1

Aggregate Demand

Aggregate demand is a very crucial variable in the determination of the level of employment and
output in an economy. Aggregate demand refers to the total volume of expenditure that consumers,
investors, government and rest of the world are willing to undertake on final goods and services
produced in an economy in a particular period of time. The four components of aggregate demand are
consumption demand, investment demand, government expenditure and net exports.

1.1 Aggregate Consumption Demand: Consumption Function

Aggregate consumption demand refers to the total expenditure on consumer goods and
services produced in an economy during a particular period of time. In all economies of the world
consumption demand constitutes the single largest component of aggregate demand.

The aggregate consumption demand depends on a large number of objective and subjective
factors. Among them real disposable income is often cited as the most important factor. The functional
relation between real disposable income and aggregate consumption is called the propensity to
consume or the consumption function.

Ct = f (yt ), where ‘C’ is the aggregate consumption demand, ‘y’ is aggregate real disposable
income and ‘t’ indicates time.

The above functional relationship is based on the assumption that all other factors that
influence aggregate consumption demand remain constant. It is also assumed that the aggregate
consumption function is a linear summation of consumption functions of individual households.
Therefore the relationship is valid both at micro and macro levels. The consumption-income relationship
can be illustrated with the help of a hypothetical example of disposal of income by a household.

Table: 1.1
Consumption-Income Relationship
Income (Rs) Consumption (Rs ) Saving (Rs)
0 200 -200
1000 1000 0
2000 1800 200
3000 2600 400
4000 3400 600
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In the example given above, consumption expenditure is shown as Rs 200, even when income is
zero. This may be referred to as basic level of consumption or autonomous consumption, independent
of the level of income. It is financed through dissavings (negative savings).

Further increases in income induce additional consumption expenditure. When income

increases to Rs 1000, consumption expenditure also rises to Rs 1000, and saving increases to zero. The
level of income at which consumption is equal to income and saving is zero, is called the break-even
level of income. As higher levels of income, consumption expenditure is also higher, but less than
income and saving become positive.

In the figure consumption is measured along the vertical axis and income along the
horizontal axis. The 45o line represents all points along which consumption is equal to income. It
is labeled ‘y = C’ line. The ‘C’ line gives the consumption function. When income is zero,
consumption is 200. The consumption function, therefore, starts from a point on the vertical axis.
As income increases, consumption also increases. It lies above the 45 o line at all levels of income
less than Rs 1000, implying that at such levels of income consumption exceeds income and
saving is negative. At the income, Rs 1000, the consumption function intersects the 45 o line. It
means that at that level of income consumption is equal to income (break–even point). Beyond
that level of income the consumption function lies below the 45 o line, means that at such levels
of income consumption is less than income and saving is positive.

Consumption

y=C

1000 e

45o
O 1000 Income
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1.2 Technical Attributes of Consumption Function

A consumption function is described by two technical properties: Average propensity to

consume (APC) and Marginal propensity to consume (MPC).

1.2.1 Average propensity to consume: APC refers to the proportion of aggregate real
income that is devoted to aggregate consumption. It is given by the ratio between aggregate
consumption (C) and aggregate income (Y).

If APC is constant and does not vary with income, consumption function is said to be
‘proportional’ and if it varies with income, consumption function is ‘non- proportional’.

APC = C / Y

1.2.2 Marginal propensity to consume: MPC refers to the proportional change in

consumption, consequent upon a change in income. It is given by the ratio between change in
consumption (ΔC) and change in income (ΔY).

MPC = ΔC / ΔY

Geometrically, MPC is given by the slope of the consumption function. If MPC is constant at all
levels of income, consumption function will be a straight line and is said to be ‘linear’. If MPC
varies with income, consumption function is ‘non-linear or curvi-linear’.

Relation between APC and MPC

1 If MPC > APC, APC will increase as income increases.

2 If MPC = APC, APC will remain constant.
3 If MPC < APC, APC will decline as income increases.

1.3 SAVING FUNCTION

Saving is the excess of income over consumption.

S=Y–C

Saving being a residue of income after consumption, which in turn is determined by income,
saving is also treated as a function of income. The functional relation between saving and income
is called ‘saving function’. It gives the saving at each level of income. The saving – income
relationship given in table 1.1 is presented in the following figure.
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Saving

+ve S

O a Income

- ve

The saving function is represented by the ‘S’ curve in the figure. In the beginning, it lies below
the horizontal axis, implying negative saving (dissaving) at low levels of income. As income
increases, saving also increases (dissaving declines) and becomes zero at the point (a) where
saving function crosses the horizontal axis. The point ‘a’ represents the break-even level of
income. As income increases further, saving becomes increasingly positive.

1.3.1 Technical Attributes of Saving Function

Two technical attributes of saving function are Average propensity to save (APS) and Marginal
propensity to save (MPS).

1.3.1.1 Average propensity to save: APS refers to the proportion of income that is saved. It is
given by the ratio between aggregate saving (S) and aggregate income (Y).

APS = S / Y

1.3.1.2 Marginal propensity to save: MPS refers to the proportional change in saving
consequent upon a change in income. MPS is equal to the ratio between change in saving and
change in income.

MPS = ΔS / ΔY

Geometrically, MPS is given by the slope of the saving function.

