Aggregate Demand : "The total amount of money or sales proceeds which is actually expected from the sale of output produced at a given level of employment".
Aggregate Supply : "The minimum amount of money or sales proceeds which entrepreneurs must expect to receive from the sale of output at any given level of employment".
9.2 Aggregate Demand
9.3 Aggregate Supply
9.4 Equilibrium of Aggregate Demand and Aggregate Supply
9.5 Keynesian Psychological Law of Consumption
9.6 Propensity to Consume
9.7 Determinants of Consumption Function
9.8 Saving Function
To enable the students to understand the meaning of aggregates, such as aggregate demand, aggregate supply consumption function as well as propensity to consume.
"Ideas shape the course of history." (Lord. J.M. Keynes)
Lord J.M. Keynes, a British economist, in his book, "The General Theory of Employment, Interest and Money", published in 1936, discussed his theory of employment. The theory was published in the post-Great Depression period of 1929-1933. The General Theory is, in fact, an outcome of the depression and was basically a criticism on the classical theory of full employment. According to Keynes, in a capitalist economy, the level of employment depends on effective demand. Keynes has emphasised that, effective demand results in output, output creates income and income provides employment. Thus, employment is a function of income. At equilibrium, effective demand, output, income and employment are equal to each other.
Effective demand in the economy is determined by two factors, Aggregate Demand Function (A.D.F.) and Aggregate Supply Function (ASF).
Keynes concentrates on short-term analysis hence, out of the two forces A.D.F and A.S.F, A.S.F is assumed to be constant, as it is not possible to change the costs in the short period. So Keynes concentrates on ADF.
9.2 Aggregate Demand
Aggregate Demand refers to the amount of sales proceeds which is actually expected from the sale of output produced at a given level of employment during the year. The different types of goods demanded by the people include agricultural goods of the primary sector, industrial goods of the secondary sector and all the services provided by the tertiary sector. 'How much goods and services people demand' is measured in terms of 'how much people spend' on the goods and services. Thus, aggregate demand in an economy, is measured in terms of total expenditure on goods and services. It is the actual amount entrepreneurs expect from the sale in the market.
Determinants of Aggregate Demand
The determinants of aggregate. demand are symbolically expressed as follows:
AD = C + I + G + (X-M)
AD = Aggregate demand
C = Consumption expenditure
I = Investment expenditure
G = Government expenditure
X-M = Net earnings from foreign transactions where X = exports, and M = imports.
1. Consumption Expenditure (C): Consumption expenditure refers to the expenditure increased for those goods and services which satisfy the wants of private individuals and institutions directly. For example, expenditure for food, clothes, houses, motor cars, education, health services, milk, vegetables etc. The consumption expenditure may be partly autonomous and partly induced as shown below.
C = a + b where,
C = Consumption expenditure
a = Autonomous consumption expenditure
b = Induced consumption expenditure
Autonomous consumption expenditure refers to the expenditure, which is independent of income. That is, it is expenditure irrespective of the size of income. It is income inelastic. In order to sustain life, every. individual rich or poor, must have minimum of food, water, clothing and shelter. Without these minimum essential things to sustain life, no individual will be alive. In case of India; there are millions of people who do not have any type of job, and therefore absolutely no source of income.
The above type consumption expenditure is not dependent on those people's income. Such consumption expenditure is, therefore, called 'autonomous' consumption expenditure. It should be noted that even this type of autonomous consumption expenditure does, mean demand for various types of goods and services.
Induced Consumption expenditure, refers to the expenditure directly related to the income. Higher the income, greater is the volume of consumption expenditure and lesser the income smaller is the volume of consumption expenditure.
2. Investment Expenditure (I)
Investment in economics means an addition to the country's physical stock of capital, like new factory buildings, plant and machinery, tools, equipments, raw materials, as well as finished and semi-finished goods. It is also known as capital formation.
Saving is the starting point of capital formation because savings are used for investing into new capital assets.
