UNIT II

CLASSICAL AND KEYNESIAN ECONOMICS

Syllabus:
 Classical theory of income, output and employment- Say’s Law of Markets - Wage –
price flexibility, Critical Evaluation
 Keynesian theory of income, output and employment- Effective demand and supply
 Consumption function: APC, MPC, Factors affecting consumption function
 Investment function – MEC
 Multiplier, Accelerator
 Comparison between Classical and Keynesian theories

Say’s Law of Markets

Say’s law of markets is the core of the classical theory of employment. An early 19 th century
economist, J.B. Say enunciated the proposition that “supply creates its own demand”. Therefore
there cannot be general overproduction and the problem of unemployment in the economy. Even
if there is over production in the economy, it is only a temporary phenomenon and it will correct
itself in the long run. In the long run, the economy will automatically tend towards full
employment.
Propositions of Say’s Law of markets
Say’s propositions will present the true picture of the law of markets. They are as given below:
1. Full employment in the economy. The law is based on the proposition that there is full
employment in the economy. Production continues to increase until the level of full
employment is reached. Under such a situation the level of production will be the
maximum.
2. Proper Utilisation of Resources. If there is full employment in the economy, idle
resources will be properly utilized which will further help to produce more.
3. Perfect competition. There is perfect competition in labour and product markets. Other
conditions of perfect competition are:
a. Size of the market: the size of the market will be large enough to create demand for
goods.
b. Automatic Adjustment Mechanism: the law is based on the proposition that there is
automatic and self-adjusting mechanism in different markets. Disequilibrium in any
markets is a temporary phenomenon.
c. Role of money is neutral: the law is based on the proposition of a barter system
where goods are exchanged for goods. But it is also assumed that the role of money is
neutral.
4. Laissez-faire policy: the law assumes a closed capitalist economy which follows the
policy of laissez-faire.
5. Saving is a social virtue. Whatever is saved is automatically invested for further
production. In other words, saving is a social virtue.
Important facts about the Law
In Say’s words, “it is production which creates markets for goods. A product is no sooner
created than it, from that instant, affords a market for other products to the full extent of its
own value.” The following important facts can be explained from this definition.
1. Production Creates Demand for goods. When producers obtain various inputs to
produce a commodity, they start production process and they generate income. For
example, labourers get their wages and they go to the market and buy the goods that they
need for their own use. This in turn creates demand for goods. Thus, supply creates its
own demand.
2. Barter system as its basis. In its original form, the law is applicable to a barter economy
where goods are ultimately sold for goods. Therefore, whatever is produced is ultimately
consumed in the economy.
3. General over-production is impossible. If the production process is continued under
normal conditions, then there will be no difficulty for the producers to sell their products
in the market. According to Say, work being unpleasant, no person will produce a good
unless he wants to exchange it for another good that he desires. Thus, the very act of
supplying goods implies a demand for them and hence there will be no general
overproduction as a whole and if there is any, that will be only a temporary phenomenon.
4. Saving – Investment Equality. Income accruing to the factors of production as wages,
rent, profits etc. is partly used for consumption and the rest is saved. Whatever is saved is
automatically invested for further production. Thus, savings always equals investment in
the economy.
5. Rate of interest as a determinant factor. Say’s law of markets regards the rate of
interest as the determinant factor in maintaining the equality between saving and
investment. If there is any divergence between the two, the equality is maintained
through the mechanism of rate of interest. Savings are considered to be directly related to
rate of interest and investment is inversely related to rate of interest. So if at any point of
time, investment is more than savings, the rate of interest becomes high and as a result
investment falls and savings increases.
6. Labour market. According to Say’s Law, there will be full employment in the economy
under normal conditions. There will be unemployment only when there are interventions
in the labour markets like from the side of trade unions.

Criticisms against the law

J.M. Keynes made a frontal attack on the classical theory and Say’s law of markets. He criticised
the Say’s law of markets on the following grounds:
1. Supply does not create its own demand. In the modern economies, demand does not
increase as much as the production increases.
2. Money is not neutral. Keynes has given due importance to money unlike Say. He regards
money as a medium of exchange. Money is held for income and business motives.
3. Over production is possible. According to Keynes, all of the income which is saved is not
automatically invested by the people. Therefore saving and investment is not always equal and it
becomes the problem of overproduction and unemployment.
4. Underemployment situation. Keynes regards full employment as a special case because there
is underemployment in capitalistic economies. This is because the capitalistic economies do not
function according to Say’s law and supply always exceeds its demand.
5. State intervention. Say’s law is based on the existence of laissez-faire policy. But Keynes
highlighted the need for state intervention in the case of general overproduction and mass
unemployment.
These are some of the criticisms which were levelled against Say’s law of markets by Keynes.

Wage – Price Flexibility

The fundamental principle of the classical theory is that the economy is self‐regulating.
Classical economists maintain that the economy is always capable of achieving the natural level
of real GDP or output, which is the level of real GDP that is obtained when the economy's
resources are fully employed. While circumstances arise from time to time that cause the
economy to fall below or to exceed the natural level of real GDP, self‐adjustment
mechanisms exist within the market system that work to bring the economy back to the natural
level of real GDP. The classical doctrine—that the economy is always at or near the natural level
of real GDP—is based on two firmly held beliefs: Say's Law and the belief that prices, wages,
and interest rates are flexible.
Say's Law. According to Say's Law, when an economy produces a certain level of real GDP, it
also generates the income needed to purchase that level of real GDP. In other words, the
economy is always capable of demanding all of the output that its workers and firms choose to
produce. Hence, the economy is always capable of achieving the natural level of real GDP.
The achievement of the natural level of real GDP is not as simple as Say's Law would seem to
suggest. While it is true that the income obtained from producing a certain level of real GDP
must be sufficient to purchase that level of real GDP, there is no guarantee that all of this income
will be spent. Some of this income will be saved.Income that is saved is not used to purchase
consumption goods and services, implying that the demand for these goods and services will
be less than the supply. If aggregate demand falls below aggregate supply due to aggregate
saving, suppliers will cut back on their production and reduce the number of resources that they
employ. When employment of the economy's resources falls below the full employment level,
the equilibrium level of real GDP also falls below its natural level. Consequently, the economy
may not achieve the natural level of real GDP if there is aggregate saving. The classical theorists'
response is that the funds from aggregate saving are eventually borrowed and turned into
investment expenditures, which are a component of real GDP. Hence, aggregate saving need not
lead to a reduction in real GDP.
Consider, however, what happens when the funds from aggregate saving exceed the needs of all
borrowers in the economy. In this situation, real GDP will fall below its natural level because
investment expenditures will be less than the level of aggregate saving. This situation is
illustrated in Figure .

Aggregate saving, represented by the curve S, is an upward‐sloping function of the interest rate;
as the interest rate rises, the economy tends to save more. Aggregate investment, represented by
the curve I, is a downward‐sloping function of the interest rate; as the interest rate rises, the cost
of borrowing increases and investment expenditures decline. Initially, aggregate saving and
investment are equivalent at the interest rate, i. If aggregate saving were to increase, causing
the S curve to shift to the right to S′, then at the same interest rate i, a gap emerges between
investment and savings. Aggregate investment will be lower than aggregate saving, implying that
equilibrium real GDP will be below its natural level.
Flexible interest rates, wages, and prices. Classical economists believe that under these
circumstances, the interest rate will fall, causing investors to demand more of the available
savings. In fact, the interest rate will fall far enough—from i to i′ in Figure —to make the supply
of funds from aggregate saving equal to the demand for funds by all investors. Hence, an
increase in savings will lead to an increase in investment expenditures through a reduction of the
interest rate, and the economy will always return to the natural level of real GDP. The flexibility
of the interest rate as well as other prices is the self ‐adjusting mechanism of the classical theory
that ensures that real GDP is always at its natural level. The flexibility of the interest rate keeps
the money market, or the market for loanable funds, in equilibrium all the time and thus
prevents real GDP from falling below its natural level.
Similarly, flexibility of the wage rate keeps the labor market, or the market for workers, in
equilibrium all the time. If the supply of workers exceeds firms' demand for workers, then wages
paid to workers will fall so as to ensure that the work force is fully employed. Classical
economists believe that any unemployment that occurs in the labor market or in other resource
markets should be considered voluntary unemployment. Voluntarily unemployed workers are
unemployed because they refuse to accept lower wages. If they would only accept lower wages,
firms would be eager to employ them.
Graphical illustration of the classical theory as it relates to a decrease in aggregate
demand. Figure considers a decrease in aggregate demand from AD 1 to AD 2.

The immediate, short‐run effect is that the economy moves down along the SAS curve
labeled SAS 1, causing the equilibrium price level to fall from P 1 to P 2, and equilibrium real
GDP to fall below its natural level of Y 1 to Y 2. If real GDP falls below its natural level, the
economy's workers and resources are not being fully employed. When there are unemployed
resources, the classical theory predicts that the wages paid to these resources will fall. With the
fall in wages, suppliers will be able to supply more goods at lower cost, causing the SAS curve to
shift to the right from SAS 1 to SAS 2. The end result is that the equilibrium price level falls to P 3,
but the economy returns to the natural level of real GDP.

Keynesian Theory of Employment

Introduction
John Maynard Keynes was the main critic of the classical macroeconomics. He in his book
‘General Theory of Employment, Interest and Money’ out-rightly rejected the Says Law of
Market that supply creates its own demand. He severely criticized A. C. Pigou’s version that cuts
in real wages help in promoting employment in the economy He also opposed the idea that
saving and investment can be brought about through changes in the rate of interest. In addition to
this, the assumption of full employment in the economy is not realistic. The Great Depression of
1930′s created problems of increasing unemployment, reducing national income, declining prices
and failing firms increased in intensity. The classical model miserably failed to explain and
provide a workable solution for how to escape the depression.

It was at that time when J. M. Keynes wrote his famous book ‘General Theory’. In it he
presented an explanation of the Great Depression of 1930′s and suggested measures for the
solution. He also presented his own theory of income and employment.

Assumptions
1. It is a three-sector closed economy with no foreign trade.
2. The economy is at less than full employment level.
3. The price levels remains constant up to the full employment level.
4. The analysis relates to short-run period.

Determinants of Income

The determinants of effective demand and so of equilibrium level of national income and
employment is the aggregate demand and aggregate supply.

(1) Aggregate demand,

Aggregate demand refers to the sum of three components: Consumption expenditure (C) which
is a stable function of income, Business investment expenditure (I) depends on business
expectations and rate of interest to it is inversely related and Government spending (G). I and G
do not depend directly on income and hence are called autonomous components.
The aggregate demand curve AD, (C+I+G) would be positively sloping signifying that as the
level of employment increases, the level of output also increases, thereby increasing
of aggregate demand (C+I+G) for goods.

(2) Aggregate Supply

The aggregate supply refers to the flow of output produced by the employment of workers in an
economy during a short period. The aggregate supply is denoted by (C+S+T) because a part of
this is consumed (C), a part is saved (S) in the form of inventories of unsold output and a part is
paid out as taxes to the government. The aggregate supply curve AS, (C+S+T) is positively
sloped indicating that as the level of employment increases, the level of output also increases,
thereby, increasing the aggregate supply.

Determination of level of employment and income

According to Keynes, the equilibrium levels of national income and employment are determined
by the interaction of aggregate demand curve (AD) and aggregate supply curve (AS). In our
model, condition for equilibrium can be given as,

Y=E ……………………………..... (1)

Where, Y is the national output or aggregate supply and
E is the aggregate demand.
E = C+I+G
Thus in equilibrium, Y = E = C+I+G .................................................. (2)
Since Y is the national income we can write
Y = C+S+T .................................................... (3)
From equations (2) and (3) we can write
C+S+T = Y = C+I+G or
S+T = I+G .................................................... (4)
Thus in equilibrium,
Y = E = C+I+G
And S+T = I+G
The above figure depicts the determination of equilibrium income. Income (output) is measured
along the horizontal axis and the components of aggregate demand are measured along the Y
axis. In panel (a), The 450 line shows the aggregate supply curve, Y = C+S+T. The consumption
function C = a + bYD is shown on the graph and also the aggregate demand curve, E = C+I+G.
because the autonomous expenditure components (I, G) do not depend directly on income, the
(C+I+G) schedule lies above the consumption function by a constant amount.
As shown in panel (b) of the figure, the line plotting the autonomous components alone, I+G
line, is horizontal because their level do not depend on income (Y). The upward sloping line
marked S+T in the graph, plots the value of saving plus taxes. It is upward sloping because
saving varies directly with income.
In panel (a) of the figure, the equilibrium level of income is shown at the point where the C+I+G
schedule crosses the 450 line and aggregate demand is therefore equal to aggregate supply. Since
unemployment results from the deficiency of aggregate demand, employment and income can be
increased by increasing investment. Once, investment increases, employment and income
increase. Increased income levels lead to a rise in the demand for consumption goods which
leads to further increase in employment and income. Once set in motion, employment and
income tend to increase in a cumulative manner through the multiplier process till they reach the
equilibrium level. The equilibrium point E is the point of effective demand where the
equilibrium level of income and employment OY E is determined. This is the level of under-
employment equilibrium and not of full employment. There are no automatic forces that can
make the two curves cross at a full employment level. Keynes regarded the under-employment
equilibrium level as a normal case and the full employment income level as a special case. To
reach the full employment level, OY F, autonomous investment has to be increased by I 1, so that
the new aggregate demand curve is C+I+I 1+G and it intersects the aggregate supply curve at E 1.
Thus, once investment increases, employment and income increases. In equilibrium it must also
be true that the (S+T) schedule intersects the (I+G) schedule. It illustrates the equilibrium
condition, S+T = I+G.
If the income or output is below OY E, for example, the point marked by OY in panel (a) of the
figure, aggregate demand, C+I+G, exceeds aggregate supply and in panel (b) S+T is less than
I+G. conversely at levels of income above OY E, aggregate supply will exceed aggregate demand.
It is only at OYE the aggregate demand equals aggregate supply.
Criticisms
1. In the under developed countries there are so many other factors which are responsible for
unemployment, like over population and lack of skill.

2. Perfect competition is not found in real world.

3. In the long run its chances of success are limited.

The Principle of Effective Demand: Aggregate Demand and Aggregate Supply

Introduction:

The logical starting point of Keynes’s theory of employment is the principle of effective demand.
In a capitalist economy, the level of employment depends on effective demand. Thus
unemployment results from a deficiency of effective demand and the level of employment can be
raised by increasing the level of effective demand.

1. Effective Demand:

In ordinary parlance, demand means desire. It becomes effective when income is spent in buying
consumption goods and investment goods. Keynes used the term ‘effective demand’ to denote
the total demand for goods and services at various levels of employment. Different levels of
employment represent different levels of aggregate demand. But there can be a level of
employment where aggregate demand equals aggregate supply.

This is the point of effective demand. In Keynes’s words, “The value of D (Aggregate Demand)
at the point of Aggregate Demand function, where it is intersected by the Aggregate Supply
function, will be called the effective demand.” Thus according to Keynes, the level of
employment is determined by effective demand which, in turn, is determined by aggregate
demand price and aggregate supply price.

Aggregate Demand Price:

“The aggregate demand price for the output of any given amount of employment is the total sum
of money or proceeds, which is expected from the sale of the output produced when that amount
of labour is employed.”

Thus the aggregate demand price refers to the expected revenue from the sale of output produced
at a particular level of employment. Different aggregate demand prices relate to different levels
of employment in the economy.

A statement showing the various aggregate demand prices at different levels of employment is
called the aggregate demand price schedule or aggregate demand function. “The aggregate
demand function,” according to Keynes, “relates any given level of employment to the expected
proceeds from that level of employment.” Table I shows the aggregate demand schedule.

The table reveals that with the increase in the level of employment proceeds expected rise and at
lower levels of employment decline. When 45 lakh people are provided employment the
aggregate demand price is Rs.280 crores and when 25 lakh people are provided jobs, it is Rs.240
crores. According to Keynes, the aggregate demand function is an increasing function of the
level of employment and is expressed as D = F (AO, where D is the proceeds which
entrepreneurs expect from the employment of N men.

The aggregate demand curve can be drawn on the basis of the above schedule. It slopes upward
from left to right because as the level of employment increases aggregate demand price also
rises, shown as AD curve in Figure 1.
Aggregate Supply Price:

When an entrepreneur gives employment to certain amount of labour, it requires certain

quantities of co-operant factors like land, capital, raw materials, etc. which will be paid
remuneration along with labour. Thus each level of employment involves certain money costs of
production including normal profits which the entrepreneur must cover.

“At any given level of employment of labour aggregate supply price is the total amount of
money which all the entrepreneurs in the economy, taken together, must expect to receive from
the sale of the output produced by that given number of men, if it is to be just worth employing
them.”

In brief, the aggregate supply price refers to the proceeds necessary from the sale of output at a
particular level of employment. Thus each level of employment in the economy is related to a
particular aggregate supply price and there are different aggregate supply prices for different
levels of employment.

A statement showing the various aggregate supply prices at different levels of employment is
called the aggregate supply price schedule or aggregate supply function. In the words of Prof.
Dillard, “The aggregate supply function is a schedule of the minimum amounts of proceeds
required to induce varying quantities of employment.” Table II shows the aggregate supply
schedule.
The above table reveals that the aggregate supply price rises with the increase in the level of
employment. If entrepreneurs are to provide employment to 20 lakh workers, they must receive
Rs.215 crores from the sale of the output produced by them.

It is only when they expect to receive the minimum amounts of proceeds (Rs.230 crores, Rs.245
crores and Rs.260 crores) that they will provide employment to more workers (25 lakhs, 30 lakhs
and 35 lakhs respectively).

But when the economy reaches the level of full employment (at 40 lakh workers) the aggregate
supply price (Rs.275, 290 and 305 crores) continues to increase but there is no further increase in
employment. According to Keynes, the aggregate supply function is an increasing function of the
level of employment and is expressed as Z = фN, where Z is aggregate supply price of the output
from employing N men.

The aggregate supply curve can be drawn on the basis of the schedule. It slopes upward from left
to right because as the necessary expected proceeds increase, the level of employment also rises.
But when the economy reaches the level of full employment, the aggregate supply curve
becomes vertical. Even with the increase in the aggregate supply price, it is not possible to
provide more employment as the economy has attained the level of full employment.

Determination of Effective Demand:

We have studied the two determinants of effective demand separately and now are in a position
to analyse the process of determining the level of employment in the economy. The level of
employment is determined at the point where the aggregate demand price equals the aggregate
supply price.

In other words, it is the point where what entrepreneurs expect to receive equals what they must
receive and their profits are maximized. This point is called the effective demand and here
entrepreneurs earn normal profits.
So long as the aggregate demand price is higher than the aggregate supply price, the prospects of
getting additional profits are greater when more workers are provided employment. The proceeds
expected (revenue) rise more than the proceeds necessary (costs).

This process will continue till the aggregate demand price equals the aggregate supply price and
the point of effective demand are reached. This point determines the level of employment and
output in the economy. The point of effective demand is, however, not necessarily one of full
employment but of underemployment equilibrium.

If the entrepreneurs try to provide more employment after this point, the aggregate supply price
exceeds the aggregate demand price indicating that the total costs are higher than the total
revenue and there are losses. So the entrepreneurs will not employ workers beyond the point of
effective demand till the aggregate demand price rises to meet the aggregate supply price at the
new equilibrium point which may be one of full employment.

If the aggregate demand price is raised still further, it will lead to inflation because no increase in
employment and output is possible beyond the level of full employment. The following table
explains the determination of the point of effective demand.

Table III shows that so long as the aggregate demand price is higher than the aggregate supply
price, it is profitable for entrepreneurs to employ more workers, when they expect to receive
Rs.230 crores, Rs.240 crores and Rs.250 crores than the proceeds necessary amounting to Rs.215
crores, Rs.230 crores and Rs.245 crores, they will provide increasing employment to 20 lakh, 25
lakh and 30 lakh workers respectively.

But when the proceeds necessary and proceeds expected equal Rs.260 crores the level of
employment rises to 35 lakhs. This is the point of effective demand. If we assume the level of
full employment to be 40 lakh workers in the economy, it will necessitate the drawing up of a
new aggregate, demand price schedule as shown in Table III last column.

As a result, the new point of effective demand is 40 lakh workers because both the aggregate
demand price and the aggregate supply price equal Rs 275 crores. Beyond this point there is no
change in the level of employment which is steady at 40 lakh workers.
Figure 1 illustrates the determination of effective demand where AD is the aggregate demand
function and AS the aggregate supply function. The horizontal axis measures the level of
employment in the economy and the vertical axis the proceeds expected (revenue) and the
proceeds necessary (costs).

The two curves AD and AS intersect each other at point E. This is effective demand where ON
workers are employed. At this point, the entrepreneurs’ expectations of profits are maximized. At
any point other than this, the entrepreneurs will either incur losses or earn subnormal profits.

At ON1 level of employment, the proceeds expected (revenue) are more than the proceeds
necessary (costs), i.e., RN1 > CN1. This indicates that it is profitable for the entrepreneurs to
provide increasing employment to workers till ON level is reached where the proceeds expected
and necessary equal at point E.

It would not be, however, profitable for the entrepreneurs to increase employment beyond this to
NF level because the proceeds necessary (costs) exceed the proceeds expected (revenue), i.e.,
C1NF > R1NF and they incur losses. Thus E, the point of effective demand, determines the actual
level of employment in the economy which is of underemployment equilibrium.
Of the two determinants of effective demand, Keynes regards the aggregate supply function to be
given because it depends on the technical conditions of production, the availability of raw
materials, machines etc. which do not change in the short run.

It is, therefore, the aggregate demand function which plays a vital role in determining the level of
employment in the economy. According to Keynes, the aggregate demand function depends on
the consumption function and investment function.

The cause of unemployment may be a fall in either consumption expenditure or investment

expenditure, or both. The level of employment can be raised by increasing either consumption
expenditure or investment expenditure, or both. Thus, it is the aggregate demand function which
is the “effective” element in the principle of effective demand. Prof. Dillard regards this as the
core of the principle of effective demand.

It follows that to raise the economy to the level of full employment requires the raising of the
point of effective demand by increasing the aggregate demand. This is illustrated in Figure 2,
where E is the point of effective demand which determines ON level of employment.

If ONF is the level of full employment for the economy, it requires the raising of the point of
effective demand. This is possible by raising the aggregate demand curve to AD 1 (last column of
Table III) where it intersects aggregate supply curve AS at E1.

This is the new point of effective demand which provides an optimum level of employment ON’
to the economy. If the aggregate demand function is raised beyond this point the economy will
experience inflation because all the existing resources are fully employed and their supply cannot
be increased during the short run, as is apparent from the vertical portion of the AS curve in
Figure 2.

2. Importance of Effective Demand:

The principle of effective demand is the most important contribution of Keynes. It is the soul of
the Keynesian theory of employment. Dr. Klein attributes the Keynesian revolution solely to the
development of a theory of effective demand.

1. Determinant of Employment:

Effective demand determines the level of employment in the economy. When effective demand
increases, employment also increases, and a decline in effective demand decreases the level of
employment. Thus unemployment is caused by a deficiency of effective demand.

Effective demand represents the total expenditure on the total output produced at an equilibrium
level of employment. It indicates the value of total output which equals national income.
National income equals national expenditure. National expenditure consists of expenditure on
consumption goods and investment goods.

In the Keynesian analysis of effective demand, consumption and investment expenditures relate
to the private sector because Keynes considers government expenditure as autonomous. But the
post-Keynesian economists include government expenditure as a component of effective
demand. Thus, Effective Demand (D) = Private consumption expenditure (C) + Private
investment (I) + Government expenditure (G) on both.

We may conclude that the importance of the principle of effective demand lies in pointing out
the cause and remedy of unemployment. Unemployment is caused by a deficiency of effective
demand and it can be removed by an increase in consumption expenditure or/and investment
expenditure and in case the private expenditures are insufficient and ineffective in bringing about
the required level of employment, the same can be achieved by government expenditure. Thus
the principle of effective demand is the basis of the theory of employment.

2. Repudiation of Say’s Law and Full Employment Thesis:

The principle of effective demand repudiates Say’s law of markets that supply creates its own
demand and that full employment equilibrium is a normal situation in the economy. This
principle points out that underemployment equilibrium is a normal situation and full employment
equilibrium is accidental.

In a capitalist economy, supply fails to create its own demand because the whole of the earned
income is not spent on the consumption of goods and services. Moreover, the decisions to save
and invest are made by different people. As a result, the existence of full employment is not a
possibility and the point of effective demand at any time represents underemployment
equilibrium.

The Pigouvian view that full employment can be achieved by a reduction in money wage-cut is
also repudiated by this principle. A money wage-cut will bring about a reduction in expenditure
on goods and services leading to a fall in effective demand and hence in the level of
employment. Thus the importance of this principle lies in repudiating Say’s Law and the
classical thesis of full employment equilibrium.

3. Role of Investment:

The principle of effective demand highlights the significant role of investment in determining the
level of employment in the economy. The two determinants of effective demand are
consumption and investment expenditures.

When income increases consumption expenditure also increases but by less than the increase in
income. Thus there arises a gap between income and consumption which leads to decline in the
volume of employment. This gap can be bridged by an increase in either consumption
expenditure or investment expenditure in order to achieve full employment level of effective
demand in the economy.

Since the propensity to consume is stable during the short run, it is not possible to raise the
consumption expenditure. Therefore, the level of effective demand and hence of employment can
be raised by an increase in investment. In this lies the importance of investment.

4. The Paradox of Poverty in the midst of Potential Plenty:

The importance of effective demand lies in explaining the paradox of poverty in the midst of
potential plenty in modern capitalism. Effective demand is mainly determined by the aggregate
demand function. Which is composed of consumption expenditure and investment expenditure?

A fundamental principle is that when income increases consumption also increases but less than
proportionately (i.e., the marginal propensity to consume is less than one). This creates a gap
between income and consumption which must be filled up by the required investment
expenditure. If the appropriate investment is not forthcoming to fill this gap, it leads to a
deficiency of effective demand resulting in unemployment.

It follows that in a poor community, the gap between income and consumption is small because
the marginal propensity to consume is high. It will, therefore, have little difficulty in employing
all its resources by filling the gap through small investment expenditure.

On the contrary, in a wealthy community the gap between income and consumption is very large
because the marginal propensity to consume is low. It will, therefore, require large investment
expenditure to fill the gap between income and consumption in order to maintain a high level of
income and employment.

But in a rich community investment demand is not adequate to fill this gap and there emerges a
deficiency of aggregate demand resulting in widespread unemployment. When the aggregate
demand falls, the potential wealthy community will be forced to reduce its actual output until it
becomes so poor that the excess of output over consumption will be reduced to the actual amount
of investment.

Further, in such a community there is an accumulated stock of capital assets which weakens the
inducement to invest because every new investment competes with an already existing large
supply of old capital assets.

This inadequacy of investment demand reacts in a cumulative manner on the demand for
consumption and will, in turn, lead to a further fall in employment, output and income. Thus as
Keynes said, “The richer the community, the more obvious and outrageous the defects of the
economic system that lead to unemployment on a mass scale in the midst of potential plenty
because of the deficiency of effective demand.”

CONSUMPTION FUNCTION

Given the aggregate supply, the level of income or employment is determined by the level of
aggregate demand; the greater the aggregate demand, the greater the level of income and
employment and vice versa. Keynes was not interested in the factors determining the aggregate
supply since he was concerned with the short run and the existing productive capacity. We will also not
explain in detail the factors which determine the aggregate supply and will confine ourselves to
explaining the determinants of aggregate demand.

Aggregate demand consists of two parts—consumption demand and investment demand. In this
article we will explain the consumption demand and the factors on which it depends and how it
changes over a period of time. Consumption demand depends upon the level of income and the
propensity to consume.

The Concept of Consumption Function:

As the demand for a good depends upon its price, similarly consumption of a community
depends upon the level of income. In other words, consumption is a function of income. The
consumption function relates the amount of consumption to the level of income. When the
income of a community rises, consumption also rises.

How much consumption rises in response to a given increase in income depends upon the
marginal propensity to consume. It should be borne in mind that the consumption function is the
whole schedule which describes the amounts of consumption at various levels of income.

We give below such a schedule of consumption function:

Table 6.1. Linear Consumption Function:

Consumption function should be carefully distinguished from the amount of consumption. By
consumption function is meant the whole schedule which shows consumption at various levels of
income, whereas amount of consumption means the amount consumed at a specific level of
income. The schedule described above reflects the consumption function of a community i.e., it
indicates how the consumption changes in response to the change in income.

In the above schedule it will be seen that at the level of income equal to Rs. 1200 crores, the
amount of consumption is Rs. 900 crores. As the national income increases to Rs. 1500 crores,
the consumption rises to Rs. 1125 crores. Thus, with a given consumption function, amount of
consumption is different at different levels of income.

The above schedule of consumption function reveals an important fact that when income rises,
consumption also rises but not as much as the income. This fact about consumption function was
emphasised by Keynes, who first of all evolved the concept of consumption function. The reason
why consumption rises less than income is that a part of the increment in income is saved.

Therefore, we see that when income increases from Rs. 1000 crores to Rs. 1100 crores, the
amount of consumption rises from Rs. 750 crores to 825 crores. Thus, with the increase in
income by Rs. 100 crores, consumption rises by Rs. 75 crores; the remaining Rs. 25 crores are
saved. Similarly, when income rises from Rs. 1100 crores to Rs. 1200 crores, the amount of
consumption increases from Rs. 825 crores to Rs. 900 crores.

Here also, as a result of increase in income by Rs. 100, the amount of consumption has risen by
Rs. 75 crores and the remaining Rs. 25 crores has been saved. The same applies to further
increases in income and consumption. We shall see later that Keynes based his theory of
multiplier on the proposition that consumption increases less than income and this theory of
multiplier occupies an important place in macroeconomics.
Consumption demand depends on income and propensity to consume. Propensity to consume
depends on various factors such as price level, interest rate, stock of wealth and several
subjective factors. Since Keynes was concerned with short-run consumption function he assumed
price level, interest rate, stock of wealth etc. constant in his theory of consumption. Thus with
these factors being assumed constant in the short run, Keynesian consumption function considers
consumption as a function of income. Thus

C= f(Y)

In a specific form, Keynesian function can be written as:

C = a + bY

where a and b are constants. While a is intercept term of the consumption function, b stands for
the slope of the consumption function and therefore represents marginal propensity to consume.

Keynesian consumption function has been depicted by CC’ curve in Fig. 6.1 in which along the
X-axis national income is measured and along the Y-axis the amount of consumption is
measured. In this figure, a line OZ making 45° angle with the X-axis, has been drawn. Because
line OZ makes 45° angle with the X-axis every point on it is equidistant from both the X-axis
and Y-axis.

Therefore, if consumption function curve coincides with 45° line OZ it would imply that the
amount of consumption is equal to the income at every level of income. In this case, with the
increase in income, consumption would also increase by the same amount.

As has been said above, in actual practice consumption increases less than the increase in
income. Therefore, in actual practice the curve depicting the consumption function will deviate
from the 45° line. If we represent the above consumption schedule by a curve, we would get the
propensity to consume curve such as CC in Fig. 6.1.

It is evident from this figure that the consumption function curve CC’ deviates from the 45° line
OZ. At lower levels of income, the consumption function curve CC lies above the OZ line,
signifying that at these lower levels of income consumption is greater than the income.

It is so because at lower levels of income, a nation may draw upon its accumulated savings to
maintain its consumption standard or it may borrow from others. As income increases,
consumption also increases and at the income level OY0, consumption is equal to income.
Beyond this, with the increase in income, consumption increases but less than the increase in
income and therefore, consumption function curve CC lies below the 45° line OZ beyond Y 0. An
important point to be noted here is that beyond the level of income OY 0, the gap between con-
sumption and income is widening. The difference between consumption and income represents
savings. Therefore, with the increase in income, saving gap also widens and as we shall see later,
this has a significant implication in macroeconomics.

It is useful to point out here that when the consumption function of a community changes, the
whole consumption function curve changes or shifts. When propensity to consume increases, it
means that at various levels of income more is consumed than before.

Therefore, as a result of increase in propensity to consume of the community, the whole

consumption function curve shifts upward as has been shown by the upper curve C’C’ in Fig.
6.2. On the contrary, when the propensity to consume of the community decreases, the whole
consumption function curve shifts downward signifying that at various levels of income, less is
consumed than before.
Average and Marginal Propensity to Consume:

There are two important concepts of propensity to consume, the one being average propensity to
consume and the other marginal propensity to consume. They should be carefully distinguished,
for they are equal in some cases but different in others. Consider Table 6.1, where we have
calculated the average and marginal propensity to consume in columns 3 and 4. As seen above,
consumption changes as income changes.

Now, how much consumption changes in response to a given change in income depends upon
the average and marginal propensity to consume. Thus, propensity to consume of a community
can be known by the average and marginal propensity to consume. Average propensity to
consume is the ratio of the amount of consumption to total income. Therefore, average
propensity to consume is calculated by dividing the amount of consumption by the total income.
Thus,

APC = C/Y, where

APC stands for average propensity to consume,

C for amount of consumption, and

Y for the level of income.

In the Table 6.1 it will be seen that at the level of income Rs 1000 crores, consumption
expenditure is equal to Rs. 750 crores. Therefore, average propensity to consume is here equal to
750/1000 = 0.75. Likewise, when the income rises to Rs. 1200 crores, consumption rises to Rs.
900 crores.

Therefore, the average propensity to consume will be 900/1200 = 0.75. In this schedule of
consumption function, the average propensity to consume is the same at all levels of income.
Keynesian consumption function CC is shown in Fig. 6.3.
Average propensity to consume at a point on the consumption function curve can be obtained by
measuring the slope of the ray from the origin to that point. For example, at income level
OY1 corresponding point on the consumption function curve is A. Therefore, at OY 1 income
level, average propensity to consume (APC) is the slope of the ray OA.

Similarly, at income level OY2, average propensity to consume is the slope of the ray OB. It will
be observed from Fig.6.3 that slope of OB is less than that of OA. Therefore, average propensity
to consume at income level OY 2 is less than that at income level OY 1. In other words average
propensity to consume has declined with the increase in disposable income.

Keynes’s Theory of Consumption:

Keynes in his “General theory”, published in 1936, laid the foundations of modern
macroeconomics. The concept of consumption function plays an important role in Keynes’
theory of income and employment. Keynes mentioned several subjective and objective factors
which determine consumption of a society. However, according to Keynes, of all the factors it is
the current level of income that determines the consumption of an individual and also of society.

Since Keynes laid stress on the absolute size of current income as a determinant of consumption,
his theory of consumption is also known as absolute income theory of consumption. Further,
Keynes put forward a psychological law of consumption, according to which, as income
increases consumption increases but not by as much as the increase in income. In other words,
marginal propensity to consume is less than one.

1> ΔC/ΔY>0
While Keynes recognized that many subjective and objective factors including interest rate and
wealth influenced the level consumption expenditure, he emphasised that it is the current level of
income on which the consumption spending of an individual and the society depends.

he suggests that consumption expenditure depends mainly on absolute income of the current
period, that is, consumption is a positive function of the absolute level of current income. The
more income in a period one has, the more is likely to be his consumption expenditure in that
period. In other words, in any period the rich people tend to consume more than the poor people
do. Secondly, Keynes points out that consumption expenditure does not have a proportional
relationship with income.

According to him, as the income increases, a smaller proportion of income is consumed. The
proportion of consumption to income is called average propensity to consume (APC). Thus,
Keynes argues that average propensity to consume (APC) falls as income increases.

The Keynes’ consumption function can be expressed in the following form

C = a + bYd

where C is consumption expenditure and Y d is the real disposable income which equals gross
national income minus taxes, a and b are constants, where a is the intercept term, that is, the
amount of consumption expenditure at zero level of income. Thus, a is autonomous
consumption. The parameter b is the marginal propensity to consume (MPC) which measures the
increase in consumption spending in response to per unit increase in disposable income. Thus

MPC = ΔC/ΔY

Since the average propensity to consume falls as income increases, the marginal propensity to
consume (MPC) is less than the average propensity to consume (APC). The Keynesian con-
sumption function is depicted in Figs. 6.3.

In Fig. 6.3 we have shown a linear consumption function with an intercept term. In this form of
linear consumption function, though marginal propensity to consume (ΔC/ΔY) is constant,
average propensity to consume is declining with the increase in income as indicated by the
slopes of the lines OA and OB at levels of income Y 1 and Y2 respectively. The straight line OB
drawn from the origin indicating average propensity to consume at higher income level Y 2 has a
relatively less slope than the straight line OA drawn from the origin to point A at lower income
level Y1.

The decline in average propensity to consume as the income increases implies that the proportion
of income that is saved increases with the increase in national income of the country. This result
also follows from the studies of family budgets of various families at different income levels.
The fraction of income spent on consumption by the rich families is lower than that of the poor
families. In other words, the rich families save a higher proportion of their income as compared
to the poor families.

The assumption of diminishing average propensity to consume is a significant part of Keynesian

theory of income and employment. This implies that as income increases, a progressively larger
proportion of national income would be saved. Therefore, to achieve and maintain equilibrium at
full-employment level of income, increasing proportion of national income is needed to be
invested.

If sufficient investment opportunities are not available, the economy would then run into trouble
and in that case it would not be possible to maintain full-employment because aggregate demand
will fall short of full-employment output. On the basis of this increasing proportion of saving
with the increase in income and consequently, the emergence of the problem of demand
deficiency, some Keynesian economists based the theory of secular stagnation on the declining
propensity to consume.

Factors Affecting Consumption Functions: (Subjective and Objective Factor)

According to Keynes, two types of factors influence the consumption function: subjective and
objective. The subjective factors are endogenous or internal to the economic system itself. The
subjective factors relate to psychological characteristics of human nature, social structure, social
institutions and social practices.

These are likely to remain more or less stable during the short period. Established behaviour
pattern undergoes material change only over long periods. These factors fundamentally
determine the form of the consumption function (i.e., slope and position of the propensity to
consume, the С curve).

The objective factors affecting the consumption function are exogenous, or external to the
economy itself. These factors may at times undergo rapid changes. Thus, objective factors may
cause a shift in the consumption function.

Subjective Factors:

Subjective factors basically underlie and determine the form of the consumption function (i.e., its
slope and position).

The subjective factors concerned are:

(1) behaviour patterns fixed by the psychology of human nature

(2) the institutional arrangements of the modern social order, and social practices relating to the
behaviour patterns of business firms with respect to wage and dividend payments and retained
earnings, and the institution controlling the distribution of income.

Human behaviour regarding consumption and savings out of increased income depends on
psychological motives.

First, there are motives which “lead individuals to refrain from spending out of their incomes.”

Keynes enlists eight such motives:

1. The Motive of Precaution:

The desire to build up a reserve against unforeseen contingencies.

2. The Motive of Foresight:

The desire to provide for anticipated future needs, e.g., in relation to old age, family education,
etc.

3. The Motive of Calculation:

The desire to enjoy interest and appreciation, because a larger real consumption, at a later date, is
preferred to a smaller immediate consumption.

4. The Motive of Improvement:

The desire to enjoy a gradually increasing expenditure since it gratifies the common instinct to
look forward to a gradually improving standard of life rather than otherwise.

5. The Motive of Independence:

The desire to enjoy a sense of independence and the power to do things.

6. The Motive of Enterprise:

The desire to secure a mass de manoeuvre to carry on speculation or establish business projects.

7. The Motive of Pride:

The desire to possess or to bequeath a fortune.

8. The Motive of Avarice:

The desire to satisfy pure miserliness, i.e., unreasonable, but insistent abstinence from
expenditure as such.
To this, Keynes adds a corresponding list of motives on consumption such as enjoyment, short-
sightedness, generosity, miscalculation, ostentation and extravagance.

Subjective motivations also apply to the behaviour patterns of business corporations and
governmental bodies. In this respect, Keynes listed the following motives for accumulation:

(a) The Motive of Enterprise:

The desire to do big things, to expand, to secure resources to carry out further capital investment.

(b) The Motive of Liquidity:

The desire to face emergencies and difficulties successfully.

(c) The Motive of Improvement:

The desire to secure a rising income and to demonstrate successful management.

(d) The Motive of Financial Prudence:

The desire to ensure adequate financial provision against depreciation and obsolescence and to
discharge debts.

Keynes maintains that the strength of all these motives may vary considerably according to the
institution and the organisation of the economic society. Since economic and social institutions
and organisations are formed by habits, race, education, morals, present hopes and past
experiences, techniques of capital equipment and the prevailing distribution of wealth and
established standard of life — all these factors are unlikely to vary in the short run. They,
therefore, affect secular progress only very gradually. In other words, these factors, subject to
slow change and over a long period, may be considered as given or stable.

Objective Factors:

Objective factors, subject to rapid changes and causing violent shifts in the consumption
function, are considered below:

1. Windfall Gains or Losses:

When windfall gains or losses accrue to people their consumption level may change suddenly.
For instance, the post-war windfall gains in stock exchanges seem to have raised the
consumption spending of rich people in the U.S.A., and to that extent, the consumption function
was shifted upward.

2. Fiscal Policy:
The propensity to consume is also affected by variations in fiscal policy of the government. For
instance, imposition of heavy taxes tends to reduce the disposable real income of the community;
so its level of consumption may adversely change. Similarly, withdrawal of certain taxes may
cause an upward shift of consumption function.

3. Change in Expectations:

The propensity to consume is also affected by expectations regarding future changes. For
instance, an expected war considerably influences consumption by creating fears about future
scarcity and rising prices. This leads people to buy more than they immediately need, i.e., to
hoard. Thus, the ratio of consumption to current income will rise, which means that the
consumption function will be shifted upward.

4. The Rate of Interest:

In the long run, substantial changes in the market rate of interest may also influence
consumption. A significant rise in the rate of interest may induce people to reduce their
consumption at each income level, because people will save more in order to take advantage of
the high interest rate.

Moreover, if the rate of interest rises, then the lending of the present saving (realised by
consuming less) will enable one to obtain an even larger quantity of consumption goods in the
future. Keynes, thus, argues that “Over a long period, substantial changes in the rate of interest
probably tend to modify social habits considerably.”

In addition to these four factors, Keynes also mentioned changes in the wage level, in accounting
practices with respect to depreciation (indicating the difference between income and net income),
as the objective factors affecting the consumption function.

Keynes’ disciples, however, considered his list of objective factors inadequate and have
listed others which we consider below:

1. The Distribution of Income:

With the given level of income, aggregate consumption will vary if income is distributed in
different ways among the people. A community with a greatly unequal distribution of income
tends to have a low propensity to consume on the whole, while a community with a high degree
of equality of income will have a high propensity to consume in general.

Thus, redistribution of income through fiscal measures of the State will affect the propensity to
consume. Joan Robinson explicitly states that “the most important influence on the demand for
consumption goods is the distribution of income.” It may be noted here that Keynes does not
specify income distribution as an objective factor but includes it under the common heading of
fiscal policy.
2. Holding of Saving — Liquid Assets:

According to Kurihara another factor affecting the consumption function is the volume of
accumulated savings by the people. The larger the amount of such savings (i.e., holding of liquid
assets, like cash balances, savings accounts and government bonds), the more likely people will
tend to spend out of their current income, because the holding of savings in the form of liquid
assets, will give them a greater sense of security. A change in the real value of such assets held
by them, owing to general price changes, might also affect the consumption function.

3. Corporate Financial Policies:

Kurihara observes that business policies of corporations with respect to income retention,
dividend payments, and re-investments, produce some effect on the propensity of equity holders
to consume. A cautious dividend policy followed by corporations and corporate savings will
reduce the consumption function by reducing the residual disposable income of the shareholders
(who are consumers, in a way).

All the above-mentioned factors will affect the consumption function in one direction or another.
However, all of them are relatively unchanging in the normal short run and, therefore, cannot
explain the changes in total consumption during the short-run period. Income is the only variable
which will change considerably in the short run and affect consumption. Thus, it may be asserted
that consumption varies only in the level of income.

INVESTMENT FUNCTION

In ordinary parlance, investment means to buy shares, stocks, bonds and securities which already
exist in stock market. But this is not real investment because it is simply a transfer of existing
assets. Hence this is called financial investment which does not affect aggregate spending. In
Keynesian terminology, investment refers to real investment which adds to capital equipment.

It leads to increase in the levels of income and production by increasing the production and
purchase of capital goods. Investment thus includes new plant and equipment, construction of
public works like dams, roads, buildings, etc., net foreign investment, inventories and stocks and
shares of new companies. In the words of Joan Robinson, “By investment is meant an addition to
capital, such as occurs when a new house is built or a new factory is built. Investment means
making an addition to the stock of goods in existence.”

Capital, on the other hand, refers to real assets like factories, plants, equipment, and inventories
of finished and semi-finished goods. It is any previously produced input that can be used in the
production process to produce other goods. The amount of capital available in an economy is the
stock of capital. Thus capital is a stock concept.

To be more precise, investment is the production or acquisition of real capital assets during any
period of time. To illustrate, suppose the capital assets of a firm on 31 March 2004 are Rs 100
crores and it invests at the rate of Rs 10 crores during the year 2004-05. At the end of the next
year (31 March 2005), its total capital will be Rs 110 crores. Symbolically, let I be investment
and К be capital in year t, then It = Kt– Kt- 1.

Capital and investment are related to each other through net investment. Gross investment is the
total amount spent on new capital assets in a year. But some capital stock wears out every year
and is used up for depreciation and obsolescence. Net investment is gross investment minus
depreciation and obsolescence charges for replacement investment. This is the net addition to the
existing capital stock of the economy.

If gross investment equals depreciation, net investment is zero and there is no addition to the
economy’s capital stock. If gross investment is less than depreciation, there is disinvestment in
the economy and the capital stock decreases. Thus for an increase in the real capital stock of the
economy, gross investment must exceed depreciation, i.e., there should be net investment.

2. Types of Investment:

1. Induced Investment:

Real investment may be induced. Induced investment is profit or income motivated. Factors like
prices, wages and interest changes which affect profits influence induced investment. Similarly
demand also influences it. When income increases, consumption demand also increases and to
meet this, investment increases. In the ultimate analysis, induced investment is a function of in-
come i.e., I = f(Y). It is income elastic. It increases or decreases with the rise or fall in income, as
shown in Figure 1.

I1 I1is the investment curve which shows induced investment at various levels of income. Induced
investment is zero at OY1 income. When income rises to OY3 induced investment is I3Yy A fall
in income to OY2 also reduces induced investment to I2Y2.

Induced investment may be further divided into (i) the average propensity to invest, and (ii) the
marginal propensity to invest:
(i) The average propensity to invest is the ratio of investment to income, I/Y. If the income is Rs.
40 crores and investment is Rs. 4 crores, I/Y = 4/40 = 0.1. In terms of the above figure, the
average propensity to invest at OY3 income level is I3Y3/ OY3

(ii) The marginal propensity to invest is the ratio of change in investment to the change in
income, i.e., I/ Y. If the change in investment, I=Rs 2 crores and the change in income, Y =
Rs 10 crores, then I/∆Y = 2/10=0.2 In Figure 1, I/ Y =I3a/Y2Y3

2. Autonomous Investment:

Autonomous investment is independent of the level of income and is thus income inelastic. It is
influenced by exogenous factors like innovations, inventions, growth of population and labour
force, researches, social and legal institutions, weather changes, war, revolution, etc. But it is not
influenced by changes in demand. Rather, it influences the demand. Investment in economic and
social overheads whether made by the government or the private enterprise is autonomous.

Such investment includes expenditure on building, dams, roads, canals, schools, hospitals, etc.
Since investment on these projects is generally associated with public policy, autonomous in-
vestment is regarded as public investment. In the long-run, private investment of all types may
be autonomous because it is influenced by exogenous factors. Diagrammatically, autonomous
investment is shown as a curve parallel to the horizontal axis as I 1I’ curve in Figure 2. It indicates
that at all levels of income, the amount of investment OI1remains constant.

The upward shift of the curve to I 2I” indicates an increased steady flow of investment at a
constant rate OI2 at various levels of income. However, for purposes of income determination,
the autonomous investment curve is superimposed on the С curve in a 45° line diagram.

3. Determinants of the Level of Investment:

The decision to invest in a new capital asset depends on whether the expected rate of return on
the new investment is equal to or greater or less than the rate of interest to be paid on the funds
needed to purchase this asset. It is only when the expected rate of return is higher than the
interest rate that investment will be made in acquiring new capital assets.

In reality, there are three factors that are taken into consideration while making any investment
decision. They are the cost of the capital asset, the expected rate of return from it during its
lifetime, and the market rate of interest. Keynes sums up these factors in his concept of the
marginal efficiency of capital (MEC).

Marginal Efficiency of Capital:

The marginal efficiency of capital is the highest rate of return expected from an additional unit of
a capital asset over its cost. In the words of Kurihara, “It is the ratio between the prospective
yield to additional capital goods and their supply price.” The prospective yield is the aggregate
net return from an asset during its life time, while the supply price is the cost of producing this
asset.

If the supply price of a capital asset is Rs. 20,000 and its annual yield is Rs. 2,000, the marginal
efficiency of this asset is 2000/20000 × 100 = 10 per cent. Thus the marginal efficiency of
capital is the percentage of profit expected from a given investment on a capital asset.

Keynes relates the prospective yield of a capital asset to its supply price and defines the MEC as
“equal to the rate of discount which would make the present value of the series of annuities given
by the returns expected from the capital assets during its life just equal to its supply price.”

Symbolically, this can be expressed as:

SP =R1/ (1+i) + R2 (1+i)2 + Rn/(1+i)n

Where Sp is the supply price or the cost of the capital asset, R 1 R2… and Rn are the prospective
yields or the series of expected annual returns from the capital asset in the years, 1, 2… and
n, i is the rate of discount which makes the capital asset exactly equal to the present value of the
expected yield from it.

This i is the MEC or the rate of discount which equates the two sides of the equation. If the
supply price of a new capital asset is Rs 1,000 and its life is two years, it is expected to yield Rs
550 in the first year and Rs 605 in the second year. Its MEC is 10 per cent which equates the
supply price to the expected yields of this capital asset.

Thus

(Sp) Rs 1000 = 550/(1.10) + (605)/(1.10)2 = Rs. 500 + 500

In equation (1), the term R1/(1+i) is the present value (PV) of the capital asset. The present value
is “the value of payments to be received in the future.” It depends on the rate of interest at which
it is discounted.
Suppose we expect to receive Rs 100 from a machine in a year’s time and the rate of interest is 5
per cent. The present value of this machine is

R1 / (1+ i) =100/(1.05) = Rs 95.24

If we expect Rs 100 from the machine after two years then its present value is100/ (1.05) 2 = Rs
90.70. The present value of a capital asset is inversely related to the rate of interest. The lower
the rate of interest, the higher is the present value, and vice versa. For instance, if the rate of
interest is 5 per cent, PV of an asset of Rs 100 for one year will be Rs 95.24; at 7 per cent interest
rate, it will be Rs 93.45; and at 10 per cent interest rate, it will be Rs 90.91.

The relation between the present value and the rate of interest is shown in Figure 3, where the
rate of interest is taken on the horizontal axis while the present value of the project on the
vertical axis. The curve PR shows the inverse relation between the present value and the rate of
interest. If the current rate of interest is i i the present value of the project is P1 On the other hand,
a higher rate of interest (i 2) will lead to a lower present value (P 2) when the present value curve
(PR) cuts the horizontal axis at point (Z), the net present value becomes zero.

As a matter of fact, the MEC is the expected rate of return over cost of a new capital asset. In
order to find out whether it is worthwhile to purchase a capital asset it is essential to compare the
present value of the capital asset with its cost or supply price. If the present value of a capital
asset exceeds its cost of buying, it pays to buy it. On the contrary, if its present value is less than
its cost, it is not worthwhile investing in this capital asset.

The same results can be had by comparing the MEC with the market rate of interest. If the MEL
of a capital asset is higher than the market rate of interest at which it is borrowed, it pays to
purchase the capital asset, and vice versa. If the market interest rate equals the MEC of the
capital asset, the firm is said to possess the optimum capital stock.
If the MEC is higher than the rate of interest, there will be a tendency to borrow funds in order to
invest in new capital assets. If the MEC is lower than the rate of interest, no firm will borrow to
invest in capital assets. Thus the equilibrium condition for a firm to hold the optimum capital
stock is where the MEC equals the interest rate.

Any disequilibrium between the MEC and the rate of interest can be removed by changing the
capital stock, and hence the MEC or by changing the rate of interest or both. Since the stock of
capital changes slowly, therefore, changes in the rate of interest are more important for bringing
equilibrium. The above arguments which have been applied to a firm are equally applicable to
the economy.

Figure 4 shows the MEC curve of an economy. It has a negative slope (from left to right
downward) which indicates that the higher the MEC, the smaller the capital stock. Or, as the
capital stock increases, the MEC falls. This is because of the operation of the law of diminishing
returns in production.

As a result, the marginal physical productivity of capital and the marginal revenue fall. In the
figure, when the capital stock is OK1, the MEC is Or1. As the capital increases from OK1to
ОK2 the MEC falls from Or1 to Or2 .The net addition to the capital stock K1K2 represents the net
investment in the economy.

Further, to reach the optimum (desired) capital stock in the economy, the MEC must equal the
rate of interest. If, as shown in the figure, the existing capital stock is OK 1 the MEC is Or2and the
rate of interest is at Or1 Everyone in the economy will borrow funds and invest in capital assets.

This is because MEC (Or1) is higher than the rate of interest (at Or 2). This will continue till the
MEC (Or1) comes down to the level of the interest rate (at Or 2). When the MEC equals the rate
of interest, the economy reaches the level of optimum capital stock. The fall in the MEC is due to
the increase in the actual capital stock from OK2 to the optimum (desired) capital stock OK2.
The increase in the firm’s capital stock by K1K2 is the net investment of the firm. But it is the rate
of interest which determines the size of the optimum capital stock in the economy. And it is the
MEC which relates the amount of desired capital stock to the rate of interest. Thus the negative
slope of the MEC curve indicates that as the rate of interest falls the optimum stock of capital
increases.

KEYNES’ THEORY OF INVESTMENT MULTIPLIER

The Concept of Investment Multiplier:

The theory of multiplier occupies an important place in the modern theory of income and
employment.

The concept of multiplier was first of all developed by F.A. Kahn in the early 1930s. But Keynes
later further refined it. F.A. Kahn developed the concept of multiplier with reference to the
increase in employment, direct as well as indirect, as a result of initial increase in investment and
employment.

Keynes, however, propounded the concept of multiplier with reference to the increase in total
income, direct as well as indirect, as a result of original increase in investment and income.

Therefore, whereas Kahn’s multiplier is known as ’employment multiplier’, Keynes’ multiplier

is known as investment or income multiplier. The essence of multiplier is that total increase in
income, output or employment is manifold the original increase in investment. For example, if
investment equal to Rs. 100 crores is made, then the income will not rise by Rs. 100 crores only
but a multiple of it.

If as a result of the investment of Rs. 100 crores, the national income increases by Rs. 300 crores,
multiplier is equal to 3. If as a result of investment of Rs. 100 crores, total national income
increases by Rs. 400 crores, multiplier is 4. The multiplier is, therefore, the ratio of increment in
income to the increment in investment. If ∆I stands for increment in investment and ∆Y stands
for the resultant increase in income, then multiplier is equal to the ratio of increment in income
(∆Y) to the increment in investment (∆I).

Therefore k = ∆Y/∆I where k stands for multiplier.

Now, the question is why the increase in income is many times more than the initial increase in
investment. It is easy to explain this. Suppose Government undertakes investment expenditure
equal to Rs. 100 crores on some public works, say, the construction of rural roads. For this
Government will pay wages to the labourers engaged, prices for the materials to the suppliers
and remunerations to other factors who make contribution to the work of road-building.

The total cost will amount to Rs. 100 crores. This will increase incomes of the people equal to
Rs. 100 crores. But this is not all. The people who receive Rs. 100 crores will spend a good part
of them on consumer goods. Suppose marginal propensity to consume of the people is 4/5 or
80%.

Then out of Rs. 100 crores they will spend Rs. 80 crores on consumer goods, which would
increase incomes of those people who supply consumer goods equal to Rs. 80 crores. But those
who receive these Rs. 80 crores will also in turn spend these incomes, depending upon their
marginal propensity to consume. If their marginal propensity to consume is also 4/5, then they
will spend Rs. 64 crores on consumer goods. Thus, this will further increase incomes of some
other people equal to Rs. 64 crores.

In this way, the chain of consumption expenditure would continue and the income of the people
will go on increasing. But every additional increase in income will be progressively less since a
part of the income received will be saved. Thus, we see that the income will not increase by only
Rs. 100 crores, which was initially invested in the construction of roads, but by many times
more.

Derivation of Investment Multiplier:

How much increase in national income will take place as a result of an initial increase in
investment can be expressed in the following mathematical form:

It is thus clear that if the marginal propensity to consume is 4/5, the investment of Rs. 100 crores
leads to the increase in the national income by Rs.500 crores. Therefore, multiplier here is equal
to 5. We can express this in a general formula.

If ∆Y stands for increase in income, ∆l stands for increase in investment and MPC for
marginal propensity to consume, we can write the equation (i) above as follows:
It is clear from above that the size of multiplier depends upon the marginal propensity to
consume of the community. The multiplier is the reciprocal of one minus marginal propensity to
consume. However, we can express multiplier in a simpler form. As we know that saving is
equal to income minus consumption, one minus marginal propensity to consume will be equal to
marginal propensity to save, that is, 1 – MPC = MPS. Therefore, multiplier is equal to 1/ 1- MPC
=1/MPS.

Algebraic Derivation of Multiplier:

The multiplier can be derived algebraically as follows:

Writing the equation for the equilibrium level of income we have

Y = C + I … (1)

As in the multiplier analysis we are concerned with changes in income induced by changes in
investment, rewriting the equation (1) in terms of changes in the variables we have

∆Y = ∆C + ∆I … (2)

In the simple Keynesian model of income determination, change in investment is considered to

be autonomous or independent of changes in income while changes in consumption are function
of changes in income.

In the consumption function,

C = a + bY

where a is a constant term, b is marginal propensity to consume which is also assumed to remain
constant. Therefore, change in consumption can occur only if there is change in income. Thus
This is the same formula of multiplier as obtained earlier. Note that the value of multiplier ∆Y/∆I
will remain constant as long as marginal propensity to consume remains the same.

The Size or Value of Investment Multiplier:

The multiplier tells us how much increase in income occurs when autonomous investment
increases by Rs. 1, that is, investment multiplier ∆Y/∆I is and its value is equal to 1/1-b where b
stands for marginal propensity to consume (MPC). Thus, multiplier =∆Y/∆I =1/ 1-b equals
marginal propensity to save (MPS) the value of investment multiplier is equal to 1/1-b = 1/s
where s stands for marginal propensity to save. In other words, the size of multiplier is equal to
1/1- MPC = 1/MPC Thus, the value of multiplier can be obtained if we know either the value of
MPS or MPS.

Now, higher the marginal propensity to consume (b) (or the lower the value of marginal
propensity to save (s), the greater the value of multiplier. For example, if marginal propensity to
consume (b) is 0.8, investment multiplier is

As mentioned above, the size or value of multiplier can be calculated using either the value of
marginal propensity to consume (MPC) or the value of marginal property to save (MPS or s). In
fact, the value of multiplier is the reciprocal of marginal propensity to save (∆Y/∆I = 1/MPS or
1/s) When marginal propensity to consume is 0.8, marginal propensity to save will be 1 – 0.8 =
0.2.
The multiplier will be 1/0.2 or 1/2/10 = Likewise if marginal propensity to consume (b) is 0.75,
marginal propensity to save will be 1 – 0.75 = 0.25 and multiplier will be 1/0.25 = 1/25/100 = 4.

Given the size of multiplier we can find out the increase in income (∆Y) resulting from a certain
increase in investment (∆I) by using the multiplier relationship. Thus

Two Limiting Cases of the Value of Multiplier:

There are two limiting cases of the multiplier. One limiting case occurs when the marginal
propensity to consume is equal to one, that is, when the whole of the increment in income is
consumed and nothing is saved.

In this case, the size of multiplier will be equal to infinity, that is, a small increase in investment
will bring about a very large increase in income and employment so that full employment is
reached and even the process goes beyond that. “In such circumstances, the Government would
need to employ only one road builder to raise income indefinitely, causing first full employment
and then a limitless spiral of inflation.”

However, this is unlikely to occur since marginal propensity to consume in the real world is less
than one. The other limiting case occurs when marginal propensity to consume is equal to zero,
that is, when nothing out of the increment in income is consumed, and the whole increment in
income is saved.

In this case, the value of the multiplier will be equal to one. That is, in this case, the increment in
income will be equal to the original increase in investment and not a multiple of it. But in actual
practice the marginal propensity to consume is less than one but more than zero (1 ˃ ∆C/∆Y ˃
0). Therefore, the value of the multiplier is greater than one but less than infinity.

Working of Multiplier and its Assumptions:

In our above explanation of multiplier, we have made many simplifying assumptions. First, we
have assumed that the marginal propensity to consume remains constant throughout as the
income increases in various rounds of consumption expenditure. However, the marginal
propensity to consume may differ in various rounds of consumption expenditure.

But this constancy of marginal propensity to consume is a realistic assumption, since all
available empirical evidence shows that marginal propensity to consume is very stable in the
short run. Secondly, we have assumed that there is a net increase in investment in a period and
no further indirect effects on investment in that period occur or if they occur they have been
taken into account so that there is a given net increase in investment.

Further, we have assumed that there is no any time-lag between the increase in investment and
the resultant increment in income. That is, increment in income takes place instantaneously as a
result of increment in investment. J.M. Keynes ignored the time-lag in the process of income
generation and therefore his multiplier is also called instantaneous multiplier. In recent years, the
importance of time-lag has been recognized and concept of dynamic multiplier has been
developed on that basis.

Another important assumption in the theory of multiplier is that excess capacity exists in the
consumer goods industries so that when the demand for them increases, more amounts of
consumer goods can be produced to meet this demand. If there is no excess capacity in consumer
goods industries, the increase in demand as a result of some original increase in investment will
bring about rise in prices rather than increases in real income, output and employment.

As we shall see later, Keynes’ multiplier was evolved in the context of advanced capitalist
economies which were in grip of depression and in times of depression and there did exist excess
capacity in the consumer goods industries due to lack of aggregate demand. The Keynesian
multiplier effect is very small in developing countries like India since there is not much excess
capacity in consumer goods industries.

In our above analysis of the multiplier process we have taken a closed economy, that is, we have
not taken into account imports and exports. If ours were an open economy, then a part of the
increment in consumption expenditure would have been made on imports of goods from abroad.

This would have caused increment in income in foreign countries rather than within the country.
This will reduce the value of the multiplier. Imports are important leakage from the multiplier
process and we have ignored them in our above analysis for the purpose of simplicity.

It is worth noting that multiplier not only works in money terms but also in real terms. In other
words, multiple increment in income as a result of a given net increase in investment does not
only take place in money terms but also in terms of real output, that is, in terms of goods and
services.
When incomes increase as a result of investment and these increments in income are spent on
consumer goods, the output of consumer goods is increased to meet the extra demand brought
about by increased incomes. Therefore, real income or output increases by the same amount as
the increment in money incomes, since the prices of goods have been assumed to be constant.

Of course, we have assumed, that there exists excess productive capacity in the consumer goods
industries so that when the demand for consumer goods increases, their production can be easily
increased to meet this demand. However, if due to some bottlenecks output of goods cannot be
increased in response to increasing demand, prices will rise and as a result the real multiplier
effect will be small.

Diagrammatic Representation of Multiplier:

The level of national income is determined by the equilibrium between aggregate demand and
aggregate supply. In other words, the level of national income is fixed at the level where C + I
curve intersects the 45° income curve. With such a diagram we can explain the multiplier.

The multiplier is illustrated in Fig. 10.1. In this figure C represents marginal propensity to
consume. Marginal propensity to consume has been here assumed to be equal to 1/2 i.e., 0.5.
Therefore, the slope of the curve C of marginal propensity to consume curve C has been taken to
be equal to 0.5. C + I represents aggregate demand curve.

It will be seen from Fig. 10.1 that the aggregate demand curve C + I which intersects the 45° line
at point E so that the level of income equal to OF, is determined. If investment increases by the
amount EH we can then find out how much increment in income occur as a result of this. As a
consequence of increase in investment by EH, the aggregate demand curve shifted upward to the
new position C + I’.

This new aggregate demand curve C + I intersects income line at point F so that the equilibrium
level of income increases to OF As a result of net increase in investment equal to EH. the income
has increased by Y2Y2It is seen from the figure that F, Y 2 is greater than EH. On measuring it
will be found that Y1 Y2 is twice the length of EH. This is as it is expected because the market
propensity to consume is here equal to and 1/2 therefore the size of multiplier will be equal to 2.

The multiplier can be illustrated through savings investment diagram also. The multiplier can be
explained with the help of savings investment diagram, as has been shown in Fig. 10.2. In this
figure SS is the saving curve indicating that as the level of income increases, the community
plans to save more. II is the investment curve showing the level of investment planned to be
undertaken by the investors in the community. The investment has been taken to be a constant
amount and autonomous of changes in income.
This investment level OI has been determined by the marginal efficiency of capital and the rate
of interest. Investment being autonomous of income means that it does not change with the level
of income. Keynes treated investment as autonomous of income and we will here follow him. It
will be seen from Fig. 10.2 that saving and investment curves intersect at point E, that is, planned
saving and planned investment are in equilibrium at the level of income OY 1Thus, with the given
saving and investment curves level of income equal to OY1 is determined.

Now suppose that there is an increase in investment by the amount II”. With this increase in
investment, the investment curve shifts to the new dotted position TF. This new investment curve
II intersects the saving curve at point F and a new equilibrium is reached at the level of income
OY2 A glance at Fig. 10.2 will reveal that the increase in income Y 1 Y2 is greater than the
increase in investment by II”.

On measuring these increments in income and investment it will be found that the increment in
income Y1 Y2 is two times the increment in investment II. This is because we have here assumed
that propensity to save is equal to 1/2 (Or marginal propensity to consume is equal to 1/2)
Therefore, the slope of the saving curve has been taken to be equal to 1/2 or 0.5 Thus in this case
multiplier is equal to 2.

Multiplier = ∆Y/∆I = Y1 Y2/II, 1/MPS =2

Since marginal propensity to save is here equal to1/2 the multiplier on the basis of our above
formula, namely, k =1/ MPS will be equal to 2.

Leakages in the Multiplier Process:

We have seen above that as a result of increase in investment, the level of income increases by a
multiple of it. In our above analysis, saving is a leakage in the multiplier process. Had there been
no saving and as a result marginal propensity to consume were equal to 1, the multiplier would
have been equal to infinity.

In that case as a result of some initial increase in investment, income would go on rising
indefinitely. Since marginal propensity to consume is actually less than one, some saving does
take place. Therefore, multiplier in actual practice is less than infinity.

But besides saving, there are other leakages in the process of income generation which reduce
the size of the multiplier. Therefore, the increase in income as a result of some increase in
investment will be less than warranted by the size of the multiplier measured by the given
marginal propensity to consume. We explain below the various leakages that occur in the income
stream and reduce the size of multiplier in the real world.

Paying off debts:

The first leakage in the multiplier process occurs in the form of payment of debts by the people,
especially by businessmen. In the real world, all income received by the people as a result of
some increase in investment is not consumed. A part of the increment in income is used for
paying back the debts which the people have taken from moneylenders, banks or other financial
institutions.

The incomes used for paying back the debts do not get spent on consumer goods and services
and therefore leak away from the income stream. This reduces the size of the multiplier. Of
course, when incomes received by the moneylenders, banks or institutions are again lent back to
the people, they come back to the income stream and enhance the size of multiplier. But this may
or may not happen.

Holding of idle cash balances:

If the people hold apart of their increment in income as idle cash balances and do not use it for
consumption, they also constitute leakage in the multiplier process. As we have seen, people
keep part of their income for satisfying their precautionary and speculative motives, money kept
for such purposes is not consumed and therefore does not appear in the successive rounds of
consumption expenditure and therefore reduces the increments in total income and output.

Imports:

In our above analysis of the working of the multiplier process we have taken the example of a
closed economy, that is, an economy with no foreign trade. If it is an open economy as is usually
the case, then a part of increment in income will also be spent on the imports of consumer goods.
The proportion of increments in income spent on the imports of consumer goods will generate
income in other countries and will not help in raising income and output in the domestic
economy.

Therefore, imports constitute another important leakage in the multiplier process. Suppose
marginal propensity to save of an open economy is 1/4, i.e., marginal propensity to consume is
3/4. Suppose further that marginal propensity to import is 1/4 , the size of the multiplier without
imports will be equal 4 to equal to 4 but the size of the multiplier with the marginal propensity to
import equal to 1/4 and the marginal propensity to consume equal to 3/4 will be smaller.

Multiplier in an Open Economy = 1/ 1 -(MPC-MPI) = 1/1 – MPC + MPI

where MFC stands for marginal propensity to consume and MP1 for marginal propensity to
import.

In our example quoted above, where marginal propensity to consume is equal to 3/4 and
marginal 3/4 propensity to import is equal to 1/4, the multiplier is:

K = 1/1- (3/4 – 1/4) = 1/1/2 =2

We, therefore, see that the size of multiplier instead of being equal to 4, as it would have been in
the case of a closed economy, is equal to 2 in the open economy with — as the marginal
propensity to import.

Taxation:

Taxation is another important leakage in the multiplier process. The increments in income which
the people receive as a result of increase in investment are also in part used for payment of taxes.
Therefore, the money used for payment of taxes does not appear in the successive rounds of
consumption expenditure in the multiplier process, and the multiplier is reduced to that extent.

However, if the money raised through taxation is spent by the Government, the leakage through
taxation will be offset by the increase in Government expenditure. But it is not necessary that all
the money raised through taxation is spent by the Government as it happens when Government
makes a surplus budget.

No doubt, if the Government expenditure increases by an amount equal to the taxation, it would
not have any adverse effect on the increases in income and investment and in this way there
would be no leakage in the multiplier process.

Increase in Prices:

Price inflation constitutes another important leakage in the working of the multiplier process in
real terms. The multiplier works in real terms only when as a result of increase in money income
and aggregate demand, output of consumer goods is also increased.
When output of consumer goods cannot be easily increased, a part of the increases in the money
income and aggregate demand raises prices of the goods rather than their output. Therefore, the
multiplier is reduced to the extent of price inflation. In developing countries like India the extra
incomes and demand are mostly spent on food-grains whose output cannot be increased so
easily.

Therefore, the increments in demand raise the prices of goods to a greater extent than the
increase in their output. Besides, in developing countries like India, there is not much excess
capacity in many consumer goods industries, especially in agriculture and other wage-goods
industries.

Therefore, when income and demand increase as a result of increase in investment, it generally
raises the prices of these goods rather than their output and therefore weakens the working of the
multiplier in real terms. Thus, it was often asserted in the past that Keynesian theory of multiplier
was not very much relevant to the conditions of developing countries like India. However, we
shall discuss later that this old view about the working of Keynes’ multiplier is not fully correct.

The above various leakages reduce the multiplier effect of the investment undertaken. If these
leakages are plugged, the effect of change in investment on income and employment would be
greater.

Importance of the Concept of Multiplier:

Multiplier is one of the most important concepts developed by J.M. Keynes to explain the
determination of income and employment in an economy. The theory of multiplier has been used
to explain the cumulative upward and downward swings of the trade cycles that occur in a free-
enterprise capitalist economy. When investment in an economy rises, it has a multiple and
cumulative effect on national income, output and employment.

As a result, economy experiences rapid upward movement. On the other hand, when due to some
reasons, especially due to the adverse change in the expectations of the business class,
investment falls, then backward working of the multiplier causes a multiple and cumulative fall
in income, output and employment and as a result the economy rapidly moves on downswing of
the trade cycle. Thus, Keynesian theory of multiplier helps a good deal in explaining the
movements of trade cycles or fluctuations in the economy.

The theory of multiplier has also a great practical importance in the field of fiscal policy to be
pursued by the Government to get out of the depression and achieve the state of full
employment. To get rid of depression and remove unemployment, Government investment in
public works was recommended even before Keynes.

But it was thought that the increase in income will be limited to the amount of investment
undertaken in these public works. But the importance of public works is enhanced when it is
realised that the total effect on income, output and employment as a result of some initial
investment has a multiplier effect. Thus, Keynes recommended Government investment in public
works to solve the problem of depression and unemployment.

The public investment in public works such as road building, construction of hospitals, schools,
irrigation facilities will raise aggregate demand by a multiple amount. The multiple increase in
income and demand will also encourage the increase in private investment.

Thus, the deficiency in private investment which leads to the state of depression and
underemployment equilibrium will now be made up and a state of full employment will be
restored. If the multiplier had not worked, the income and demand would have risen as a result of
some public investment but not as much as they rise with the multiplier effect.

Inspired by the Keynesian theory of multiplier, expansionary fiscal policy of increase in

Government expenditure and reduction in income tax have been adopted by President John
Kennedy and President George W. Bush in the United States of America to remove involuntary
unemployment and depression. This had a great success in removing unemployment and
depression and therefore, Keynesian theory of multiplier was vindicated and as a result people’s
belief in it increased.

The Paradox of Thrift:

An interesting paradox arises when all people in a society try to save more but in fact they are
unable to do so. The multiplier theory of Keynes helps a good deal in explaining this paradox.
According to this paradox of thrift, the attempt by the people as a whole to save more for hard
times such as impending period of recession or unemployment may not materialize and in their
bid to save more the society in-fact may not only end up with the same savings (or, even lower
savings) but also in the process cause their consumption or standard of living to decline.

Thrift (i.e., the desire to save more) is considered to be a virtue in most of the societies and it is
regarded as an act of prudence on the part of individuals to save for a rainy day. According to a
proverb, “a penny saved is a penny earned”. Further, according to classical economists, savings
determine investment which plays a crucial role in accelerating the rate of economic growth.

However, the paradox of thrift shows that the efforts to .save more, especially in times of
depression, may actually deepen the economic crisis and cause output to fall and unemployment
to increase. It goes to the credit of Keynes that with his multiplier theory he was able to resolve
the paradox of thrift. Keynesian explanation of paradox of thrift has been shown in Fig. 10.4.
According to the Keynesian theory, the saying “penny saved is penny earned” is quite
inappropriate for the economy as a whole when it is working at underemployment equilibrium,
that is, when there prevails recession or depression. Keynes has showed that if all people in a
society decide to save more, they may actually fail to do so but nevertheless reduce their
consumption.

This is because, according to Keynes, the effort to save more by all in a society will lower the
aggregate demand for goods and services resulting in a drop in the level of national income. At
the lower level of national income, the savings fall to the original level but consumption will be
less than before which implies that the people would become worse off.

Consider Fig. 10.4, where SS is the saving curve with a slope equal to 0.5, and II is the planned
investment curve. It will be seen that saving and investment curves intersect at point E1 and
determine level of income equal to K, or Rs.300 crores. Now suppose that expecting hard times
ahead all people try to save more by the amount of Rs. 50 crores which would cause an
autonomous downward shift in the consumption function.

This downward shift in the consumption function brings about an upward shift by Rs. 50 crores
or E A in the saving function curve to S’S’. This new saving function curve S’S’ cuts the
planned investment curve II at point E 2 according to which new equilibrium level of income falls
to Y2 or Rs. 200 crores. It is important to note that level of income does not drop only by the
amount (E1A or RS. 50 crores), that is, by the extent of reduction in consumption due to more
saving but by a multiple of it.

With marginal propensity to save (MPS) being equal to 0.5 or 1/2, the value of multiplier would
be 1/MPS= 1/1/2= 2. Further, the decline in consumption due to more saving would cause the
multiplier to work in reverse, that is, the multiplier would operate to reduce the level of
consumption and income by a magnified amount. The decline in consumption expenditure of the
people by Rs. 50 crores in the first instance due to more saving by them implies that the
producers and sellers of goods and services will find their income to fall by Rs. 50 crores. But
the reverse process will not stop here.

Given the marginal propensity to consume being equal to 0.5 or the producers/sellers of goods
and services in turn would spend Rs.25 crores less when they find their income has fallen by
Rs.50 crores. It will be observed from Fig. 10.4 that this process of reduction of the level of
income will continue till the new saving is equal to investment at the lower level of income
Y2 (Rs.200 crores), that is, the level of income has declined by Rs. 100 crores (50 x 2) from its
initial equilibrium level of income Y1 of Rs. 300 crores.

Thus the attempt by all people to save more has led to the decline in the equilibrium level of
income to Y2 or Rs. 200 crores at which, with marginal propensity to consume remaining
unchanged at 0.5 or ½, saving of the society will fall to the initial level of Y 1E or Rs. 100 crores
(200 x 0.5 = 100). This is clearly depicted in Fig. 10.4. With the decrease in planned saving by
Rs. 50 crores at every level of income the saving function (SS) shifts upward.

This sets in motion the operation of the multiplier in the reverse and as will be seen from the
10.4, the new equilibrium is reached at the new lower level of income Y 2 (Rs. 200 crores). It is
important to observe that the saving which had risen to Y 1A (Rs. 150 crores) has once again
fallen to the original level of Rs. 100 crores (Y 2E2 = Y1E1) due to reduction in consumption
expenditure inducing the working of multiplier in the reverse which causes a decline in the
equilibrium level of income from Y1 (Rs. 300 crores) to Y2 (Rs. 200 crores).

In other words, the increases in saving by Rs. 50 crores has led to the fall in income by Rs. 100
crores because the multiplier is equal to 2. This explains the paradoxical feature of an economy
gripped by recession. This is paradoxical because in their attempt to save more the people have
caused a decline in their income and consumption with no increase in the saving of the society at
all.

In our analysis we have assumed that the planned investment is fixed, that is, determined outside
the model. In other words, the investment has been assumed to be autonomous of income, that is,
it does not vary with income.

Can We Avert the Paradox of Thrift?

Paradox of thrift holds good when a free market economy is in the grip of recession or
depression and investment demand is inadequate due to lack of profit opportunities. However, it
has been pointed out by some economists that paradox of thrift can be averted if the extra
savings that the people do for a rainy day are somehow channeled into additional investment
through financial markets.
Indeed, the classical economists argued that the increase in the supply of savings would lead to
the fall in the rate of interest which would induce increase in planned investment. If this happens,
then in our saving-investment diagram the investment curve II would shift up to I’I’ and as will
be seen from Fig. 10.5 the new equilibrium level of income may not fall and therefore the
paradox of thrift is averted.

In Fig. 10.5, initially the saving curve (S 1S1) and investment curve (II) intersect at point E1 and
determine Y1 level of income. Now, if the people of the society expecting difficult times ahead,\
desire to save E1A more. If these extra savings, for reasons mentioned above, result in more
investment, the investment curve will shift to I’I’, the new equilibrium will be at point A
corresponding to the original level of income Y1. In this way the paradox of thrift has been
averted.

However, according to the modern economists, especially the followers of Keynes, the empirical
evidence does not support the above argument of averting the paradox of thrift. This is because
at times of recession or depression, the prospective yields from investment are so small that no
possible reduction in the rate of interest will induce sufficient increase in investment.

Thus, according to them, in a free-market and private enterprise economy without Government
intervention paradox of thrift cannot be averted. Of course, if the Government intervenes as it
does even in the present- day predominantly private enterprise economies of the USA and Great
Britain, it can mobilise the extra savings of the people and invest them in some worthwhile
projects and thus prevent aggregate demand and income from falling.

This can happen because the Government undertakes investment because it is not motivated by
profit motive but by the considerations of promoting social interest and economic growth. It is
because of this that the role of the Government has greatly increased for overcoming recession in
the capitalist countries.
ACCELERATOR

Meaning of Accelerator:

The multiplier and the accelerator are not rivals: they are parallel concepts. While multiplier
shows the effect of changes in investment on changes in income (and employment), the
accelerator shows the effect of a change in consumption on private investment.

