Consumption Function and Investment Function.pptx

Consumption Function
Prof. Nithin Kumar S
Assistant Professor
Department of Economics
J.S.S Banashankari Arts, Commerce
And Shantikumar Gubbi Science College
Vidyagiri, Dharwad - 580004

Introduction
• 'Consumption function' explains the functional
relationship between consumption (C) and income
(Y).
• According to Kurihara, consumption function is a
"functional relationship between two
aggregates. i.e., total consumption and gross
national income".
Prof. Nithin Kumar S 2

• Consumption function is also called propensity to
consume.
• It is represented as
• C = f (Y)
• C = Consumption
• Y = Income
• Other determinants of consumption being constant an
increase in income increases the consumption and a
decrease in income decreases the consumption.

APC and MPC
• The consumption function has two technical
attributes-
i. Average Propensity to Consume and
ii. Marginal Propensity to Consume.

Average Propensity to Consume
[APC]
• It refers to the total amount of consumption
expenditure out of the given total income at a
particular period.
• According to Kurihara, "The average propensity
to consume may be defined as the ratio of
consumption expenditure to any particular level
of income"

• APC is found by dividing the consumption
expenditure [C] by income [Y] APC = C ÷ Y.
• Suppose that the aggregate income of nation is
Rs. 80000 crores and its aggregate consumption
expenditure is Rs. 60000 crores. Then
• APC=C÷Y or
𝟔𝟎𝟎𝟎𝟎
𝟖𝟎𝟎𝟎𝟎
=
𝟑
𝟒
or 0.75

• Y=1 and the APC is always less than one [APC<1] because a
portion of the income is saved. In the above example, the residue
remained after consumption is savings.
• Average propensity to save [APS] is found either by subtracting
APC from income [APS =Y-APS] or by dividing the savings by
income. [APS=S/Y]APS should be less than one, because,
• Y=APC+APS
• Y=1 so APC is < and APS is also <1.

• Marginal Propensity to Consume [MPC]: It
refers to the additional consumption out of given
additional income.
• Kurihara defines it as "the ratio of change in
consumption to the change in income or as the
rate of change in the average propensity to
consume as income changes".

• MPC is obtained by dividing the change in consumption [∆C] by
change in income (∆Y).
• MPC = ∆C/∆Y. If the additional income is Rs.5000 crores and
additional consumption expenditure is Rs.3000 crores then
• MPC = ∆C/ ∆Y or
𝟑𝟎𝟎𝟎
𝟓𝟎𝟎𝟎
=
𝟑
𝟓
or 0.6
• The remaining portion of the additional income is called the
marginal propensity to save additional savings [MPS]. The
marginal propensity to save can be derived from the formula
• MPS = ∆S/∆Y or 1-MPC

Consumption Function

• The 45° line Y [CY] is unity line where income and
consumption are equal at all levels.
• Linear consumption curve C is based on the
assumption that consumption changes by the same
amount throughout.
• In other words, the MPC is the same at all levels of
income.
• Consumption is the increasing function of income.

• At point E consumption is equal to income.
• At E entire income is pent on consumption.
• A rise in income to YF2 increases the
consumption to OC2.
• The increase in consumption [CC2] is less than
the increase in income [YFYF2].
• CC2<YFYF2.
• Points RS show the savings.
• Thus the consumption function measures
both the amounts of consumption and savings
simultaneously.

• Keynes has given more importance to MPC in
his analysis.
• The value of MPC is assumed to be positive
and less than one as the increased income is
not entirely spent on consumption.
• The MPC is helpful in three ways:

i. In explaining the possibility of general over
production or underemployment equilibrium.
ii. In explaining necessity of filling the gap
between income and consumption and
iii. In finding out the multiplier effect.

Psychological Law of Consumption
• Consumption function is based on the
Keynesian psychological law of consumption.
• The psychological law explains human
tendency to spend less on consumption [or to
save more] when income increases

Propositions
• An increase of income will be divided in some
proportion between consumption expenditure and
savings.
• As the income increases, both the consumption
expenditure and the savings will go up. In other words,
increased income neither decreases the consumption
expenditure nor the savings.
• When the aggregate income increases the aggregate
consumption expenditure also increases, but by a
somewhat smaller amount. In other words with an
increase in income the consumption expenditure also
increases, but less than proportionately.