According to Lord Keynes, the demand or volume of investment undertaken by private entrepreneurs in an economy depends on
1) Marginal Efficiency of Capital (MEC) or Marginal Efficiency of Investment (MEI) - MEC is the expected rate of return from an additional unit of capital good invested.
2) Rate of Interest: It is the cost of borrowing funds for investments. There is an inverse relationship between rate of interest and investment demand. An increase in the rate of interest, reduces the profitability resulting in a fall in investment demand and decrease in rate of interest will increase profitability & investment demand.
Any businessman will put his money in business only if the rate of return on his investment (M.E.C.) is greater than the market rate of interest. In other words a businessman will consider an investment worthwhile if-
MEC or MEI > Market rate of interest. If MEC < Market rate of interest, he will not invest.
Thus, higher the MEC or expected rate of return, higher will be the investment in the private sector economy. This higher investment will result in more employment, more production and more income generation in the economy.
TYPES OF INVESTMENT EXPENDITURE
1. Financial Investment and Real Investment
Financial Investment refers to the investment under taken for the purchase of financial assets,..such as shares, securities, bonds, debentures etc. It does not help in the production of goods and services directly. Real Investment refers to the net addition to the existing stock of capital, such as machines, raw, materials, building etc., which are used to the production of goods and services directly.
2. Gross Investment and Net Investment
Gross Investment refers to the total investment in capital assets, buildings, raw materials, machines, without deducting depreciation or capital consumption allowance. Net Investment = Gross Investment – Depreciation. So it is the amount of investment after allowance has been made for depreciation of existing capital.
3. Autonomous Investment and Induced Investment
Autonomous Investment: This type of investment is made irrespective of income, profit and rate of interest. It is income inelastic that means it is not directly linked with profit. There is generally no profit motive. It is influenced by government's monetary, fiscal policies, change in the level of income, size of population, technological changes etc. Autonomous investment is generally made by the government in the public sector, with a view to provide public utilities and to make maximum social welfare. For example, Investment made by the government in public sector undertakings, such as railways, electricity generation plant, automic energy projects, small, medium. and large scale irrigation projects, construction of roads, express highways etc., is autonomous investment.
Induced Investment : It refers to the investment made by businessmen, industrialists and entrepreneurs in a private sector economy with the motive of profit. It is income elastic. That means such type of investment is directly or positively linked with profit. Changes in price level, interest fate, consumption pattern, changes in the level of income, possibility of high profit margins, savings, supply of money, availability of credit, etc., influence such type of investment, e.g., in India the investments made by the Tatas, Birlas, Kirloskars, Cummins Group, Maruti Udyhog Ltd. and also by many I.T. firms are generally induced investment.
3. Government Expenditure (G) :
In the modern economy, government is an important buyer of goods and services on a large scale. Government purchases of goods and services constitute government demand. Government incurs expenditure is done for the purpose of maximizing welfare and having maximum growth and development. Government's expenditure, is done either-for consumption purposes 6i,, for investment purpose.
Government's consumption expenditure includes expenditure on defence, police, maintenance of law and order, public utilities, such as water, electricity, parks, etc., interest on loans, provision of social security measures and public administration.
Government's investment expenditure includes the expenditure incurred on increasing the stock of capital assets in the economy. It includes expenditure on economic and social overheads, such as transport and communication, banking; finance and insurance, irrigation facilities, education, health, etc., and the expenditure on public sector units - such as automic energy, power, iron and steel, fertilizers, etc.
All these government expenditures add to aggregate demand in the economy.
4. Net Earnings from Foreign Transaction (X-M)
In modern period, due to development in science and technology, means of transport and communication, it is observed that international trade among different countries has increased:
There are two sides of international trade, (1) Import and (2) Export.
1. Import : It refers to purchase of goods and services, capital as well as consumer goods by a country from different countries in the world.
When goods and services are imported from other countries, importing country has to make payment to foreigners in terms of foreign exchange.
2. Export: It refers to selling of capital as well as consumer goods and services by a country to another country/countries. When a country exports goods, it receives income in the form of foreign exchange, which can be utilized by a country, to import required goods and services.
