∆I Where, ∆Y is the change in income; K stands for multiplier and I for investment. Therefore, multiplier coefficient can be expressed as, K =∆ Y/∆I Thus, K is the co-efficient that shows the number of times at which income increased due to increase in investment. K can also be calculated by another way. K = 1 / MPS 75 Where MPS = Marginal Propensity to save or K = 1 / 1-MPC CU IDOL SELF LEARNING MATERIAL (SLM)

Where MPC = Marginal Propensity to consume. 4.2.1 Static Multiplier Keynes considers his theory of multiplier as an integral part of his theory of employment. The multiplier, according to Keynes, “establishes a precise relationship, given the propensity to consume, between aggregate employment and income and the rate of investment. It tells us that, when there is an increment of investment, income will increase by an amount which is K times the increment of investment” i.e., ∆Y=K∆I. The static multiplier is also called comparative static multiple simultaneous multiplier, logical multiplier, timeless multiplier, legless multiplier and instant multiplier. In the multiplier theory, the important element is the multiplier coefficient, K which refers to the power by which any initial investment expenditure is multiplied to obtain a final increase in income. The value of the multiplier is determined by the marginal propensity to consume. The higher the marginal propensity to consume, the higher is the value of the multiplier, and vice versa. Since c is the marginal propensity to consume, the multiplier K is, by definition, equal to 1- 1/c. The multiplier can also be derived from the marginal propensity to sax e (MPS) and it is the reciprocal of MPS, K = 1/MPS. If the multiplier is one, it means that the whole increment of income is saved and nothing is spent because the MPC is zero. On the other hand, an infinite multiplier implies that MPC is equal to one and the entire increment of income is spent on consumption. It will soon lead to full employment in the economy and then create a limitless inflationary spiral. But these are rare phenomena. Therefore, the multiplier coefficient varies between one and infinity. 4.2.2 Dynamic Multiplier Keynes’s logical theory of the multiplier is an instantaneous process without time lags. It is a timeless static equilibrium analysis in which the total effect of a change in investment on income is instantaneous so that consumption goods are produced simultaneously and consumption expenditure is also incurred instantaneously. But this is not borne out by facts because a time lag is always involved between the receipt of income and its expenditure on consumption goods and also in producing consumption goods. Thus “the timeless multiplier analysis disregards the transition and deals only with the new equilibrium income level” and is, therefore, unrealistic. The dynamic multiplier relates to the time lags in the process of income generation. The series of adjustments in income and 76 CU IDOL SELF LEARNING MATERIAL (SLM)

consumption may take months or even years for the multiplier process to complete, depending upon the assumption made about the period involved. The concept of dynamic multiplier recognizes the fact that the overall change in income as a result of the change in investment is not instantaneous. There is a gradual process by which income change as a result of change in investment or other determinants of income. The process of change in income involves a time lag. The multiplier process works through the process of income generation and consumption expenditure. The dynamic multiplier takes into account the dynamic process of the change in income and the change in consumption at different stages due to change in investment. The dynamic multiplier is essentially a stage-by stage computation of the change in income resulting from the change in investment till the full effect of the multiplier is realized. 4.2.3 Principle of Acceleration According to the theory of Multiplier, the increase in investment generates manifold increase in income. Such increase in income increases consumption. The initial increase in demand automatically gathers momentum. The available capacities will be exhausted fully. This in turn encourages more investment to meet the expanding demand. As the existing productive capacity would not be enough to meet the expanding demand, productive capacities will be expanded by new investments. Thus, the level of investment depends the rate of change in income and the resultant change in consumption. This is what called as Principle of Accelerator. According to this principle, net investment is positively related to changes in income. The theory of Multiplier states that the effect of investment upon the level of income. The principle of accelerator states that the effect of an increase in income upon the level of investment. 4.2.4 Importance of Multiplier Multiplier is an important contribution to economic theory. It not only has theoretical importance but also is an important tool for formulation of various economic policies. It has given emphasis on investment as the major dynamic element in the economy. Investment helps in directly creating employment in the economy and also in generating income manifold. The introduction of the concept of multiplier has strengthened the importance of public investment in the economy. It indicates that a small increase in investment results in a large increase in investment and employment. Multiplier is also helpful in analysing the matters 77 CU IDOL SELF LEARNING MATERIAL (SLM)

