Unit – 3 (consumption, saving and investment)

Consumption function (propensity to consume)

Consumption means the process of utilizing the goods and services to satisfy human wants.
Production and consumption are two opposite activities because; production is the process of
creating utilities whereas consumption is the process of destroying utilities. The level of
consumption always depends on the level of income.
Consumption function refers to the come consumption relationship. It is the functional
relationship between two aggregates i. e. total consumption and total income. It can be expressed
as C= f(y) -------- (1)
Where, c = consumption.
y = Income.

Thus, consumption function is the schedule of various amount of consumption expenditure at

different level of income. Consumption is an increasing function of income because consumption
expenditure increases with increase in Income but the increase in consumption is less than the
increase in income.
It can be shown by the following table and diagram.
National income (y)in crore Consumption (c) in crore
0 20
60 70
120 120 (basic consumption level)
180 170
240 220
300 270
360 320

In fig. B is the breakeven point where income

is equal to consumption. When income rises
to oy1 consumption also rises to OC1, but
increase in consumption is less than the
increase in income. i.e. CC1 < yy1.
Consumption function also measures saving.
At oy1 level of income saving is SS1.

Classification of consumption function:

There are two types of consumption function.
1. Average propensity to consume (APC): APC is defined as the ratio of consumption
expenditure to a particular level of income. thus it can be expressed as,
APC = C/Y --------- (1)

Where, C = consumption expenditure

Y = national income
The APC decline as income increases because the proportion of income spent on
consumption decreases. We can measure average propensity to save (APS) with the help
of APC, because total income is divided into consumption expenditure and saving.
APS = 1 – APC ------- (1)

Where, APS = average propensity to save.

APC = Average propensity to consume.
APC can be shown by the following diagram.

2. Marginal propensity to consume (MPC): MPC is defined as the ratio of change in

consumption to the change in income. In other words it is the rate of change in APC as
income changes. Thus MPC can be expressed as:
MPC = ∂C/∂y ------ (2)

Where, ∂C = change in consumption.

∂y = change in income.
The MPC is constant at all level of income. Marginal propensity to save (MPS) can be
derived from MPC.
MPS = 1 – MPC since, (0 < MPC < 1)
MPC + MPS = 1

MPC can be shown by the following figure.

Psychological law of consumption: this law was propounded by J. M. Keynes. According to
Keynes consumption function shows the functional relationship between income and
consumption. This law is based on common experience. This law states that consumption
increases with increase in income but not to the extent of increase in income. This law is based
on the following propositions:
1. When income increases consumption expenditure also increases but by a smaller amount.
2. The increased income will be divided into consumption expenditure and saving.
3. Increase in income always leads to an increase in both consumption and saving

This law is shown by the following table and diagram.

Income (y) Consumption (C) Saving ( s = y – c)
0 20 - 20
60 70 - 10
120 120 0
180 170 10
240 220 20
300 270 30
360 320 40

