i.e., AD = C + I
5. The consumption demand depends on propensity to consume and income. At a given propensity to consume, as income increases, the consumption demand will also increase.
6. In the above diagram the 45o line represents aggregate supply line and it is also called ‘income line’. This income line shows two things:
(a) Total output or aggregate supply (C + I), and (b) National income.
7. In the above diagram, the curve C rises upward to the right which means that as income increases consumption also increases. The distance between income line and consumption line represents saving. Thus, NI = C + S or Y = C + S.
8. One noteworthy thing about propensity to consume is that it remains stable or constant during the short period. Because the propensity to consume depends on the tastes and needs of the people and these do not change in the short run.
9. Since consumption is more or less stable and cannot be varied, therefore, variation in NI depends on variation in investment.
10. Investment is the second component of AD. Investment depends on two things: (a) Marginal efficiency of capital, and
(b) The rate of interest
11. The rate of interest is more or less stable, hence, change in investment depends on the marginal efficiency of capital (MEC).
12. The MEC means expectations of profit from investment. In other words, the expected rate of profit is called MEC.
13. The MEC depends on two factors:
(a) Replacement cost of capital goods, and (b) Profit expectations of investors.
14. If we join the investment demand with the curve C of propensity to consume, we get AD curve C + I in which C represents consumption and I investment. The distance between propensity to consume curve C and AD curve C + I is equal to investment.
15. The level of NI will be determined at point at which the AD and AS curves intersect each other. At this point AD and AS are in equilibrium.
16. In the above diagram, the equilibrium level of income is OY. At this point the AD curve and AS curve intersect each other.
17. If the income is more than OY, than total output or AS is greater than AD (C + I), and the entire output cannot be sold out.
18. If the income is less than OY, then total output or AS is less than AD (C + I), and the entire output will be sold out. In such a situation there is a shortage of supply, but the output will be increased in order to cover the shortage and the NI will also increase. 19. OY is the equilibrium level of income which is less than full employment level, i.e., OYF.
20. The economy will be in full employment level only when investment demand increases so as to cover this saving. But there is no guarantee that investment demand will exactly be equal to savings.
Equality of Saving and Investment:
1. There is another way of determining the equilibrium level of NI, i.e., through equality of savings and investment.
2. Take the same diagram of AD and AS. At point E, the savings and investment are equal to GE. At above the point the saving is more than investment, and for income less than this point, the investment is more than saving. Saving and investment are only equal at the equilibrium level of income, and when they are not equal, the NI is not in equilibrium. 3. When at a certain level of NI intended investment by the entrepreneurs is more than
intended savings by the people, this would mean that AD is greater than total output or AS, i.e.,
I > S or AD > AS
This would induce the firms to increase production raising the level of income and employment.
4. Hence, when at any level of NI, investment is greater than savings, there will be a tendency for the NI to increase.
5. On contrary, when at any level of NI, the investment demand is less than saving, it means that AD is less than AS. As a result of a decline in national output, the national income will also reduce.
6. Saving is withdrawal of some money from the income stream. On the other hand, investment is the injection of money into the income stream. If the intended investment is more than intended saving, it means that more money has been injected in the economy. This would increase the national income.
7. But when investment is just equal to saving, it would mean that as much money has been put into income stream as has been taken out of it. The result would be that the NI will neither increase nor decrease, i.e., it would be in equilibrium. The determination of NI by investment and saving is illustrated in the following diagram:
8. In the above diagram, the investment line (II curve) has been drawn parallel to the X-axis. This is done on the assumption that in any year, the entrepreneurs intend to invest a certain amount of money. That is, we assume that investment does not change with income.
9. The saving line (SS curve) shows intended saving at different levels of income.
10. The saving line and investment line intersect each other at the equilibrium point E, where the intended saving and the intended investment are equal at OY level of income. Hence OY is the equilibrium level of NI.
11. In the above diagram, there is no tendency for income to increase or decrease.
12. If the income level is greater than OY, the amount of intended investment is less than saving, as a result, the income will finally decrease.
13. If the income level is less than OY, the amount of intended investment is greater than intended saving, as a result, the income will continue to increase to the equilibrium level.
Inflationary Gap:
Inflationary gap arises when consumption and investment spending together are greater than the full employment GNP level. This means that people are demanding more goods and services than can be produced. In other words, the implication of inflationary gap is that national income, output and employment cannot rise further. The only consequence of increased demand is that the price level will increase. Or we may say that there will be an inflationary gap if scheduled investment tends to be greater than full employment saving. In a situation like this, more goods will be demanded than the economic system can produce. The result will be that price will begin to rise and an inflationary situation will emerge. Thus, if full employment saving falls short of scheduled investment at full employment (which means that peoples’ propensity to spend is higher than the propensity to save), there will be an inflationary gap.
In the above diagram, C + I + G (consumption, investment and government spending) line shows the total expenditure on demand in the economy. At this level, Y is the real output, as shown by the intersection, point D, with the 45o line. YF represents a full employment level on real output.
Real income of the economy, obviously cannot reach Y. At YF, total demand (C + I + G) exceeds
total output, leaving a gap AB, which is the inflationary gap in the Keynesian sense.
Deflationary Gap:
The deflationary or recessionary gap is the amount by which the aggregate expenditure falls short of the full employment level of national income. It causes a multiple decline in real NI.
In the above diagram, Y is the total output at full employment level. Let us assume that the total demand is (C + I + G)’ which cuts the 45o line at B, with real output Y’, AB then is the deflationary gap.