related to business cycle. Thus, the concept of multiplier is of vital importance in economic analysis. 4.2.5 Leakages in Working of Multiplier Saving: Saving is an important leakage in the income stream. A part of increase in income is saved, thereby limiting the value of multiplier. It is thus clear that higher the saving lower will be the value of multiplier. 1. Payment of old debts: A part of income received by the people is used to pay off the old debts, thereby reducing money for consumption and hence the value of multiplier. 2. Imports: In case of excess imports over exports, part of increased income goes to increase income in the foreign countries. In the long period, the increased income in foreign countries will help in increasing demand for exports and thus have beneficial effects on the income of the country importing goods. However, it may or may not happen also. As such imports are important leakages. 3. Inflation: Price inflation results in degeneration of increased income instead of promotion of consumption, income, and employment. 4. Hoarding: Hoarding means holding idle cash balances. It is an important form of leakage. If people have high liquidity preference or high demand for money for holding as cash, expenditure on consumption decreases as a result of which multiplier value goes down. 5. Purchase of stocks and securities: People are also having tendency to buy old stocks and securities when their income is increased. As such consumption expenditure goes down. Such financial investment restricts the value of the multiplier. It is therefore clear that these leakages in the flow of income in the economy severely restrict the value of multiplier. It is necessary to control such leakages to have greater multiplier effects. 4.3 INVESTMENT Investment has specific meaning in economics. It means additions to the existing productive capacities (stock of fixed capital and inventories). They include fixed equipment’s, machinery, building, raw materials, replacement due to depreciation, etc. It lays down the basis for future production. Investment is the key structural component of total spending or aggregate spending. By investment, Keynes means real investment and not financial investment. Investment is the addition to real capital assets. It does not mean the purchase of bonds or shares which are 78 CU IDOL SELF LEARNING MATERIAL (SLM)

financial investment. The distinction between consumption and investments is fundamental in Keynesian theory. Importance of investment as a component of aggregate demand rises due to the fact that it is another major component. Component is a stable function of income. So, it was not possible to change aggregate demand by changing consumption expenditure as it depends on income. Keynes found that investment is an autonomous expenditure determined independently of the level of income. He found it may to be the major cause for the variation and instability in income and employment. The worldwide depression of 1930s was also caused by a fall in investment. The investment function refers to investment -interest rate relationship. There is a functional and inverse relationship between rate of interest and investment. The investment function slopes downward. I = f (r) I= Investment (Dependent variable) r = Rate of interest (Independent variable) 4.3.1 Meaning In the words of Joan Robinson, “By investment is meant an addition to capital, such as occurs when a new house is built or a new factory is built. Investment means making an addition to the stock of goods in existence.” The term capital here refers to the real assets like factories, plants, equipment, and other inventories of finished and semi-finished goods. Capital also means any previously produced input that can be used in the process to produce other goods. The amount of capital available in the economy is nothing but the aggregate stock of capital in that economy. Thus, capital is a stock concept. 4.3.2 Gross Investment vs Net Investment The total addition made to the capital stock of economy in a given period is termed as Gross Investment. Capital stock consists of fixed assets and unsold stock. So, gross investment is the expenditure on purchase of fixed assets and unsold stock during the accounting year. However, gross investment does not indicate the actual change in economy’s stock of productive assets for a given year. During the production process, some amount of fixed capital is used up. This loss of fixed capital is known as depreciation. By subtracting depreciation from gross investment, we get Net Investment. 79 CU IDOL SELF LEARNING MATERIAL (SLM)

The actual addition made to the capital stock of economy in a given period is termed as Net Investment. Net Investment = Gross Investment – Depreciation 4.3.3 Induced Investment vs Autonomous Investment Investment may be categorised as induced or autonomous. Autonomous investment is independent of the level of income, output, and profit and sales of a business firm. Prof Alvin Hanson and some other economists are of the opinion that this type of investment is associated generally with the factors like the development of new resources, growth of population and labour force and technological innovations or invention like the introduction of new products into the market. The investment expenditure which is related in some way with the current income, output and sales is termed as induced investment. If there is a change in income and output, it will result in change in induced investment. Since the incentive for such an investment is the direct consequence of the change in current income, output or demand. The autonomous investment is generally undertaken by the public authorities like Union, State or local governments. On the other hand, most of the induced investment is undertaken by private authorities. This is because people are driven by profit motive. Autonomous investment is generally not induced by profit, but induced investment is induced by profit. Fig 4.1 Induced and Autonomous Investment Source: www.economicsdiscussion.net 4.3.4 Planned and Unplanned Investment Investment is known as planned and intended investment, which inspired the deliberate for expand the present stock by the establishment of an extra instrument or increment in the 80 CU IDOL SELF LEARNING MATERIAL (SLM)