In fig. C is consumption function curve and 45*

line is income curve. When income increases from
oy1 to oy2consumption also increases from C1y1
to C2y2, but the increase in consumption is less
than the increase in income. Similarly as income
increases saving also rises from C1A1 to C2A2.
This law is based on the following assumptions.
 1. No change in institutional factors: among the factors influencing consumer only the
income will change. Other institutional factors such as desire, behavior, fashion,
population, price etc. related to Psychology do not change.
2. Normal situation: For the application of this law, the normal situation should always
prevail in the economy. The abnormal situation such as war, revolution, hyperinflation
etc. should not occur in the economy.
3. No government intervention: For the application of the law there should be capitalist
economy without any government intervention.
Determinants of consumption function: According to Keynes there are two major
factors which influence the consumption function. They are
1. Subjective factors: the internal factors influencing the consumption function is known
as subjective factor. It includes psychological characteristics of human nature, social
practice, institutions, and so on. According to Keynes these factors do not change in the
short period. The subjective factors affecting the consumption function are as follows:
a. Security motive: Due to pre cautionary motive people are motivated to save regularly
out of their inome. Similarly, the business man also wants to keep certain amount of
funds in the form of cash. This reduces consumption function.
b. Demonstration effect: The poor imitate the life style of rich people; this tendency has
been called demonstration effect. It increases the Consumption function.
c. Desire for improvement: if the people are motivated to improve their life in the future,
they wish to save more As a result propensity to consume decreases.
2. Objective factors: the external factors influencing the consumption function is called
objective factors. These are as follows:
a. Change in wage level: There is Positive relationship between wage level and propensity
to consume. If wage level increases consumption function will shift upward.
b. Change in the rate of interest: if the rate of interest is high, people save more which
reduces consumption.
c. Change in the fiscal policy: change in fiscal policy in the form of taxation and subsidies
affect the consumption function. If tax rate goes up, consumption may go down and vice
versa. Similarly when public expenditure increases, consumption also rises.
d. Windfall gain or losses: windfall gain or losses also affects the consumption. If there
is windfall gain, the consumption function may go up and there is wind fall losses,
consumption may go down.
e. Change in expectation: when People expect the price level to go up in the future, they will
consume more at Present. This raises the consumption function in the current Period.
f. Distribution of income: if there is large disparities in income distribution between rich and
poor, the consumption function go down, because rich have low propensity to consume and poor
are unable to spend more on consumption.
Measures to raise the propensity to consume (consumption)
According to Keynes it is necessary to increase propensity to consume because increase in
propensity to consume increases the demand for goods. This increases investment, which
increases national income and level of employment. The propensity to consume can be
increased by the following measures:
1. Income redistribution: the income should be redistributed in favor of poor people to
increase propensity to consume. It can be done by the state through its taxation and
expenditure policy. For this progressive tax should be levied on income, wealth and profit.
2. Social and security measures: social security measures tend to raise consumption in the
long run.
Provision of unemployment compensation, old age pension, medical facilities etc. removes
future uncertainties. Therefore, the state should provide larger security measures to raise
propensity to consume.
3. Liberal wage Policy: the government should adopt liberal wage Policy to increase the
propensity to consume. The increase in wage rate increases the propensity to consume. But
the marginal productivity of labor should be increased with the increase in wage rate.
Because increase in wage rate tends to increase price level and unemployment.
4. Credit facilities: The availability of credit facilities increases the propensity to consume. If
loans are easily and cheaply available to the people, they can buy more durable consumer
goods like T.V. set, refrigerator motor car etc. This increases propensity to consume.
5. Advertisement: Advertisement is one of the most significant ways to raise the propensity to
consume in modern time. The consumers get information regarding different goods from
advertisement. This raises the propensity to consume.
6. Development of means of transport: Well developed means to transport increases the
consumption function, because the movement of goods from Place to place becomes easy,
size of market expands. The price may also fall due to reduction of transport cost. This raises
the propensity to consume.
7. Urbanization: The urbanization also helps to raise the propensity to consume. The people of
urban areas consume varieties of goods. When urbanization takes place, people move from
rural to urban areas. This tends to shift consumption function.
Investment function
In ordinary sense, investment means to buy shares, bonds and securities which already exist to
the stock market. But this is not real investment because it simply transfers of assets from one
person to another. It does not add to the nation's Physical stock of capital and does not increase
income and employment.
According to Keynes investment means real investment which adds to capital equipments. In
other words investment means an addition to nation’s physical Stock of capital which creates
employment and generates income. It includes new plant and equipments, building of new
factories, shares of new company, construction of road, dams, buildings etc.
According to John Robinson
“By investment is meant an addition of capital such as occurs when a new house is built or new
factory is built. Investment means making an addition to the stock of goods in existence.”
Thus, any transaction that increases the real capital and yields additional income is known as
investment.
Investment function is related with private induced investment. According to the classical
economists' investment is a negative function of the rate of interest.

i.e. higher the rate of interest, lower will be the investment and vice versa.