Net Earnings from foreign transactions can be obtained by finding a difference between value of export and import.
It can be calculated as follows:
Net Earnings from foreign transactions = (X-M).
Where X = Exports,
M = Imports.
Net earning from foreign transactions can be positive, negative or even zero.
When a country's export is more than the import, net earning from foreign transactions will be positive; when import is more than export, net earning from foreign trade will be negative; arid when the export is exactly equal to import, earning from foreign trade will be zero.
When net earning from foreign trade is positive, it is to be added to national income, when it is negative, it is to be, deducted and when it is zero, it does not affect national income.
9.3 Aggregate Supply
Meaning: "Aggregate supply refers to the minimum amount of sales proceeds which entrepreneurs expect to receive from the sale of output at any given level of employment". It essentially refers to the total national product or national income.
The determinants of Aggregate Supply can be shown in the following formula:
O = f (N.L.K.T.), where
O = Aggregate Supply or Output.
f = function of
N = Natural resources like land, water, minerals, seacoast, climate, nature or annual rainfall, and so on. It is the minimum expectations of entrepreneurs from the market to cover their cost of production.
L = Labour force or human resource, which is an active factor of production working on natural resources.
K = Stock of Capital, and T = State of technology
Wherever we use the bar (-) it indicates that the factor supply is held constant, during the short run. Now let us consider these factors in details and understand their effect on aggregate supply.
(1) Natural Resources (N) : Natural resources include all those natural gifts, which are on the surface, below the surface and above the surface of the earth. These are called `land' in economics. If a country has plentiful supply of natural resources like fertile soil, temperate and moderate climate, perennial rivers and regular and satisfactory rainy season, availability of essential minerals and such other essential industrial raw materials, it follows that aggregate supply in such a country (as for example :in the case of the United States), is likely to be higher than in a country where natural resources are relatively scarce. One reason, why the United States annually produces nearly one fourth of the total output of the world, as a whole is the abundant availability of natural resources in the United States.
(2) Human Resources (L): Aggregate supply is also greatly influenced by the amount of available labour force in the country. Thus, if the labour force in a country is abundant, highly skilled, industrious and highly motivated, devoted, dedicated to work hard and to produce all types of goods and services, with a view to earn rising income that would enable it, to enjoy rising standard of living, such as labour force will have great influence on aggregate supply of output of goods arid services. Japan, China and Korea are the best examples of the countries having great influence of labour force on aggregate supply.
(3) Stock of Capital (K) : Capital is a man-made factor of production. Aggregate supply depends upon the stock of capital. The use of capital helps to increase the productivity and efficiency of other factors of production. Capital formation and accumulation of capital depends upon the savings made by the people in the country. Saving depends upon the level of income. Savings are converted into investment of capital goods. Greater the investment, greater is the accumulation of capital thus greater the availability of capital for production. The aggregate supply and employment in the economy depends upon the stock of capital, its quality and use. Raw materials, machinery tools, electricity generation plants, roads, dams, factory buildings, plants, etc., are the examples of capital. During the short run, it is not possible to produce and supply these things, and therefore during the short run the supply of capital is fixed.
(4) State of Technical Knowledge (T): Aggregate supply is also greatly influenced by the state of technical knowledge, at any particular moment of time. The use of new technology means using scientific knowledge acquired through research in the production process. With the use of modern technology, it is possible to explore new resources and the new use of available resources. For example, exploration of new sources of oil wells in the ocean is possible, because of the adoption of modern technology.
The productive capacity of the economy increases due to the adoption of modern technology. Improvement in the quality of production is also possible. Large-scale production with minimum cost is also possible because of the use of new technology. For example, use of computer and internet in business and industries has facilitated expansion of business transactions.
The productive efficiency of capital and labour increases with the use of modern technology.
Thus, Aggregate Supply (O) of any country is determined by the four factors N, L, K and T.
9.4 Equilbrium between Aggregate Demand And Aggregate Demand And Aggregate Supply
According to Lord Keynes, the equilibrium level of employment, output and income, at any time, depends on effective demand in an economy. The higher the effective demand, higher is the level and volume of employment and lower the effective demand lower will be the volume and level of employment. Deficiency in effective demand will result in unemployment. Effective demand is the actual expenditure incurred by all the people, on all types of consumer goods and capital goods in the economy during a given period of time. The flow of expenditure, in turn, determines the flow of income. Hence, in the economy -
Effective Demand = Total Expenditure = Total Income = Total Output. According to Keynes the level of effective demand is determined by the intersection of Aggregate Demand Function (A.D.F ) and Aggregate Supply Function (A.S.F ).
In this context, let us study Aggregate Demand Function first, then Aggregate Supply Function and then the actual equilibrium of AD and AS, which is given in Keynesian theory.
Aggregate Demand Function (A.D.F.)
Aggregate Demand Function or Aggregate Demand is measured with the help of aggregate demand price. Here, price means expected maximum sales proceeds. Thus, aggregate demand price refers to what the households and firms are expected to spend on the purchase of different goods and services in the economy. It is this expenditure which becomes the actual sales proceeds or the revenue which producers expect to earn at a given level of employment from the sale of output.
With the increase in the level of employment, aggregate demand price also increases and there is a positive relationship between the level of employment and aggregate demand price. (i.e. expected sales proceeds)
The Aggregate Demand curve or the Aggregate Demand Function (A.D.F.) as given in the following figure No. 9.1 shows various maximum amounts of sales proceeds, which all the entrepreneurs taken together expect to receive, from the sale of the output produced at different alternative levels of employment, in the economy as a whole.
ADF = f (N). Here ADF = Maximum expected sale proceeds
N = employment and output f = function of.
The ADF is a positive function of the level of employment and output.
In the figure 9.1, Y axis shows the aggregate demand price or the maximum expected sales proceeds. The X axis shows the volume or levels of output and employment. The ADF Curve slopes upwards from left to right because, as the level of output and employment increases, income and expenditure of workers also increases. This, in turn increases the aggregate expected sale proceeds. The ADF curve begins from above the origin on vertical axis (Y) at point `a' indicating that, even at zero level of income (Output and employment), there is some positive consumption, (i.e., to meet the basic minimum needs), for which Keynes uses the word "autonomous consumption expenditure."
AGGREGATE SUPPLY FUNCTION (A.S.F)
Aggregate Supply Function or Aggregate Supply, is measured with the help of aggregate supply price. Here price implies minimum sales proceeds. In order to produce goods and services, the producers employ different factors of production and pay them in the form of wages, rent, interest, etc. This cost of production including the normal profits must be recovered through sale proceeds.
Aggregate supply price is the minimum amount of money (sales proceeds), which all the entrepreneurs in the economy must receive from the sale of output produced by them, at any given level of employment. If they do not receive this minimum amount, they will reduce output and employment. According to Keynes, aggregate supply price is the minimum sales proceeds which the producers must get to continue production at any given level of employment.
Aggregate Supply Curve or the Aggregate Supply Function (A.S.F.), as shown in the figure 9.2, indicates various minimum amounts of sales proceeds, which must be received by all entrepreneurs, by selling different quantities of output, at various levels of output and employment, in the economy as a whole.
In the figure 9.2, ASF curve starts from the origin, showing that the cost of production is zero when there is no employment. The curve slopes upwards to the right as employment increases. In the beginning, it rises slowly and then rapidly. This is because cost of production increases as more and more people are employed. Hence, the minimum sales proceeds required also rise. Once all the persons willing to work get employed, then we have full employment (point F on X axis). The ASF Curve becomes a vertical line, parallel to Y axis (that is, perfectly inelastic), after the full employment level (F), has been achieved in the economy. This indicates that even if aggregate supply price increases, employment cannot increase. Above point Q in the figure,. the Aggregate Supply Function (A.S.F.) or curve becomes vertical.