materials tables. It can be inspired by the condition of favourable market or heavy sells. Entrepreneurs are thought about its investment according to certain time period or decide objective. Apposite it, unplanned investment is the forced investment of entrepreneurs. It happens, when some non-saleable goods are collected because of short sells. It is not necessary that realized investment is equals to the planned investment. Realized investment is equals to the addition of planned or unplanned investment. When unplanned investment is equals to zero, then realized investment is equals to the planned investment. Briefly, Realized investment = planned investment + unplanned investment. 4.3.5 Financial and Real Investment Financial investment means devaluate the authority form one person to another. By this real capital stock of economy is not increase. For example, bank deposit, home by one person, present shares, debentures, and bonds are not generating something new. In it only involve the devolution of the authority from one person to another, but total capital of economics is unchanged. When one buyer invested, then other is disinvested. Investor gets some returns by this investment. But there is no investment for economies. Apposite it, real investment created more production capacity in economy. The construction of new industry and workshop are the examples of real investment. That work of investment is not only important for that, but also important for economy. Keynes used that investment in national income analysis. It is important for attention that when one person purchases new shares of a company, then different investment will be the indicator of real investment. 4.3.6 Public and Private Investment One more important classification of investment, on that bases who is investing, can possible in public investment and self-investment. Now, the big part of total investment in capital economies is doing by government. Investment is effective by political and social ideas in public field. Government normally invested in the services of profits, loss, concession and free project like schools, colleges, hospitals, roads, electricity, gas, water, travel and house for population. That investment is for purchasing the capital things by public officers like central government, state government, local officers and public corporations. The profit presenting services are also affected by welfare of society. In the situation of public investment, the comparison of proceeds of project with their investment cost is not possible. Public investment decision to select the mostly profitable projects in different project is based on cost-benefit analysis. For that object, we will have to decide the social profit and social cost of presented 81 CU IDOL SELF LEARNING MATERIAL (SLM)

investment. The mean of social profit is the total satisfaction by the whole society, which are not fully presented in receipts by entrepreneur. For example, the housing facility of government is more by the social profit, receipts by the teachers of university. Like that, social cost by society from air, water and sound pollution is not ignorable at the time of evaluate real cost of public investment because of the public field entrepreneurs. Public investment is inspired by the social welfare, but self-investment inspires by profit on purchasing the capital goods like instrument, plant, industries, offices, store and shop. Entrepreneurs are invested whenever they expected a satisfied return by the projects. Marginal efficiency of capital is decided to meet the required income and its purchase price by the capital property. Investment is profitable whenever the marginal efficiency of capital is more than the investment rate of market. 4.4 DETERMINANTS OF INVESTMENT The classical economists believed that investment depended exclusively on rate of interest. In reality investment decision depends on a number of factors. They are as follows: 1. Rate of interest 2. Level of uncertainty 3. Political environment 4. Rate of growth of population 5. Stock of capital goods 6. Necessity of new products 7. Level of income of investors 8. Inventions and innovations 9. Consumer demand 10. Policy of the state 11. Availability of capital 12. Liquid assets of the investors 82 CU IDOL SELF LEARNING MATERIAL (SLM)

However, Keynes contended that business expectations and profits are more important in deciding investment. He also pointed out that investment depends on MEC (Marginal Efficiency of Capital) and rate of interest. 4.5 MARGINAL EFFICIENCY OF CAPITAL MEC was first introduced by J.M Keynes in 1936 as an important determinant of autonomous investment. The MEC is the expected profitability of an additional capital asset. It may be defined as the highest rate of return over cost expected from the additional unit of capital asset. Meaning of Marginal Efficiency of Capital (MEC) is the rate of discount which makes the discounted present value of expected income stream equal to the cost of capital. Marginal efficiency of capital is defined as the productivity of capital. Generally, marginal efficiency of capital shows the cost of capital asset and the expected rate of return from additional investment made. If the rate of return on any prospective investment is greater than the cost of investment, the entrepreneur is bound to make the investment and vice versa. Thus, Keynes pointed out MEC as an important factor in capital investment and highlighted on the following: ▪ If MEC > r, then the investment project is acceptable ▪ If MEC = r, then the investment project is acceptable on a non-profit basis ▪ If MEC < r, then the investment project is rejected MEC depends on two factors: 1. The prospective yield from a capital asset. 2. The supply price of a capital asset. Factors Affecting MEC: The marginal efficiency of capital is influenced by short - run as well as long-run factors. These factors are discussed in brief: a) Short - Run Factors (i) Demand for the product: If the market for a particular good is expected to grow and its costs are likely to fall, the rate of return from investment will be high. If entrepreneurs expect a fall in demand for goods and a rise in cost, the investment will decline. 83 CU IDOL SELF LEARNING MATERIAL (SLM)

(ii) Liquid assets: If the entrepreneurs are holding large volume of working capital, they can take advantage of the investment opportunities that come in their way. The MEC will be high. (iii) Sudden changes in income: The MEC is also influenced by sudden changes in income of the entrepreneurs. If the business community gets windfall profits, or tax concession the MEC will be high and hence investment in the country will go up. On the other hand, MEC falls with the decrease in income. (iv) Current rate of investment: Another factor which influences MEC is the current rate of investment in a particular industry. If in a particular industry, much investment has already taken place and the rate of investment currently going on in that industry is also very large, then the marginal efficiency of capital will be low. (v) Waves of optimism and pessimism: The marginal efficiency of capital is also affected by waves of optimism and pessimism in the business cycle. If businessmen are optimistic about future, the MEC will be likely to be high. During periods of pessimism the MEC is under estimated and so will be low. b) Long - Run Factors The long run factors which influence the marginal efficiency of capital are as follows: (i) Rate of growth of population: Marginal efficiency of capital is also influenced by the rate of growth of population. If population is growing at a rapid speed, it is usually believed that the demand of various types of goods will increase. So, a rapid rise in the growth of population will increase the marginal efficiency of capital and a slowing down in its rate of growth will discourage investment and thus reduce marginal efficiency of capital. (ii) Technological progress: If investment and technological development take place in the industry, the prospects of increase in the net yield brightens up. For example, the development of automobiles in the 20th century has greatly stimulated the rubber industry, the steel and oil industry etc. So, we can say that inventions and technological improvements encourage investment in various projects and increase marginal efficiency of capital. (iii) Monetary and Fiscal policies: Cheap money policy and liberal tax policy pave the way for greater profit margin and so MEC is likely to be high. (iv) Political environment: Political stability, smooth administration, maintenance of law- and-order help to improve MEC. 84 CU IDOL SELF LEARNING MATERIAL (SLM)