Assumptions
1. The present psychological and institutional
complex remains unchanged.
2. The conditions of the economy are normal
3. The existence of a laissez faire capitalist
economy.
The law explains the tendency of people who
fail to spend on consumption the full amount
of an increment of income.

Psychological Law of Consumption

• In the above figure, line Y shows income and
line C the consumption.
• At E they are in equilibrium.
• Above E the gap between consumption and
income goes on increasing.
• At higher income the ratio of savings will be
more.
• It is a human tendency to save more when
income increases.

Implication of Psychological Law
• The psychological law has some important implications. Important among them
are the following:
1. Invalidates Say's law
2. Repudiates laissez faire
3. Existence of under employment equilibrium
4. Highlights the importance of investment
5. Declining tendency of MEC
6. Possibility of Underinvestment
7. Income generation
8. Economic fluctuations

1. Invalidates Say's law
• It invalidates Say's law of markets by showing
the possibility of overproductions.
• It shows how the supply fails to create its own
demand.
• Psychological law clearly shows that a gap
exists between income and consumption
when the former increases.
• This is under-consumption or over production
gap leading to unemployment.

2. Repudiates laissez faire
• It repudiates the laissez faire policy and
stresses the need for government
intervention.
• State intervention arises in the economy to
avert general overproduction and
unemployment through macroeconomic
policies.

3. Existence of under employment
equilibrium
• Psychological law explains the logic behind the
assumption of under employment equilibrium.
• Consumers do not spend the full increment of
their income on consumption.
• This results in the deficiency in aggregate
demand.
• So the point of effective demand which
determines equilibrium level of employment is of
underemployment equilibrium.

4. Highlights the importance of
investment
• Psychological law highlights the importance of
investment.
• Investment is of crucial importance in filling
the gap between income and consumption.
• Inadequacy of investment is responsible for
unemployment.
• Keynes law highlights the significance of
investment in solving unemployment.

5. Declining tendency of MEC
• It points out the declining tendency of marginal
efficiency of capital in a laissez faire economy.
• Under consumption [gap between income and
consumption] decreases the demand for
consumer goods.
• Reduction in the production brings down the
demand for capital goods.
• Ultimately the marginal efficiency of capital
declines.
• Decline in the MEC implies a fall in the expected
rate of profits and business expectations.

6. Possibility of Underinvestment
• It pinpoints the dangers of existence of
permanent over saving or under consumption
gap in the capitalist economy.
• The gap between income and consumption
widens when people become rich.
• Increased income increases the savings.
• Richness results in over savings or under
investment.
• Under investment is responsible for the secular
stagnation of a capitalist economy.

7. Income generation
• Psychological law explains the unique nature of income
generation in an economy.
• The process of income generation is explained by multiplier
theory.
• The multiplier is a tool to find out the impact of investment
on income.
• Since people do not spend their full increment of income
on consumption the MPC is always less than one.
• The value of multiplier is derived from the MPC.
• [K=1-1/MPC].
• The higher the MPC higher in income generation.

8. Economic fluctuations
• Psychological law explains the turning point of
a business cycle.
• A business cycle is characterized by two
phases, boom and depression.
• The downturn starts before the economy
reaches the full depression level because the
fall in consumption is less than the fall in the
income

Determinants of Consumption
Function
I. Subjective Factors
A. Individual Motives
1. Motive of Precaution
B. Business Motives
II. Objective Factors

I. Subjective Factors
A. Individual Motives
1. Motive of Precaution
2. Motive of foresight
3. Motive of Calculation
4. Motive of Improvement
5. Motive of Independence
6. Motive of Speculation
7. Motive of Pride
8. Motive of Avarice

B. Business Motives
1. Motive of Enterprise
2. Motive of Liquidity
3. Motive of Progress
4. Motive of Financial Prudence

II. Objective Factors
1. Windfall gains and losses
2. Wage level
3. Fiscal policy
4. Changes in expectations
5. Interest rate
6. Corporate policies
7. Liquid assets
8. The distribution of income
9. Forced savings
10. Consumption imitations