Propensity to consume is also called consumption function. In the Keynesian theory, we are concerned not with the consumption of an individual consumer but with the sum total of consumption spending by all the individuals. However, in generalizing the consumption behaviour of the whole economy, we have to draw some useful conclusions from the study of the behaviour of a normal consumer, which may be valid for all consumers’ behaviour of the economy. Aggregate consumption depends on consumption function or propensity to consume. The economic term ‘consumption’ means the amount spent on consumption at a given level of income. ‘Consumption function’ or ‘propensity to consume’ means the whole of the schedule showing consumption expenditure at various levels of income. It tells us how consumption expenditure increases as income increases. The consumption function or propensity to consume, therefore, indicates a functional relationship between the aggregates, viz., total consumption expenditure and the gross national income. It is a schedule that expresses relationship between consumption and disposable income.
According to Keynesian theory, following are the factors that influence consumption: (a) The real income of the individual,
(b) The past savings, and (c) Rate of interest.
Average and Marginal Propensities to Consume:
The average propensity to consume (apc) is a relationship between total consumption and total income in a given period of time. In other words, apc is the ratio of consumption to income. Thus:
apc = C
Y
Where C : Consumption
Y : Income
apc : Average propensity to consume
While, the marginal propensity to consume (mpc) measures the incremental change in consumption as a result of a given increment in income. In other words, mpc is the ratio of change in consumption to the change in income.
mpc = ΔC ΔY
Where ΔC : Incremental change in consumption ΔY : Incremental change in income mpc : Marginal propensity to consume
the normal relationship between income and consumption is that when income increases, consumption also increases, but by less than the increase in income. In other words, in normal circumstances, mpc is less than one. It is drawn as a straight-line with a slope of less than one. This slope indicates the percentage of additional disposable income that will be spent. It is assumed that the whole additional income is not spent, i.e., a certain amount is spent and the remainder is saved. This can be further explained with the help of following table and diagram:
Income Consumption Saving
100 75 25
120 90 30
140 105 35
180 135 45
220 165 55
In the above diagram, OL is the income line and OP is income consumption curve. The income consumption line OP lies below the income line OL. The mpc will be measured by the tangent of the angle that income consumption curve makes with X-axis.
The curve as we have drawn turns out to be straight line rising from the origin, which means that mpc is constant throughout. This, however, need not be so and the curve may well become flatter as income rises, for as more and more consumption needs have been satisfied, a greater share of an increase in income than before may be saved. The dotted curve OM represents such a relationship showing that as income rises, mpc becomes smaller and smaller.
There is a level of disposable income (DI) at which the entire income is spent and nothing is saved. This point is often known as ‘point of zero savings’. Below this level of DI, the consumption expenditure will exceed the DI. There may be cases in which the consumer has no income at all. In such cases, the income consumption curve may not rise from the origin but from farther left showing that when income is zero, consumption is not zero and that the individual is living on his past savings.
In the above diagram, ON represents the saving-income curve. Savings at a given level of income can also be read off from the distance between a point on income-consumption curve and corresponding point on income curve (See the figure of income-consumption relationship). The marginal propensity to save (mps) can be measured by the slope of income-saving curve ON. Marginal propensity to save (mps) is the increment in savings caused by a given increment in income. The mps is always equal to one minus mpc:
Keynes’ Law of Consumption:
Keynes propounded a law based on the analysis of consumption function. This law is known as
‘Fundamental Law of Consumption’ or ‘Psychological Law of Consumption’. It states that
aggregate consumption is a function of aggregate disposable income.
Propositions of the Law:
This law consists of three propositions:
(a) When aggregate income increases, consumption expenditure will also increase but by a somewhat smaller amount.
(b) When income increases, the increment of income will be divided in same proportion between saving and consumption. Consumption and saving go side by side. What is not consumed is saved. Savings is, thus, the complement of consumption.
(c) As income increases, both consumption spending and saving go up. An increment in income is unlikely to lead either to less spending or less savings than before. It will seldom happen that a person may decrease his consumption or his savings when he has got more income.
Assumptions:
(a) Habits of people regarding spending do not change or that the propensity to consume remains the same or stable.
(b) The economic conditions remain normal. There is no hyper-inflation or war or other
abnormal conditions.
(c) The economy is a free-market economy. There is no government intervention.
(d) The important characteristic of the slope of consumption function is that the marginal propensity to consume (mpc) will be less than unity. This results in low-consumption
and high-saving economy.
Implications:
According to Keynesian theory, the mpc is less than unity, which brings out the following implications:
(a) Since consumption largely depends on income and consumption function is more or less stable, it is necessary to increase investment fill the gap of declining consumption
as income increases. If this is not done, the increased output will not be profitable.
(b) When the income increases, and the consumption are not increased, there is a danger of over-production. The government will have to step in to remedy the situation.
Therefore, the policy of laissez-faire will not work here.
(c) If the consumption is not increased, the marginal efficiency of capital (MEC) will diminish. The demand for capital will also diminish, and all the economic progress will
come to a standstill.
(d) Keynes’ Law explains the turning points in the business cycle. When the trade cycle
has reached the highest point of prosperity, income has gone up. But since consumption does not correspondingly go up, the downward cycle starts, for demand has lagged behind. In the same manner, when the business cycle has touched the lowest point, the cycle starts upwards, because consumption cannot be diminished beyond a certain point. This is due to the stability of mpc.
(e) Since the mpc is less than unity, this law explains the over-saving gap. As income
goes on increasing, consumption does not increase as much. Hence saving process proceeds cumulatively and there arises a danger of over-saving.
(f) This law also explains the unique nature of income generation. If money is injected
increase in income. This again is due to the fact that consumption does not increase along with increase in income.
Factors Influencing Consumption Function:
There are certain factors affecting the propensity to consume in the long-run: