Determination of Income:

Consumption Function and Multiplier

 Introduction
• For a long time the classical economists believed that the
operation of market forces would result automatically in full
employment.
• It was argued that if the wage rates and prices were
sufficiently elastic there should be no reason for
unemployment.
• A reduction in wage rate would cure any temporary
unemployment.
• The possibility of a general glut in the in the economy was
also ruled out by classical economists.
• One of the postulates of the classical economists was
known as Say’s law which stated that supply creates its
own demand
 Introduction
• it is true that a productive process, by paying out income to
the factors employed, generates demand at the same time
as it adds to supply.
• However it does not necessary follow that the value of the
output will always be equal to the demand for the output.
• Say’s law holds true in a purely barter economy.
• But in a money economy where saving are possible, the
value of and the demand for output need not coincide.
• Strict adherence to say’s law led the classical economists to
believe that a general glut in the economy was possible.
• However, history has shown that the capitalist system did
not progress smoothly.
 Introduction
• Periods of prosperity were followed by periods of decline in output
and employment.
• These have been termed as business cycles .
• The recurrences of business cycles and more particularly the
depression of the 1930s destroyed the belief in automatic
adjustment.
• Roughly one-fifth of the labour force was unemployed in the early
1930s in the United States.
• Lord Keynes drew attention to the fact that the capitalist
system was in equilibrium in the sense that expenditure were
equal to income but that equilibrium was not necessary a full
employment equilibrium.
• it need not generate a level of income at which all those who
are willing to work can be given employment.
 Introduction
• Investment, defined as the increases in the real capital
stock, plays an important role in any economy.
– It adds to the productive capacity of a country.
• However it is not necessary that the savings of the society
will be equal to the desired investment since savings and
investment are activities performed by different people
• The motivations for savings and investment are different.
– Savings are made primarily by business firms motivated by profit
considerations.
• According to the Keynes, it is the divergence between the
saving and investment that causes fluctuations in income.
– When the desired investment exceeds savings, the economy is
pushed forward to expand its output.
– if the savings exceed desired investment, income tends to fall.
 Introduction
• Also, more importantly there is no guarantee that the
amount of investment decided by entrepreneurs will be
equal to that needed to secure full employment.
• The modern theory of income determination was largely
developed by Keynes in his epoch-making work General
Theory of Employment, Interest and money. Although
written forty years ago the broad frame work of analysis
suggested by Keynes is still useful.
• Keynes concentrated on aggregate demand or effective
demand as the key to understanding the behavior of an
economy.
• Effective demand as the key to understanding the behavior of
an economy. Effective demand must be kept at a high level.
• Effective demand determines the level of employment in the
economy. When effective demand increases, employment also
increases, and a decline in effective demand decreases the level of
employment. Thus unemployment is caused by a deficiency of
effective demand.
• Effective demand represents the total expenditure on the total
output produced at an equilibrium level of employment. It
indicates the value of total output which equals national income.
National income equals national expenditure. National expenditure
consists of expenditure on consumption goods and investment
goods.
• Thus the main determinants of effective demand and the level of
employment are consumption and investment. In brief, Effective
Demand = Value of National Output = Volume of Employment =
National Income = National Expenditure = Expenditure on
consumption goods + Expenditure on investment goods.
 Introduction
• He therefore, focused on the two important components of
aggregate demand, consumption and investment and
tried to explain the factors influencing these variables
• In the Keynesian model of income determination, there are
three building blocks
– (1) consumption and its relation to income,
– (2) investment and the factors influencing it and
– (3) money market and the determination of interest rate. By
suitable linking these blocks,
– Keynes measured all the variables in real terms building blocks
separately and then put them together to see how the model as a
whole explains the behavior of economics.
 Consumption Function
• The most important determinant of consumption is
income, as confirmed by all of us from our daily
experience.
• In technical language consumption is a function
of(determined by) income.
• This relationship between consumption and income
is termed as consumption function or the
propensity to consume.
 Consumption Function
Average Propensity to Consume /SAVE
• The ratio of total consumption to total income is the
Average propensity to consume (APC).=C/Y
• The Average to Save (APS) is the ratio of total
savings to total income = S/Y
• APC declines and the APS increases as income rises.
• Since consumption plus savings equal income, APC
and APS must add up to 1 at all income levels
 Consumption Function
Marginal Propensity to C/S
• The marginal Propensity to consume (MPC)
measures the changes in consumption (∆C) due to
change in income (∆Y).
• The MPC can be defined as ∆C/∆Y.
• Similarly the Marginal Propensity to save can be
defined as ∆S/∆Y
• MPC declines as income increases and
correspondingly the MPS increases as income rises.
• In the same way as APC and APS add up to 1, PC and
MPS also add up to 1
 Consumption Function
Y C S APC APS MPC MPS
(income) (consumption (saving)
0 60 -60 - - - -
100 150 -50 1.5 -0.5 0.90 0.10
200 220 -20 1.1 -0.1 0.70 0.30
250 250 0 1 0 0.60 0.40
350 300 50 0.89 0.11 0.50 0.50
450 345 105 0.77 0.23 0.45 0.55
•consumption exceeds income resulting in negative savings.
beyond that income there are positive savings
• The MPC is positive but is always less than 1.
• As income increases, consumption increases but by less than
the increase in income.
• This is a proposition of major importance in the model of income
determination.
• This behavioral characteristic of MPC being less than 1 was termed
by Keynes as a fundamental psychological law.
• Human beings have a working life which is shorter than their total
life.
• Therefore, they have to provide for their non-earning period
while they are working.
• Their savings serve as a hedge against unforeseen contingencies.
• This is the main motivation for not spending all the increase in
income.
• Even at low income this is true. If MPC is always less than 1, it
follows that MPS is always positive.
 CONSUMPTION FUNCTION FOR INDIA AND OTHER
COUNTRIES S. No. Country MPC
1 Argentina .81
• An estimation of the 2
3
Australia
Belgium
.76
.80
consumption function 4 Brazil .83

