SCERT

12TH ECONOMY Learn from the Experienced

CHAPTER-4
Consumption and Investment Functions

Introduction

1. Multiplier refers to the change in national income resulting from change in

investment
2. The value of multiplier itself depends on consumption function for marginal
propensity to consume
3. The unspent portion of money is called saving which becomes investment and
thereby capital
4. The principle of accelerator is the relationship between consumption expenditure
and capital expenditure

Consumption function

1. It is nothing but income and consumption relationship

C=f(y)
C is dependent variable
Y is independent variable
C is determined by Y

2. Propensity- the habit of behaving in a particular way

3. Consumption expenditure increases with increase in income
4. When income is zero people spend out of their past savings on consumption
in order to live
5. The consumption function measures not only the amount spent on
consumption but also the amount saved

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Technical attributes of the consumption function

𝐶
1. The average propensity to consume =
𝑌
Δ𝐶
2. The marginal propensity to consume =
Δ𝑌
𝑆
3. The average propensity to save =
𝑌
Δ𝑠
4. The marginal propensity to save=
Δ𝑦

Keynes's psychological law of consumption

1. He propounded the fundamental psychological law of consumption

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2. Men are disposed as a rule on the average to increase their conception as

their income increases but they are not spending on consumption to the full
increment income

Determinants of consumption function: Subjective-eight factors and nine objective factors

Subjective-eight factors
1. The Motive of precaution
a. Reserve against unforeseen conditions eg: Accidents and thickness
2. The motive of foresight
a. Desire to provide for anticipated future needs eg:old age
3. The motive of calculation
a. The desire to enjoy interest and appreciation
4. The motive of improvement
a. The decide to enjoy for improving standard of living
5. The motive of financial independence
6. The Motive of enterprise
7. The motive of pride
8. The motive of avarice (purely miserly instinct)

Government institutions and business corporations they have their own motives

1. The motive of Enterprises

2. The motive of liquidity
a. To meet emergencies and difficulties
3. The motive of improvement
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a. Security rising income and demonstrate successful management

4. The motive of financial prudence-
a. Ensure adequate financial provisions against depreciation and
obsolescence and to discharge debt

Objective-Nine factors

Objective factors are the external factors which are real and measurable and it
can be changed in the long run
1. Income distribution
a) Large disparity between rich and poor
b) Consumption is low because rich people have low propensity to consume
and high propensity to save
c) When there is more equal distribution there will be high propensity to
consume
d) But this views has been corroborated by V.K.R.V Rao
2. Price level
a) When the price level Falls real income goes up
b) People will consume more and propensity to save in the society
increases
3. Wage level
a) There is a positive relationship between Wage and consumption
b) Consumption expenditure increases with rise in wages
4. Interest rates
a) Higher rate of interest will encourage people to save more money and
reduce consumption
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5. Fiscal policy
a) In government reduces the tax, disposable income rises and the
propensity to consume of the community increases
b) The progressive tax system increases the propensity to consume of the
people by altering the Income distribution in favour of poor
6. Consumer credit
a) Availability of consumer credit card and easy instalment will encourage
household to buy consumer durables this will increase the consumption
7. Demographic factors
a) Larger the size of the family, greater is the consumption
b) Families with children of college education stage spend more than the
children with primary education
c) Urban families spend more than rural families
8. Duesenberry hypothesis
He mentioned two factors which affects the consumption
a) The consumption expenditure not only depends upon his current income
but also from the past income and standard of living ,As the individual
are accustomed to a particular standard of living they continue to live
and spend the same amount even the current income is reduced
b) The consumption standard of low income group are influenced by the
consumption standard of high income group The poor people want to
imitate the consumption pattern of rich this results in spending beyond
their income level
9. Windfall gains or losses

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a) Unexpected changes in the stock market leading to gains or losses

which leads to shift in consumption function upward or downward

Investment function

1. It is a relationship between investment and interest rate

I=f(r)
I= Investment(dependent Variable)
r= Rate of Interest (Independent Variable)
Meaning of investment
1. The term investment means purchase of stocks and shares debentures
Government Bonds and equities
2. According to Keynes investment includes expenditure on capital investment

Types of investment

Autonomous investment and induced investment

a) Autonomous investment
1. Investment which are on the expenditure on capital formation
2. Investment that is not dependent on the national income
3. It is done with the Welfare motive and not for making profits
4. Example construction of roads bridges schools charitable houses
5. It is not affected by rise in Raw materials are wages of workers
6. Essential to development of nation and out of depression
7. Autonomous investment is investment in elastic
8. During the time of economic depression government right to boost the
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economy hence autonomous investment is one of the key concept in welfare

economics

b) Induced investment
1. This investment is expenditure on fixed asset and stocks
2. This investment is done when level of income and demand in an economy
goes up
3. It is profit motivated
4. It is related to changes of national income
5. Decrease in national income decrease in induced income and vice versa
6. It is income elastic

c) Determinants of investment function

Classical economists believed that investment depend upon rate of interest
In reality investment depends upon number of factors they are
1. Rate of interest
2. Level of uncertainty
3. Political environment
4. Rate of growth of population
5. Stock of capital goods
6. Necessity of new products
7. Level of income of investors
8. Inventions and innovations
9. Consumer demand
10. Policy of the state
11. Availability of capital
12. Liquid Assets of the investors
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Relationship between rate of interest and investment