I = f (r) ------- (i)

Where, I = investment, r = rate of interest.

According to Keynes, investment depends on two factors that is marginal efficiency of capital
(MEC) and the rate of interest (r). Mathematically,

I = f (MEC, r) ------- (ii)

Where, I = investment

MEC = marginal efficiency of capital,

r = rate of interest

Types of investment:
There are various types of investment. They are
1. Gross investment and net investment
The total amount of expenditure made on capital assets in a year is called gross investment. It
also includes depreciation. On the other hand net investment is gross investment minus
depreciation. Thus, this is the net addition to the existing capital stock of the economy.
2. Private investment and public investments; the investment made by private investors
are called private investment. It is profit elastics. On the other hand the investment made
by govt. is called public investment. Such investments are made for social welfare.
3. Autonomous investment and induced investment: Autonomous investment means the
investment which does not change with the change in income level. It is independent of
the level of income or income inelastic. Generally these investments are made by govt. in
various development Projects. Such investments are made for public welfare and not for
Profit motive. It can be shown from the
following diagram.

In fig. AI is Autonomous investment curve, which is

horizontal straight line. This indicates that investment
remains constant whatever be the level of income.
On the other hand induced investment is that
investment which is affected by the change in the level
in of income. These investments are made with a profit
motive. Generally these investments are made by
private sector. It can be shown by the following
diagram.

In fig. ii is induced investment curve which is upward

slopping. It indicates that as income increase investment also
increase
Differences between autonomous and induced investment.
Autonomous investment Induced investment
It does not depend on income. It depends on income.
It is made by government. It is made by private sector.
It is made with welfare motive. It is made with profit motive.
It is income inelastic. It is income elastic.
It is not affected by the rate of interest. It is highly affected by the rate of interest.