1.4 Relation between APC and APS

The sum of APC and APS is one.

Y=C+S
Dividing both sides of the equation with Y,
Y/Y = C/Y + S/Y
1 = APC + APS
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1.5 Relation between MPC and MPS

The sum of MPC and MPS is one.

ΔY = ΔC + ΔS

Dividing both sides of the equation with ΔY,

ΔY/ ΔY = ΔC/ ΔY + ΔS/ ΔY

1 = MPC + MPS.

And MPC = 1- MPS

1.6 The Psychological Law of Consumption – J.M. Keynes

J M Keynes was the first economist to develop a systematic theoretical

consumption function. Consumption function constitutes one of the main building blocks of ‘the
General Theory’. He has presented the relationship in the form of a fundamental psychological
law of consumption. According to the law, “… men are disposed, as a rule and on the average, to
increase their consumption as their income increases, but not by as much as increase in their
income”. The law implies that an increase in income will be followed by an increase in
consumption, but the increase in consumption will be less than the increase in income. Main
propositions of the law are the following:
Proposition – 1: When income increases, consumption expenditure will also
increase. Consumption is a direct function of income. In other words, MPC > 0 (Positive)
Proposition – 2: The increase in consumption will be less than the increase in
income. ΔC < ΔY. It means that MPC < 1.
This proposition is the core of the Keynes’s psychological law of consumption. Increase
in income is accompanied by a progressively widening gap between income and consumption
expenditure, because increment in consumption is always less than the increase in income. This
argument constitutes the basis of Keynes’s attack on the Say’s law of markets.
Proposition – 3: An increase in income is divided between consumption and saving.
ΔY = ΔC+ ΔS and MPS > 0 (positive).
Proposition – 4: Consumption is a stable function of income. In the short run an
increase in income is unlikely to be followed by a decline in consumption; instead both
consumption and saving are likely to increase only.
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1.6.1 Implications of the Psychological law

Keynes’s analysis of consumption function constituted the basis of his attack on the
Classical theory of full employment. The theoretical implications of the law are the following.
1) Repudiation of the Say’s law of markets : It invalidates the Say’s law of market.
Keynes’s law of consumption implies that an increase in production and income need
not always be matched by new demand because additional consumption generated
will be less than the increase in income.
2) Importance of investment demand: It highlights the importance of non- consumption
demand like investment. Consumption demand alone will not be sufficient to sustain a
particular level of income or production. Non-consumption demand like investment is
required to fill the gap between real income and consumption demand so that the
macroeconomic equilibrium is maintained.
3) Underemployment equilibrium: The consumption function is used to explain the
existence of under employment equilibrium. Full employment is attained when the
difference between real income at full employment and the corresponding aggregate
consumption demand is exactly filled by non-consumption components of aggregate
demand. But according to Keynes this is only a chance event and the result will be
under employment equilibrium.
4) Secular stagnation: As MPC < 1 and consumption function is relatively stable,
Keynesians pointed out the possibility the possibility of chronic excess saving over
desired investment demand – a situation Keynesians called secular stagnation.
5) Role of Economic policy: Demand management policies assume importance as a
measure to offset the deficiency in consumption demand and to maintain economic
stability.
6) Trade cycle: The lag in consumption response to changes in income is used to explain
the turning points of a trade cycle.
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1.7 Determinants of Consumption Demand

Consumption demand depends on a number of factors that influences consumer

behaviour. Keynes has identified many objective and subjective factors that determine
consumption demand.

1.7.1 Objective Factors

Objective factors that influence consumption are the material things which are
quantifiable in nature. They are subject to change in the short run and are capable of causing
rapid changes in consumption. Among these factors, income is identified as the most important
influence on consumption. The other factors that affect the consumer bahaviour are explained
below:
1) Price level: Changes in the price level influences consumption demand through its
impact on the real disposable income. For example, if the real disposable income
diminishes as a result of an increase in price level, it may lead to fall in consumption
demand.
2) Expectations about price changes: Expectations about future rise in the price level
may encourage present purchases and vice-versa.
3) Rate of interest: An increase in the rate of interest may induce people to reduce
consumption and save more and vice – versa.
4) Wealth: It is pointed out that an increase in the stock of wealth may reduce the desire
to accumulate more wealth. As a result saving will decline and consumption will
increase.
5) Wind fall gains/losses: Wind fall gains/losses refer to sudden and unexpected
gains/losses in the income or wealth of people. Such gains/losses may
encourage/discourage consumption expenditure.
6) Liquid assets: The proportion of liquid assets in total wealth is a very important
influence on consumption. Larger the proportion, higher is likely to be the
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consumption spending. This is so because, existence of liquid assets makes spending