Effective Demand is also called macroeconomic equilibrium.
According to Keynes effective demand is determined with the intersection of aggregate demand and aggregate supply in the economy.
The aggregate demand consists of consumption demand, investment demand, government demand, and foreign demand. Similarly aggregate supply depends on natural resources, labour, capital and technology.
The equilibrium point of effective demand is that point, where aggregate demand function equals to aggregate supply function.
Effective Demand can be shown in the following diagram.
The diagram indicates.
ASF = Aggregate Supply Function Curve
ADF = Aggregate Demand Function Curve
e = Point of effective demand (Equilibrium point) is a point at which total expenditure is equal to total income i.e. ADF intersect ASF at this point.
9.5 Keynesian Psychological Law of Consumption
Lord J.M: Keynes explains the relationship between consumption (C) and income (Y), in terms of his psychological law of consumption. According to this law, as aggregate income increases, the total consumption expenditure in the economy also increases, but in a lesser proportion than the increase in income. In other words the proportion of income spent on consumption goes on falling as income increases.
This is because as income increases, the individual wants are satisfied to a larger and larger extent. So when income increases further, people do not consume the entire income. They save a part of it. Hence, there is bound to be a gap between income and consumption. According to Keynes, with the increase in income, both consumption and savings increase; but (a) consumption increases at a diminishing rate, and (b) saving increases at an increasing rate. It is common observation that as the income of an individual rises, his consumption expenditure also rises, but not to the full extent of rise in income of the individual. Broadly, it may be sold that this rule of consumption is true of the community as a whole, as the community is composed of individuals.
The following table indicates how consumption expenditure (C) rises with rise in income (Y).
Table No. 9.1
Consumption and Saving Function
Aggregate Consumption Expenditure
(` in Crores)
(` in Crores)
(` in Crores)
S = Y-C
The table related to Aggregate Income and Aggregate Consumption Expenditure indicates that initially the people have to manage their minimum consumption expenditure, even if there is no income. This is autonomous consumption expenditure. Although income is zero, some people have to spend, some amount on consumption in order to keep their body and soul together. If income is zero, some people may be required to borrow or beg or resort to dissaving (i.e., drawing down past savings for meeting current consumption expenditure) or live on charity. Thus, one part of expenditure on consumption is independent of income and is constant or autonomous.
Thus, from the table, it will be observed that at lower levels of aggregate income, say zero and ` 1000 crores, consumption expenditure is more, e.g., ` 500 crores and ` 1,200 crores, respectively, and saving is negative (i.e., dissaving of ` 500 crores and ` 200 crores, respectively). When aggregate income is T 2000 crores, consumption expenditure is ` 2000 crores. At this level, income (Y) is equal to consumption expenditure (C) hence, saving (S) is zero. When aggregate income further increases to T 3000 crores, consumption expenditure is ` 2600/- crores and saving is ` 400 crores. When aggregate income increases to ` 4000 crores and ` 5000 crores, consumption expenditure is ` 3300 crores and ` 4000/- crores, respectively. The level of saving is ` 700 crores and ` 1000 crores, respectively. Thus, with increase in the level of income, consumption expenditure does not increase at the same rate. There is a gap between aggregate income and consumption expenditure.
Thus, J.M. Keynes' psychological law of consumption states that "as income goes on increasing, the consumption also increases but at a rate less than increase in income."
Following is the diagrammatic representation of the behaviour of consumption function as given in the psychological law of consumption.
In figure 9.4, horizontal axis represents aggregate income (Y) and vertical axis represents consumption expenditure (C). The 45° line indicates that Y=C (Aggregate income = Aggregate consumption) which is a base line. But this 45° line does not represent the actual relationship between consumption and income. The line ABC = a + bY represents actual consumption or propensity to consume as given in the Keynesian Psychological Law of Consumption.
OA on the vertical axis shows autonomous consumption at zero level of income. Thus, consumption curve starts at A and moves to B and then further to C = a + bY Point B denotes the breakeven point. At this point consumption is equal to income. The vertical distance between line C = a + bY and C = Y upto point B is dissaving, which is shown by the triangle OAB. After point B, line C=Y is vertically above the line. C = a + bY. which shows that offer point (B) the savings (S) are positive and saving increases with the increase in the level of aggregate income (Y).
9.6 Propensity to Consume (Consumption Function)
The Propensity to Consume, which is also called consumption function, is an expression of an empirical income consumption relationship. J.M. Keynes states that other things being equal consumption is a function of income.
Algebraically, the relationship between consumption, as a dependent variable, and aggregate income, as the independent variable, is expressed as:
C = f (Y)
where C = Aggregate Consumption Expenditure
Y = Aggregate income
f = functional relationship
The Propensity to Consume or the consumption function shows the relationship between aggregate consumption expenditure (C) and aggregate income (Y).
The Propensity to Consume does not mean a mere desire to consume, but the actual amount of real consumption, that takes place or that is expected to take place at various income levels.
We can construct a schedule of propensity to consume, by using the same data, which is used in understanding the Keynesian Psychological Law of Consumption.
Table No. 9.2
Schedule of Propensity to Consume
Aggregate Income (in crore)
Aggregate Consumption (in crore)
A.P.C. Average Propensity to Consume
M.P.C. Marginal Propensity to Consume
A schedule of the -propensity to consume is a statement showing the functional relationship between the level of aggregate consumption and aggregate income at each level of income.
Two aspects of Propensity to Consume, viz., Average Propensity to Consume (A.P C:) and Marginal Propensity to Consume (M.P C.)
In dealing with the Propensity to Consume or consumption function, Lord J.M. Keynes considered its two technical attributes: (1) The A.P C. and (2) the M.P C.
The Average Propensity to Consume (A.P.C.)
The Average Propensity to Consume (APC) is defined as the ratio of aggregate consumption to aggregate income in a given period of time. The value of average propensity to consume, for any income level, may be calculated by dividing consumption by income. Symbolically,
A.P.C. = C/Y
Where, C = Aggregate Consumption Expenditure and
Y = Aggregate Income (National Income)
In the schedule of Propensity to Consume (Table 9.3) the A.P C. is calculated at various income levels. It is obvious that the proportion of income spent on consumption decreases as income increases. The A.P.C. is 1.2, 1.0, 0.86, 0.82 and 0.80, respectively, as given in the schedule. It follows that A.P.C. decreases as income increases.
Given the Consumption Function C = f (Y)
APC = C/Y
If Y = 3000 and C = 2600
Then C/Y = 2600 / 3000 CIY = 0.86
APC = 0.86
Marginal Propensity to Consume (M.P.C.)
The Marginal Propensity to Consume (MPC) is defined as the ratio of the change in the level of aggregate consumption to a change in the level of aggregate income. M.P C. can be calculated by dividing a change (increase or decrease) in consumption by a change (increase or decrease) in income.
MPC = DAC/DAY
where, DAC indicates change in consumption and AY indicates change in income. 0 (called delta) indicates small change.
Given the consumption Function, C = f (Y)
The MPC is the ratio of small change in consumption (DC) to small change in Income (AY). Thus,
MPC = DC/DY
As per Table No. 9.2
When Aggregate Income is T zero, Aggregate consumption is ` 500 & when Aggregate Income will increase to T 1000, Aggregate consumption will increase to ` 1200.
If DC is ` 700 and DY is ` 1000
DC/DY= 700 = 0.7
Thus, MPC = 0.7
9.7 Determinants of Consumption Function :
The consumption function depends upon the income level. According to Keynes, consumption function is affected by certain subjective (psychological) factors and objective (institutional) factors. These factors can be briefly described as follows:
A) Subjective or Psychological factors
These factors are internal factors. They are dependent on the psychological characteristics of human nature, institutional pattern and social practices. Basically, they are human behavioural factors, which have an influence on individual's consumption decisions and are fairly stable during the short period.