indicates that the MPC for

5 Canada .77
6 Ceylon .87

India is 0.85. 7
8
Chile
Cyprus
.89
.86

• In general, the MPC is high 9

10
Ethiopia
France
.90
.76
for low income countries. 11
12
Ghana
India
.87
.85

• Japan has the lowest MPC. 13

14
Iraq
Israel
.75
.90
15 Italy .78
16 Japan .66
17 Pakistan .89
18 South Korea .88
19 Taiwan .83
20 West Germany .72
 OTHER FACTORS INFLUENCING CONSUMPTION
• Examining the consumption behavior in America, argued that when
income fell, consumption did not fall proportionately because the
people, used to a certain standard of living, could not let their
consumption fall below a point. This came to be known as the ratchet
effect.
• Wealth or the stock of assets also has an impact on consumption
behavior. The larger the present stock of assets, the less is the motive
for saving out of a given income.
• Consumption, therefore, will be higher with more wealth. The propensity
to consume which varies from one income group to another is higher for
low income groups. Therefore, besides total income, its distribution is
also a relevant factor.
• More recently friendman has made a distinction between income
actually received (measured income) and income on which consumers
base their behavior (permanent income).
• A similar distinction is drawn between measured and permanent
consumption. Friendman argues that permanent consumption is
proportional to permanent income, the proportionality being dependent
upon various economic and demographic factors.
 DETERMINATION OF INCOME
• Simple economy with no government and no relationship with the rest of the world.
The amount of investment is treated as constant, i.e., at all income levels the
investment made is the same. These two factors can determine the equilibrium
income.
• The equilibrium income may be defined as that income where the total of the
consumption and investment expenditure will be equal to the aggregate output
(income).
– If the total planned expenditures is greater or smaller than the income, that level of
income cannot be maintained.
– If the planned expenditures are higher than income, the latter will have to grow to make
them equal.
– Similarly if the planned expenditures are less, income will have to come down to be equal
with them.
– Alternatively, we can consider the equilibrium income as that at which planned
investment is equal to planned saving.
– Given the consumption function, the savings of society at each income level can be
determined.
– Since the desired investment is fixed, it can be balanced only at that income where the
desired savings are equal to the desired investment.
The consumption function is shown as a
straight line.

The line C is the consumption function.

Since the amount of investment to be
made is fixed , we draw the line C+I
which lifts the C curve by an equal
amount at all income levels.

As before , we have drawn the 45° line

to indicate the points where the
expenditures will be equal to income.

The C+I curve interests the 45° line at E

giving the equilibrium income OY. Why
is this income called an equilibrium
income?
It can be clearly seen from the diagram
that at OY0 the planned expenditures
EY0 composed of AY0 of consumption
expenditure and EA of investment
expenditure are equal to income OY0.
• Equilibrium income could also be defined as that
income where planned savings are equal to planned
Invetsment
• In the Keynisian analysis, the equality between
planned savings and planned investment is brought
about through changes in income rather than
through interest rate as postulated by classical
economists.
• Keynes made savings function of income whereas the
earlier economists treated savings as a function of
the interest rate investment
Numerical Presentation
• The consumption behavoiur depicted in fig.3.2 (a) conforms to the function C = 30 +.8Y. the
MPC is .8 . let us assume that an investment of Rs 40 will be made. With this information we
can find out the equilibrium income. The equilibrium condition as stated before is that the
aggregate expenditures must equal to the aggregate output, i.e., Y =C+I. we can put together
these three ideas to form a model.
• C = 30 +.8Y………(1)
• I = 40……………..(2)
• Y = C + I …………(3)
• Equation (1) is the consumption function. Equation (2) specifies the investment at all incomes
levels. Equation (3) is the equilibrium condition. The solution to this model is obtained by
substituting Eqs.(1) and (2) in (3) . WE then get
• Y = 30 + .8Y * 40
• Y = 350
• At an income of Rs 350, consumption will be Rs 310. The condition that planned expenditure
will be equal to income will be satisfied by Adding to it the investment of Rs. 40. Without
solving the model this way, one can calculate the consumption plus planned investment at
each income level and find out that income where both are equal.
–
• We will now work out consumption and investment at each income
level for the example given earlier.
• Only when income is Rs. 350, the condition that total expenditure is
equal to total income is satisfied.
Income Consumption Investment Aggregate Aggregate
Demand Demand Income
100 110 40 150 +50
200 190 40 230 +30
300 270 40 310 +10
350 310 40 350 0
400 350 40 390 -10
 IMPACT OF CHANGE IN INVESTMENT
• Let us assume that investment is to be raised to a higher level
so that the new aggregate expenditure line is C + I1.
• This new line intersects the 45˚ line at F and the new
equilibrium income is OY1. Thus income increases from OY0 to
OY1 as a result of the investment going up from I0 to I1.
• Figure 3.3 (a) shows that change in income (ΔY) is greater
than change in investment (ΔI). The investment income
multiplier or the multiplier in short, is the ratio of ΔY to ΔI.
• This ratio is greater than 1. Hence the use of the expression
multiplier. Figure 3.3 (b) shows the impact of an increase in
investment on income through the saving function.
• Why should an increase in investment lead to an increase in
income that is a multiple of the increase in investment? Since
investment is part of income, an increase in investment will
lead to an increase in income equal to it.
• But a rise in income following an increase in I induces an
increase in consumption spending also. Thus the ultimate
increase in income is composed of the original increase in
investment and the induced increase in consumption brought
about by it.
• Let us suppose that a firm enlarges its business by making an
additional investment of Rs 1,000 by buying a machine and
installing it. This investment expenditure will become income
for the machinery producers and the workers employed to
install it. These income earners will spend this income on
consumption expenditures.
• If the MPC is assumed to be 0.8, they will spend Rs
800 on new consumption goods.
• The producers of these goods will have an extra
income of Rs 800 and they will in turn spend Rs 640
on additional goods, if their MPC is also assumed to
be 0.8.
• Thus there is a chain of income and consumption
expenditures generated from an original increase in
investment.
• The total increase in income can be calculated as the
sum of the increase in income at each stage.
• In our present example it will be

• using the formula for geometric progression, this will be equal to

• The value of the multiplier depends on the MPC.
• It is equal to or
• The larger the MPC, the bigger is the multiplier because if the
MPC is higher, the secondary expansion in income at each stage
is higher.* *the value of the multiplier can also be derived as follows:

𝑌𝑌 = 𝐶𝐶 + 𝐼𝐼

∴ ∆𝑌𝑌 = ∆𝐶𝐶 + ∆𝐼𝐼

Dividing throughout by ∆𝑌𝑌, we get

∆𝐶𝐶 ∆𝐼𝐼
1= +
∆𝑌𝑌 ∆𝑌𝑌
∆𝐼𝐼 ∆𝐶𝐶 ∆𝑌𝑌 1
∆𝑌𝑌
= 1 − ∆𝑌𝑌 or ∆𝐼𝐼
= ∆𝐶𝐶
1−
∆𝑌𝑌
 Multiplier and Time Factor

• Figure 3.4 shows the impact of a single injection of investment.