(v) Resource availability: Cheap and abundant supply of natural resources, efficient labour and stock of capital enhance the MEC. 4.6 RATE OF INTEREST The first element affecting inducement to invest is in fact the rate of interest. The Keynesian theory dealing with determination of rate of interest is known as the Liquidity Preference Theory. According to Keynes, demand for money (liquidity preference) arises out of three basic motives, viz., transaction motive, precautionary motive and speculative motive. Transaction motive relates to the need of the people to hold money for purchasing goods and services to fulfil the daily necessities of life. Apart from fulfilling the transaction purposes, people also have to hold money to take proper precautions against unforeseen future contingencies like sickness, unemployment, accidents, old age etc. Holding of money for such precautions is called the precautionary motive. According to Keynes, people also keep cash in hand to take advantage of the rise and fall of prices of bonds and securities. Keynes called this as speculative demand for money. This speculative demand for money arises, as Keynes argued, on account of the uncertainty regarding the future rate of interest. All the three motives of holding money, i.e., transaction motive, precautionary motive and speculative motive when added give us the total demand for money. The liquidity preference (i.e., demand for money) for transaction motive and precautionary motive is more or less stable and is interest-inelastic. They basically depend on the level of income. On the other hand, holding of money under the speculative motive is very much sensitive to the changes in the market rate of interest. If the rate of interest in investment instruments, e.g., bond is higher, say 10%, people would choose to hold less amount of money in hand or more to invest in bond. On the contrary, if the rate of interest on bond is lower, say 2%, people would be reluctant to invest more in bonds; they would choose to hold money in cash. Let us suppose, we represent the demand for money for transaction and precautionary motives by M1 and the demand for speculative motive by M2, then we can write: M = M1 + M2, where M stands for total demand for money. As we have already stated, the demand for money for transaction and precautionary motives are interest-inelastic and the demand for speculative motive as interest elastic, we can write: M = M1 (Y) + M2 (r) where M1 (Y) indicates that M1 is a function of income (Y) and M2 (r) indicates that M2 is a function of the rate of interest (r). 85 CU IDOL SELF LEARNING MATERIAL (SLM)

According to Keynes, the equilibrium rate of interest is determined at the point where the demand for money equals the supply of money. 4.7 MARGINAL EFFICIENCY OF INVESTMENT Another important concept relating to the investment function is the Marginal Efficiency of Investment (MEI). Please note that the MEI is nothing but MEC when the possibility of increasing supply price of capital is taken into account. In Keynesian MEC, the supply price of capital is constant. This implies that capital supply is perfectly elastic. But in the real world, capital is scarce. Thus, when the volume of investment increases causing an increase in the demand for capital goods, the supply price of capital goes up. The MEI concept recognises this aspect of capital price. Hence, MEI is an improvement over the concept of MEC as it is far more realistic. 4.8 RELATION BETWEEN MEC, INTEREST RATE AND MEI As we have already studied, MEC and the rate of interest are the two important factors that affect the volume of investment. We know that the rate of interest is the price paid for loanable funds and is determined, like any other price, by the demand for and supply of loanable funds. A potential investor will go on comparing the MEC on new investment against the rate of interest. As long as MEC is more than the rate of interest, investment will continue to be made, till MEC and the rate of interest are equalled. Once MEC becomes equated to the rate of interest, equilibrium investment is determined. The relationship of MEC and the rate of interest in the determination of inducement to invest has been shown with the help of Table 4.1 SUPPLY ANNUAL MEC RATE OF EFFECT ON PRICE RETURN INTEREST INVESTMENT Rs. 30000 1500 5% 5% Neutral Rs. 20000 1500 7.5% 5% Favourable Rs. 50000 1500 3% 5% Adverse Table 4.1 Relation of MEC, Interest rate and Effect on Investment 86 CU IDOL SELF LEARNING MATERIAL (SLM)

In above Table 4.1 it has been assumed that the new capital asset gives a constant return of Rs. 1,500/- annually. Now it can be seen that when the rate of MEC (5%) is equal to the rate of interest, the effect on investment is neutral. When the rate of MEC (7.5%) is higher than the rate of interest (5%), there is a favourable effect on investment. On the contrary, when the rate of MEC (5%) is less than the rate of interest (2%), the effect on investment is unfavourable. 4.9 SUMMARY • Multiplier is the ultimate determinant of income and employment. • Multiplier expresses the relationship between initial investment and the final increment in the GNP. • Multiplier = Change in equilibrium income / Change in expenditure. • The theory of multiplier states the effect of investment upon the level of income. • Static multiplier implies that there is no time lag between the change in investment and change in income. • Dynamic multiplier implies that there is a gradual process by which income changes as a result of change in investment. • Investment is the addition to real capital assets. • The investment function refers to investment- interest rate relationship. • Marginal Efficiency of capital is defined as the productivity of capital. 4.10 KEYWORDS • K- Multiplier • △Y- Change in Equilibrium income. • △I- Change in expenditure • I- Investment • r – Rate of Interest • MEC- Marginal Efficiency of Capital 4.11 LEARNING ACTIVITY 1. In a closed economy with no government, the equilibrium level of income is £22 billion, the full employment level of income is £25 billion. To reach full employment would require an injection of £1 billion. What can be deduced from this information? 87 CU IDOL SELF LEARNING MATERIAL (SLM)

___________________________________________________________________________ ___________________________________________________________________________ 2. you are going to invest Rs.10,00,000 in a textile business& the expected rate of return is 5%. Find the MEC & whether the project is acceptable or not? ___________________________________________________________________________ ___________________________________________________________________________ 4.12 UNIT END QUESTIONS 88 A. Descriptive Questions Short Questions 1. Write the Multiplier function. 2. What is static Multiplier? 3. What is dynamic Multiplier? 4. What is hoarding? 5. What is investment function? 6. What is MEC? Long Questions 1. Define Multiplier and its types. 2. What is the importance of Multiplier? 3. What are the leakages in working of Multiplier? 4. What are the determinants of investment? 5. What is Marginal efficiency of capital? 6. What are the factors that determine the MEC? B. Multiple Choice Questions 1. The magnified effect of initial investment on income is called____ effect. a. Multiplier b. Consumption c. Investment d. Marginal efficiency of capital CU IDOL SELF LEARNING MATERIAL (SLM)

2. According to _____, net investment is positively related to changes in income. a. Multiplier b. Principle of Accelerator c. Marginal Propensity to consume d. Savings 3. _____ is the addition to real capital assets. a. Savings b. Consumption c. Investments d. Rate of interest 4. ______ is Productivity of Capital a. MPC b. MPS c. C d. MEC 5. If MEC is ___ than r, the investment project is acceptable. a. Less b. Equal c. Greater d. None of these Answers 1-a, 2-b, 3-c, 4-d, 5-c 4.13 REFERENCES Reference books • Baird, C.W. (1977). Elements of Macro Economics, London: West Publishing Company. • Dernburg, T.F.& McDougal, D.M. (1983). Macro Economics. New York: McGraw Hill. • Gardner Ackley, G. (1985). Macro-Economic Theory. New York: McMillan. 89 CU IDOL SELF LEARNING MATERIAL (SLM)

• Ghuman, R.S. (1998). Antar-RashtriyaArthVigyan, Patiala: Punjabi University. • Harvey, J.&Johnson, M. (1971). Introduction to Macro Economics, London: McMillan Textbooks • Jain, T.R. (1997). Macro Economics, New Delhi: V.K. Publications. • Jhingan, M.L. (2003). Macro-Economic Theory, New Delhi: Varinda Publishers. • Sharma, O.P. (2003). Macro Economics, Patiala: Punjabi University. • Vaish, M.C. (2008). Macro-Economic Theory. New Delhi: Oxford University Press. Websites • www.economicdiscussions.net • www.economicshub.in 90 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-5 THEORIES OF MONEY AND INTEREST 91 Structure 5.0 Learning Objectives 5.1 Introduction 5.2 Monetary Theory of Interest 5.3 The risk Aversion Theory of Liquidity preference 5.4 The Quantity Theory of Money 5.5 Friedman’s Quantity Theory of Money 5.5.1 Demand for money 5.5.2 Criticism 5.6 Money 5.6.1 Functions of Money 5.6.2 Role of Money 5.6.3 Components of money 5.6.4 Money supply measures in India 5.6.5 Determinants of Money Supply 5.7 Money Market 5.7.1 Meaning & definitions 5.57.2 Importance of Money market 5.7.3 Functions of Money market 5.7.4 Money Market Instruments 5.8 Capital Market 5.8.1 Meaning & definitions 5.8.2 Importance of capital market 5.8.3 Functions of capital market 5.8.4 Capital Market Instruments 5.9 Difference between money market and capital market 5.10 Summary 5.11 Keywords 5.12 Learning activity 5.13 Unit End Questions 5.14 References CU IDOL SELF LEARNING MATERIAL (SLM)

