There are various concepts of National Income.

The main concepts of NI are: GDP, GNP, NNP, NI, PI, DI, and PCI.
These different concepts explain about the phenomenon of economic activities of the various sectors of the various
sectors

of

the

Gross

Domestic

economy.

Product

(GDP)

The most important concept of national income is Gross Domestic Product. Gross domestic product is the money
value of all final goods and services produced within the domestic territory of a country during a year.

Algebraic

expression

under

product

method

is,

GDP=(P*Q)

where,
GDP=Gross

Domestic

P=Price

of

Q=Quantity

goods
of

denotes

Product
and

goods

the

service

and

summation

of

service
all

values.

According to expenditure approach, GDP is the sum of consumption, investment, government expenditure, net
foreign

Algebraic

exports

expression

of

country

under

expenditure

during

year.

approach

is,

GDP=C+I+G+(X-M)

Where,
C=Consumption
I=Investment
G=Government
(X-M)=Export

expenditure
minus

GDP includes the following types of final goods and services. They are:

import

1.

Consumer goods and services.

2.

Gross private domestic investment in capital goods.

3.

Government expenditure.

4.

Exports and imports.

Gross

National

Product

(GNP)

Gross National Product is the total market value of all final goods and services produced annually in a country plus
net factor income from abroad. Thus, GNP is the total measure of the flow of goods and services at market value
resulting from current production during a year in a country including net factor income from abroad. The GNP can
be

expressed

GNP=GDP+NFIA

as

the

following

Factor

Income

from

(Net

or,

equation:

Abroad)
GNP=C+I+G+(X-M)+NFIA

Hence, GNP includes the following:

1.

Consumer goods and services.

2.

Gross private domestic investment in capital goods.

3.

Government expenditure.

4.

Net exports (exports-imports).

5.

Net factor income from abroad.

Net National Product (NNP)

Net National Product is the market value of all final goods and services after allowing for depreciation. It is also called
National Income at market price. When charges for depreciation are deducted from the gross national product, we get
it. Thus,
NNP=GNP-Depreciation
or, NNP=C+I+G+(X-M)+NFIA-Depreciation
National Income (NI)
National Income is also known as National Income at factor cost. National income at factor cost means the sum of all

incomes earned by resources suppliers for their contribution of land, labor, capital and organizational ability which go
into the years net production. Hence, the sum of the income received by factors of production in the form of rent,
wages, interest and profit is called National Income. Symbolically,
NI=NNP+Subsidies-Interest Taxes
or,GNP-Depreciation+Subsidies-Indirect Taxes
or,NI=C+G+I+(X-M)+NFIA-Depreciation-Indirect Taxes+Subsidies
Personal Income (PI)
Personal Income i s the total money income received by individuals and households of a country from all possible
sources before direct taxes. Therefore, personal income can be expressed as follows:
PI=NI-Corporate Income Taxes-Undistributed Corporate Profits-Social Security
Contribution+Transfer Payments
Disposable Income (DI)
The income left after the payment of direct taxes from personal income is called Disposable Income. Disposable
income means actual income which can be spent on consumption by individuals and families. Thus, it can be
expressed as:
DI=PI-Direct Taxes
From consumption approach,
DI=Consumption Expenditure+Savings
Per Capita Income (PCI)
Per Capita Income of a country is derived by dividing the national income of the country by the total population of a
country. Thus,
PCI=Total National Income/Total National Population

National income is the sum total of wages, rent, interest, and profit earned by the factors of
production of a country in a year. Thus it is the aggregate values of goods and services rendered
during a given period counted without duplication.
Below are given some of the important concepts of national income.
1. Gross Domestic Product at Market Price.
2. Gross National Product at Market Price.
3. Net Domestic Product at Market Price.
4. Net National Product at Market Price.
5. Net Domestic Product at Factor Cost.
6. Net National Product at Factor Cost.
7. Gross Domestic Product at Factor Cost.
8. Gross National Product at Factor Cost.
9. Private Income.

10. Personal Income

11. Disposable Income.
(1) Gross Domestic Product at Market Price (GDP at MP):Gross domestic product at market price is the aggregate money value of the final goods and services
produced within the country's own territory. So as to calculate GDP at MP all goods and services
produced in the domestic territory are multiplied by their respective prices. Symbolically GDP at MP
= PXQ. Where P is market price and Q is final goods and services. GDP includes only those goods
which come to the market for sale. The values of final goods are only expressed in money terms.
Value of depreciation and transfer payments are not included in GDP at MP. The value of second
hand goods is excluded from gross domestic product.
[Gross Domestic Product at Market Price = value of gross domestic output - value of intermediate
consumption]
(2) Gross National Product of Market Price (GNP at MP):Gross national product at market price is broade and comprehensive concept. GNP at MP measures
the money value of all the final products produced annually in a counter plus net factor income from
abroad. In short GNP is GDP plus net factor incomes earned from abroad. Net factor incomes is
derived by reducing the factor incomes earned by foreigners from the country, in question from the
factor incomes earned by the residents of that country from abroad.
[Gross National Product at Market Price = Gross domestic product at market price + Net factor
income from abroad.]
(3) Net Domestic Product at Market Price (NDP at MP):Net domestic product- at market price is the difference between Net National Product at market
price and net factor income from abroad. Net domestic product at market price is the difference been
GNP at market price minus depreciation and net factor incomes from abroad.
[Net Domestic Product at Market Price = GNP at MP - Depreciation - Net factors income form
abroad]
(4) Net National Product at Market Price (NNP at MP):Net National product measures the net money value of final goods and services at current prices
produced in a year in a country. It is the gross national product at market price less depreciation. In
production of output capital assets are constantly used up. This fixed capital consumption is called
depreciation. Depreciation constitutes loss of value of fixed capital. Thus net national product is the
net money value of final goods and services produced in the course of a year. Net money value can be
arrived at by excluding depreciation allowance from total output.
[NNP at MP = GNP at MP - Depreciation]
(5) Net Domestic Product at Factor Cost (NDP at FC):Net Domestic product of factor cost or domestic income is the income earned by all the factors of
production within the domestic territory of a country during a year in the form of wages, interest,
profit and rent etc. Thus NDP at FC is a territorial concept. In other words NDP at factor cost is equal
to NNP at FC less net factor income from abroad.

[NDP at FC = NNP at FC - Net factor income from abroad]

(6) Net National Product at Factor Cost (NNP at FC)
Net national product at factor cost is the aggregate payments made to the factors of production. NNP
at FC is the total incomes earned by all the factors of production in the form of wages, profits, rent,
interest etc. plus net factor income from abroad. NNP at FC is the NDP at FC plus net factor income
from abroad. NNP at FC can also be derived by excluding depreciation from GNP at FC.
[NNP at FC = NDP at FC + Net Factor Income from abroad]
(7) Gross Domestic Product at Factor Cost (GDP at FC):
Gross Domestic Product at factor cost refers to the value of all the final goods and services produced
within the domestic territory of a country. If depreciation or consumption of fixed capital is added to
the net domestic product at factor cost, it is called Gross domestic Product at Factor cost.
[GDP at FC = NDP at FC - Depreciation]
(8) Gross National Product at Factor Cost (GNP at FC):Gross national product at factor cost is obtained by deducting the indirect tax and adding subsidies
to GNP at market price or Gross national Product at factor cost is obtained by adding net factor
incomes from abroad to the GDP at factor cost.
[GNP at FC = GNP at MP - Indirect tax + Subsidies] or, [GNP at FC = GDP at FC + Net Factor
Income from abroad]
(9) Private Income:Private income means the income earned by private individuals from any source whether productive
or unproductive. It can be arrived at from NNP at factor cost by making certain additions and
deduction. The additions include (a) transfer earnings from Govt, (b) interest on national debt (c)
current transfers from rest of the world. The deductions include (a) Income from property and
entrepreneurship (b) savings of the non- departmental undertakings (e) social security
contributions. In order to arrive at private income the above additions and subtraction are to be
made to and from NNP at factor Cost.
[Private Income = NNP at FC + transfer payments + Interest on public debt - social securities profits and surpluses of public undertakings]
(10) Personal Income:Personal Income is the total income received by the individuals of country from all sources before
direct taxes. Personal income is not the same as National Income, because personal income includes
the transfer payments where as they are not included in national income. Personal income includes
the wages, salaries, interest and rent received by the individuals. Personal income is derived by
excluding undistributed corporate profit taxes etc. from National Income.
[Personal Income = Private Income - Saving of Private enterprise - Corporate tax]
(11) Disposable Income:Disposable income means the actual income which can be spent on consumption by individuals and
families. It refers to the purchasing power of the house hold. The whole of disposable income is not

spent on consumptions; a part of it is paid in the form of direct tax. Thus disposable income is that
part of income, which is left after the exclusion of direct tax.
[Disposable Income = Personal Income - Direct tax]

The
IS

curve
The IS curve is derived with the aid of the
following three diagrams: Diagram (a)
represents the investment function, diagram (b)
the goods market with a flexible interest rate and
diagram (c) the IS curve.
Assuming that the interest rate is i2 the
corresponding level of investment spending,
according to the given investment schedule, is I1. Given
an interest rate of i2 with a level of investment spending I1, the
corresponding demand for goods is ZZ1. Given this demand for goods a goods market
equilibrium occurs at point 1 where Z = Y and the equilibrium level of income is Y1.
With this information we can plot the first point of the IS-curve in diagram (c). In this diagram
the interest rate is measured on the vertical axis and the level of output is measured on the
horizontal axis. Note that the level of output is measured on the horizontal axis for both the
goods market and the IS-curve.

Using the information in diagrams (a) and (b) which indicates that at an interest rate of i2 the
goods market is in equilibrium at an income level of Y1, the first point of the IS curve is plotted.
This point indicates that at an interest rate of i2 goods market equilibrium occurs at a level of
output Y1. Note that point 1 in diagram (c) represents goods market equilibrium as indicated by
point 1 in diagram (b).

Shortcomings of AD-AS model

An AD-AS model of the type just described has many well-known weaknesses and limitations,
of which three are relevant for our purposes.
The criticisms that have received the most attention concern the alleged lack of
microeconomic foundations of the model. NKs who have been vocal in this criticism, wish to
supplant the model with models based on explicit optimization. We shall take up the issue of
optimizing micro foundations in section 4 where we discuss the NK approach. But the behavioral
approach of the AD-AS model has also been criticized from another angle. Many post Keynesian

economists, but also some impeccably mainstream old Keynesians, have suggested that the
model is too mechanical and does not take into account uncertainty and expectations in a serious
manner.It is beyond the scope of the present paper to address this important issue in any detail
but in our view, mechanical mathematical formalization can be extremely useful. This
formalization needs to be supplemented by verbal descriptions and empirical analysis, and less
formal discussions of possible outcomes may also come into play if the relations determining the
evolution of the system are not capable of being formalized in a precise manner. Even this
informal discussion, however, will often benefit from using more formal analyses as points of
reference and by suggesting where and how the results of the models may need to be modified.
A second set of criticisms claims that the AD-AS model omits many important features of reality
and that some of its implications are not consistent with empirical observation. Assumptions of
imperfect competition, for instance, should replace perfect competition, and the money supply
should not be treated as an exogenous variable in an economy with modern monetary
institutions. The consumption function should also take into account income distributional
effects on consumption, increases in aggregate demand should provide a direct stimulus to
investment, and the distinction between nominal and real rates of interest may be critical (not
least for the reactions of aggregate demand to changes in money wages and the stability of full
employment). These (and other) modifications may complicate the model and affect some of its
properties, but in principle their introduction is quite straightforward and the resulting model can
still be depicted with AD and AS curves. The modifications, moreover, help to address some of
the empirical criticisms of the AD-AS model. The simple model, for instance, predicts a countercyclical movement of the real wage. This implication, which finds little support in the, no longer
holds in versions of the model that include imperfect competition and some Combination of
non-diminishing returns to labor and/or a counter-cyclical pattern in the markup.
A third set of problems with the AD-AS model concerns the unsatisfactory treatment of
dynamics. There is a lack of integration between the analysis of the short-run and more longterm issues, and even when it comes to the treatment of the short run, the analysis often relies on
unstated or questionable assumptions concerning the process leading to a short-run Keynesian
equilibrium. Our own presentation above is quite explicit in its assumptions but, perhaps
unrealistically, it presumes that the adjustment to market-run equilibrium is very fast relative to
the adjustments of price expectations. The adjustment to market-run equilibrium could therefore
be based on given price expectations, and in the analysis of adjustments to short-run equilibrium
it could be assumed that there is continuous market equilibrium during the adjustment process.
The shortcomings of simple AD-AS models with respect to dynamics may be a legacy of
Keynes's own focus on short-run equilibria in GT. The assumption of fulfilled expectations
facilitated the presentation of the fix-wage general equilibrium. Unfortunately, it makes it hard to
discuss the stability issues, and from today's perspective having before us a well-developed
theory of general equilibrium the truly revolutionary and provocative message of the GT
concerns the destabilizing effects of money wage flexibility, rather than the existence of a fixwage equilibrium with unemployment.
The AD-AS model does not address the stability issue it takes the money wage as given - but
can serve as a starting point. The model can be easily extended in a way which makes it have the
implications presented in the typical textbook:

(i)
(ii)

(iii)

that unemployment can exist in the model because the money wage is exogenously
fixed;
that if one allows the money wage to fall in response to the existence of
unemployment, the AS curve, given by P = F(F-1(Y))/W is shifted downwards; and
that
this leads to an expansion of output and employment along the negatively-sloped AD
curve and moves the economy to the natural rate of unemployment. The mechanism
behind this adjustment is the Keynes effect by which a reduction in wage and price
increases the real supply of money, lowers the interest rate, and increases investment
and aggregate demand. This effect can be supplemented by the real balance effect by
which the rise in real balances directly stimulates the aggregate demand for goods.

This standard analysis is at odds with Keyness own argument in GT where, in chapter
19, he insisted that involuntary unemployment would not be eliminated by increased wage
flexibility. Falling money wages will influence the economy in a number of ways but, on
balance, are unlikely to stimulate output. Keynes's analysis of the effects of changes in money
wages may have been sketchy, but the logic behind potential instability is impeccable. The real
balance effect was overlooked by Keynes, but has been found to be empirically insignificant, and
the expansionary effects of a decline in money wages due to the Keynes effect may be more than
offset by the adverse influences of debt deflation, distributional shifts, and expectations of
continuing reductions of wages and prices. Old Keynesians have been aware of these stability
problems, and post Keynesians have stressed additional problems arising from the role of
uncertainty, the financial situation of firms and the effects of an endogenous money supply.
Aggregate Investment Function
Lets start with the simple Keynesian investment function:
It = AI f (i)
Where:
AI
f

intercept of the investment function, or what investment expenditures would be if

interest rates were zero
slope of the investment function, or the change in investment
with respect to a change in the interest rate (known as the
marginal efficiency of investment)

rate of interest

It

gross investment expenditures

Capital stock:
The desired productive capital stock of businesses at the end of the year
would be given by:

K*t = Kt-1 + It Dt
where:
K*t

desired productive capital stock (plant and equipment) at the

end of the year

Kt-1

productive capital stock (plant and equipment) at the beginning

of the year

Dt

depreciation during the year

Net investment expenditures:

Net investment is equal to gross investment, or new capital expenditures,
minus depreciation is given by:
NIt = It -Dt
where It (gross investment expenditures) and Dt (depreciation). Depreciation here also represents
replacement investment.
Aggregate Production:
The aggregate production for all businesses taken together can be
represented by the following function:
Yt = aLt[{K*t +Kt-1}/2]
where:
a

production constant

Lt

size of the labor force

Kt-1

partial elasticity of production with respect to labor (Y/L)

existing productive capital stock

partial elasticity of production with respect to capital (Y/K)

Interest Rate Effects on Investment and Labor:

We know that a contractionary monetary policy action will raise interest rates. When this
occurs, the following chain of events can be expected:
it It K*t Yt Lt

This suggests that an increase in interest rates dampens planned investment expenditures. This
will reduce productive capacity growth and potential output and reduces the need for labor to
produce the lower output. This will increase unemployment rate.
We know that a expansionary monetary policy action will lower interest rates. When this
occurs, the following chain of events can be expected:
it It K*t Yt Lt
This suggests that a decrease in interest rates enhances planned investment expenditures, which
expands productive capacity and planned potential output. This will increase employment
(decrease the unemployment rate).
Average Propensity to Consume and Marginal Propensity to Consume!
(1) Average Propensity to Consume (APC):
Average propensity to consume refers to the ratio of consumption expenditure to the
corresponding level of income.
APC = Consumption (C) / Income (Y)
If consumption expenditure is Rs 70 crores at national income of Rs 100 crores,
Rs 70
Then: APC C/Y = 70/100 = 0.70, i.e. 70% of the income is spent on consumption.
Let us understand APC with the help of following schedule and diagram:

In Table 7.4, at the income level of Rs 100 crores, APC = 1.20. APC falls to 1 when income rises
to Rs 200 crores. The value of APC further falls to 0.933 and then to 0.90. In Fig 7.4, income is
measured on the X-axis and consumption is measured on the Y-axis. CC is the consumption
curve. APC represents any one point on the consumption
Curve: At point A on the consumption curve CC, APC = ON/OY1
Important Points about APC:
(i) APC is more than 1:
As long as consumption is more than national income, i.e. before the break-even point, APC > 1.
(ii) APC = 1:
At the Break-even point, consumption is equal to national income. So, APC = 1 at the income
level of Rs 200 crores.
(iii) APC is less than 1:
Beyond the break-even point, consumption is less than national income. As a result, APC <1.
(iv) APC falls with increase in income:
APC falls continuously with increase in income because the proportion of income spent on
consumption keeps on decreasing.
(v) APC can never be zero:
APC can be zero only when consumption becomes zero. However, consumption is never zero at
any level of income. Even at zero level of national income, there is autonomous consumption (c).
2. Marginal Propensity to Consume (MPC):
Marginal propensity to consume refers to the ratio of change in consumption expenditure to
change in total income. MPC explains what proportion of change in income is spent on
consumption.
MPC = Change in Consumption (C) / Change in Income (Y)
If consumption expenditure increases from Rs 70 crores to Rs 110 crores with an increase in
income from Rs 100 crores to Rs 200 crores, then:
MPC = C/Y = 110 70/200-100 = 40/100= 0.40 i.e., 40% of the incremental income is spent
on consumption.
Let us understand MPC with the help of following schedule and diagram:
Table 7.5 Marginal Propensity to Consume
Income Consumption Change in
Change MPC =
(Y)
(C) (Rs
Consumption in
C/Y
(Rs
Crores)
(C) (Rs
Income

Crores)
0
100
200
300
400

Crores)
40
120
200
280
360

80
80
80
80

(Y) (Rs
Crores)

100
100
100
100

0.80
(=80/100)
0.80
(=80/10)
0.80 =
(80/10)
0.80 =
(80/100)
As seen in Table 7.5, MPC is 0.80, when consumption increases from Rs 40 crores to RS 120
crores with increase in income from zero to t 100 crores. Value of MPC remains same at 0.80
throughout the consumption function.
Since MPC {AC/AY} measures the slope of Y /Y
Consumption curve, constant value of MPC indicates that the consumption curve is a straight
line.
In Fig. 7.5, MPC at point A with respect AC MN to point B = AC/AY=MN/Y1Y2

Important Points about MPC:

1. Value of MPC varies between 0 and 1:
We know, incremental income is either spent on consumption or saved for future use.
i. If the entire additional income is consumed, i.e. AS = 0, then MPC = 1.
ii. However, if entire additional income is saved, i.e. AC = 0, then MPC = 0 In normal situations,
value of MPC varies between 0 and 1.
2. MPC of poor is more than that of rich:
It happens because poor people spend a greater percentage of their increased income on
consumption as most of their basic needs remain unsatisfied.
On the other hand, rich people spend a smaller proportion as they already enjoy a high standard
of living. Similarly, MPC of developing countries like India, Bangladesh, etc. is more than MPC
of developed countries like America or England.
3. MPC falls with successive increase in income:

It happens because as an economy becomes richer, it has the tendency to consume smaller
percentage of each increment to its income.
Comparison between APC and MPC:
Basis
APC
MPC
Meaning
It is the ratio of
It is the ratio of change
consumption
in consumption
expenditure (C) to
expenditure (C) to
the corresponding
change in income (Y)
level of income (Y) over a period of time.
at a point of time.
Value more
APC can be more
MPC cannot be more
than one
than one as long as than one as change in
consumption is more consumption cannot be
than national income, more than change in
i.e. till the breakincome.
even point.
Response to When income
When income
change in
increases, APC falls increases, MPC also
income
but at a rate less than falls but at a rate more
that of MPC.
than that of APC.
Formula
APC = C/Y
MPC= C/Y

Technical attributes of consumption function are: 1. Average Propensity to Consume (APC) 2.

Marginal Propensity to Consume.
In dealing with the consumption function or the propensity to consume, Keynes considered its
two technical attributes: (i) the propensity to consume and (ii) the marginal propensity to
consume, both having substantial economic significance.
1. Average Propensity to Consume (APC):
The average propensity to consume (APC) is defined as the ratio of aggregate or total
consumption to aggregate income in a given period of time.
Thus, the value of average propensity to consume, for any income level, may be found by
dividing consumption by income. Symbolically,
APC = C/Y
Where, stands for consumption and
Y stands for income.
In Table 2, the APC is calculated at various income levels. It is obvious that the proportion of
income spent on consumption decreases as income increases. Since the average propensity to
consume is 100%, 95%, 92% and 88%. It follows that the average propensity to save (S/Y) is
respectively, 0.5%, 8%, 10% and 12%,
APS = S/Y = 1 C/Y
Table 2 Schedule of Propensity to Consume:
Income Consumption Average
Marginal
(Y)
(C)
Propensity to Propensity to
Consume
Consume MPC =

APC =
C/Y
300
300
300/300 = 1 or
100%
400
380
380/400 = 0.95 80/100 =0.8 or
or 95%
80%
500
460
460/ 500 = 0.92 80/ 100 = 0.8 or
or 92%
80%
600
540
540/ 600 = 0.90 80/ 100 = 0.8 or
or 90%
80%
700
620
620/ 700 = 0.88 80/ 100 = 0.8 or
or 88%
80%
Thus, the proportion of income saved increases as income increases.
The economic significance of the APC is that it tells us what proportion of the total cost of a
given output from planned employment may be expected to be recovered by selling consumer
goods alone. It tells us what proportion of the total amount of goods and services demanded by
the community originates in the demand for consumers goods.
The average propensity to save tells what proportion of the total cost of a given output will have
to be recovered by the sale of capital goods. Other things remaining equal, the relative
development of consumer goods and capital goods industries in an economy depends on the APC
and the APS. This suggests that in highly industrialised economies, the APC is persistently low
and the APS is persistently high.
2. Marginal Propensity to Consume:
The marginal propensity to consume (MPC) is the ratio of the change in the level of aggregate
consumption to a change in the level of aggregate income. The MPC, thus, refers to the effect of
additional income on consumption.
MPC can be found by dividing a change (increase or decrease) in consumption by a change
(increase or decrease) in income. Symbolically,
MPC = C/Y
Where, (delta) indicates the change (increase or decrease), and
denote consumption and
Y denote income.
In Table 2 above, the MPC is calculated at various income levels. It is obvious that the MPC is
0.8 or 80% at all levels. Thus, the MPC is constant here because the linear consumption function
is non-linear, MPC will not be constant.
Again, the marginal propensity to consume {MPC) is always positive but less than one. This
behavioural characteristic of the MPC is attributed by Keynes to the fundamental psychological
law of consumption that consumption increases less proportionately than income when income
increases.
Peoples main motivation for not spending the entire increase in income is to save and to create a
hedge against special risks and unforeseen contingencies. Thus, DC < DY always. This means
that
MPC = C/Y < 1.
Keynes hypothesis that the marginal propensity to consume is positive but less than unity 0 <
C/Y < 1 has great analytical and practical significance. It tells us not only that consumption is
an increasing function of income but also that it usually increases by less than 100% of any
increase in income. K.K. Kurihara observes that this hypothesis will be found helpful in

explaining: (1) the theoretical possibility of underemployment equilibrium, and (2) the relative
ability of a highly developed industrial economy. For the hypothesis implies that the gap between
income and consumption at all high levels of income is too wide to be easily filled by
investment, with a possible consequence that the economy may fluctuate around unemployment
equilibrium.
From the marginal propensity to consume (MPC), we can derive the marginal propensity to save
(MPS) by the following formula:
MPS = 1 MPC or (1 C/Y)
Thus, if the marginal propensity to consume is 0. 8, the marginal propensity to save, according to
this formula, must be 0.2, as MPC + MPS = 1. Again, as MPC is always less than unity, MPS
tends to be always positive.
According to Keynes, the propensity to consume is a fairly stable function of income with the
marginal propensity to consume being positive but less than unity. Keynes, however, did not
state what would be the exact nature of the MPC within the limits laid down.
The MPC may rise, fall or remain constant between the limits set. However, Keynes implicitly
stated that the MPC will not be constant when cyclical fluctuations cause change in objectives
factors determining the propensity to consume. Thus, it may be inferred that during the cyclical
upswing, the MPC will fall while during the downswing, it will rise. Keynes, however, opines
that the long-run MPC has tended to decline as nations have become richer.
The economic significance of the concept of marginal propensity to consume (MPC) is that it
throws light on the possible division of any extra income consumption and investment, thus,
facilitating the planning of investment to maintain the desired level of income. It has further
significance in the multiplier theory.
It has been observed that the MPC is higher in the case of poor than in that of rich people.
Therefore, in underdeveloped countries, the MPC tends to be high, whereas in advanced
countries it tends to be low. Consequently, the MPC is high in rich sections and is low in poor
sections of the community. The same is true of rich nations and poor nations.
Graphical Measurement of APC and MPC:
Diagrammatically, the average propensity to consume is measured at a single point on the
curve. In Fig. 4, it is determined at Point A (where C/Y gives APC).

The marginal propensity to consume, on the other hand, is measured by the slope or gradient of
the curve, i. e., the consumption function schedule or curve. To ascertain the slope of the
curve, we draw a horizontal line through A, the previous consumption Income point, and then
measure vertically to the tangent P, the changed consumption-income point. We shall find that
the ratio of the vertical length PM to the horizontal length AM is 0.8.

Empirical relationship between APC and MPC:

The two consumption propensities are closely inter-related:
i. When the MPC is constant, the consumption function is linear, i.e., a straight line curve. The
APC will also be constant only if the consumption function passes, through the origin. When it
does not pass through the origin, the APC will not be constant.
ii. As income rises, the MPC also falls, but it falls to greater extent than the APC.
iii. As income falls, the MPC rises. The APC will also rise but at a slower rate

Absolute, Relative and Permanent Income Hypothesis

1. Absolute Income Hypothesis:
Keynes consumption function has come to be known as the absolute income hypothesis or
theory. His statement of the relationship between income and consumption was based on the
fundamental psychological law.
He said that consumption is a stable function of current income (to be more specific, current disposable incomeincome after tax payment).
Because of the operation of the psychological law, his consumption function is such that 0 <
MPC < 1 and MPC < APC. Thus, a non- proportional relationship (i.e., APC > MPC) between
consumption and income exists in the Keynesian absolute income hypothesis. His consumption
function may be rewritten here with the form
C = a + bY, where a > 0 and 0 < b < 1.
It may be added that all the characteristics of Keynes consumption function are based not on any
empirical observation, but on fundamental psychological law, i.e., experience and intuition.
(i) Consumption Function in the Light of Empirical Observations:
Meanwhile, attempts were made by the empirically-oriented economists in the late 1930s and
early 1940s for testing the conclusions made in the Keynesian consumption function.
(ii) Short Run Budget Data and Cyclical Data:
Let us consider first the budget studies data or cross-sectional data of a cross section of the
population and then time-series data. The first set of evidence came from budget studies for the
years 1935-36 and 1941-42. These budget studies seemed consistent with the Keynes own
conclusion on consumption-income relationship. The time-series data of the USA for the years
1929-44 also gave reasonably good support to the Keynesian theoretical consumption function.
Since the time period covered is not long enough, this empirical consumption function derived
from the time- series data for 1929-44 may be called cyclical consumption function. Anyway,
we may conclude now that these two sets of data that generated consumption function consistent
with the Keynesian consumption equation, C = a + bY. Further, 0 < b < 1 and AMC < APC.
(iii) Long Run Time-Series Data:

However, Simon Kuznets (the 1971 Nobel prize winner in Economics) considered a long period
covering 1869 to 1929. His data may be described as the long run or secular time-series data.
This data indicated no long run change in consumption despite a very large increase in income
during the said period. Thus, the long run historical data that generated long run or secular
consumption function were inconsistent with the Keynesian consumption function.
From Kuznets data what is obtained is that:
(a) There is no autonomous consumption, i.e., a term of the consumption function and
(b) A proportional long run consumption function in which APC and MPC are not different. In
other words, the long run consumption function equation is C = bY.
As a = 0, the long run consumption function is one in which APC does not change over time and
MPC = APC at all levels of income as contrasted to the short run non-proportional (MPC < APC)
consumption-income relationship. Being proportional, the long run consumption function starts
form the origin while a non-proportional short run consumption function starts from point above
the origin. Keynes, in fact, was concerned with the long run situation.
But what is baffling and puzzling to us that the empirical studies suggest two different
consumption functions a non-proportional cross-section function and a proportional long run
time-series function.
2. Relative Income Hypothesis:
Studies in consumption then were directed to resolve the apparent conflict and inconsistencies
between Keynes absolute income hypothesis and observations made by Simon Kuznets. Former
hypothesis says that in the short run MPC < APC, while Kuznets observations say that MPC =
APC in the long run.
One of the earliest attempts to offer a resolution of the conflict between short run and long run
consumption functions was the relative income hypothesis (henceforth R1H) of ).S.
Duesenberry in 1949. Duesenberry believed that the basic consumption function was long run
and proportional. This means that average fraction of income consumed does not change in the
long run, but there may be variation between consumption and income within short run cycles.
Duesenberrys RIH is based on two hypotheseis first is the relative income hypothesis and
second is the past peak income hypothesis.
Duesenberrys first hypothesis says that consumption depends not on the absolute level of
income but on the relative income income relative to the income of the society in which an
individual lives. It is the relative position in the income distribution among families influences
consumption decisions of individuals.
A households consumption is determined by the income and expenditure pattern of his
neighbours. There is a tendency on the part of the people to imitate or emulate the consumption
standards maintained by their neighbours. Specifically, people with relatively low incomes

attempt to keep up with the Jonesesthey consume more and save less. This imitative or
emulative nature of consumption has been described by Duesenberry as the demonstration
effect.
The outcome of this hypothesis is that the individuals APC depends on his relative position in
income distribution. Families with relatively high incomes experience lower APCs and families
with relatively low incomes experience high APCs. If, on the other hand, income distribution is
relatively constant (i.e., keeping each families relative position unchanged while incomes of all
families rise). Duesenberry then argues that APC will not change.
Thus, in the aggregate we get a proportional relationship between aggregate income and
aggregate consumption. Note MPC = APC. Hence the R1H says that there is no apparent conflict
between the results of cross-sectional budget studies and the long run aggregate time-series data.
In terms of the second hypothesis short run cyclical behaviour of the Duesenberrys aggregate
consumption function can be explained. Duesenberry hypothesised that the present consumption
of the families is influenced not just by current incomes but also by the levels of past peak
incomes, i.e., C = f(Yri, Ypi), where Yri is the relative income and Ypi is the peak income.
This hypothesis says that consumption spending of families is largely motivated by the habitual
behavioural pattern. It current incomes rise, households tend to consume more but slowly. This is
because of the relatively low habitual consumption patterns and people adjust their consumption
standards established by the previous peak income slowly to their present rising income levels.
On other hand, if current incomes decline these households do not immediately reduce their
consumption as they find if difficult to reduce their consumption established by the previous
peak income. Thus, during depression consumption rises as a fraction of income and during
prosperity consumption does increase slowly as a fraction of income. This hypothesis thus
generates a non-proportional consumption function.
Duesenberrys explanation of short run and long run consumption function and then, finally,
reconciliation between these two types of consumption function can now be demonstrated in
terms of Fig. 3.39. Cyclical rise and fall in income levels produce a non-proportional
consumption-income relationship, labelled as CSR. In the long run as such fluctuations of income
levels are get smoothened, one gets a proportional consumption-income relationship, labelled as
CLR.

As national income rises consumption grows along the long run consumption, CLR. Note that at
income OY0 aggregate consumption is OC0. As income increases to OY1, consumption rises to
OC1. This means a constant APC consequent upon a steady growth of national income.
Now, let us assume that recession occurs leading to a fall in income level to OY0 from the
previously attained peak income of OY1. Duesenberrys second hypothesis now comes into
operation: households will maintain the previous consumption level what they enjoyed at the
past peak income level. That means, they hesitate in reducing their consumption standards along
the CLR. Consumption will not decline to OC0, but to OC1 (> OC0) at income OY0. At this
income level, APC will be higher than what it was at OY1 and the MPC will be lower.
If income rises consequent upon economic recovery, consumption rises along CSR since people
try to maintain their habitual or accustomed consumption standards influenced by previous peak
income. Once OY1 level of income is reached consumption would then move along CLR. Thus,
the short run consumption is subject to what Duesenberry called the ratchet effect. It ratchets
up following an increase in income levels, but it does not fall back downward in response to
income declines.
3. Permanent Income Hypothesis:
Another attempt to reconcile three sets of apparently contradictory data (cross-sectional data or
budget studies data, cyclical or short run time-series data and Kuznets long run time-series data)
was made by Nobel prize winning Economist, Milton Friedman in 1957. Like Duesenberrys
RIH, Friedmans hypothesis holds that the basic relationship between consumption and income is
proportional.

But consumption, according to Friedman, depends neither on absolute income, nor on relative
income but on permanent income, based on expected future income. Thus, he finds a
relationship between consumption and permanent income. His hypothesis is then described as
the permanent income hypothesis (henceforth PIH). In PIH, the relationship between permanent
consumption and permanent income is shown.
Friedman divides the current measured income (i.e., income actually received) into two:
permanent income (Yp) and transitory income (Yt). Thus, Y = Yp + Yt. Permanent income may be
regarded as the mean income, determined by the expected or anticipated income to be received
over a long period of time. On the other hand, transitory income consists of unexpected or
unanticipated or windfall rise or fall in income (e.g., income received from lottery or race).
Similarly, he distinguishes between permanent consumption (Cp) and transistory consumption
(Ct). Transistory consumption may be regarded as the unanticipated spending (e.g., unexpected
illness). Thus, measured consumption is the sum of permanent and transitory components of
consumption. That is, C = Cp + Ct.
Friedmans basic argument is that permanent consumption depends on permanent income. The
basic relationship of PIH is that permanent consumption is proportional to permanent income
that exhibits a fairly constant APC. That is, C = kYp where k is constant and equal to APC and
MPC.
While reaching the above conclusion, Friedman assumes that there is no correlation between Yp
and Yt, between Yt and Ct and between Cp and Ct. That is
RYt. Yp = RYt . Ct = RCt. Cp = 0.
Since Yt is uncorrected with Yp, it then follows that a high (or low) permanent income is not
correlated with a high (or low) transitory income. For the entire group of households from all
income groups transitory incomes (both positive and negative) would cancel each over out so
that average transitory income would be equal to zero. This is also true for transitory components
of consumption. Thus, for all the families taken together the average transitory income and
average transitory consumption are zero, that is,
Yt = Ct = 0 where Y and C are the average values. Now it follows that
Y = Yp and C = Cp
Let us consider some families, rather than the average of all families, with above-average
measured incomes. This happens because these families had enjoyed unexpected incomes
thereby making transitory incomes positive and Yp < Y. Similarly, for a sample of families with
below-average measured in come, transitory incomes become negative and Yp > Y.
Now, we are in a position to resolve the apparent conflict between the cross-section and the long
run time-series data to show a stable permanent relationship between permanent consumption
and permanent income.

The line Cp = kYp in Fig 3.40 shows the proportional relationship between permanent
consumption and permanent income. This line cuts the CSR line at point L that corresponds to the
average measured income of the population at which Yt = 0. This average measured income
produces average measured and permanent consumption, Cp.

Let us first consider a sample group of population having an average income above the
population average. For this population group, transistory income is positive. The horizontal
difference between the short run and long run consumption functions (points N and B and points
M and A) describes the transitory income. Measured income equals permanent income at that
point at which these two consumption functions intersect, i.e., point L in the figure where
transitory income in zero.
For a sample group with average income above the national average measured income (Y1)
exceeds permanent income (YP1). At (CP1) level of consumption (i.e., point B) average measured
income for this sample group exceeds permanent income, YP1. This group thus now has a
positive average transitory income.
Next, we consider another sample group of population whose average measured income is less
than the national average. For this sample group, transitory income component is negative. At Cp2
level of consumption (i.e., point A lying on the CSR) average measured income falls short of
permanent income, Yp2. Now joining points A and B we obtain a cross- section consumption
function, labelled as CSR. This consumption function gives an MPC that has a value less than
long run proportional consumption function, Cp = kYp. Thus, in the short run, Friedmans
hypothesis yields a consumption function similar to the Keynesian one, that is, MPC < APC.

However, over time as the economy grows transitory components reduce to zero for the society
as a whole. So the measured consumption and measured income values are permanent
consumption and permanent income. By joining points M, L and N we obtain a long run
proportional consumption function that relates permanent consumption with the permanent
income. On this line, APC is fairly constant, that is, APC = MPC.

The Theory of the Consumption Function

Contents:
1.

Keynes Consumption Function: The Absolute Income Hypothesis

2.

The Consumption Puzzle

3.

The Drift Theory of Consumption

4.

The Relative Income Hypothesis

5.

The Permanent Income Hypothesis

6.

The Life Cycle Hypothesis

1. Keynes Consumption Function: The Absolute Income Hypothesis:

Keynes in his General Theory postulated that aggregate consumption is a function of aggregate
current disposable income. The relation between consumption and income is based on his
Fundamental Psychological Law of Consumption which states that when income increases
consumption expenditure also increases but by a smaller amount.
The Keynesian consumption function is written as:

C = a + cY a > 0, 0 < c < 1

Where a is the intercept, a constant which measures consumption at a zero level of disposal
income; c is the marginal propensity to consume (MPC); and Y is the disposal income.
The above relation that consumption is a function of current disposable income whether linear or
non-linear is called the absolute income hypothesis.
This consumption function has the following properties:
1. As income increases, average propensity to consume (APC = C/Y) falls.
2. The marginal propensity to consume (MPC) is positive but less than unity (0 < c < 1) so that
higher income leads to higher consumption.
3. The consumption expenditure increases (or decreases) with increase {or decrease) in income
but non-proportionally. This non-proportional consumption function implies that in the short-run
average and marginal propensities do not coincide (APC > MPC).
4. This consumption function is stable both in the short-run and the long-run.
This consumption function is explained in Fig. 1 where C = a + cY is the consumption function.
At point E on the C curve the income level is OY1. At this point, APC > MPC where APC =
OC1/OY1 and MPC = C/K = ER/REO. This shows disproportional consumption function. The
intercept a shows the level of consumption corresponding to a zero level of income.
At income level OY0, where the curve C intersects the 45 line, point E0 represents APC (=OC0 /
OY0). Below the income level consumption is more than income. In this range, APC > 1. Above
the income level OY0, consumption increases less than proportionately with income so that APC
declines and it is less than one.

Empirical Studies:
Keynes put forth this hypothesis on the basis of knowledge of human nature and derailed
facts of experience. His followers in a number of empirical studies based on cross-section
budget figures and short-run time series data in the late 1930s and mid-1940s confirmed his
hypothesis.
They found that families with higher income levels consumed more which confirms that MPC is
greater than zero (c > 0), but by less than the increase in income (c < 1). They also found that
families with higher income levels saved more and so consumed a smaller proportion of income
which confirms that APC falls as income rises.
2. The Consumption Puzzle:

Keynes assertion that the APC falls as income rises led some Keynesians to formulate the
secular stagnation thesis around 1940. According to these economists, as incomes grew in the
economy, households would save more and consume less.
As a result, aggregate demand would fall short of output. If the government spending was not
increased at a faster rate than income, the economy would lapse into stagnation. But after World
War II, the American economy experienced inflation rather than stagnation even when the
government expenditures were reduced below 1941 level in constant dollars.

The Keynesian consumption function had been proved wrong. This was due to the conversion of
government bonds into liquid assets after the War by the households in order to meet their pent
up demand for consumer goods.
In 1946, Kuznets studied the consumption and income data for the United States during the
period 1869-1938 and estimated the consumption function for this period as 0.9. Further, he
arrived at two conclusions: one, over the long-run, on the average, the APC did not show any
downward trend so that the MPC equaled the APC as income increased along a long-run trend.
This means that the consumption function is a straight line through the origin, as shown by the
CL line in Fig. 2, and two, the years in which the APC was below the long-run average were
boom periods, and the years in which the APC was above the long-run average were of slump
periods. This implies that in the short-run as income changes over the business cycle, the MPC is
less than the APC, as shown by the Cs curve in Fig. 2

These findings were later verified by Goldsmith in 1955 who

found the long-run consumption function to be stable at 0.87. Thus these two studies revealed
that for the short-run time series, the consumption function is non-proportional because APC >
MPC and for the long-run time series, the consumption function is proportional, APC = MPC.
The failure of the secular stagnation hypothesis and the findings of Kuznets and Goldsmith were
a puzzle to the economists which is known as the consumption puzzle. Figure 2 illustrates this

puzzle where there are two consumption functions. Cs is the Keynesian consumption function
which is non-proportional (APC > MPC) and based on the short-run time series data.
CL is the long-run proportional consumption function (APC = MPC) based on long-run time
series data. Over the years, economists have been engaged in solving this puzzle by reconciling
the two consumption functions.
We study below a few important theories which try to reconcile the two consumption functions.
3. The Drift Theory of Consumption:
One of the first attempts to reconcile the short-run and long-run consumption functions was by
Arhur Smithies and James Tobin. They tested Keynes absolute income hypothesis in separate
studies and came to the conclusion that the short-run relationship between consumption and
income is non- proportional but the time series data show the long-run relationship to be
proportional. The latter consumption-income behaviour results through an upward shift or drift
in the short- run non-proportional consumption function due to factors other than income.
Smithies and Tobin discuss the following factors:
1. Asset Holdings:
Tobin introduced asset holdings in the budget studies of negro and white families to test this
hypothesis. He came to the conclusion that the increase in the asset holdings of families tends to
increase their propensity to consume thereby leading to an upward shift in their consumption
function.
2. New Products:

Since the end of the Second World War, a variety of new household consumer goods have come
into existence at a rapid rate. The introduction of new products tends to shift the consumption
function upward.
3. Urbanisation:
Since the post-War period, there has been an increased tendency toward urbanisation. This
movement of population from rural to urban areas has tended to shift the consumption function
upward because the propensity to consume of the urban wage earners is higher than that of the
farm workers.
4. Age Distribution:
There has been a continuous increase in the percentage of old people in the total population over
the long-run. Though the old people do not earn but they do consume commodities.
Consequently, the increase in their numbers has tended to shift the consumption function
upward.
5. Decline in Saving Motive:
The growth of social security system which makes automatic saving and guarantees income
during illness. Unemployment disability and old age has increased the propensity to consume.
6. Consumer Credit:
The increasing availability and convenience of short-term consumer credit shifts the
consumption function upward. The greater ease of buying consumer goods with credit cards,
debit cards, use of ATMs and cheques, and availability of installment buying causes an upward
shift in the consumption function.

7. Expectation of Income Increasing:

Average real wages of workers have increased and they expect them to rise in the future. These
cause an upward shift in the consumption function. Those who expect higher future earnings tend
to reduce their savings or even borrow to increase their present consumption.
The consumption drift theory is explained in Fig. 3 where CL is the long-run consumption
function which shows the proportional relationship between consumption and income as we
move along it. CS1 and CS2 are the short-run consumption functions which cut the long-run
consumption function CL at points A and B. But due to the factors mentioned above, they tend to
drift upward from point A to point B along the CL curve.
Each point such as A and B on the CL curve represents an average of all the values of factors
included in the corresponding short-run functions, CS1 and CS2 respectively and the long-run
function, CL, connecting all the average values. But the movement along the dotted portion of the
short-run consumption functions, CS1 and CS2, would cause consumption not to increase in
proportion to the increase in income.

Its Criticisms:

The great merit of this theory is that it lays stress on factors other than in income which affect the
consumer behaviour. In this sense, it represents a major advance in the theory of the consumption
function. However, it has its shortcomings.
1. The theory does not tell the rate of upward drift along the CL curve. It appears to be a matter of
chance.
2. It is just a coincidence if the factors explained above cause the consumption function to
increase proportionately with increase in income so that the average of the values in the short-run
consumption function equals a fixed proportion of income.
3. According to Duesenberry, all the factors mentioned as causes of the upward shift are not
likely to have sufficient force to change the consumption-savings relationship to such an extent
as to cause the drift.
4. Duesenberry also points out that many of the factors such as decline in saving motive would
lead to a secular fall in the consumption function. Such saving plans as life insurance and
pension programs tend to increase savings and decrease the consumption function. Moreover,
people want more supplementary savings to meet post-retirement needs which tend to decrease
their current consumption.
4. The Relative Income Hypothesis:

The relative income hypothesis of James Duesenberry is based on the rejection of the two
fundamental assumptions of the consumption theory of Keynes. Duesenberry states that:
(1) every individuals consumption behaviour is not independent but interdependent of the
behaviour of every other individual, and

(2) that consumption relations are irreversible and not reversible in time.
In formulating his theory of the consumption function, Duesenberry writes: A real
understanding of the problem of consumer behaviour must begin with a full recognition of the
social character of consumption patterns. By the social character of consumption patterns he
means the tendency in human beings not only to keep up with the Joneses but also to surpass
the Joneses. Joneses refers to rich neighbours.
In other words, the tendency is to strive constantly toward a higher consumption level and to
emulate the consumption patterns of ones rich neighbours and associates. Thus consumers
preferences are interdependent. It is, however, differences in relative incomes that determine the
consumption expenditures in a community.
A rich person will have a lower APC because he will need a smaller portion of his income to
maintain his consumption pattern. On the other hand, a relatively poor man will have a higher
APC because he tries to keep up with the consumption standards of his neighbours or associates.
This provides the explanation of the constancy of the long-run APC because lower and higher
APCs would balance out in the aggregate. Thus even if the absolute size of income in a country
increases, the APC for the economy as a whole at the higher absolute level of income would be
constant. But when income decreases, consumption does not fall in the same proportion because
of the Ratchet Effect.
The Ratchet Effect:
The second part of the Duesenberry theory is the past peak of income hypothesis which
explains the short-run fluctuations in the consumption function and refutes the Keynesian
assumption that consumption relations are reversible.

The hypothesis states that during a period of prosperity, consumption will increase and gradually
adjust itself to a higher level. Once people reach a particular peak income level and become
accustomed to this standard of living, they are not prepared to reduce their consumption pattern
during a recession.
As income falls, consumption declines but proportionately less than the decrease in income
because the consumer dissaves to sustain consumption. On the other hand, when income
increases during the recovery period, consumption rises gradually with a rapid increase in
saving. Economists call this the Ratchet Effect.
Duesenberry combines his two related hypothesis in the following form:
Ct/Yt = a c Yt/Y0
Where C and Y are consumption and income respectively, t refers to the current period and the
subscript (o) refers to the previous peak, a is a constant relating to the positive autonomous
consumption and c is the consumption function. In this equation, the consumption-income ratio
in the current period (Ct/Yt) is regarded as function of Yt/Y0, that is, the ratio of current income to
the previous peak income.
If this ratio is constant, as in periods of steadily rising income, the current consumption income
ratio is constant. During recession when current income (Yt) falls below the previous peak
income (YO), the current consumption income ratio (Ct/Yt) will increase.
The relative income hypothesis is explained graphically in Fig. 4 where CL is the long-run
consumption function and CS1 and CS2 are the short-run consumption functions. Suppose income
is at the peak level of OY1 where E1Y1 is consumption. Now income falls to OY0. Since people
are used to the standard of living at the OY1 level of income, they will not reduce their
consumption to E0Y0 level, but reduce it as little as possible by reducing their current saving.

Thus they move backward along the CS1 curve to point C1 and be at C1Y0 level of consumption.
When the period of recovery starts, income rises to the previous peak level of OY1. But
consumption increases slowly from C1 to E1 along the CS1 curve because consumers will just
restore their previous level of savings.
If income continues to increase to OY2 level, consumers will move upward along the CL curve
from E1 to E2 on the new short-run consumption function CS2. If another recession occurs at OY2
level of income, consumption will decline along the CS7 consumption function toward C2 point
and income will be reduced to OY1 level.
But during recovery over the long-run, consumption will rise along the steeper CL path till it
reaches the short-run consumption function CS2. This is because when income increases beyond
its present level OY1, the APC becomes constant over the long-run. The short-run consumption
function shifts upward from CS1 to CS2 but consumers move along the CL curve from E1 to E2.
But when income falls, consumers move backward from E2 to C2 on the Cs2 curve. These upward
and downward movements from C1 and C2 points along the CL curve give the appearance of a
ratchet. This is the rachet effect. The short-run consumption function ratchets upward when
income increases in the long run but it does not shift down to the earlier level when income
declines. Thus the ratchet effect will develop whenever there is a cyclical decline or recovery in
income.

Its Criticisms:
Although the Duesenberry theory reconciles the apparent contradictions between budget studies
and short-term and long-term time series studies, yet it is not without its deficiencies.
1. No Proportional Increase in Consumption:
The relative income hypothesis assumes a proportional increase in income and consumption. But
increases in income along the full employment level do not always lead to proportional increases
in the consumption.
2. No Direct Relation between Consumption and Income:
This hypothesis assumes the relation between consumption and income to be direct. But this has
not been borne out by experience. Recessions do not always lead to decline in consumption, as
was the case during the recessions of 1948-49 and 1974-75.
3. Distribution of Income not Unchanged:
This theory is based on the assumption that the distribution of income remains almost unchanged
with the change in the aggregate level of income. If with increases in income, redistribution
occurs towards greater equality, the APC of all persons belonging to the relatively poor and
relatively rich families will tend to be reduced. Thus the consumption function will not shift
upward from CS1 to CS2 when income increases.
4. Reversible Consumer Behaviour:
According to Micheal Evants, The consumer behaviour is slowly reversible over time, instead
of being truly irreversible. Then previous peak income would have less effect on current
consumption, the greater the elapsed time from the last peak. Even if we know how a consumer
spent his previous peak income, it is not possible to know how he would spend it now.

5. Neglects Other Factors:

This hypothesis is based on the assumption that changes in consumers expenditure are related to
his previous peak income. The theory is weak in that it neglects other factors that influence
consumer spending such as asset holdings, urbanisation, changes in age-composition, the
appearance of new consumer goods, etc.
6. Consumer Preferences do not depend on others:
Another unrealistic assumption of the theory is that consumer preferences are interdependent
whereby a consumers expenditure is related to the consumption patterns of his rich neighbour.
But this may not always be true.
George Katonas empirical study has revealed that expectations and attitudes play an important
role in consumer spending. According to him, income expectations based on levels of aspirations
and the attitudes toward asset holdings affect consumer spending behaviour more than the
demonstration effect.
7. Reverse Lightning Bolt Effect:
Smith and Jackson have criticised Duesenberys empirical evidence that the recovery in income
after recession is not caused by ratchet effect. Rather, the consumption experience of consumer is
similar to the reverse lightning bolt effect.

That is why the consumer gradually increases his consumption due to his inconsistent habit
stability with the increase in his income after recession. This is shown is Fig.5 where the levels
of consumption with the increments in income have been shown by arrows as reverse lightning
bolt takes place.
5. The Permanent Income Hypothesis:

Another solution to the apparent contradiction between the proportional long-run and nonproportional short-run consumption function is Friedmans permanent income hypothesis.
Friedman rejects the use of current income as the determinant of consumption expenditure and
instead divides both consumption and income into permanent and transitory components, so
that
Ym or Y=Yp+Y1 (1)
and C = Cp+ C1 (2)
Where p refers to permanent, t refers to transitory, Y to income and C to consumption. Permanent
income is defined as the amount a consumer unit could consume (or believes that it could)
while maintaining its wealth intact.

It is the main income of a family unit which in turn depends on its time-horizon and
farsightedness. It includes non-human wealth that it owns, the personal attributes of earners in
the unitthe attributes of the economic activity of the earners such as the occupation followed,
the location of economic activity, and so on.
Y being the consumers measured income or current income, it can be larger or smaller than his
permanent income in any period. Such differences between measured and permanent income are
due to the transitory component of income (Yt).
Transitory income may rise or fall with windfall gains or losses and cyclical variations. If the
transitory income is positive due to a windfall gain, the measured income will rise above the
permanent income. If the transitory income is negative due to theft, the measured income falls
below the permanent income. The transitory income can also be zero in which case measured
income equals permanent income.
Permanent consumption is defined as the value of the services that it is planned to consume
during the period in question. Measured consumption is also divided into permanent
consumption (CP) and transitory consumption (Ct).
Measured consumption (or current consumption) may deviate from or equal permanent
consumption depending on whether the transitory consumption is positive, negative or zero,
Permanent consumption (Cp) is a multiple (k) of permanent income, Yp .
Cp = kYp
and k = f(r, w, u)
Therefore, Cp = k (r, w, u) Yp (3)

where k is a function of the rate of interest (r), the ratio of property and non-property income to
total wealth or national wealth (iv), and the consumers propensity to consume (u). This equation
tells that over the long period consumption increases in proportion to the change in Yp. This is
attributable to a constant k (=Cp/Yp) which is independent of the size of income. Thus k is the
permanent and average propensity to consume and APC = MPC.
Friedman analyses the offsetting forces which lead to this result. To take the rate of interest (r),
there has been a secular decline in it since the 1920s. This tends to raise the value of k. But there
has been a long-run decline in the ratio of property and non-property income to national wealth
(w) which tends to reduce the value of k. The propensity to consume has been influenced by
three factors.
First, there has been a sharp decline in the farm population which has tended to increase
consumption with urbanisation. This has led to increase of k. Second, there has been a sharp
decline in the size of families. It has led to increase in saving and reduction in consumption
thereby reducing the value of k. Third, larger provision by the state for social security.
This has reduced the need for keeping more in savings. It has increased the tendency to consume
more resulting in the rise in the value of k. The overall effect of these off-setting forces is to raise
consumption in proportion to the change in the permanent income component.
Therefore, there is a proportional relation between permanent income and consumption,
Cp = kYp (4)
Where k is the coefficient of proportionality in which APC and MPC are endogenous and it
depends upon the above mentioned factors. In other words, it is that proportion of fixed income
which is consumed. Now take permanent income which is based on time series. Friedman

believes that permanent income depends partly on current income and partly on previous
periods income. This can be measured as
Ypt = aYt + (1-a) Yt-1 (5)
where Ypt = permanent income in the current period, Yt = current income in the current period,
Yt-1 = previous periods income, a ratio of change in income between current period (t) and
previous period (t-1).
This equation tells that permanent income is the sum of current periods income (Yt) and
previous periods income (Yt-1) and the ratio of income change between the two (a). If the current
income increases at once, there will be small increase in permanent income.
For the permanent income to increase, income will have to be raised continuously for many
years. Then only people will think that it has increased. By integrating equations (4) and (5),
short-run and long-run consumption function can be explained as
C t = kYpt = kaYt + k (1-a) Yt-1 (6)
Where Ct = current period consumption, ka = short-run MPC, k = long-run MPC and k (1-a) Yt-1,
is the intercept of short-run consumption function.
According to Friedman, k and ka are different from one another and k > ka. Further, k = 1 and ka
=0
Equation (6) tells that consumption depends both on previous income and current income.
Previous income is important for consumption because it helps in forecasting the future income
of people.
Its Assumptions:

Given these, Friedman gives a series of assumptions concerning the relationships between
permanent and transitory components of income and consumption.
1. There is no correlation between transitory income and permanent income.
2. There is no correlation between permanent and transitory consumption.
3. There is no correlation between transitory consumption and transitory income.
4. Only differences in permanent income affect consumption systematically.
5. It is assumed that individual estimates of permanent income are based on backward looking of
expectations.
Explanation of the Theory:
These assumptions give the explanation of the cross-section results of Friedmans theory that the
short-run consumption function is linear and non-proportional, i.e., APC > MPC and the long-run
consumption function is linear and proportional, i.e., APC = MPC.
Figure 6 explains the permanent income hypothesis of Friedman where CL is the long-run
consumption function which represents the long-run proportional relationship between
consumption and income of an individual where APC = MPC. Cs is the non- proportional shortrun consumption function where measured income includes both permanent and transitory
components.
At OY income level where Cs and CL curves coincide at point E, permanent income and
measured income are identical and so are permanent and measured consumption as shown by
YE. At point E, the transitory factors are non-existent. If the consumers income increases to OY1
he will increase his consumption consistent with the rise in his income.

For this, he will move along the Cs curve to E2 where his measured income in the short-run is
OY1 and measured consumption is Y1E2. The reason for this movement from E to E2 is that
during the short-run the consumer does not expect the rise in income to be permanent, so APC
falls as income increases.
But if the OY1 income level becomes permanent, the consumer will also increase his
consumption permanently. Now his short-run consumption function will shift upward from Cs to
CS1 and intersect the long-run consumption function CL at point E1.
Thus the consumer will consume Y1E1 at OY1 income level. Since he knows that the increase in
his income OY1 is permanent, he will adjust his consumption Y1E1 accordingly on the long-run
consumption function CL at E1 where APC = MPC

Its Criticisms:
This theory has been criticised on the following counts:
1. Correlation between Temporary Income and Consumption:
Friedmans assumption that there is no correlation between transitory components of
consumption and income is unrealistic. This assumption implies that with the increase or
decrease in the measured income of the household, there is neither any increase nor decrease in

his consumption, because he either saves or dissaves accordingly. But this is contrary to actual
consumer behaviour.
A person who has a windfall gain does not deposit the entire amount in his bank account but
enjoys the whole or part of it on his current consumption. Similarly, a person who has lost his
purse would definitely cut or postpone his present consumption rather than rush to the bank to
withdraw the same amount of money to meet his requirements.
2. APC of all Income Groups not Equal:
Friedmans hypothesis states that the APC of all families, whether rich or poor, is the same in the
long-run. But this is against the ordinary observed behaviour of households. It is an established
fact that low-income families do not have the capacities to save the same fraction of their
incomes as the high income families.
This is not only due to their meagre incomes but their tendency to prefer present consumption to
future consumption in order to meet their unfulfilled wants. Therefore, the consumption of lowincome families is higher relative to their incomes while the saving of high-income families is
higher relative to their incomes. Even in the case of persons at the same level of permanent
income, the level of saving differs and so does consumption.
3. Use of Various terms Confusing:
Friedmans use of the terms permanent, transitory, and measured have tended to confuse
the theory. The concept of measured income improperly mixes together permanent and transitory
income on the one hand, and permanent and transitory consumption on the other.
4. No Distinction between Human and Non-human Wealth:

Another weakness of the permanent income hypothesis is that Friedman does not make any
distinction between human and non-human wealth and includes income from both in a single
term in the empirical analysis of his theory.
5. Expectations not Backward-Looking:
Estimates of permanent income are based on forward looking expectations and not on backwardlooking expectations. In fact, expectations are rational because changes in consumption are due
to unanticipated changes in income that lead to changes in permanent income.
Conclusion:
Despite these weaknesses, it can be fairly said, according to Micheal Evans, that the evidence
supports this theory and that Friedmans formulation has reshaped and redirected much of the
research on the consumption function.
6. The Life Cycle Hypothesis:

Ando and Modigliani have formulated a consumption function which is known as the Life Cycle
Hypothesis. According to this hypothesis, consumption is a function of lifetime expected income
of the consumer.
The consumption of the individual consumer depends on the resources available to him, the rate
of return on capital, the spending plan, and the age at which the plan is made. The present value
of his resources includes income from assets or wealth or property and from current and
expected labour income. Thus his total resources consist of his income and wealth.
Its Assumptions:
The life cycle hypothesis is based on the following assumptions:

1. There is no change in the price level during the life of the consumer.
2. The rate of interest paid on assets is zero.
3. The consumer does not inherit any assets and his net assets are the result of his own savings.
4. His current savings result in future consumption.
5. He intends to consume his total lifetime earnings plus current assets.
6. He does not plan any bequests.
7. There is certainty about his present and future flow of income.
8. The consumer has a definite conscious vision of life expectancy.
9. He is aware of the future emergencies, opportunities and social pressures which will impinge
upon his consumption spending.
10. The consumer is rational.
Its Explanation:
Given these assumptions, the aim of the consumer is to maximise his utility over his lifetime
which will, in turn, depend on the total resources available to him during his lifetime. Given the
life-span of an individual, his consumption is proportional to these resources.
But the proportion of resources that the consumer plans to spend will depend on whether the
spending plan is formulated during the early or later year of his life. As a rule, an individuals
average income is relatively low at the beginning of his life and also at the end of his life.

This is because in the early years of his life, he has little assets (wealth) and during the late years,
his labour-income is low. It is, however, in the middle of his life that his income, both from
assets and labour, is high.
As a result, the consumption level of the individual throughout his life is somewhat constant or
slightly increasing, shown as the CC1 curve in Fig. 7, the Y0YY1 curve shows the individual
consumers income stream during his lifetime T.
During the early period of his life represented by T1 in the figure, he borrows or dissaves CY0B
amount of money to keep his consumption level CB which is almost constant. In the middle
years of his life represented by T1T2, he saves BSY amount to repay his debt and for the future. In
the last years of his life represented by T2T1 he dissaves SC1T1 amount.
According to this theory, consumption is a function of lifetime expected income of the consumer
which depends on his resources. In some resources, his current income (Yt); present value of his
future expected labour income (YeLt ) and present value of assets (At) are included.
The consumption function can be expressed as:
Ct = f (Vt) (1)
Where Vt = total resources at time t.

and Vt = f (Yt + YeLt + At) (2)

By substituting equation (2) in (1) and making (2) linear and weighted average of different
income groups, the aggregate consumption function is
Ct = 1Yt + 2YeL + 3At (3)
Where a1 = MPC of current income, 2 = MPC of expected labour income; and 3 = MPC of
assets or wealth.
Now APC is
Ct / Yt 1+ 2YeL /Yt + 3 At/Yt
APC is constant in the long-run because a portion of labour income in current income and the
ratio of total assets to current income are constant when the economy grows. On the basis of the
life cycle hypothesis, Ando and Modigliani made a number of studies in order to formulate the
short-run and long-run consumption functions. A cross-section study revealed that more persons
in the low-income groups were at low income level because they were at the end period of their
lives.
Thus their APC was high. On the other hand, more than average persons belonging to the highincome groups were at high income levels because they were in the middle years of their lives.
Thus their APC was relatively low. On the whole, the APC was falling as income rose thereby
showing APC> MPC. The observed data for the U.S. revealed the APC to be constant at 0.7 over
the long-run.
The Ando-Modigliani short-run consumption function is shown by the Cs. curve in Fig. 8. At any
given point of time, the CS curve can be considered as a constant and during short-run income
fluctuation, when wealth remains fairly constant, it looks like the Keynesian consumption

function. But it- intercept will change as a result of accumulation of wealth (assets) through
savings.
As wealth increases overtime, the non-proportional short-run consumption function Cs shifts
upward to CS1 to trace out the long-run proportional consumption function. The long-run
consumption function is CL, showing a constant APC as income grows along the trend. It is a
straight line passing through the origin. The APC is constant over time because the share of
labour income in total income and the ratio of wealth (assets) to total income are constant as the
economy grows along the trend.

Its Implications:
1. The life cycle hypothesis solves the consumption puzzle. According to this hypothesis, the
short-run consumption function would be non-proportional as in the short-run time series
estimates. Its intercept (W in Fig. 8) measures the effect of wealth and the life cycle
consumption function looks like the Keynesian consumption function as Cs in the figure.
But it holds only in the short run when wealth is constant. As wealth grows (W1), this
consumption function shifts upward as Cs1. The shifting of the Cs to Cs1 traces out the long-run
consumption function, CL. This is consistent with the evidence from long-run time series data
that the long-run consumption function is proportional. The slope of the CL curve shows that the

average propensity to consume does not fall as income increases. In this way, Audo-Modigliani
solved the consumption puzzle.
2. The life cycle hypothesis reveals that savings change over the life time of a consumer. If a
consumer starts his life in adulthood with no wealth, he will save and accumulate wealth during
his working years. But during retirement, he will dissave and run down his wealth. Thus the life
cycle hypothesis implies that the consumer wants smooth and uninterrupted consumption over
his lifetime. During working years, he saves and when retires, he dissaves.
3. The life cycle hypothesis also implies that a high-income family consumes a smaller
proportion of his income than a low-income family. In its peak earning years, (shown as portion
BSY in Fig. 7), its income is more than its consumption and its APC is the lowest. But in the case
of a low-income family and a retiree family, the APC is high.
Its Criticisms:
The life cycle hypothesis is not free from certain criticisms.
1. Plan for Lifetime Consumption Unrealistic:
The contention of Audo and Modigliani that a consumer plans his consumption over his lifetime
is unrealistic because a consumer concentrates more on the present rather than on the future
which is uncertain.
2. Consumption not directly related to Assets:
The life cycle hypothesis pre-supposes that consumption is directly related to the assets of an
individual. As assets increase, his consumption increases and vice versa. This is also unwarranted
because an individual may reduce his consumption to have larger assets.
3. Consumption depends on Attitude:

Consumption depends upon ones attitude towards life. Given the same income and assets, one
person may consume more than the other.
4. Consumer not Rational and Knowledgeable:
This hypothesis assumes that the consumer is rational and has full knowledge about his income
and future lifetime. This is unrealistic because no consumer is fully rational and knowledgeable.
5. Estimation of Variables not Possible:
This theory depends on many variables such as current income, value of assets, future expected
labour income, etc., and the estimation of so many variables is very difficult and not possible.
6. Liquidity Constraints:
This hypothesis fails to recognise the existence of liquidity constraints for a consumer. Even if he
possesses a definite and conscious vision of future income, he may have little opportunity for
borrowing in the capital market on the basis of expected future income. As a result, consumption
may response more to changes in current income than predicted on the basis of the life cycle
hypothesis.
7. neglects Locked-up Savings:
This theory neglects the role of locked-up savings in consumption. It regards savings as a pool
from which people spend on consumption over their lifetime. In fact, people keep their savings
in locked-up form in mutual funds, pension plans, life insurance etc.
Conclusion:

Despite these, the life cycle hypothesis is superior to the other hypotheses on consumption
function because it includes not only wealth as a variable in the consumption function but also
explains why APC > MPC in the short-run and APC is constant in the long-run.