more comfortable and less costly.
7) Consumer credit: Availability of easy and cheap credit will encourage consumers to
spend more than what their income will permit.
8) The stock of consumer durables: The stock of consumer durables in the possession of
consumers will discourage them from making additional purchases.
9) Distribution of income: It is argued that the propensity to consume is higher among
the poor than the rich. Therefore a redistribution of income in favour of the poor will
lead to an increase in consumption demand.
10) Changes in consumer preferences: Consumer preferences/fashion are influenced by
the sales promotion measures adopted by producers/sellers and are highly significant
in the determination of the size and pattern of consumption expenditure.
11) Taxation policy of the government: A reduction in the taxation will increase the
disposable income of the people and encourage consumption spending and vice versa.
12) Demographic factors: The size and age composition of population, degree of
urbanization etc are also important in the determination of aggregate consumption
expenditure.
1.7.2 Subjective Factors
Subjective factors are those things that determine the psychological attitude of people.
They are highly subjective and vary with respect to person, place and time. They are non-
material in nature and cannot be measured.
Keynes has identified eight motives which refrain people from spending on consumption.
They are motives of precaution, foresight, calculation, improvement, independence, enterprise,
pride and avarice. Corresponding motives that encourage consumption are motives of enjoyment,
shortsightedness, generosity, miscalculation, ostentation and extravagance.
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1.8 Measures to Increase consumption

Some important measures that can be adopted to increase consumption demand are the
following:
1 A redistribution of income in favour of low income groups.
2 Provision for availability of consumer credit with easy installments and low
interest rates.
3 A tax policy with low rates of taxation on income, wealth and consumption and
high levels of subsidization.
4 Promotion of consumption through advertisements and other sales promotion
measures.
5 Introduction of social security measures like unemployment compensation, old
age pension, health insurance etc.
6 Promotion of urbanization.
1.9 Types of Consumption Function
Two most popular types of consumption functions are often used in economic analysis
and their properties are given below:
1.9.1 Linear Proportional Consumption Function
A typical linear proportional consumption function is given by the relation C = cy, where
‘c’ is a constant.
In this case APC = C / y = cy / y =c
MPC = ΔC / Δy = c Δy / Δy = c
Both APC and MPC are constant and consumption function is linear and proportional.
Consumption function is represented by a straight line from the origin with slope equal to ‘c’.
C

C = cy

co
O y
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1.9.2 Linear Non-Proportional Consumption Function

A typical linear but non-proportional consumption function is given by the equation
C = a + c y, where ‘a’ and ‘c’ are two constants.
APC = C / y = a + cy / y = a/y + c.
As ‘a’ and ‘c’ are constants APC will diminish as income increases. The consumption
function is non-proportional.
MPC = ΔC/ Δy = c Δy/ Δy = c.
MPC is constant and the consumption function is linear.
Graphically the consumption function is given by an upward sloping straight line with a
vertical intercept.
C

C = a + cy

O y

If both APC and MPC are variable as income changes the consumption function is non-
linear and non- proportional and is represented by curves.
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1.10 Empirical Consumption Function: Consumption Puzzle

Various empirical studies were conducted by economists to establish the relation between
consumption and income. Consumption function was tested with National income and Product
Accounts data for the US economy.
The short run time series data from National income and product Accounts for the US
economy for the period 1929-41 yielded a non-proportional but linear consumption function. The
consumption function fitted to the data is given by the equation C = 26.5 + .75 di, where ‘di’
stands for disposable income. As per the consumption function APC declines as income
increases.
However the long run time series data presented by Simon Kuznets for the U S A, for the
period 1869 – 1938 yielded a different result. Kuznets estimate has shown that over the period
national income has recorded seven-fold increase, but the APC remained more or less stable,
varying only slightly between 0.84 and 0.89. Kuznets data implied a linear proportional
consumption in the long run.
Empirical studies thus produced the conflicting result that in the short run consumption
function is non-proportional and the long consumption function is proportional. This is known as
consumption puzzle. The conflict between short run and long run consumption functions led to a
controversy among economists with regard to the exact nature of consumption function. Post-
Keynesian economists have advanced many theoretical explanations for the consumption puzzle.
1.11 THE ABSOLUTE INCOME HYPOTHESIS (AIH)
The AIH states that current consumption is a function of current income. Many
economists have subscribed to the view and prominent among them are Arthur Smithies and
James Tobin. However, the idea that consumption depends on income was given first clear and
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full statement by J M Keynes in the ‘General Theory’. Even though Keynes has not specified it,
Keynes’s theory of consumption function is also classified as AIH.
Smithies and Tobin believed that consumption is an undated function of income.
According to them consumption function is basically non-proportional and APC will decline as
income increases. In other words people will save larger proportion of their income as income
increases.
1.11.1 Reconciliation between Short run and Long run Consumption Functions: AIH
According to Smithies and Tobin, in the long run consumption-income relationship
becomes proportional because of the upward drift in consumption functions. Upward drift in
consumption functions implies an increase in the propensity to spend, even with unchanged
income, because of certain exogenous motivations. The upward drift in consumption functions
tends to offset the tendency of APC to fall as income increases.

[The figure given below explains the drift theory.

Consumption

LRC
SRC2
C2 c SRC1

C1i b

C1 a

O Y1 Y2 Income
In the figure two short run consumption functions SRC 1 and SRC2 are shown. Given
SRC1, with OY1 income consumption demand is OC1. If the consumption function drifts upward
to SRC2, with the same income consumption will increase to O C1i.
In the absence of drift in the consumption function increase in income from OY 1 to OY2
will induce a movement from point ‘a’ to point ‘b’ along the consumption function SRC 1. APC
would have declined. But because of the upward drift in the consumption to SRC 2, increase in
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income to OY2 will produce a movement to point ‘c’, rather than to point ‘b’. APC remains the
same as that on point ‘a’. According to AIH the data estimated by Kuznets consisted of points
like C1Y1, C2Y2 and so on. By incidence they fall on the LRC line, whose equation is roughly C =
0.9Y. Thus the long run consumption function becomes proportional because of the tendency of

consumption functions to drift upward.]