Determinants of investment: there are various factors which affect investment decision. They
are:
1. Marginal efficiency of capital (MEC)
MEC is the rate of return expected from an additional unit of capital assets over its cost.
According to Keynes the volume of Private investment depends on MEC. MEC is the expected
rate of return over cost of new capital goods. It is the expected rate of profit. If MEC is high, the
investment increases and vice versa.
2. Rate of interest. There is inverse relationship between rate of interest and investment.
Higher the rate of interest, lower the investment and lower the rate of interest higher the
investment.
3. Political environment: if political climate is uncertain and unstable investment cannot
grow. Thus Political stability a needed for increasing volume of investment.
4. Level of income: if the level of income increases in the economy, it increases the
demand for goods. As a result investment increases.
5. State policy: The economic Policies of govt. also affect the investment decision. If govt.
imposes heavy taxes, it discourages the investment and vice versa.
6. Growth of Population: if the rate of growth of population is high, investment is also
high and vice versa.
7. Business expectation: when businessmen expect more profit on future due to prosperity
in the economy, the rate of investment increases. Similarly, when they expect loss due to
depression in future, the rate of investment falls.
Measures to raise the investment:
The following measures should be taken to increase the investment.
1. Reduction of taxes: the imposition of high taxes on business income discourages the
investment in the economy. Thus the taxes imposed on business income should be reduced to
encourage the investment.
2. Reduction of interest rate: The rate of interest should be reduced to encourage the
investment. Reduction in the rate of interest causes a fall in the cost of capital and encourages the
investment.
3. Building infrastructures: Private investors do not invest in infrastructures, because private
sectors are profit oriented. Hence govt. should develop the infrastructures like road, bridge,
electricity, telephone etc. This encourages the private investment.
4. Price support policy: certain amount of stability in price level is needed to encourage the
private investment. For this, the govt. should adopt price support policy. According to this policy
govt. should purchase and sell the storable goods in large quantity with a view of adjusting their
supply to demand. When prices are falling, govt. should purchase more to prevent further fall in
price and vice versa.
5. Promotion of new technology and invention: An introduction of new goods, new method of
production, discovery of new market and new organization encourage the investment. These
methods help to reduce cost and increase demand, which definitely encourage the investment.
Thus university, non govt. organizations, research center and scientific agency should conduct
new scientific research to encourage investment.
6. Abolition of monopoly: Monopoly privileges of the large business firm should be abolished
by the law. Due to monopoly tendency, new techniques cannot be initiated in all firms. This
reduces investment.
Despite these measures private investment cannot be induced except profit motives. Hence
public investment should work as a balancing factor. Public investment should be increased at
the time of depression. Likewise, public investment should be reduced at the time of inflation.
According to Keynes public investment should work as a complement of private investment
rather than as a substitute.
Marginal efficiency of capital (MEC) 
Marginal efficiency of capital is the highest rate of return of capital assets over its cost. It is also
known as the internal rate of return, which is used on investment decisions.
According to Kurihara “MEC is the ratio between the prospective yield of additional capital
goods and their supply price.” Prospective yield is aggregate net return from an asset during its
lifetime and supply price is the cost of producing this asset.
Keynes says that any entrepreneur when investing in new capital assets compares the expected
rate of return with the interest that will be required to be paid when buying such capital assets. If
the return from the investment is more than the interest amount that is required for the payment
then the entrepreneur will be ready to invest in such new capital assets. Thus, Keynes described
MEC as the rate of discount, which would make the present value of expected future income
from fixed capital assets equal to the current supply price of the asset. It is the expected rate of
return over cost from the additional unit of capital asset. 
If C is expected cost and R is expected yield then MEC can be expressed as:
MEC = R/1+r = C ------- (I)
In this equation r is a discount rate which makes the discounted value of R equal to C.
From equation (I)
     R/1+r = C
  Or, R = C (1 + r)
 Or, R/C = 1 + r
Or, r = R/C - 1 --------- (ii)
If a project costing C is expected to generate an income stream over a number of years as R1,
R2, and R3 ………. Rn, then MEC of the project can be calculated as:
C = R1/1+r + R2/ (1+r) R3/(1+r) .....Rn/(1+r)
If MEC > market rate of interest, then the investor considered the new project as profitable. 
If MEC = market rate of interest, he may or may not choose to invest on the project.
If MEC < market rate of interest, the project is unprofitable.
MEC is directly related to prospective yield (R) and inversely related to supply price of capital
asset(C).  The investor will be ready to invest in new capital assets only when prospective yields
are higher than the supply price of new capital asset. MEC can be shown by the following
diagram.