• If there is a fresh injection of investment of Rs 10 and if the MPC is
0.8, then the expansion of income from period to period will be as
shown in fig. 3.4.
This figure indicates
what will happen if
there is a continuous
injection of
investment of Rs 10
and the MPC is 0.8.
after some time, in
each period,

• We have so far examined the effect of a “one shot” increase in investment.

• The problem of time lag, of how long it takes to have full effect, disappears when an increase in
investment is sustained over the subsequent periods.
• A continuous injection of investment will mean that after a time, in each period, the increase in
income will be multiplier times the increase in investment.
• Each period’s investment produces a chain of subsequent increases in income thus the change in
income in any period is affected by changes in investment in all the previous periods. In this
situation the multiplier will be true “always and simultaneously”.
 APPLICATION OF MULTIPLIER
• Part of the Keynesian model which has been presented so far
can provide some policy guideline.
• Let us look at the numerical example presented earlier. If the
consumption function is 30 + 0.8Y and the investment is Rs 40,
the equilibrium level of income is Rs 350.
• there is no guarantee that this income will necessarily ensure
full employment. If it is known that the full employment
income is Rs 450, what guidance does this model offer to policy
makers? Since the multiplier is 5, it follows that if the
investment can be raised by Rs 20, income can be increased by
Rs 100.*
• In terms of the diagrams we have used earlier, the C+I curve
needs to be lifted by Rs 20 either by increasing investment or
by shifting the consumption function upwards. The former is
easier to manipulate.
 APPLICATION OF MULTIPLIER
• This analysis also throws new light on what is known as the paradox
of thrift.
• Thriftiness and frugal behavior have always been perceived as
desirable characteristics in human beings.
• However, except in certain situations, these will not benefit the nation.
• Every individual attempting to save more can produce no change in
total savings. How does this happen?
• The attempt to reduce consumption by increasing the savings of an
individual will result in less income being passed on to the next person
since one person's expenditure is another person's income,
• Thus the secondary expansion in income will be curtailed.
• The result, when everyone starts saving more, can be seen clearly
from the Savings - investment diagram presented earlier.
• The increase in savings will result in the savings function being
shifted upwards.
• This will mean that given a fixed level of investment the equilibrium
income will be lower.
 APPLICATION OF MULTIPLIER
• Figure 3.6 shows
the effect of the
upward shift of
the savings
function on
income. When
the savings curve
shifts to the new
position, S1,
income goes
down to Y1 from
Y0.
 APPLICATION OF MULTIPLIER
• The only situation in which an increase in
thriftiness does not cause a reduction in aggregate
income is when the economy continues to remain
at a full employment level.
• Under such conditions less consumption will
result in more investment. Aggregate
expenditures will remain the same and, therefore,
income will stay at that level.
 FOREIGN TRADE MULTIPLIER
• In the simple model of income determination, we
abstracted from the influence of foreign trade. To
incorporate the effects of important forces of
exports and imports in the equilibrium level of
income, we can rewrite the basic income identity
as
• Y=C+I+X–M
• Where X denotes exports and M denotes imports.
 FOREIGN TRADE MULTIPLIER
• It can be readily seen from this identity that a change in exports
will have essentially the same kind of multiplier effect on
domestic output and employment as a similar change in
investment generally has.
• The reason is that additional exports increase the flow of total
spending in the economy which in turn generates a chain of
induced responses.
• In addition to the multiplier effects of exports, foreign trade also
introduces another important effect in the form of. Income –
induced imports. Just as additional exports have effects similar to
additional investment, an in-crease in imports will have effects
similar to an increase in saving.
• If, we assume that imports are essentially income-induced, we
can define marginal propensity to import as the fraction of
additional income that is spent on imports. An increase in
imports arising out of a positive marginal propensity to import
constitutes a 'leakage' in the same way as does the increase in
saving arising out of a positive marginal propensity to save.
 FOREIGN TRADE MULTIPLIER
• To examine the total impact of foreign trade on the equilibrium
level of income, let us assume that the marginal propensity to
consume is 0.75, the marginal propensity to import is 0.15, and all
investment as well as exports are autonomous.
• Under these conditions, let us suppose that exports increase by Rs
1000.
• This will result in a primary increase in the income of the export
industries by an equivalent amount (Rs 1000).
• This increase will induce a secondary consumption response of
0.75 times 1000.
• However, it will also cause imports to increase by 0.15 times 1000.
• Hence out of the initial increase of 1000 in income, only 0.6 times
1000 (equal to 0.75 × 1000 -0.15 × 1000) will constitute increased
expenditure on domestic consumption goods and, therefore,
induced increase in domestic income in the next round.
 FOREIGN TRADE MULTIPLIER
• Thus the whole chain of induced income
generation set into motion by the initial increase in
exports will be
• 1000 + 600 + 360 + 216 + ……………
• = 1000 + 1000 (0.75 – 0.15) + 1000 (0.75 - 0.15)2 +
1000 (0.75 - 0.15)3…………
=1000(1 + 0.6 + 0.62 + 0.63 + ……………..).
• The sum of the geometric progression shown in
the bracket equals
 FOREIGN TRADE MULTIPLIER
• It represents the foreign trade multiplier and implies that in
the above case, if exports increase by Rs 1000, the
equilibrium level of income will ultimately increase by Rs
2500.
• Thus the foreign trade multiplier can be obtained by using
the formula