Smithies and Tobin pointed out the following reasons for the upward drift in
consumption functions:
1) Increase in the wealth of households,
2) Increasing urbanization of population,
3) Increase in the percentage of old people in total population and
4) Introduction of new consumer goods.
The AIH was criticised by James Duesenberry on the ground that the reasons cited by
Smithies and Tobin are insufficient to produce drifts in consumption functions sufficient to make
the long run consumption function proportional.
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1.12 THE RELATIVE INCOME HYPOTHESIS

The Relative Income Hypothesis (RIH) was developed by James S. Duesenberry, in his
book” Income, Saving and Consumer Behaviour”, published in 1949. According to RIH
consumption depends on relative income, rather than on absolute income and basically the
relationship is one of proportionality.
Duesenberry has explained the consumption-income relationship on the basis of two
hypotheses:
1) Consumption expenditure by an individual family depends on its relative income; i.e.,
income of the family in relation to the income of families with which it identifies. As
long as the relative income remains unchanged, the fraction of income spent on
consumption (APC) will remain unchanged. If the income all families increase
proportionately, their relative position will remain unchanged. Absolute consumption
and saving will increase, but APC will remain constant. If a family’s absolute income
rises slower than the increase in the income of others its relative income will
deteriorate and APC will increase. On the other hand an improvement in the relative
income of the family will lead to a reduction in its APC.
This proposition is based on the imitative or emulative nature of consumption. A family
with a given level of income will spend larger proportion of income on consumption if it lives in
a society where that income is relatively low. According to Duesenberry this is due to the
tendency of the family to imitate the superior consumption pattern of richer neighbours.
Duesenberry called this as the demonstration effect.
2 Consumers adjust their consumption, not only to current income, but also to previous
income, particularly previous peak income. As long as the ratio between current
income (yt) and previous peak income (y0) remains unchanged APC will remain
constant. If current income falls temporarily, people will try to protect their
consumption standards previously attained by reducing their savings. APC will
increase. When income rises in a subsequent recovery, consumption will rise slowly,
with much of the increase in income is used to restore the saving rate. APC will
decline. Only when income rises beyond the previous peak level, consumption will
rise proportionately with income.
It follows that consumers find it easier to increase consumption than to reduce it. The
irreversibility or lag in the adjustment of consumption to changes in income is called the ‘ratchet
effect’.
1.12.1 Reconciliation between Short run and Long run Consumption Functions: RIH
According to Duesenberry the basic relation between consumption and income is one of
proportionality. Then in the short run consumption becomes non-proportional because of the
ratchet effect. Had income grown steadily as shown by the solid line ‘y’ in the figure given
below, consumption would grow in the same proportion, as shown by the solid line ‘C’.
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Consumption and Income y’

y

C’
C

O Time
But growth of income over time is not steady. It is characterised by spurts and dips, as
shown by the broken line y’. The short run fluctuations make the consumption – income
relationship non- proportional. In a recession, when income falls people will try to maintain their
consumption levels attained previously. As a result they will spend larger proportion of income
on consumption. APC will increase (and APS will fall).
Then as recovery succeeds recession, the income level begins to increase, but
consumption will not rise as fast as income rises. Much of the increase in income will go to
restore the savings depleted in the recession period. It means in a recovery APC will fall and
APS will increase.
Thus in periods of fluctuations consumption also fluctuate, but not as much as the
fluctuations in income. Short run movements in consumption are represented by broken line c’,
in which consumption fluctuates at amplitudes much less than that in short run income
represented by y’. This makes short run consumption-income relationship non-proportional.
In the long run cyclical fluctuations in income smooth out, showing a steady growth and
consumption would also grow in the same proportion as income.
Ref: 1) Macroeconomic Theory – Gardner Ackley
2) Macroeconomic Analysis – Edward Shapiro
3) Macroeconomic Theory and Policy – William H. Branson
***************
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1.13 THE PERMANENT INCOME HYPOTHESIS