The behavior of investors and business firm with respect to new investment can be explained
with the schedule of marginal efficiency of capital or investment demand. It shows functional
relationship between the marginal efficiency of capital and the amount of investment. There is
inverse relationship between MEC and amount of investment.
Figure shows the derivation of investment demand curve. The curve MEC represents marginal
efficiency of capital which slopes downward from left to the right. This indicates that as the
capital investment increases, the MEC goes on declining. MEC depends on current rate of
interest. Higher the rate of interest, lower will be the investment and lower the rate of interest
higher will be the investment. MEC curve is also called investment demand curve.
Accelerator theory
The principle of acceleration explains the interrelationship between consumer goods industries
and capital goods industries in an economy. This principle states that when demand for consumer
goods increases, the demand for capital goods also increases i.e. there is positive relationship
between capital goods industries and consumer goods industries. 
According to Edward Shapiro “the basic relationship between the changes in the level of output
and the volume of investment spending is known as the acceleration principle”
According to Kurihara “the accelerator coefficient is the ratio between induced investment and
an initial change in consumption expenditure”
According to Samuelson accelerator coefficient (V) is defined as the ratio of change in
investment to the change in consumption demand i.e.
V = ∆I/∆C
V = Accelerator coefficient
∆ I = change in investment
∆C = change in consumption
But this acceleration principal has been more broadly explained by Hicks according to Hicks
accelerator coefficient is the ratio of change in investment to the change in level of output i.e.
V =∆I/∆y
Where,
 V = accelerator Coefficient 
 ∆I = change in investment 
∆y = change in output 
Assumptions 
1. It assumes a constant capital output ratio.
2.  It assumes that resources are easily available. 
3. It assumes that technology remains constant.
4. There is permanent change in consumption demand.
On the basis of these assumptions acceleration coefficient can be defined as the ratio of change
in capital to the change in output i.e. V = ∆K/∆y
i.e. V = Kt/yt 
V = Accelerator coefficient 
Kt = Capital at time period t 
yt = Output at time period t 
Equation model of accelerator
a. Int = V (yt - yt-1)
Int is the accelerator time change in output.
Where, Int = net investment at time period t.
V = accelerator
Yt = output at time period t
Yt-1 = output at preceding period 
b. Igt = Int + R
Where, Igt = gross investment at time period t.
R = replacement investment (depreciation) which is assumed to be constant. 
c. Static concept 
V = Kt/yt = COR
Or, Kt = V yt
Where,
Kt = Capital stock at time period t.
Yt = output a time period t.
The working of acceleration principle is explained with the help of following table 
Period (1) Total Require Replacement Net Gross
output d capital investment(R) investment(Int) investment(igt)
(y) (3) (4) (5) (6) (R+Int)
(2)
0 200 400 40 - 40
1 200 400 40 0 40
2 210 420 40 20 60
3 230 460 40 40 80
4 260 520 40 60 100
5 280 560 40 40 80
6 290 580 40 20 60
7 280 560 40 -20 20
8 260 520 40 -40 0
9 250 500 40 -20 20

 
Column 1 shows a series of time period.
Column 2 shows total output in each period 
Column 3 shows required stock of capital in each period assuming V = 2
Column 4 shows replacement investment. It is based on the assumption of 10% level of
replacement investment in each period of the capital stock in period zero (0).
Column 5 shows net investment i.e. change in required capital (3).
Column 6 shows gross investment is the sum of net investment and replacement investment. It is
the total demand for capital goods.
From the above table it is concluded that when total output increases at an increasing rate (from
period 1 to period 4), net investment increases. But when output increases at a decreasing rate
(from period 5 to 6), net investment decreases. From periods 7 to 9 total output falls and net
investment becomes negative. It can be shown by the following diagram 

 
 
In figure the first two time periods when output remains constant in an economy net investment
is zero which implies that the accelerator does not work. 
When output increases at an increasing rate Int or net investment increases and gross investment
also increases in the time period 2 to 4. When output increases at a decreasing rate both net
investment and gross investment fall it is shown by the time period between 5 to 7. 
When output decreases, net investment is negative but gross investment is positive. From the
above we can conclude that when output increases in an economy, the accelerator works such
that net investment is positive. Constant output makes the accelerator stop to work. If the rate of
change in output is negative, there is negative net investment, which implies that the accelerator
has negative impacts on the economy. 

Saving function
Saving is the difference between income and consumption expenditure saving function shows
the functional relationship between total saving and total income. Mathematically, it can be
written as, S = f (y) ------ (1)
Where, S = Total saving.
Y = Total income.
According to Keynes saving is the excess of income over consumption expenditure. It is the
difference between income and consumption expenditure. Thus it can be expressed as,
S = y – c -- --- (i)
Where, s = saving.
y = income.
c = consumption.
S=y–c
Or, s = y – (a + by)
Or, s = y – a – by
Or, s = -a +y - by
Or, s = -a + y (1 – b)
Or, s = - a + s y ------ (ii) (since, 1 – b = MPS)
Where, - a = saving at zero income.
Saving function can be shown by the following table and diagram.