Measures to increase Consumption
Function
1. Even distribution of income
2. Suitable wage policy
3. Social security measures
4. Easy credit facilities
5. Urbanization
6. Transport system
7. Publicity
8. Government policy

Uses of Consumption Function
1. Measures the changes
2. Shows the necessity of investment:
3. Provides multiplier
4. Shows over production gap

• Keynes thus highlights the importance of
consumption in an economy through
consumption function.
• As a macro economic tool it shows the
necessity of government intervention in filling
the gap between income and consumption.

Introduction
• Investment function explains the functional
relationship between income and investment [I= f
(Y)].
• According to Keynes consumption and
investment are the major components of
effective demand.
• In short run consumption is more or less stable.
• So Keynes gives more importance to investment
as the major determinant of employment.

Autonomous and Induced
Investments
• Keynes distinguishes between two types of
investments:
i. Autonomous Investment And
ii. Induced Investment.
• Autonomous Investment is income inelastic
whereas induced investment is income elastic.

• Public investments which are expected to pay for
themselves over a long period are autonomous
investments.
• Investment not motivated by profit is
autonomous investment.
• Autonomous investments are neither influenced
by marginal efficiency of capital nor by rate of
interest.
• Investment in economic and social overheads like
construction of buildings dams, canals, bridges,
roads, railways, schools, hospitals etc. are the
autonomous investments.

• Induced investment is income elastic. Investment
motivated by profit is induced investment.
• It is a function of income [II = f (Y)]. It is
influenced by marginal efficiency of capital and
rate of interest.
• It is income or profit motivated. The ratio of
investment to income is called the average
propensity to invest [AP=I/Y].
• The ratio of change in investment to the change
in income is the marginal propensity to invest
[MPI = ΔΙ/ΔΥ].

Autonomous and Induced Investment

• ‘II’ represents the induced investment.
• It increases with the rise in income. It
decreases with a fall in income.
• Al represents autonomous investment.
• At all levels of income it remains constant.
• Induced investment is income elastic.
• Autonomous investment is income inelastic.

Determinants of Investment Function
• Investment, according to Keynes, is
determined by the marginal efficiency of
capital and the rate of interest.
• Marginal efficiency of capital [MEC] exercises
greater influence on the volume of
investment.

Marginal Efficiency of Capital [MEC]
• MEC was first employed in economic theory
by the American economist Irving Fisher.
• Later Keynes popularizes it in macro economic
analysis.
• According to Dillard, "The marginal efficiency
of a particular type of capital asset is the
highest rate of return over cost expected
from an additional or marginal unit of that
type of asset"

• MEC is the highest rate of return over cost
expected from producing an additional unit of
the most profitable capital asset.
• MEC is determined by
i. supply price of capital assets and
ii. prospective yield from capital assets.

• The MEC of an asset is the rate at which the prospective yield expected
from that asset is to be discounted if it is to be equal to the price of the
asset. In other words-
• Supply price = Discounted prospective yield.
• Symbolically,
• Cr =
𝑸𝟏
(𝑰+𝒓)
+
𝑸𝟐
𝟏+𝒓 𝟐
+
𝑸𝟑
𝟏+𝒓 𝟑
+
𝑸𝒏
𝟏+𝒓 𝒏
• Cr = supply price or replacement cost of new capital asset
• Q1, Q2, Q3, Qn =series of prospective annual yield from capital asset
• r = rate of discount or marginal efficiency of capital

• The MEC falls when the investment increases because of the
declining prospective yields and rising supply price.
• The MEC falls because of two reasons
 Rising investment results in a larger supply of goods which decrease
the prices. A decrease in the prices will lower the prospective yield.
 Increases in investment raises the demand for capital assets. The
cost of production of these capital assets goes on rising because of
diminishing returns.
 The relationship between investment and MEC is shown in the
following Figure

• The MEC curve, like a typical demand curve is
downward sloping.
• The downward slope illustrates the inverse
relationship existing between investment and
MEC.
• The supply price of an asset rises when more
and more investment takes place in the asset.
• When the supply price rises but prospective
yields fall then naturally the MEC will fall.
• Hence the MEC curve slopes downwards to
right.