1. Higher interest rate reduced Investments

2. higher interest rates it is more expensive to borrow money from the bank
3. Saving money in a bank gives a higher rate of interest

Marginal efficiency of capital

1. This concept was first introduced by J.M.keynes in 1936
2. An important determinant of autonomous investment
3. Higher rate of return over cost expected from the additional unit of capital
assets
4. Marginal efficiency of capital depends on two factors
a) Prospective yield from capital assets
b) The supply price of a capital assets

5. There are three Factors which affects marginal efficiency of capital

a) Cost of the Capital Asset
b) The expected rate of return from during his lifetime
c) The market rate of interest

6. The marginal efficiency of capital is influenced by short run as well as long

run factors

Short run factors

a) Demand for the product

If the demand for the product is high in the market the rate of return
from investment will be high vice versa
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b) Liquid assets
If an entrepreneur is having large volume of working capital they can take
advantage of the investment opportunities that come in the way

c) Sudden change in income

To the business community gets windfall profit or tax concession the
marginal efficiency capital will be high on other hand if marginal efficiency
capital falls with the decrease in income

d) Current rate of investment

In a particular industry much investment has already taken place but the
rate of investment in that industry is also very large then the marginal
efficiency of capital will be low

e) Waves of optimism and pessimism

If Businessman are optimistic about the future the marginal efficiency of
capital will be likely to be high, if the market is underestimated hence their
marginal efficiency capital also will be low

Long-run factors

a) Rate of growth of population

If population is growing at a rapid speed it is believed that the demand
for various types of goods will increase at the same time the population is
slow down it will discourage investment and reduce the marginal efficiency
of capital

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b) Technological progress
Due to the advancement of technological development the prospects of
increase in the net yield brightens up encourage investment in various
projects and increase marginal efficiency of capital

c) Monetary and physical policies

Cheap money policy and liberal tax policy pave the way for greater profit
margin

d) Political environment
Political stability smooth administration maintenance of law and order helps
to improve marginal efficiency capital

e) Resource availability
Cheap and abundant supply of natural resources, efficient labour and stock
of capital enhance the marginal efficiency capital

Marginal efficiency of investment

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MEI is is defined as expected rate of return on investment as additional units

of investment are made under specified conditions for over a period of time

Multiplier
1. The concept of multiplier was first developed by R.F.Khan in terms of
employment
2. J.M. keynes redefined it as investment multiplier
3. The multiplier is defined as the ratio of the change in national income to
change in investment
4. when investment increases resultant income is also increases

a) Assumption of multiplier
1. Change in autonomous investment
2. No induced investment
3. Marginal propensity to consume is constant
4. Consumption is a function of current income
5. There are no time lacs in the multiplier process
6. Consumer goods are available in response to effective demand for them
7. There is a closed economy and affected by foreign influences
8. There are no changes in prices
9. There is less than full employment level in the economy

b) Classification of multiplier
Static and dynamic multiplier

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Static multiplier

1. It is also called as simultaneous multiplier timeless multiplier and logical

multiplier
2. In static multiplier the change in investment and the resulting change in
Income or simultaneous
3. There is no time lag

Dynamic multiplier

1. It is also known as frequency multiplier

2. In real life income level does not increase instantly with investment
3. There is a time lag between increase in income and consumption expenditure

Leakages of multiplier
The multiplier assumes that people who earn their income and their likely to
spend a portion of the additional income on consumption but in practice people
tend to spend the additional income on some other items that is called
leakages
a) Payment towards past debt
Payment for the old loan
b) Purchasing of existing wealth
Purchase of existing wealth such as land, building and share. money is
circulated among people and never enters into the conception stream
c) Imports of goods and services
Income spent on imports of goods or services out of country and as little
chances to return to Income stream

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d) Non availability of consumer goods

Instantaneous supply of consumer goods follows demand
But sometimes there is lag so called inflation
e) Full employment situation
Under the condition of full employment resources are almost fully employed
additional investment will lead to inflation
Uses of multiplier

1. It highlights the importance of investment in income and Employment theory

2. The process throws light on the different stages of trade cycle
3. It helps in bringing the equality between S and I
4. It helps in formulating government policies
5. It helps to reduce unemployment and achieve full employment

The accelerator principle

1. The origin of oscillator principle can be traced back in the writings of Aftalion
1909, Hawtrey-1913 and Bickerdike 1914
2. But the systematic development of the simple as a little model was made by
J.M. clerk in 1917
3. It was further developed by Hicks,Samuelson and Harrod in relation to the
business cycle

a) Meaning
1. Increase in the demand for consumption goods in the economy leads to an
accelerated demand for machineries
2. It is a relationship between an increase in consumption and the resulting
increase in investment
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Δ𝐼
Accelerator (ß)=
Δ𝐶
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Leverage effect

The combined effect of the multiplier and accelerator is also called as leverage effect

Good luck

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