The Permanent Income Hypothesis (PIH) of consumption function was developed by
Milton Friedman of the University of Chicago, in his book “A Theory of Consumption Function”
published in 1957. Friedman held the view that current consumptions depends not on current
income alone. According to him, consumers take into account future income and consumption
requirements when they plan current consumption.
According to Friedman consumption is related to a long-term estimate of income, which
he called the ‘permanent income’. In the words of Friedman “permanent income of a family in
any one-year is the mean income regarded as permanent by the consumer unit in question ,
which in turn depends its horizon and farsightedness’. It is that part of income that people expect
to persist in to the future. Each family arrives at an approximation of its permanent income on
the basis of his total wealth, both human and non-human. Permanent a family for any year is
equal to its total wealth multiplied by the rate of interest.
According to Friedman, the measured income (Ym) or observed income of a family has
two components: permanent income (Yp) and transitory income (Yt).
Ym = Yp + Yt.
Transitory income is the part of the income that people expect to be temporary. It is the
random deviation from the permanent income. It may be positive or negative.
If Yt is positive (an unanticipated gain), Ym > Yp. If Y t is negative (an unanticipated
loss) Ym < Yp.
Similarly measured consumption (Cm) of a family too has two components: permanent
and transitory consumption. Cm = Cp + Ct.
Permanent consumption is the planned component of aggregate consumption
expenditure. Transitory consumption is unexpected purchases or deferred purchases. The ‘Ct’
may be positive or negative and as such ‘C’ may be greater than or less than ‘Cp’.
The basic proposition of the PIH is that permanent consumption is a constant proportion
of permanent income. Cp = kYp. The APC out of permanent income is ‘k’ and remains constant .
It implies that all families, both rich and poor spend the same fraction of income on
consumption.
Another important argument of the PIH is that the transitory consumption is not
correlated with transitory income. It means that a positive transitory income will not induce any
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additional spending, but is saved completely. Similarly a negative transitory income will not
reduce consumption, but will be maintained at the cost of savings. In other words MPC out of
transitory income is zero.
These propositions imply that how a change in measured income (Ym) affect measured
consumption (Cm) depends on the way the household perceive the change in ‘Y’. If the
household thinks that the entire change in ‘Y’ is permanent, current consumption will change
proportionately (i.e., k times) to the change in ‘Ym’. On the other hand if the entire change in
‘Ym’ is considered to be transitory, current consumption will remain unaltered. Thus MPC out of
measured income is highly unstable.
1.13.1 Reconciliation between Short run and Long run Consumption Functions: PIH
The PIH is consistent with both the proportional long-run consumption function and the
short-run non-proportional consumption function.
In the long-run income growth is mainly dominated by growth in permanent income.
Positive and negative short-run changes in income tend to cancel out in the long-run. The long-
run consumption-income relationship will therefore be approximately the proportional relation
between permanent consumption and permanent income, with APC equal to ‘k’.
Short-run is characterized by booms and depressions. Booms are periods of high income,
with positive transitory income. Ym > Yp. In these high-income years, consumption will not rise
as much as income rises because most of the increase in income is considered to be transitory. As
a result in short-run booms the APC will decline. Depressions are generally periods with
negative transitory income. So, Ym < Yp. Consumption will not fall as measured income
declines because people think the decline in income is transitory. APC will increase. In short in
the short run APC is highly unstable and consumption function is non-proportional.
Ref:
1. Macroeconomics – Levacic and Rebmann
2. Macroeconomics- Theory and Policy – Edward Shapiro.
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1.14 THE LIFE–CYCLE HYPOTHESIS

The Life-cycle hypothesis (LCH) was developed by economists like Franco Modigliani,
Richard E. Brumberg, and Albert Ando. The LCH is based on the utility maximising behaviour
of households. According to the LCH current consumption is part of a long term plan which
spreads over their entire life term. Suppose that an individual knows his life span and intends to
leave no legacies. Then the objective of his saving is to rearrange his lifetime consumption in
relation to expected lifetime income stream so that he gets maximum utility. Lifetime
consumption can be arranged in an even manner, by accumulating non-human wealth through
saving.
The typical time profile of income and consumption of a household is given below.
Income and Consumption

O Time
The line ‘Y represents the profile of lifetime income stream. It rises in the early working
years, reaches a plateau in the middle years and declines thereafter. The ‘C’ line represents the
profile of lifetime consumption stream. It gradually increases over time. To even out the profile
of consumption, a typical household dissave in the early years of working life, save in the middle
years – not only to repay previous debts, but also to accumulate assets- and finally dissave in the
late years of life. This dissaving is financed not by borrowing, but out of savings accumulated
during middle years. The APC of the household will be very high in the early and late years of
life, and very low in the middle years.
It follows that the age distribution of total population is an important determinant of
aggregate consumption expenditure in an economy. But it is observed that the age distribution of
population change quite gradually. So the LCH is based on the assumption that age distribution
of population remains unchanged.
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According to the LLCH a household’s consumption is proportional to its total resources.

This relationship holds good at the aggregate level also.
Total resources of a household consist of current labour income, the present value of the
expected future labour income and the assets accumulated as of the previous year.
Any change in the total resources, due to any of its three components, will lead to a
proportional change in planned consumption in all future periods. The effect of a change in
current income on consumption depends on the effect of the change on the total resources of the
household. If the change is regarded as temporary, it will have very little effect on current
consumption. If the change is regarded as permanent, then future income will be revised
accordingly and consumption will change proportionately.
1.14.1 Reconciliation between Short run and Long run Consumption Functions (LCH)
The LCH also explains the observed non- proportionality of short-run consumption
function and the proportionality of long-run consumption function. Short run changes in income
are considered to be temporary and will not affect lifetime resources and consumption of people.
Short run fluctuations in income are absorbed by non-human assets of people. As result APC will
vary in the short run.
Long run changes in income are regarded as permanent and bring about changes in
lifetime resources. As such consumption will vary in proportion with long run changes in
income. In the long-run APC will remain constant.