According to Keynes, individual's nature compels them not to spend their entire income. Hence, they save part of their income. Following are the motives which induce people to save and hence influence consumption levels.
1) Motive of Precaution: Generally, people save a large part of their income as a precaution against future unforeseen contingencies and thus, to that extent, the current consumption is reduced.
2) Motive of Foresight: Individual has to provide for the future needs like higher education of children, maintenance of dependants, maintenance during old age etc. Hence, individual is likely to reduce his or her present consumption in order to save more.
3) Motive of Calculation: In order to earn income, people invest in shares, debentures or other income earning assets. This is likely to reduce their present consumption. Investment decisions depend on future expected trends in the prices of income earning assets.
4) Motive of Improvement: Generally, people have the desire to enjoy improved standard of living and also higher status in the future. Such a motive for improvement reduces current consumption.
5) Motive of Independence: In order to attain some measure of independence and power in man's life, man intends to save more. This motive is likely to dampen present consumption.
6) Motive of Enterprise: Undertaking business in future, providing for capital investment in future, which can be achieved through current savings i.e. to start a business and earn.
7) Motive of Pride: Individual takes pride in leaving substantial wealth to his or her children. Also, a person may like to give donations: Such a motive of pride may dampen present consumption.
8) Motive of Avarice: The desire to satisfy pure miserliness i.e. unreasonable but insistant abstinance from expenditure.
(B) Objective or Institutional Factors :
These factors are called exogenous or, external factors as they , are external to the individual's behaviour, which,, in turn, has a strong bearing on their consumption expenditures.
(1) Changes in Wage Rate: If income in terms of wage rate increases, consumption expenditure increases. A change in income distribution will cause change in expenditure on consumption.
(2) Change in Disposable Income: Consumption expenditure depends upon disposable income. If there is a change in disposable income there will be a change in expenditure, on consumption.
(3) Change in the Rate of Interest: Change in the rate of interest is likely to affect consumption function. An increase in the rate of interest may have a dampening impact on consumption. .On the other hand, a fall in the rate of interest may encourage people to consume more.
(4) Change in Capital Value (Windfall Gains or Unexpected Gains): Capital gains are due to sudden change in money value of wealth. The consumption expenditure of wealthy classes is likely to be extremely susceptible to unforeseen change in the value of their wealth. During the period of prosperity, huge unexpected gains or windfall gains may accure to the capitalist class, and as a result their consumption may increase. Some examples of windfall' gains are unexpected rise in profits caused due to unexpected upswing in business. Unexpected rise in the rate of return on investment in some company's shares or debentures is also an example of windfall gain. All these windfall gains may cause increase in consumption.
(5) Fiscal Policy: Changes in fiscal policy of the government affected consumption. Certain type of changes in fiscal policy adversely affect consumption. For example, increase in income tax, capital gains tax, estate duty etc. On the other hand, increase in government spending in various ways (including deficit financing) would increase propensity to consume.
(6) Expectations about the Future Income: If future income is expected to increase people are likely to save less and,. consume more. On the contrary, if future income ,is expected to fall, people may save more for the future and spend less on present consumption.
(7) Changes in Depreciation Allowances: Increase in depreciation allowance would reduce income of shareholders and consequently, their consumption may decrease.
(8) Demographic Factor: Size of population, family size would affect consumption.
Keynes, who was concerned with the problem of unemployment, was of the opinion that the above subjective and objective factors will not have very great influence on saving function in the short period. Keynes, therefore, believed that in the short period of time, consumption function and the saving function would be fairly stable.
9.8 Saving Function (Propensity to Save) (S = Y – C)
The Saving Function is also called as Propensity to Save. The Saving Function is the counter part of the consumption function. The amount of saving at any level of income, is equal to the difference between the income and consumption expenditure. It can be expressed as follows:
In the figure 9.5, SS is the saving curve. CC is the consumption curve. At Ob level of income, consumption equals income at point B and saving is zero. When income is less than Ob, consumption is more than income and therefore there is dissavings. When income is more than Ob, consumption expenditure is less than income, this results in savings. Thus the savings curves SS is above the OX axis. This gap after B goes on widening with rising income. It suggests that saving rises with increase in income SS curve representing the saving function.