Income (y) Consumption (c) Saving (s = y – c)

0 20 -20
40 50 -10
 80 80 0
120 110 10
160 140 20
200 170 30

In fig.SS is saving function. It is

upward slopping which indicates that as
income increases saving also rise. Saving
can be both negative and positive. There
are two types of saving function.
1. Average propensity to save
(APS): APS is defined as the ratio
of total to the total income. i. e.
APS = S/y ------- (i)
Where, APS = average propensity to save.
S = saving
Y = income
APS = 1 – APC ---- (ii) (y = c + s
Dividing both sides by y
y/y = c/y + s/y

or, 1 = APC + APS

:. APS = 1 – APC)

2. Marginal propensity to save (MPS): MPS is the ratio of change in saving to the change in
income. i. e MPS = ∆s/∆y ------(i)
MPS = 1 – MPC ---- (ii)
Where,
∆s = change in saving
∆y = change in income
MPS = marginal propensity to save.
MPC = marginal propensity to consume.

Y=c+s

∆y = ∆c + ∆s
∆y/∆y = ∆c/∆y + ∆s/∆y

1 = MPC + MPS

MPS = 1 – MPC (o< MPS <1)

Determinants of saving: saving is determined by the following factors:

1. Level of income: There is positive relationship between saving and level of investment.
Higher the level of income higher will be the saving and lower the level of income lower will
be the saving.
2. Distribution of wealth: if there is equal distribution of wealth in the society, it increases the
consumption as a result saving decreases. On the other hand unequal distribution of wealth
increases the saving.
3. Rate of interest: in general there to positive relationship between rate of interest and saving.
At higher rate of interest, People are encouraged to save more to earn interest and vice versa.
4. Fiscal policy: Fiscal Policy also affects the saving. if govt. increases tax rate, the saving
decreases and vice versa. Similarly, if govt. expenditure increases to provide public goods,
this increases the saving.
5. Price level: When Price level rises, the amount of saving decreases and vice versa.
6. Social security system: if govt. provides more social security, people will feel fully secured
for the future and will not be encouraged towards saving. Similarly, if Govt. does not provide
any social security, people will have to arrange for their own securities. For this they will
start saving.
7. Development of banking and financial institutions. The development of bank and
financial institutions in the country increases the saving and vice versa.
8. Structure of the economy: According to Arthur Lewis, saving depends on structure of the
economy. Most of the developing countries have dual economies in one hand there is
traditional sector and on the other hand, there is modern sector. The principal source of
saving is the modern sector. Hence, saving increases only if the modern sector is expanded.

9. Structure of population: the age composition of population also affects the saving. If the
ratio of dependent population is high, there will be low saving and vice versa.

Paradox of thrift
Classical economists were in favor of saving. They encouraged people to spend less and to save
more. Because according to them thriftiness improves the future of the society and prosperity of
a nation. But Keynes had a different view in regarded to saving. He criticized the concept of
saving given by classical economists and said that saving may be a virtue for an individual
because it adds to the individual wealth. But saving is harmful for the society, because the
expenditure of one person is the income of another person. Hence, saving by one person leads to
decline in the income of other person. If savings are invested, there will be no decrease in
effective demand and it is not Public vice. But if savings are hoarded, at may reduce income,
output, employment and then saving itself will decline. Hence, it becomes vice. This is called
paradox of thrift. It can be shown from the following diagram.

In this fig. ss and I I are saving and investment curves

respectively. These curves intersect each other at
point e. Thus, e is initial equilibrium point where oy
national income is determined. Suppose that total
saving increases and saving curve shifts upward in the
form of S1S1. Now e1 is new equilibrium Point,
where oy1 level of income is determined. Here,
income has decreased from oy to oy1.similarly the
volume of saving has also declined from ey to e1y1.
Thus community’s efforts to save more have actually
resulted in a decline in income as well as in saving.
On this account Keynes called saving as a social vice.