5.0 LEARNING OBJECTIVES After studying this unit, students will be able to: • Explain the Monetary theory of interest • Analyse the Quantity theory of money • Summarize the meaning and functions of money • Describe the meaning of money market • Define the meaning of capital market 5.1 INTRODUCTION Money is the commonly accepted medium of exchange. In an economy which consists of only one individual there cannot be any exchange of commodities and hence there is no role for money. Even if there are more than one individual but they do not take part in market transactions, such as a family living on an isolated island, money has no function for them. However, as soon as there is more than one economic agent who engage themselves in transactions through the market, money becomes an important instrument for facilitating these exchanges. Economic exchanges without the mediation of money are referred to as barter exchanges. However, they presume the rather improbable double coincidence of wants. Consider, for example, an individual who has a surplus of rice which she wishes to exchange for clothing. If she is not lucky enough she may not be able to find another person who has the diametrically opposite demand for rice with a surplus of clothing to offer in exchange. The search costs may become prohibitive as the number of individuals increases. Thus, to smoothen the transaction, an intermediate good is necessary which is acceptable to both parties. Such a good is called money. The individuals can then sell their produces for money and use this money to purchase the commodities they need. Though facilitation of exchanges is considered to be the principal role of money, it serves other purposes as well. 5.2 MONETARY THEORY OF INTEREST The determinants of the equilibrium interest rate in the classical model are the ‘real’ factors of the supply of saving and the demand for investment. On the other hand, in the Keynesian analysis, determinants of the interest rate are the ‘monetary’ factors alone. 92 CU IDOL SELF LEARNING MATERIAL (SLM)

Keynes’ analysis concentrates on the demand for and supply of money as the determinants of interest rate. According to Keynes, the rate of interest is purely “a monetary phenomenon.” Interest is the price paid for borrowed funds. People like to keep cash with them rather than investing cash in assets. Thus, there is a preference for liquid cash. People, out of their income, intend to save a part. How much of their resources will be held in the form of cash and how much will be spent depend upon what Keynes calls liquidity preference, Cash being the most liquid asset, people prefer cash. And interest is the reward for parting with liquidity. However, the rate of interest in the Keynesian theory is determined by the demand for money and supply of money. Liquidity Preference refers to the cash holdings of the people. Liquidity means cash. People hold cash because money is the most liquid asset and people prefer to keep their wealth in the form of cash. Keynes gives three motives for the liquidity preference of the people. They are a. Transaction Motive b. Precautionary Motive c. Speculative Motive a) Transaction Demand for Money: Money is needed for day-to-day transactions. As there is a gap between the receipt of income and spending, money is demanded. Incomes are earned usually at the end of each month or fortnight or week but individuals spend their incomes to meet day-to-day transactions. Since payments or spending are made throughout a period and receipts or incomes are received after a period of time, an individual needs ‘active balance’ in the form of cash to finance his transactions. This is known as transaction demand for money or need- based money—which directly depends on the level of income of an individual and businesses. People with higher incomes keep more liquid money at hand to meet their need-based transactions. In other words, transaction demand for money is an increasing function of money income. Symbolically, Tdm = f (Y) Where, Tdm stands for transaction demand for money and Y stands for money income. 93 CU IDOL SELF LEARNING MATERIAL (SLM)

(b) Precautionary Demand for Money: Future is uncertain. That is why people hold cash balances to meet unforeseen contingencies, like sickness, death, accidents, danger of unemployment, etc. The amount of money held under this motive, called ‘Idle balance’, also depends on the level of money income of an individual. People with higher incomes can afford to keep more liquid money to meet such emergencies. This means that this kind of demand for money is also an increasing function of money income. The relationship between precautionary demand for money (Pdm) and the volume of income is normally a direct one. Thus, Pdm = f (Y) (c) Speculative Demand for Money: This sort of demand for money is really Keynes’ contribution. The speculative motive refers to the desire to hold one’s assets in liquid form to take advantages of market movements regarding the uncertainty and expectation of future changes in the rate of interest. The cash held under this motive is used to make speculative gains by dealing in bonds and securities whose prices and rate of interest fluctuate inversely. If bond prices are expected to rise (or the rate of interest is expected to fall) people will now buy bonds and sell when their prices rise to have a capital gain. In such a situation, bond is more attractive than cash. Contrarily, if bond prices are expected to fall (or the rate of interest is expected to rise) in future, people will now sell bonds to avoid capital loss. In such a situation, cash is more attractive than bond. Thus, at a low rate of interest, liquidity preference is high and, at a high rate of interest, securities are attractive. Now it is clear that the speculative demand for money (Sdm) varies inversely with the rate of interest. Thus, Sdm = f (r) Where, Y is the rate of interest. Liquidity preference depends on rate of interest. Higher the rate of interest, people would like to take advantage and so will part with their cash. Therefore, we can say that higher the rate of interest, lower will be the liquidity preference of the people. On the other hand, lower the interest, higher will be the liquidity preference. According to Keynes, the liquidity preference of the people is more stable as it depends on human habits which remain same. Liquidity preference relates to the demand of the money. It is important to note that it influences the demand side in determining the price of capital. The other side is the supply of money which depends on government monetary policy, and credit creation by commercial banks. 94 CU IDOL SELF LEARNING MATERIAL (SLM)