• The investors compare the MEC with rate of
interest while undertaking investment.
• Investment will increase if the MEC is higher than
the rate of interest.
• On the other hand, investment will decrease if
the MEC is lower than interest rate.
• Investment increases so long as the MEC is higher
than rate of interest.
• Investment stops when the MEC and rate interest
become equal.
• The relationship between MEC and rate of
interest shown in the following Figure

• A fall in the interest rate from r2 to r1 brings
about an increase in investment which is
equal to 11 and 12.
• At a lower rate of interest more is the
investment.
• But at a higher interest rate less is the
investment.
• Thus MEC is inversely related to rate of
interest.

• MEC is determined by various factors.
• They are grouped into Endogenous and
Exogenous factors

Endogenous factors affecting MEC
1. Nature of Demand
2. Changes in Income
3. Changes in liquid assets
4. Capital Stock
5. Expectations

1. Nature of Demand
• MEC increases if the demand for a product is expected
to rise.
• Increase in MEC increase the investment.
• On the other hand MEC decreases if the demand for
the product is expected to fall.
• Decrease in MEC decreases the investment.
• Similar is the effect of price on investment.
• An increase in price enhances the investment by
affecting favorably on MEC.
• A decrease in price has exactly the opposite effect.

2. Changes in Income
• An increase in income affects favorably on
MEC by increasing the demand.
• A decrease in income affects unfavorably on
MEC by decreasing the demand.
• Changes in income changes the investment by
changing the MEC.
• A raise in income will have favourable effects
on investment and vice versa.

3. Changes in liquid assets
• The inducement to invest in high when the
investors possess more liquid assets.
• This is true in the case of those firms which
keep large reserve funds and undistributed
profits.
• Lack of liquid assets makes investment by the
firm or investor very difficult.

4. Capital Stock
• If the existing stock of capital goods is large MEC
will decrease and investment will fall.
• Similarly if there is idle capacity in the existing
stock of capital assets investment will not take
place.
• Capital stock and MEC are inversely related. More
is the capital stock less is the MEC and
investment.
• Less is the capital stock; more is the MEC and
investment.

5. Expectations
• MEC also depends on expectations and
attitude.
• Waves of optimism raise the MEC and
investment.
• On the contrary, MEC is depressed by the
waves of pessimism.

Exogenous factors affecting MEC
1. Population
2. Inventions and Innovations
3. Sale prospects
4. Tax policy
5. Other factors

1. Population
• Rapidly growing population extends the
demand for goods and services.
• Increased demand increases both the MEC
and investments.
• A declining population contracts the demand
for goods and services.
• Decreased demand decreases the MEC as well
as investments.

2. Inventions and Innovations
• Inventions and Innovations raise the MEC. If inventions
and new technologies reduce the costs, the MEC will
rise.
• Ultimately the inducement to invest will be affected
favorably.
• Inventions and innovations lead to increased economic
activities by creating dynamic changes in the economy.
• On the other hand absence of inventions and
innovations will lead the economy into static
conditions.
• In a static state MEC is the lowest.
• So the inducement to invest will be totally absent.

3. Sale prospects
• The MEC will be high if the sale prospects of a
new product are high and costs are less.
• This will increase the inducement to invest.
The MEC will be low if the sale prospects of a
new product are low and costs are high.
• This will discourage new investments.

4. Tax policy
• MEC is favorably affected if the government levies less
direct and indirect taxes.
• Decreased direct taxes will increase the inducement to
invest.
• A decrease in the commodity taxes will increase the
demand.
• Both influence the MEC favorably.
• On the other hand a progressive direct tax will curtail the
inducement to invest.
• An increase in the indirect taxes will curtail the
consumption.
• Both affect the MEC unfavorably.

5. Other factors
• Fear of nationalization and protection to
public sector will decrease the private
investments.
• A non interventionist policy provision of the
private credit facilities and improved
infrastructural facilities to private sector will
enhance the MEC.
• These favourable factors increase the private
investments.