Ref:
1 Macroeconomics – Levacic and Rebmann
2 Macroeconomics- Theory and Policy – Edward Shapiro.
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INVESTMENT DEMAND
Investment demand is a very important component of aggregate demand in an economy.
Importance of investment demand arises not from its share in aggregate demand alone, but from
its nature also. Investment demand is considered to be the most volatile component of aggregate
demand and cyclical fluctuations in economic activities are attributed generally to the volatile
nature of investment demand.
Replacement, Net and Gross Investment
Current output of an economy consists of both consumer goods and capital goods. Capital
goods are real productive assets like machinery, tools and equipments, factory buildings,
inventories etc, which are used in further production of goods and services. New capital goods
produced in a year are used for two purposes. Each year part of the value of the existing stock of
capital goods is lost due to wear and tear and obsolescence. This is called depreciation. Part of
the new capital goods produced in a year is used to offset depreciation of the existing stock of
capital. This part of the current output of new capital goods is called replacement investment.
The objective of replacement investment is to maintain the stock of capital / productive capacity
intact. The rest of the current output of the new capital goods constitutes a net addition to the
stock of capital assets. This is called net investment.
Gross investment in an economy is the sum of replacement investment and net
investment. It is defined as that part of GNP, which takes the form of additions to or replacement
of real productive assets in an economy in a year.
Gross investment = Replacement investment + Net investment.
It follows that net investment in an economy can be positive or negative. If gross
investment in an economy is greater than replacement , net investment will be positive and the
stock of capital in the economy will increase. On the other hand if the gross investment in the
economy is less than the replacement investment, net investment will be negative and the stock
of capital in the economy will decline. If gross investment is exactly equal to replacement
investment, net investment will be zero and the stock of capital will be maintained.
Classification of Investment
Investment in capital goods is classified in different ways on different grounds. Some of
the important classifications are discussed below.
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Investment in business Fixed Assets, Residential Construction and Inventories

Business fixed investment refers to investment by business enterprises in fixed capital
assets like factory/office buildings, plant and machinery, tools and equipments etc.
Investment in residential construction refers to expenditure in a year on construction of
new residential dwellings or apartments either for rental or occupancy by house owners.
Inventory investment means the part of the current output absorbed by business firms as
an increase in the stock of finished goods/semi-finished goods/raw-materials.
Real Investment and financial Investment
Real investment means investment in new real productive assets like plant and
equipments, factory/office buildings, inventories etc. Real investment has dual effects: It creates
new productive capacity (capacity effect) and also creates income (income effect). Production of
real assets leads to employment of labour and resources and generates income.
On the other hand financial investment refers to the expenditure in a year on existing
assets. Being the expenditure on already existing assets, financial investment does not have any
capacity effect. Assets already existing are the output of some previous years and do not
constitute part of current output or income and as such have no income effect also. Financial
investment involves only a transfer of ownership from the person who disinvests to the person
who invests in the asset. Investment by the latter is nullified by the disinvestment by the former,
with no ultimate effect on the stock of capital of the economy. Examples of financial investment
are purchase of existing stocks/shares, buildings, machinery etc.
Autonomous and Induced Investment
Autonomous investment is that part of aggregate investment in an economy, which is
independent of the variations in income. Autonomous investment is not sensitive to changes in
the prospects of profits brought by variations in income and hence it is income inelastic.
Autonomous investment is generally associated with factors like technological changes,
innovations, development of resources, long-term planning, growth and development, growth of
population, social welfare etc. Most of the public investment is autonomous in nature.
Autonomous investment, in relation to income, is represented by a horizontal straight line (Ia).
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Autonomous Investment

h Ia

O Income
In terms of the figure, autonomous investment remains ‘oh’ at all levels of income.
Induced investment refers to investment expenditure that varies directly with income. An
increase in income will lead to rise in demand for consumer goods and it will encourage
entrepreneurs to accumulate more capital to increase their productive capacity to meet the rise in
demand. Similarly in periods of economic recessions, the fall in income will reduce demand;
firms will develop excess capacity which will prompt entrepreneurs to their stock of capital
through disinvestment. Induced investment will become negative. In the ‘acceleration principle’
JM Clark has related investment to changes in income. Induced investment, in relation to income
is shown by an upward sloping line (Ii) with a negative segment.
Induced Investment
Ii

+’ ve

O Income

-’ ve

Investment Demand Function

Total investment demand (I) in an economy is the sum of autonomous investment and
induced investment.
I = Ia + Ii
The figure given below shows the investment demand function (I).
 23

Investment I

+’ ve Ii

h Ia

O Income

-’ ve

Investment demand function (I) slopes upward because of the positive relation between
induced investment and income. The vertical distance between investment demand function (I)
and induced investment function (Ii) represents the constant autonomous investment demand and
hence investment demand function is parallel to induced investment function.
Public Investment and Private Investment
Public investment refers to the investment expenditure undertaken by the government and
related agencies. Public investment is generally autonomous in nature and profit insensitive.
Public investment is governed mainly by considerations of social welfare, growth and
development, long term planning, economic stability etc.
Private investment refers to investment expenditure by private individuals and business
corporations. Private investment is generally profit oriented.
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Determinants of Investment Demand