Limitations of Theory of Multiplier:

The above discussion suggests that greater the change in investment, greater will be the change
in income. However, the Keynesian multiplier analysis is viewed as an ideal one in the sense
that there occurs an instantaneous adjustment between change in investment and change in
income.
That is why Keynes multiplier is called instantaneous multiplier or static multiplier or timeless
multiplier. This multiplier analysis is based on certain assumptions. Firstly, consumption is
strictly a function of income and the MPC of the society remains unchanged. Secondly,
investment spending is autonomous. Thirdly, the economy remains below the stage of full
employment. Fourthly, there is no time lag between income and consumption. However, in
reality, the multiplier process becomes weaker due to the following reasons:
Firstly, Keynes assumed that consumption depends on income and MPC of the economy does
not change. But, experience and evidence suggest that consumption depends on other factors
including income. Keynes ignored other determinants of consumption function.
Above all, MPC does not remain static. Changes in income following a change in investment
bring about a change in income distribution which causes MPC to change. MPC for the poor is
high compared to the rich people. In such a situation, it becomes difficult to calculate the value
of the multiplier. It is true that 0 < MPC < 1. Suppose MPC is greater than one. If, so then 1/1MPC will be negative.
This suggests that an increase in autonomous investment results in a decline in national income.
Secondly, the multiplier analysis describes the effect of an increase in autonomous investment on
national income. But it neglects the effect of consumption on investment. Changes in
consumption result in a change in investment spending. This sort of investment is called induced
investment. Multiplier analysis neglects this aspect. If induced investment is taken into account
the value of multiplier will be larger than the simple multiplier presented by Keynes.
Thirdly, multiplier analysis comes to a halt if the economy remains at the full employment level
since output or income cannot increase beyond this level even if investment spending increases.
Only at the underemployment situation does multiplier work.

Fourthly, Keynesian multiplier is an instantaneous multiplier in the sense that as soon as

investment takes place income tends to rise. This is also called static multiplier as there is no
lag between income and investment expenditure. However, in reality, there exists a time lag
between incomes received and consumption spending. Greater the time lag, lower will be the
value of the multiplier because now change in income is not instantaneous. Once we introduce
time lag in the process of income change, we get dynamic multiplier as opposed to the static
multiplier.
Finally, leakages or withdrawals result in a smaller value of multiplier. In other words, due to the
presence of leakages, process of income generation slows down. For instance, if people decide to
save more from their incomes the value of the multiplier will be weaker.
This is because, in an interdependent economy, more consumption of an individual will result in
an increase in income of another individual. Thus, greater the consumption of the community
greater will be the value of income. That is why it is said that investment results in an increase in
income via consumption spending.
But, if society decides to save more (i.e., high MPS) peoples income will decline. In other
words, the multiplier process will be weaker if societys MPS is high. Again, once we include the
government in our analysis the multiplier process may not work in the above-mentioned way.
For instance, if the government raises the tax rate or if the corporate sector does not distribute a
portion of profit to shareholders, disposable income will decline.
This will cause consumption spending to rise at a slow speed. Ultimately, increase in income
consequent upon an increase in investment will be less. Similarly, if people buy more imported
goods, a countrys consumption spending for domestically produced goods would be less. Now
the resulting increase in income following an increase in investment would be smaller. Thus,
greater the leakages (i.e., S + T + M), lower is the value of the multiplier.
Despite these limitations, the multiplier analysis has some uses. Firstly, it demonstrates that a
change in investment spending results in an increase in income and employment level. Secondly,
by estimating multipliers (for government expenditure, taxes, money supply), it is possible to
estimate the effectiveness of fiscal policy and monetary policy. Thirdly, the multiplier concept
enables us to analyse cyclical fluctuations, its control and its forecasting. That is why it is said
that this concept is a path-breaking one.

Marginal Efficiency of Capital (MEC)

By M. Agarwal Marginal Efficiency of Capital

Read this article to learn about the Marginal Efficiency of Capital (MEC) at business
expectations.
The marginal efficiency of capital, at any time, depends upon the state of entrepreneurs
expectations. It is raised by invention and innovation and by the expectation of rising prices.
It is lowered by any general threat to reduce the yield of capital goods while at the same time
their supply price is likely to be increased.
It is also affected by the state of entrepreneurs animal spirits; for much investment is made not
merely as a result of calculation but under the stimulus of irrational optimism.
It is always subject to violent fluctuations, owing to fundamental uncertainty of the world in
which we live. We have little means of knowing exactly the value or yield of capital in future. So
we take the present as guide to future. We accept existing opinion, the community judgment, and
the behaviour of the majority as a correct indicator of prospects, and though this is good enough
as long as stability reigns, it exposes us lo sudden and violent changes when our expectations
turn out to be unjustified.
Thus, Keynes Theory of the marginal efficiency of capital is based on the strategic role of
business expectations. Business expectations play a significant part in the theory of employment,
because businessmen can never be quite sure in respect of the prospective yield of any capital
asset or investment. Out of the two determinants (supply price and prospective yield) of the
marginal efficiency of capital, it is the prospective yield which gives its most important
characteristic instability.
Keynes maintained that the considerations on which expectations of prospective yield base are
partly the existing events (which can be more or less ascertained) and partly future facts (which
cannot be anticipated with confidence). It is essentially due to uncertain events on which the
prospective yields mainly depend that the marginal efficiency of capital is so unstable. Hence, a
large part of the instability of economic behaviour under capitalism is ascribed to the unstable
character of prospective yield from capital assets.
The investment decisions are governed by expectations of yield and not by actual yields. For the
purchase of durable capital assets requires huge immediate expenditures before any actual
returns begin to flow back to the entrepreneur. Capital assets are, thus, a link between the present
and the uncertain future. It is, therefore, essential to analyze the true nature of business
expectations and their influences on the MEC.
These expectations are mainly of two types:
(i) Short-term expectations,
(ii) Long-term expectations.

Short-term expectations are based on the sales proceeds from the output of existing plant, these
expectations are concerned with the existing facts. Under such circumstances the plant is
presumed to be of fixed size, only the output from it is variable. Long-term expectations are the
expectations of the entrepreneur based on future events and concern the sales proceeds from the
variations in the size of plant or from the installation of an entirely new plant.
In the long-term expectations, the size of the plant as well as the amount of output from it is
variable. The difference between two types of expectations is that in the short-run, it is very
difficult to change the size of the plant, whereas in the long-run not only the size of the plant is
changed but also new machinery can be installed.
(i)
Short-Term Expectations:
Short term Under these factors are:
Expected Demand for Future
Level of Income
When Consumption Changes
Business Expectation
According to D. Dillard, short-term expectations are more stable than long-term expectations,
because the realized results of the recent past are relatively a safe guide to what will happen in
the near future, whereas there exists no past experience which will serve as a safe guide to what
will happen in the distant future. Moreover, in case of short-term expectations there is a high
degree of continuity as most of conditions which affect current output remain more or less the
same from day to day or from week to week or from month to month.
In the absence of a positive evidence necessitating a change, recent events may be expected to
continue in the near future. Short-term expectations, by their very nature, can be checked in the
light of realized result, and become a guide for ascertaining expectations relating to the near
future. Since short-term expectations are stable, they are unable to explain fluctuations in
investment. Therefore, in case of short-term plans it may be safe to rely on past results.
(ii)
Long-Term Expectations:
Long Term Factors:
Population Growth
Economic Policies of Government
Infrastructures facilities

The nature- of long-term expectations is quite different from the nature of short-term
expectations. Long-term expectations concerning future yields are highly unstable and are,
therefore, more important in explaining the fluctuations in total investment and the level of
employment in the economic system.
While it may be safe to assume that economic activity next day or next week or even next month
will be more or less the same as it was during the previous day or past week or past month,
experience warns us against assuming that the next three or seven years will be like the past three
or seven years, because the realized results of the past are not a dependable guide for the future.
Moreover, while ascertaining long-term expectations, many difficulties of a complex nature, like
the probable life of the plant, maintenance and depreciation charges, future change in technology,
level of effective demand, nature of new competition, possibility of war, shifts in tax burden, size
of the export market, conditions of labour market, political climate of future years etc. crop up.
These are the considerations which are less predictable and make any scientific judgment
regarding future highly precarious. Further, they make long-term expectations in respect of
prospective yield highly unstable and account for the utter lack of confidence even in the most
dependable forecasts, subjecting investment decisions to sudden shifts.
There are, however, some factors affecting long-term expectations which do not depend upon the
uncertain future, as the decisions to invest are to some extent based upon facts regarding the
existing stock of capital assets. For example, a decision to build a new sugar factory depends
partly upon the amount of existing sugar output, a fact which can be easily ascertained, but as we
try to project in the distant future and try to form long-term expectations, all the abovementioned factors render such a forecast difficult. The distant future is never clearly foreseen
specially when decisions are made by a large number of private businessmen.
Hence the nature of long-term expectations becomes highly uncertain, unstable and precarious.
As Keynes observes, The outstanding fact is the extreme precariousness of the basis of
knowledge of the factors which will govern the yield in which decisions to invest have to be
made. Our knowledge of the factors which will govern the yield of an investment some years
hence is usually very slight and often negligible. If we speak frankly, we have to admit that our
basis of knowledge for estimating the yield ten years or even five years hence of a railway, a
copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in
the City of London amounts to little and sometimes to nothing. In fact, those who seriously
attempt to make any such estimate are often so much in the minority that their behaviour does
not govern the market.
Stock Exchanges and Prospective Yields:

The uncertain, unstable and the precarious nature of long-term expectations, which cause
fluctuations in investment, is reflected in the activities of the stock exchange market in modern
capitalist economies. When prospective yields are viewed favourably, stock prices tend to rise;
and when these are viewed unfavourably, stock prices tend to fall. It may, however, be noted that
the purchase or sale of securities does not represent real investment, but only a financial
transaction. When one man invests (purchases) another man disinvests (sells).
Thus, the sale is equal to the purchase and the disinvestment is equal to the investment. Hence,
total social investment, as well as total financial investment remains unaffected as a result of
stock exchange transactions. What actually constitutes real investment is the employment of
additional men and materials to build new factories and other types of capital assets. Although
the transactions on the stock exchanges are primarily financial transactions and relate to sale and
purchase of old stock, yet they affect real investment by affecting the prices of new stocks,
shares and securities. Ability to float new securities at high prices tends to encourage investment
in new projects on a large scale. High quotations for existing stocks imply that the MEC for this
type of enterprise is high in relation to the rate of interest and, therefore, the inducement to invest
is strong. It will be profitable to build new capital assets of the same type.
On the other hand, when the prices of old stocks on the stock exchange are low, it will be more
profitable to purchase claim on the existing assets than to build new ones; because in these
circumstances, the MEC of capital is likely to be lower than the current rate of interest and,
therefore, there may be no inducement to invest. We find the real investment is governed by
quotations of prices of securities on the stock exchanges.
These stock exchange markets, thus, become links between the present and the future, because it
is in these markets that the existing investments are valued and revalued daily or even hourly.
The main reasons for changes in values are changes in current expectations regarding future
events. Any event that is likely to happen in future is taken into account (discounted) in the
present prices of securities.

Speculation and Enterprise:

There is a considerable degree of speculation in the stock exchange which causes the instability
of marginal efficiency of capital. Speculation consists in the attempt to anticipate the psychology
of the market. Enterprise consists in an attempt to anticipate the yield of assets over their life
time. In other words, a speculator has a tendency to get rich quick by taking advantage of the
fluctuation in prices of securities in the stock exchange market.