Rate of Interest
• Rate of interest in the second determinant of
investment function.
• Keynes treats the rate of interest as the
reward for parting with hard cash or liquidity.
• According to him interest is determined by
demand for and supply of money.

Supply of money
• It is the important determinant to rate to
interest.
• The monetary authority determines the
money supply.
• Supply of money is constant in the short run.
• So it has virtually no role to play in the
determination of rate of interest.

Demand for money
• Demand for money arises due to liquidity preference.
• It refers to the desire of the people to hold cash.
• If the desire to hold cash is intense the liquidity
preference is high.
• If the desire to hold cash becomes weaker the liquidity
preference is less.
• Liquidity preference is interest elastic.
• More is the liquidity preference when the interest is
less.
• Less is the liquidity preference when the interest rate is
high.

• The desire to hold cash arises from three
motives
i. Transaction motive
ii. Precautionary motive
iii. Speculative motive

Transaction motive
• It is the liquidity preferred to carry out daily
transactions.
• The liquidity preference for transaction motive
is determined by the level of national income,
level of employment and general price level.
• An increase in all these three variables
increase the total volume of money needed
for transactions and vice versa.

Precautionary motive
• It is the money required by the people to
meet the unforeseen contingencies of future.
• A person always keeps a portion of their
income against risks and uncertainties like
sickness old age and business losses

Speculative motive
• It is the money demanded by the people to
reap the advantages of uncertainties in the
stock market.
• The psychology of the speculators and their
anticipations are the determinants of
speculative demand for money

• The rate of interest increases with an increase
in the liquidity preference and falls with a
decrease in it.
• Supply being constant, the liquidity preference
deter mines the rate of interest

• In the above figure SS is the supply of money.
• Supply being constant in the short run the
supply curve is a horizontal straight line in
shape.
• LP downward sloping curve represents the
demand for money.
• Rate of interest decreases with a fall in the
demand for money [LP].

• Keynes has not attached much importance to
rate of interest as a determinant of
investment.
• He has focused all attention on MEC as the
true determinant of inducement to invest.

Measures to increase Investments
1. Tax Reductions
2. Interest rate Reductions
3. Pump Priming
4. Price stability
5. Encouraging Competition
6. Promotion of Research

1. Tax Reductions
• A favourable fiscal policy increases the
inducement to invest.
• Tax concessions, tax reduction, tax holidays
etc. will stimulate the private investment

2. Interest rate Reductions
• A reduction in the rate of interest will increase
the inducement to invest in some sectors of
the economy.
• Reduction in the interest rate results in the
availability of cheap credit.
• Some investors may be encouraged to invest
by the reduction in the rate of interest.

3. Pump Priming
• It refers to the government expenditure which
takes the form of socially useful projects such
as the construction of roads railways, bridges,
dams canals, hydro electricity projects etc.,
Pump priming is virtually the autonomous
investment.
• It stimulates the private investment and
creates new employment opportunities.

4. Price stability
• Private investment can be stimulated by maintaining price
stability in the economy.
• The government has to maintain price stability by reducing
the market uncertainties.
• To stabilize the price several measures have to be taken.
• Price support policy is one among them.
• Under this policy the government fixes the minimum price.
• The government may also make bulk purchases and
distribute the products.
• Price stability creates a sense of security among private
investors and encourages private investment.

5. Encouraging Competition
• Conditions of competitions are favourable for
induced investments.
• Prevalence of monopoly practices discourages
the private investment.
• So the government has to create a
competitive atmosphere to enhance the
private investments.

6. Promotion of Research
• Research and development activities create a
dynamic atmosphere conducive for
investment in the economy.
• Scientific and technological advancements will
open up new investment opportunities.

Conclusion
• It is the responsibility of the government to ensure that
the total investment in the economy is adequate.
• Public investment would supplement private
investment in a period when the latter is inadequate.
• The government should reduce public investment in a
period on inflation.
• It should enhance public investment during deflation.
• Timely public investment programmes are required to
get rid to depression quickly.

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