Investment demand in an economy is influenced by a large number of factors. Important
among them are discussed below.
1 Profit
Expectation of profit is the most important factor that motivates entrepreneurs to make
investment in capital assets. Expected profit from capital assets is the difference between (a)
expected returns from the capital asset and (b)cost of financing investment in the asset.
a. The expected returns from the capital asset depend on the marginal efficiency of
capital (MEC). The MEC refers to the rate of return expected from a capital asset during its life
time, over all costs except replacement cost and interest. The MEC of an asset depends on the net
prospective returns1 expected from the capital asset over its life time and its supply price. Supply
price capital refers to the price of the capital asset or its replacement cost. The MEC of the asset
is the rate of discount at which the discounted value of the net prospective return from the capital
asset over its life time is just equal to its supply price. Let R 1, R2, …, Rn be the expected net
annual returns from the capital asset over its life time of ‘n’ years and ‘C’ be the supply price of
the capital asset. Then the MEC, ‘m’ is defined such that
C = R1/ (1+m) + R2/ (1+m)2 + … + Rn/ (1+m)n
b. The cost of capital refers to cost of borrowing funds for financing investment.
Cost of borrowing funds is the interest which in turn depends on the interest rate (r).
The net rate of profit from investment is equal to the MEC – interest rate (r). If MEC > r,
investment is profitable and vice-versa. Given the MEC, investment demand will vary inversely
with interest rate.
2 Expectations
Investment demand is highly influenced by the expectation of entrepreneurs about future.
If they are highly optimistic about future returns investment will be very high and vice versa.
Business expectations are highly volatile in nature and the dependence of investment demand on
business expectations makes it highly unstable.

1
A prospective return from a capital unit in a year is equal to its marginal physical product times expected price of
the product. Net prospective return from the capital unit is equal to prospective return from the asset minus the
operating cost (cost labour, energy, material etc, required to operate the unit)
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3 Changes in income
Changes in income have a major influence on the level of investment in an economy.
Growth in income widens the market for output. Increase in sales will encourage entrepreneurs
to expand the productive capacity to meet the increase in demand. Investment demand will rise.
The faster the growth in income the larger will be the net investment. Any slowdown in the
growth of income will cause a decline in investment demand. The relation between the level of
investment and rate of growth in GNP is called the acceleration principle.
4 Propensity to consume
The propensity to consume determines the consumption demand and the desired stock of
capital. An increase in the propensity to consume will raise the consumption spending and
demand for capital goods will rise.
5 Liquid assets
Investment demand depends on the availability of liquid assets, which will enable
entrepreneurs to take advantage of investment opportunities quickly and easily.
6 Technological Changes
Investment is the major carrier of technological changes. New techniques are often
incorporated in new machines and plants. Therefore, technological changes usually induce
investment new capital goods.
7. Uncertainties
Uncertainties in business environment, economic policies of the government, political
conditions etc will adversely affect the volume of investment in an economy in any period.
In addition to the factors mentioned above, investment in an economy in influenced by
many exogenous factors like growth of population, degree of urbanization, political stability,
unionization of labour, economic policies of the government etc.
******
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THEORY OF INVESTMENT MULTIPLIER

The theory of investment multiplier was developed by J M Keynes and it plays a crucial
role in his theory of income determination. Originally the idea of multiplier was developed by R
F Khan in 1930 and his concept of multiplier was known as ‘employment multiplier’
[Employment multiplier is the ratio between increase in total employment and increase in
primary employment which initiated the increase in employment ]
According to Keynes, total output in an economy depends on the level of aggregate
demand. An increase in autonomous investment demand will lead to additional production and
income, provided there are unutilized resources. Keynes has pointed out that the increase in
income that results from the initial increase in investment demand will be much higher than the
latter. In other words the increase in income will be a multiple of the initial increase in
investment demand. The ratio between the change in income (ΔY) and the change in investment
demand (ΔI) is called the investment multiplier (k).
K = ΔY/ΔI
[ Suppose that an increase in investment demand by Rs 100 cr leads to an increase in
income by Rs 500 cr, the investment multiplier is
5 = 5oo/100. ]
The value multiplier depends on the value of the marginal propensity to consume (MPC)
or the marginal propensity to save (MPS).
K = 1/1-MPC = 1/MPS.
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Value of k varies directly with MPC and inversely with MPS (k is the reciprocal of
MPS).
[ If MPC = 0.8, k = 1/1-0.8 = 1/0.2 = 5
If MPC = 0.9, k = 1/1-0.9 = 1/0.1 = 10 ]

Multiplier is a mechanism through which income gets propagated by an increase in

autonomous investment demand. It can be illustrated with the help of a numerical. Suppose that
MPC = 0.8. Let there be an increase in investment demand by Rs 100 cr. Production of capital
goods and income will rise by Rs 100 cr. As a result of the increase in income, consumption
demand will rise by Rs80 cr (ΔC = c ΔY = 0.8 x Rs100 cr = Rs 80 cr). Production of consumer
goods and income will rise by Rs 80 cr. Consequently consumption will rise again by Rs 64 cr (=
0.8 x Rs 80 cr). The process will be repeated continuously. Since MPC < 1, the increase in
income becomes smaller in each period and comes to an end after a long period. By that time the
economy reaches a new equilibrium. Total increase in income that occurred as result of the initial
increase in investment demand will be Rs 100 cr + Rs 64 cr + ……. = Rs 500 cr. Value of the
multiplier is 5.
The theory of investment multiplier explains the impact of an increase in investment
demand on income. However, the multiplier effect is not limited to investment demand alone.
Any increase in aggregate demand, provided it is autonomous, can have multiplier effect on
income.
Multiplier mechanism is symmetric in its operation. It can operate both in forward and
backward directions. An increase in demand will lead to a multiple increase in income and a
decrease in demand will cause a multiple contraction in income.
Leakages from the Multiplier
The operation of the multiplier effect is weakened by many leakages from the income
stream. Some of them are explained below:
1) Savings. Saving constitute a leakage from the income flow and reduces the
multiplier effect of any increase in spending.
2) Taxation. Like savings, taxation also constitutes a leakage from the income flow
and limits the multiplier effect.
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3) Imports. A part of the induced consumption spending is incurred on imported