• where MPI denotes the marginal propensity to import. The

value of foreign trade multiplier depends on MPC and MPI.
The higher the value of MPC, the larger will be the value of
the foreign trade multiplier; and the higher the value of the
foreign trade multiplier.
 MULTIPLIER AND DEVLOPING ECONOMICS
• The operation of the multiplier in developing economies has been
studied extensively in recent years.
• The per capita income of developing economies is low and their APC
and MPC are high.
• When the APC is high, only a small gap between income and
consumption has to be filled by investment.
• When the MPC is high, the value of the multiplier is also high.
• These factors taken together will imply that the developing economics
have the most favorable conditions for the operation of the multiplier. Is
this really so?
 MULTIPLIER AND DEVLOPING ECONOMICS
• We now recapitulate how an increase in investment leads to a multiple
increase in income.
• A fresh injection of investment increases the income of one class of
people. A secondary expansion in income follows as they spend their
income on consumption.
• By summing the additional income generated at each stage, we are able
to prove that an increase in investment leads to a multiple increase in
income.
• But one important assumption in this chain of income and expenditure
is that when income earners decide to spend on consumption goods,
their output increases. Increased demand is immediately met by
increased output.
• If this does not happen, income will increase not in real terms but in
money terms. If output does not increase, increased demand will only
mean bidding for existing goods and services, resulting in an increase in
price. This situation is likely to arise very often in developing economies.
 MULTIPLIER AND DEVLOPING ECONOMICS
• Let us assume that in a developing economy an additional Rs 10,000
has been invested in a dam, and that the income earners are the
workers and other personnel. When their income increases, their
demand for consumption goods goes up.
• The most important consumption good for these people is food. The
question then is, will the output of agriculture increase in response to
the increased demand? The answer, perhaps, is no.
• The problem faced by agriculture in many of these countries is not
inadequate demand, but the inability to increase output due to various
factors.
• Perhaps the ability to meet demand even for industrial goods is limited.
When output does not expand, as mentioned earlier, prices will go up
and incomes will rise in money terms.
• Hence the contention that the multiplier operates more in money
terms than in real terms in developing economies.
 MULTIPLIER AND DEVLOPING ECONOMICS
• This problem in a sense is not peculiar to developing economies
alone.
• Even in developed economies, the multiplier has been found to
operate most vigorously only during the early phase of the
upswing of a business cycle.
• When a developed economy is trying to recover from the depth of
depression, the multiplier will operate fully because there is
enough excess capacity in the system to meet the new demands.
• Thus in general, for the effective operation of the multiplier, excess
capacities in the consumer goods industry and an absence of other
bottlenecks for expanding the output are necessary.
• If the supply of output is inelastic, as it happens in developing
economies, the multiplier does not result in an increase in real
income.
 MULTIPLIER AND DEVELOPING ECONOMICS
• This has important policy implications. Developing economies cannot
hope to increase the real output several fold just by injecting a certain
amount of investment.
• Investment and savings must be balanced at each point to increase
output.
• The conditions applicable to developed economies at the full
employment stage are applicable to developing economies even
though they do not enjoy full employment.
• However, the concept of the multiplier is still useful in understanding
the working of developing economies. It indicates when the pressure on
prices will mount.
• Any attempt to increase investment through money creation will
explode into a substantial increase in prices if no effort is made to
expand output with increase in demand.
• All developing economies are not at the same stage of development.
Some of them also develop situations of excess capacity.
• In such circumstances the multiplier concept can be used in the same
way as in the developed economies.