The Principle of Acceleration states that if the demand for consumption goods rises, there will be
an increase in the demand for the equipment, say machines, which produce these goods. But the
demand for the machines will increase at a faster rate than the increase in demand for the
product.

The accelerator, therefore, makes the level of investment a function of the rate of change in
consumption and not of the level of consumption. In other words, the accelerator measures the
changes in investment goods industries as a result of long-term changes in demand in
consumption goods industries.

The idea underlying the accelerator is of a functional relationship between the demand for
consumption goods and the demand for machines which make them. The acceleration coefficient
is the ratio between induced investments to a given net change in consumption expenditures.

v =∆I/∆C

Symbolically where v stands for acceleration coefficient; ∆I denotes the net changes in
investment outlays; and ∆C denotes the net change in consumption outlays. Suppose an
additional expenditure of Rs. 10 crores on consumption goods leads to an added investment of
Rs. 20 crores in investment goods industries, then the accelerator is 2. The actual value of the
accelerator can be one or even less than that.

In actual world, however, increased expenditures on consumption goods always lead to increased
expenditures on capital goods. Hence acceleration coefficient is usually greater than zero. Where
a good deal of capital equipment is needed per unit of output, the acceleration coefficient is very
much more than unity.

In exceptional cases, the accelerator can be zero also. Sometimes it so happens that production of
increased consumer goods (as a result of a rise in their demand) does not lead to an increase in
the demand for capital equipment producing these goods.

The existing machinery also wears out on account of over use, with the result that the increased
demand for consumer goods cannot be met. It actually happened in India and Turkey during the
Second World War.

Additional investment funds were not available. In the absence of induced investment and
acceleration effects, the increased demand for consumption levelled off and the accelerator,
which measures the effects of induced investment (in investment goods industries) as a result of
changes in consumption did not seem to work during all-these years.

The factual basis of the acceleration principle is the knowledge that fluctuations in output and
employment in investment goods industries are greater than those in consumption goods
industries. Accelerator has greater applicability to the industrial sector of the economy; and as
such it seeks to analyse the problem as to why fluctuations in employment in the capital goods
industries are more pronounced than those in the consumption goods industries.

There would be no acceleration effects in an economy which used no capital goods. But that
situation is very rare. The more capitalized the methods of production are, the greater must be the
value of accelerator.

The principle of acceleration is basically a concept related to net investment. Therefore, we must
derive an expression linking the accelerator with net investment. We know that gross investment
has two components: net investment plus replacement of capital wearing out due to depreciation.
We can write

Gross Investment = Igt= V(Yt-Yt-1) +R

which means that the quantum of gross investment in period t depends upon the value of
acceleration effects of the change in income in the previous period and the need for replacement
of capital.

Inet =V(Yt-Yt–1)

Thus, net investment in period t is which means that net investment depends only on the rate of
change of income and the accelerator (V).

Multiplier and Accelerator Distinguished:

For a clear grasp of the concept of accelerator, it is useful to distinguish between multiplier and
accelerator. Multiplier shows the effect of a change in investment on income and employment
whereas accelerator shows the effects of a change in consumption on investment. In other words,
in the case of multiplier, consumption is dependent upon investment, whereas in the case of
accelerator investment is dependent upon consumption.

Further, multiplier depends upon the propensity to consume and accelerator depends upon
durability of the machines. In other words, the former is dependent upon psychological factors,
while the latter is dependent upon technological factors. However, even accelerator is
psychological in its origin because it is linked to induced investment but it becomes highly
technical on the operational plane. The accelerator shows the reaction (effect) of changes in
consumption on investment and the multiplier shows the reaction of consumption to increased
investment.
Further, another very important point of difference between the multiplier and accelerator is in
their working backwards. Multiplier works as rigorously in the reduction of income as it does in
its increase. But the working of the accelerator is restricted in the downward direction to the rate
of replacement of capital because businessmen can at the most disinvest to the extent of not
replacing the wearing-out capital.

Importance and Limitations of the Accelerator:

The introduction of the Principle of Acceleration enables us to understand the process of income
generation more clearly. No doubt, a certain level of income (or employment) could be attained
by multiplier action alone. But along with accelerator the process of income propagation is
speeded up. When accelerator and multiplier join hands, more violent fluctuations in income
occur in upward and downward directions.

Firstly, this multiplier-accelerator interaction enables us to throw light on one of the most
important features of business cycle. This feature is that the investment goods industries fluctuate
more violently than the consumption-goods industries. It has helped us to show that small
demand changes in consumption-goods industries lead to considerably enlarged changes in
investment-goods industries.

Secondly, the multiplier-accelerator interaction has profoundly increased our understanding of

business cycles. Prof. Hicks’ theory of the business cycle is based primarily on the principle of
acceleration.

Further, Prof. R.F. Harrod has based his theory of Steady Growth on the acceleration principle.
Harrod’s analysis of economic growth grew out of his analysis of business cycle as a dynamic
economic phenomenon.

Despite its great theoretical importance, its qualifications indicate that attempts to apply very
simplified models using the acceleration principle are likely to give misleading results. The
presumptions of a fixed ratio of consumer to capital goods, of constant replacement demand, of
no excess capacity, of permanent demand are lacking in realism. In other words, acceleration
theory is valid only so long as all machines are in use (no excess capacity), overtime is excluded,
the relation between production factors is not altered (unchanged technology), sufficient raw
materials and labour are present and the entrepreneurs command the necessary financial means.

Since this is not the case generally, the simple concept of accelerator as we have studied it is of
little significance. Many attempts to measure the accelerator have yielded little result.
Entrepreneurs’ behaviour is to be explained through numerous other factors, especially future
expectations play a particularly important part. More realistic assumptions would virtually lead
to results significantly different from those obtained under simplifying assumptions.

Conclusion:
The theory of accelerator is based upon the idea that income and the stock of capital goods
increase in flexible proportion. This is not the case where fundamental changes in technology are
changing both the capital-output ratio and durability of the machines. Economic growth,
furthermore, is not only dependent on capital. The accelerator is not adequate to explain changes
in aggregate investment.

Only under special circumstances and in the short run there is a proportional relationship
between output and the stock of capital goods. The acceleration principle is less general in
application than the multiplier; whereas the latter operates in both the forward and backward
directions, the accelerator is effective only in the upward direction (in the downward direction it
works only to the extent that replacement investment is not provided for).

Thus, it is clear that at least three basic conditions must operate for a ‘pure’ accelerator
model:

(i) Existing capacity is fully utilised,

(ii) Finances are adequate to permit satisfaction of accelerator-generated demand,

(iii) The change in output is thought to be non-temporary.

Such requirements obviously limit the generality of the principle.

CLASSICAL AND KEYNESIAN THEORIES: A COMPARISON

The following points highlight the six main points of differences between Classical and Keynes
Theory. The differences are: 1. Assumption of Full Employment 2. Emphasis on the Study of
Allocation of Resources Only 3. Policy of ‘Laissez Faire’ 4. Wage-Cut Policy as a Cure for
Unemployed Resources 5. Assumption of Neutral Money 6. Interest Rate as the Equilibrating
Mechanism between Saving and Investment.

Difference # 1. Assumption of Full Employment:

Classical theorists always assumed full employment of labour and other resources.

To them, full employment was a normal situation and unemployment was an abnormal situation.

According to Classicals, even if there is less than full employment in the economy, there is
always a tendency towards full employment.

By the term full employment of the available resources, the classical economists meant that
‘there is no involuntary unemployment’. If there is unemployment in the economy, classicists
felt that it was due to the existence of monopoly in industry and governmental interference with
the free play of the forces of competition in the market or it may be due to the imperfections of
the market owing to immobility of the factors of production.

If these limitations could somehow be eliminated, full employment, according to classical

economists, would always exist. Hence, the best way to ensure full employment for the
Government was to pursue the policy of ‘laissez faire’ capitalism under which free competitive
market forces were allowed to have full and free play.

Difference # 2. Emphasis on the Study of Allocation of Resources Only:

The existence of ‘full employment’ being a normal situation in the classical scheme, it followed
that factors of production are always fully employed and there is no further scope for additional
employment of resources in new industries. The choice, according to classsicals, was not
between employment and unemployment but between employment here and employment there,
i.e., increase in production in one direction could be achieved only at the cost of some decrease
in another direction in the economy.

In other words, classicals fell there could not be any significant misallocation of resources as the
price mechanism, acting as an ‘invisible hand’ would achieve the best, the most efficient
allocation of resources. Since the optimum allocation of a given quantity of resources was the
main subject-matter of classical economics, it was but natural that they did not discuss the
problem of national output, income or employment.

With their assumption of full employment, there obviously could not be any change in the real
national income of the community through additional employment of resources. What could
possibly be done, given, the composition and volume of the real national income, was a more
efficient allocation of the given resources.

As such, they remained concerned with the special case of full employment and not with the
general factors that determine employment at any time. In brief, the well-known theory of value,
distribution and production formed the ‘core’ of classical economics. That unemployment of
resources could also persist to pose a problem did not occur to them at all.

Difference # 3. Policy of ‘Laissez Faire’:

Classicals had great faith in the philosophy of laisez-faire capitalism, which meant ‘leave alone’
or ‘let alone’ in business matters. Laissez-faire capitalism would not tolerate any kind of
intervention by the Government in business matters; they rather considered it a positive
hindrance in the free working of the market economy.

Classicals believed in Laissez-faire capitalism as it was the traditional model of study from the
very’ beginning. Classicals had great faith in price mechanism, profit-motive, free and perfect
competition and the self-adjusting nature of the system. They felt that if the system is allowed to
work freely without any encroachments on the part of the state, it has potentialities to overcome
the maladjustments in the economic system, if there are any.

Difference # 4. Wage-Cut Policy as a Cure for Unemployed Resources:

Classicals further believed that involuntary unemployment could be easily cured by cutting
wages down through office and perfect competition which always exists in the labour market.
They argued that so long as labour does not demand more than what it is ‘worth’ or more than its
marginal productivity, there in no possibility of persistent unemployment in the economy.

Classicals believed that employment is determined by the wage bargains between the workers
and employers, therefore, wage-cuts will reduce unemployment; such a policy if pursued
vigorously can restore full employment as well. Basing their reasoning on the existence of free
and perfect competition in the product and labour markets, classicals argued that the unemployed
workers will cut down wages leading to a fall in prices, which, in turn, will encourage demand
giving a fillip to sales.

As a result of all this, more will be produced as more is demanded and employment would
increase because workers are employed at lower wages to increase production. Wage-cuts, thus
occupied a central place in the classical scheme of reasoning for automatic functioning of the
capitalist economy at full employment.

Difference # 5. Assumption of Neutral Money:

Classicals did not give much importance to money treating it only as a medium of exchange its
role as a store of value was not considered. To them, money facilitated the transactions of goods
but had no effect on income, output and employment. They considered it as a ‘veil’ which hides
real things goods and services. In other words, they assumed that people have one motive for
holding money, i.e. the transaction motive.

Classicals completely ignored the precautionary and speculative motives for holding money. In
short, they never recognised that money could also influence the level of income, output and
employment. In contrast to this view, Keynes considered money on as on active force that in
influences total output.

Difference # 6. Interest Rate as the Equilibrating Mechanism between Saving and

Investment:

Classicals would give the pride of place to the rate of interest as the equalizer of saving and
investment at full employment of resources. The implied assumption was that both saving and
investment are highly sensitive to changes in the rate of interest.
The belief was firmly rooted that saving and investment can be equal only at full employment,
and that ‘under employment equilibrium’ is a disequilibrium situation which would not last long
in an atmosphere of wage price flexibility under the pressure of competition.