Propensity to save
The propensity to save depends upon the level of income. Saving is the function of income. It can be expressed as follows.
s= f (y)
It has two types that is (a) Average and (b) Marginal Propensity to save.
Average propensing to save (APS)
It is the ratio of saving to income. It can be expressed as follows.
Marginal Propensing to save (MPs)
It is the ratio of change - in saving to corresponding - change in Income it can be - expressed as follows-
The sum of MPc and MPs is equal to one
MPc + MPs = 1
MPS = 1 - MPC
APs and MPs can be explained with the help of the following schedule.
Table No. 9.3
Saving Schedule (` crore)
Aggregate Income in Rs. in cr. (y)
Aggregate Consumption Rs. in cr. (c)
Saving S=Y-C (s)
APS = S/Y
Q.1.A) Fill in the blanks with appropriate alternatives given in the brackets.
1) The General Theory of Employment, Interest and Money was written by ..................
(David Ricardo/Adam Smith/J.M. Keynes/Alfred Marshal)
2) That part of income, which is not spent on consumption, is called .................. (expenditure/saving/investment/public debt)
3) Intersection between aggregate demand and aggregate supply curves determines the point of ............ demand.
4) ............... consumption cannot be zero.
5) Investment made by the government is ................... investment.
B) Match the following Group:
'A' Group 'B' Group
1) Aggregate Supply a) Expected receipts
2) Autonomous b) Lord J.M. Investment Keynes
3) Consumption c) Government Investment
4) A.P.C. d) AC/AY
5) Investment e) C/Y
f) Addition to stock of capital
g) Destruction of utility
C) State whether the following statements are true or false.
1) Consumption expenditure is the only component of aggregate demand.
2) The difference between a country's exports and imports is termed as net earnings from foreign transactions.
3) Autonomous consumption is income elastic.
4) The equality between aggregate demand and aggregate supply determines the equilibrium level of employment.
5) At breakeven point, consumption (C) is equal to income (Y).
Q.2. A) Define or Explain the following concept.
1) Autonomous Consumption
2) Aggregate Demand
3) Aggregate Supply
4) Effective Demand
B) Give reasons or explain.
1) Investment demand is not the sole determinant of aggregate demand.
2) Saving may be used in future for unforeseen contingencies.
3) There are many subjective factors determining consumption function.
4) Aggregate demand is a positive function of the level of employment and output.
5) The Propensity to Consume means consumption function.
Q.3.A) Distinguish between.
1) Aggregate Demand and Aggregate Supply.
2) Autonomous Investment and Induced Investment.
3) Exports and Imports.
4) Consumption and Saving.
5) Consumption Function and Saving Function.
B) Write Short notes on:
1) Effective Demand
2) Saving Function
3) Breakeven Point
4) Average Propensity to Consume
5) Marginal Propensity to Consume
Q.4) Answer the following questions:
1) What are the determinants of Aggregate Demand (AD)?
2) What are the determinants of Aggregate Supply (AS)?
3) State J.M. Keynes' Psychological Law of Consumption.
4) What is autonomous consumption?
5) State the subjective factors determining consumption function?
Q.5) State with reasons whether you agree or disagree with the following statements.
1) Aggregate demand depends only on the consumption expenditure.
2) Aggregate supply is influenced by the state of technology only.
3) Positive net earnings from foreign transactions add to aggregate demand.
4) At breakeven point consumption (C) is equal to income (Y).
5) Savings are negative before breakeven point.
Q.6) Answer in detail.
1) Explain the determinants of aggregate demand.
2) What is Aggregate Supply? Explain the determinants of Aggregate Supply.
3) Explain the equilibrium between Aggregate Demand and Aggregate Supply.
4) What are the objective factors influencing consumption function?
5) Give an idea about the subjective factors determining consumption function.
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