Briefly stated, the Keynesian investment function gives immense importance to the rate of interest. If the rate of interest remains constant, then investment increases with an increase in the business confidence about the future. Fig 5.1 Liquidity Preference theory Source: www.intelligenteconomist.com In the figure 5.1, Liquidity preference is shown by L and the money supply is shown by M and the interest rate is indicated by R. Rate of interest in determined by the intersection of L and M curves. There will be increase in the rate of interest to R1, when there is increase in the demand for money to L1 or by decrease in the supply of money to M1. 5.3 THE RISK AVERSION THEORY OF LIQUIDITY PREFERNCE James Tobin presented The Risk Aversion Theory of Preference based on portfolio selection in his famous text titled as “Liquidity Preference as Behaviour towards Risk”. This theory has removed two main weaknesses of Keynesian Theory of Liquidity preference. One, Keynesian Theory of Liquidity preference depends on the flexibility of expectations of future interest rates; and second, person keeps either money or bond. Tobin has removed these weaknesses. His theory does not depend on the flexibility of expectations of future interest rates, but starts with this consideration that the expected value of capital profit or loss is always zero on keeping the interest holder assets. Again, it is also clear that there is money and bonds both in the portfolio of any person; it is not that only one in a time. Portfolio theories like the one presented by Tobin emphasises the role of money as a store of value. According to these theories, people hold money as part of their portfolio of assets. The 95 CU IDOL SELF LEARNING MATERIAL (SLM)

reason for this is that money offers a different combination of risk and return than other assets which are less liquid than money — such as bonds. To be more specific, money offers a safe (nominal) return, whereas the prices of stocks and bonds may rise or fall. Thus Tobin has suggested that households choose to hold money as part of their optimal portfolio. Portfolio theories predict that the demand for money depends on the risk and return associated with money holding as also on various other assets households can hold instead of money. Furthermore, the demand for money should depend on real wealth, because wealth measures the size of the portfolio to be allocated among money and the alternative assets. There is M portion of money and B portion of bonds in his portfolio, where the total of M and B is One. No value is negative. The function of portfolio R is: R = B (r + g) where 0 ≤ B ≤ 1 Because g is a random variable of which expected value is zero. So the function of portfolio is: RE = µR = Br. Speculative Demand for Money as Behaviour toward Risk: Tobin ignored the determination of the transactions demand for money and considered only the demand for money as a store of wealth. The focus is on an individual’s portfolio allocation between money-holding and bondholding, subject to the wealth constraint, i.e., W = M + B, where W is the total fixed wealth, M is money and B is bond. In Tobin’s theory there is no such thing as fixed normal level to which interest rates are always expected to return as has been postulated by Keynes. Following Tobin we can assume that the expected capital gain is zero. This is because the individual investor expects capital gains and losses to be equally likely. The best expectation of the return on bonds is simply the prevailing market rate of interest (r). But this is just the expected return on bonds. The actual return also includes some capital gain or loss, since the interest rate does not generally remain fixed. Thus bonds pay an expected return of interest, but they are a risky asset. Their actual return is uncertain due to the fact that the market rate of interest fluctuates even in the short run. In contrast, money is a safe asset because it yields no return at all. At the same time money is a safe asset since no capital gain or loss is made by holding money. In Tobin’s view an individual will hold some proportion of wealth in money for reducing the overall riskiness of his portfolio. 96 CU IDOL SELF LEARNING MATERIAL (SLM)

If only bonds are held, returns would be maximum no doubt but the risk to which the investor is exposed will also be maximum. A risk- adverse investor would voluntarily sacrifice some return for a reduction in risk. Tobin argues that money as an asset is demanded as an aversion to risk. Fig 5.2 Determination of optimal portfolio Source: www.economicshelp.in Tobin’s theory is explained by the diagram. On the vertical axis of the upper quadrant we measure the expected return to the portfolio; on the horizontal axis we measure the riskiness of the portfolio. The expected return on the portfolio is the interest that can be earned on bonds. This depends on two things: (i) the interest rate and (ii) the proportion of the portfolio held in bonds. The total risk to which an individual is exposed depends on (i) the uncertainty concerning bond prices — that is, the uncertainty concerning future movements in market rate of interest, and (ii) the proportion of the portfolio held in bonds. Let us denote the expected total return by R and the total risk of the portfolio as a σt. If an individual holds all his wealth (W) in money and none in bonds, i.e., W = M + 0, both R and σt will be zero, as shown by the origin (point 0) in Fig. 19.4. With an increase in the proportion of bonds, i.e., W = M + B; as M falls and B increases, R and a, will both rise. 97 CU IDOL SELF LEARNING MATERIAL (SLM)