Therefore, he is not primarily interested in real investment but in the difference of prices as a
result of speculative financial transactions to get rich overnight ; whereas an enterprise is
interested in real investment in new capital assets by affording more employment to men and
materials. He is, therefore, interested in forecasting the returns from the capital assets over their
life time in the long-run. Keynes felt that the long-term expectations which govern the quotations
of securities in the stock exchange are more the result of speculation than of enterprise.
Thus, speculation rather than the enterprise causes changes in the stock market price. The reason
is that people generally have no idea of future events and no confidence in their individual
judgments they tend to rely upon the judgment of others, who, they think, are better informed.
This is, specially, true of amateur investors who do not possess the technical psychological,
institutional and business knowledge which is used by professionals.
Their main concern is to depend upon conventional judgment (i.e., acceptance of the unique
correctness of the existing estimates of the future). That is why even the most skilled and
experienced forecaster tries to forecast the market psychology, to rationalize the irrational
activities of a large number of less skilled participants in the market. Hence, speculation tends to
predominate the enterprise in the stock market.
Whereas, it cannot be denied that the activities in the stock exchange act as a barometer
indicating the changes in the economic weather even then, such activities fail to give correct
valuation of the existing stock, share and security. The process of evaluation is highly defective
because a large number of psychological, social, political and institutional factors influence its
determination. In other words, these factors get undue importance over the purely economic
factors.
Keynes criticized the professional dealer, who is more concerned with earning quick profits
rather than genuine enterprise. He felt that, if the activities in the stock exchange were more
genuine (than of speculative nature), correct values of securities would be reflected and they
could serve as a good guide to intending investors. But in actual practice, stock exchange
quotations suffer from many handicaps and fail to further a cause of private investment.
Limitation of MEC:
Investment done by the Government for social purpose has no connection with the MEC.
Practically it is difficult to estimate MEC.
Whenever there is contractionary monetary policy, the firms may not find funds even if the
projects or investments are profitable

Every time the businessmen do not necessarily go for loans. Sufficient funds are gathered by the
businessmen for some projects, which are planned for a long time.
That is why Keynes remarked:
Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is
serious when enterprise becomes the bubble on a whirlpool of speculation.

Marginal Efficiency of Capital MEC

The marginal efficiency of capital displays the expected rate of return from investment, at a
particular given time. The marginal efficiency of capital is compared to the rate of interest.
Keynes described the marginal efficiency of capital as:
The marginal efficiency of capital is equal to that rate of discount which would make the
present value of the series of annuities given by the returns expected from the capital asset during
its life just equal to its supply price. J.M.Keynes, General Theory, Chapter 11
This theory suggests investment will be influenced by:
1.

The marginal efficiency of capital

2.

The interest rates

Generally, a lower interest rate makes investment relatively more attractive.
If interest rates, were 3%, then firms would need an expected rate of return of at least 3% from
their investment to justify investment.
If the marginal efficiency of capital was lower than the interest rate, the firm would be better off
not investing, but saving the money.
Why are interest rates important for determining the Marginal efficiency of capital?
To finance investment, firms will either borrow or reduce savings. If interest rates are lower, its
cheaper to borrow or their savings give a lower return making investment relatively more
attractive.
Marginal Efficiency of Capital


1.

A cut in interest rates from R1 to R2 will increase investment to I2.

The alternative to investing is saving money in a bank, this is the opportunity cost of
investment.
If the rate of interest is 5% then only projects with a rate of return of greater than 5% will be
profitable.
How Responsive is Investment to Interest Rates?
In Keynesian investment theory, interest rates are one important factor. However, in a liquidity
trap, investment may be unresponsive to lower interest rates. In some circumstances,

In a liquidity trap, business confidence may be very low. Therefore, despite low interest rates,
firms dont want to invest because they have low expectations of future profits.
Factors which shift the Marginal Efficiency of Capital

1. The cost of capital. If capital is cheaper, then investment becomes more attractive. For
example, the development of steel rails made railways cheaper and encouraged more investment.
2. Technological change. If there is an improvement in technology, it can make investment more
worthwhile.
3. Expectations and business confidence.
If people are optimistic about the future, they will be willing to invest because they expect higher
profits. In a recession, people may become very pessimistic, so even lower interest rates dont
encourage investment. (e.g. during recession 2008-12, interest rates were zero, but investment
low)
4. Supply of finance. If banks are more willing to lend money investment will be easier.
5. Demand for goods. Higher demand will increase profitability of capital investment.
6. Rate of Taxes. Higher taxes will discourage investment. Sometimes, governments offer tax
breaks to encourage investment.

MARGINAL EFFICIENCY OF CAPITAL

Keynes says, " The marginal efficiency of capital is equal to that rate of discount which would
make the present value of the series of annuities given by the returns expected from the capital
asset during its life just equal to its supply price."
The expected rate of return on capital is called the marginal efficiency of capital. In other words,
marginal efficiency of capital is a return on investment which is based partly on expectations of
future yields and partly on the actual price of the capital good concerned.
Actual price is the price which just includes the producer of capital good to produce a new
capital goods. A producer will produce the machine if a buyer is ready to pay actual price. Actual
price or inducement price is the same thing.
The marginal efficiency of capital depends upon two factors :
1. Expected Net return on an Asset.
2. Replacement Cost or Supply price of the asset .
EXPECTED RETURN OF AN ASSET :- The expected net return on an asset is that income
which a person receives after selling the product produced by the machine or asset , If the
expected rate of return is greater than the expenses made on it, then investment will increase
REPLACEMENT COST OR SUPPLY PRICE :- The marginal efficiency of capital will
increase other things remaining the same, if the supply price or the price of the machines falls.
On the other hand it falls with the increase in the supply price.
MEC = Expected yearly income/Supply price X 100
Increase in consumptions, leads to an increase in marginal efficiency of capital and investment.
Investment will tend to increase so long as the marginal efficiency of capital is more than the
prevailing rate of interest. In simple words investment tends to increase upto that point where
marginal efficiency of capital is equal to the rate of interest.
We can explain it by the following table :

EXPLANATION :- According to this schedule we assume that rate of interest in the market is
6% which is fixed.The table shows that as the volume of investment increases the marginal
efficiency of capital falls.The rate of interest and MEC both are equal to each other when the

investment volume is 6 crore.

EXPLANATION :- This diagram shows that when investment is RS. 6 crore the marginal
efficiency of capital and rate of interest both are equal to each other ( 6% ). So it is clear that rate
of interest and marginal efficiency of capital both determine the volume of investment.
FACTORS WHICH AFFECT THE MARGINAL EFFICIENCY OF CAPITAL
1. DEMAND OF GOODS :- If the demand is greater than the marginal efficiency of capital will
also be greater. On the other hand if the demand of goods is smaller then the marginal efficiency
of capital will also be smaller.
2. PRICE OF COMMODITIES :- With the increase in the prices of goods, marginal efficiency
of capital increases and with the fall in price the marginal efficiency of capital also falls.
3. COST OF PRODUCTION :- With the fall in the cost of production marginal efficiency of
capital increases and with the rise in the cost, marginal efficiency of capital falls.

4. PSYCHOLOGICAL FACTOR :- If the businessman are optimistic, efficiency of capital will

be higher and if they are pessimistic about future then marginal efficiency of capital will be low.
5. FOREIGN TRADE :- If the export demand increases, then producer will increase the
investment because marginal efficiency of capital increases.
6. THE QUANTITY OF CAPITAL GOODS :- If the capital goods are already in the large
quantity to meet the demand of the market, then it will not be beneficial for the investors to
invest the money in the project and the marginal efficiency of capital will fall.
7. RATE OF POPULATION GROWTH :- If the rate of population growth is high then the
demand of various goods will increase . So it will increase the marginal efficiency of capital. It
falls with the slow bith rate.
8. TECHNOLOGICAL ADVANCEMENT :- Inventions and technological improvement
encourages investment in various projects.So marginal efficiency of capital increases.
9. RATE OF TAXES :- If government imposes the taxes on various goods, it will increase the
cost of production and will reduce the profit . So with the fall in profit the rate of investment and
marginal efficiency of capital both falls.
10. LABOUR EFFICIENCY :- Efficiency of labour increases the marginal efficiency of capital
lowers.
11. GOVERNMENT INTERFERENCE :- If the government interferes in the private business
and imposes some restrictions then people will hesitate to invest and marginal efficiency of
capital falls. On the other hand if it encourages the private business then marginal efficiency of
capital will increase.

Sources and Deployments of Money Supply in India

As I posted a while back, it is useful to look at money supply in various ways. I had looked at
relationship between M1 and M3 and money multiplier.
But where does money supply come from?And where does it go? These are all important issues
to understand.
First which measure of money supply RBI follows? As I said, there are 4 measures:

M1: Currency with the public + Demand Deposits + Other deposits with the RBI.

M2: M1 + Savings deposits with Post office savings banks.

M3: M1+ Time deposits with the banking system

M4: M3 + All deposits with post office savings banks (excluding National Savings
Certificates).

RBI reports both M1 and M3. As M3 is broader in scope, it is taken as measure of money supply
in India. Now let us look at components and deployments of M3.

Components of Money Supply: If we see the components of money supply, we can see
bank deposits form bulk of the money supply. Within deposits, it is time deposits which
form around 3/4th of the money supply. The share of time deposits has declined from
74.7% in Oct Dec 09 to 74% on 9 April 2010. The share of demand deposits has risen
from 11.3% in Oct Dec 09 to 12% on 9 April 2010. The percentage contributions of
each item in components of money supply do not change much in the year.

Constituents/Components of Money Supply (in %)

Currency with the public

Demand deposits with banks
Other deposits with RBI
Time deposits with banks
Money Supply

April 09
June 09
14.1
11.4
0.2
74.3
100.0

July 09
Sep 09
13.6
11.6
0.1
74.7
100.0

Oct 09
Dec 09
13.9
11.3
0.1
74.7
100.0

Jan 10Mar 10
14.0
12.0
0.1
74.2
100.0

As on Apr
9, 2010
13.9
12.0
0.1
74.0
100.0

As both demand and time deposits form around 85% of money supply, whatever the growth in
deposits, is also the growth in money supply. RBI changes both these targets together and keeps
them near similar.

Deployments of Money Supply: There are 5 categories of money supply deployments:

1. Net bank credit to government (A): It is further divided into two categories:

RBIs credit to government: RBI lends to government for short-term expenditure

management.

Other banks credit to government This represents the total of commercial and
cooperative banks investments in government securities, including treasury bills.

2. Bank credit to commercial sector (B): It is also divided into two categories

RBIs credit to commercial sector: This is the aggregate of RBI investments in shares,
bonds of financial institutions like ARDC, DICGC, debentures of land mortgage banks,
loans and advances to financial institutions like IDBI, IFCI and state financial
corporations, and internal bills purchased and discounted.

Other banks credit to commercial sector: Loans given by commercial and cooperative
banks to commercial sector. Also includes investments by banks in securities (shares,
bonds etc) issued by commercial sector

3. Net foreign exchange assets of banking sector (C): Sum of RBIs foreign exchange and foreign
assets held by commercial and cooperative banks. The percentage of foreign assets held by banks
is very small. RBI holds majority of the foreign assets as part of its forex reserve.
4. Governments currency liabilities to the public (D): These comprise the holdings of one rupee
notes, rupee coins and small coins with the public.
5. Banking sectors net non-monetary liabilities other than time deposits (E): This includes
capital and reserves, branch adjustments, and bills payables; the liabilities are net of investments
in fixed assets, and branch adjustments. This item is subtracted from the sum of the above 4
items
Let us see how the money supply adds up using these five categories