goods. This limits the expansion of domestic production and income.
4) Inflation. In a period of inflation, increased money spending fails to increase the
real consumption spending. Impact of the increased spending is absorbed by rising prices and
this limits the multiplier effect.
*******

THE ACCELERATION PRINCIPLE

The Acceleration principle is a pre-Keynesian theory of investment. Originally the theory
was developed by Aftalion in the early years of the 19 th century. Later it was popularized mainly
through the works of J M Clark. Economists like Hicks, Samuelson, Harrod etc have also made
significant contributions in the refinement of the theory.
The acceleration principle relates the optimum stock of capital to the level of output or
demand for the output produced with the help of capital. It is assumed that there is an optimum
capital-output ratio, which enables investors to maximize profit and it remains unchanged over
time. Then in any time period, say ‘t’, the optimum capital stock, ‘K t’ is
K t = v yt
As the capital-output ratio is assumed to remain unchanged overtime, the relationship
holds good for preceding and succeeding time periods. Thus
K t –1 = v y t-1.
The net investment (I t) in between periods K t-1 and K t is
I t = K t - K t-1 = v y t – v y t-1
= v (y t – y t-1) or v Δ yt
The above formulation indicates that net investment during the time period ‘t’ is equal to
change in output in between ‘t-1’ and ‘t’ multiplied by the capital-output ratio, ‘v’. If the change
in output is positive, net investment too will be positive and vice-versa.
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Gross investment (I gt) is equal to net investment plus replacement investment (assumed
to be equal to depreciation).
I gt = v (y t – v y t-1) + Dt, Where ‘Dt’ represents depreciation in period ‘t’.
The basic relationship between change in output and the volume of investment is known
as the acceleration principle. According to the principle the level of investment depends on the
acceleration or deceleration in output. The capital-output ratio, ‘v’ is known as the accelerator.
If the value of ‘v’ is greater than one, any increase in output will lead to an investment in capital
assets greater than the increase in output itself.
Assumptions
a) Capital-output ratio remains constant overtime.
b) Firms will instantaneously increase the stock of capital, whenever output increases.
c) The gap between the actual and desired stock of capital will be closed in a single
period of time.
d) Supply of finance for capital accumulation is perfectly elastic.
Criticisms
1 The acceleration principle is criticized for the highly unrealistic assumptions of the
theory.
2 The model is based on the assumption that capital-output ratio is fixed. In fact capital-
output ratio may vary over time and space.
3 Firms need not really respond to all changes in output. Firms will react by making
investment only if the change in output is considered to be permanent.
4 Investment usually involves long gestation periods. So the gap between the actual and
desired stock of capital need not be filled in a single period. It follows that investment in any
period is not likely to be the result of current change in output. It might be induced by changes in
output over a number of previous periods.
.
Ref:
1 Macroeconomics: The Static and Dynamic Analysis of a Modern Economy, R
Levacic.
2 Macroeconomics, R Levacic and A Rebmann..
3 Macroeconomic Theory, Gardner Ackley.
 30

4 The Trade Cycle, RCO Mathews.

5 Macroeconomic Analysis, E Shapiro

ACCELERATOR – MULTIPLIER INTERACTION

Economists like Alvin H. Hansen, Paul A. Samuelson, J R. Hicks etc have shown that the
combined effect of accelerator and multiplier may cause cumulative change in income. Multiplier shows
the change in income in response to an autonomous change in investment demand. Accelerator explains
the impact of a change in income on investment demand. When these forces interact, the result of an
autonomous change in investment demand will be greater than if multiplier alone had been working. An
initial increase in investment (ΔI) will work through the multiplier to increase income (ΔY). Increase in
income will cause an increase in investment through the accelerator. Again income will increase through
the multiplier, leading to increase in investment and the process will continue in a cumulative manner.

In schematic form, accelerator – multiplier interaction can be presented as follows:

ΔI → k → ΔY → v → ΔI → k → ΔI ……… ( ‘k’ and ‘v’ represent multiplier and accelerator

respectively)

The combined effect of accelerator and multiplier interaction on income is called super multiplier
or the leverage effect. Super multiplier is the ratio between the ultimate increase in income caused by the
combined operation of accelerator and multiplier and the initial increase in autonomous investment.

Hansen and Samuelsson has shown that the interaction between accelerator and multiplier can
produce cyclical fluctuations in the economy. The nature of these fluctuations depends on the values of
accelerator and multiplier.

*********
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