The opportunity line C is a locus of points showing the terms on which the individual investor can increase R at the cost of increasing σt. A movement along C from left to right shows that the investor increases his bond holding only by reducing his money holding. The lower quadrant of Figure shows alternative portfolio allocations, resulting in different combinations of R and σt. The vertical axis measures bond holding. The amount of bonds (B) held in W increases as the investor moves down the vertical axis to a maximum of W. The difference between W and B is the asset demand for money (M). The line OB in the lower part of the diagram shows the relationship between a, and B. As the proportion of B in W increases, σt also increases. This means that as the proportion of bonds in the portfolio increases, the total risk of the portfolio increases, too. Preference of the Investor: Risk-Aversion: The optimal portfolio allocation depends on the preferences of the investor. Here we assume that the investor is risk-averse. He wants the best of both the worlds — a high return on the portfolio by avoiding risk. He will accept more risk if he is compensated by an increase in expected return. Let us assume that the utility function of the investor is U = f (R, σt) … (9) where an increase in R increases utility (U) and an increase in σT reduces U. In Fig. 19.4 we show three indifference curves of the investor for three levels of utility U1, U2 and U3. Each indifference curve shows the risk-return trade-off, i.e., the terms on which the investor is desirous of taking more risk if compensated by a higher expected return. All the points on any such indifference curve yield the same fixed level of utility. Any movement from U1 to U2 and from U2 to U3 implies higher level of utility, i.e., higher levels of R and the same or even lower levels of σt. The indifference curves are upward sloping because the investor is risk-averse. He will take more risk only if compensated by a higher return. Moreover, the curves become steeper as the investor moves to the right, implying increasing risk aversion. If we make this assumption, then the more risk the individual has already taken on, the greater will be the increase in expected return required for the investor to be exposed to a greater degree of risk. We may now determine the optimal portfolio allocation of a risk averse investor. Optimal Portfolio Allocation: 98 CU IDOL SELF LEARNING MATERIAL (SLM)

A risk-averse investor will move to that point along the line C which enables him to reach the highest attainable indifference curve. At that point he ends up choosing that portfolio which he intends to choose and, thus, maximises his utility. The reason is obvious. At the tangency point E, with R = R* and σt = σ*t, the terms on which the investor is able to increase expected return on the portfolio by taking more risk, shown by the slope of the line C, is equated to the terms on which he (she) is willing to make the trade-off, as is measured by the slope of the indifference curve. From the lower part we see that this risk-return combination is achieved by holding an amount of bonds equal to B*, and by holding the remainder of wealth (W̅ – B* = M*) in the form of money. The demand for money thus shows the investor’s ‘behaviour towards risk’, i.e., the result of seeking to reduce risk below what it would be if W̅ = B and M = 0. In Fig. 19.4 such an all- bonds-portfolio would be associated with risk of σt and the expected return of R, as shown by point F in the upper part of the diagram. This portfolio yields a lower level of utility than that represented by bond holdings of B* and money holdings of M*. The reason is that as the investor moves to the right of point E along the line 0C, the additional return expected from the portfolio by holding more bonds (and less money) is not adequate to compensate the investor for the additional risk (the slope of the line 0C is less than that of the indifference curve U2). The movement to point F takes the investor to a lower indifference curve, U1. Interest Rate Changes and the Speculative Demand for Money: In Tobin’s theory the amount of money held as an asset depends on the level of the interest rate. Fig. 19.5 shows the relationship between interest rate and asset demand for money. An increase in the rate of interest from r0 to r1 and then to r2 will improve the terms on which the expected return on the portfolio can be increased by taking more risk. So the line 0C becomes steeper. It rotates anticlockwise from C(r0) to C(r1) and then to C(r2). 99 CU IDOL SELF LEARNING MATERIAL (SLM)

Fig 5.3 Source: www.economicshelp.in The investor responds by taking more risk and earning higher expected returns by moving from E to F and then to G. It may be noted that each point is one of portfolio optimisation. In this case his holdings of bonds (risky asset) increase (from B0 to B1, and then to B2) and money holdings fall (from M0 to M1, then M2). In short, as the interest rate rises, a given increase in risk, which corresponds to a given increase in the amount of bonds in the portfolio, will result in a greater increase in expected return on the portfolio. It’s Superiority over Keynesian Theory - In comparison to the Keynes theory of liquidity preference of speculated demand of money, Tobin’s Input list Selection Risk aversion theory is the best. 1. More Satisfactory: Tobin’s theory does not depend upon the inflexibility of expectations future interest rates, but moves with this consideration that the expected value of capital profit or loss is always zero on keeping the interest holder assets. Tobin considers his theory more satisfactory from of liquidity Preference in comparison to Keynesian Theory, logically. 2. Diversified Input list: In comparison to Keynes theory this theory is also better in this thing that it tells that people instead of only bond or money, can keep the mixed form of bonds and money both as portfolio. 100 CU IDOL SELF LEARNING MATERIAL (SLM)