Business Economics

National Income Equilibrium

 The Great Depression
• Beginning in late 1929, capitalist economies of the world experienced
a severe depression which created a lot of involuntary unemployment
and also a sharp fall in their GDP.
• This depression was caused by drastic decline in private investment.
For example, in the United States in 1929, 1.5 million workers were
unemployed.
• After four years in 1933 this unemployment of labour rose to 13
million people out of labour force of 51 million, that is, around 25 per
cent of labour force became unemployed.
• The similar situation prevailed in Britain and other capitalist countries.
This depression spurred a great deal of controversy among economists
about the causes of this depression and the policies to overcome it and
Conti……
• It was at this time that a noted British economist, J.M. Keynes (1883-1946),
challenged the view of classical economists who applied microeconomic models
to explain depression and involuntary unemployment.
• By emphasising that the prevailing depression and large-scale involuntary
unemployment was due to lack of aggregate effective demand resulting from a
fall in private investment he laid the foundation of modern macroeconomics.
• In his theory he showed that a free market economy was not self-correcting
and therefore there was a need for the government to intervene and take
appropriate fiscal measures to restore full employment in the economy.
Assumptions of classical economists
• There is always full employment in the economy.
• Supply created its own demand
• During great depression of 1930s, unemployment rates were very high.

• Keynes criticized the classical economists.

 Aggregate demand

• Aggregate demand or aggregate expenditure is the total demand for goods

and services in an economy.

• Main components of the demand are

a. Consumption expenditure

b. Investment expenditure

c. Government expenditure

d. Net exports
Aggregate supply

• Aggregate supply or aggregate output is the total quantity of goods and services
produced in the economy at any given period of time.

• Equilibrium where

• AD=AS
Leakage-Injection Approach
• Leakage is a withdrawal from income-expenditure stream.

• Leakages includes

a. Savings

b. Taxes

c. imports
• Injection is an addition to the income-expenditure stream. Injections include-
a. Investment
b. Government expenditure
c. exports
• For the development of the economy, the effect of
a. Leakages should be more than injections
b. Injections should be more than leakages
Consumption

• Consumption refers to the purchase of goods and services by

individuals or households which are produced by firms.

• Consumption is directly related to disposable income.

• Consumption varying directly with variations in disposable income as

the fundamental law of consumption.
• According to this law, a person would increase his consumption as his income
increases but the expenditure will be less than the increase in income.

• Consumer will save a part of their income.

• Y= C+S
Concepts of consumption
• Average propensity to consume
• Marginal propensity to save
Average propensity to consume

• APC defines the relationship between total disposable income and consumption

• It is the ratio of total consumption to total disposable income.

• Marginal propensity to consume

• It is the ratio of change in total consumption to change in total disposable income.
Consumption function
• This refers to the relationship between the consumption level and income level.
• C= a+ by
Saving theory
• Savings are divided into two parts
a. Autonomous savings
b. Induced savings
• Autonomous savings refer to that part of savings that does not depend on the
income level.

• Induced savings is depend upon income.

Concepts of savings
• Average propensity to save
• Marginal propensity to save
• APS is the ratio of total savings to total disposable income.

• APS= S/Y

• Marginal propensity to save is the ratio of a change in total

disposable income and a change in total savings.

APC+APS= 1

MPC+MPS= 1
Disposable income Consumption Savings APC APS MPC MPS

0 50 -50 - - - -

100 125 -25 1.25 -0.25 0.75 0.25

200 200 0 1 0 0.75 0.25

300 275 25 0.92 0.08 0.75 0.25

400 350 50 0.88 0.12 0.75 0.25

Savings function

• Saving function refers to the relationship between savings and income level.

• S= -a+ (1-b)Y
Breakeven income

• Breakeven income is the level at which households consume all their income,
therefore, savings equals zero.
Non-income determinants of consumption
• Distribution of wealth
• Price and wage level
• Change in consumers’ taste and fashion
• Change in expectations
• Interest rate
Investment theory
• Investment refers to the spending on the purchase and accumulation of capital
goods such as buildings, equipment and additions to inventories.
Types of investment
• Autonomous investment
• Induced investment
Autonomous investment

• Autonomous investment is independent of income.

• Autonomous investment can be influenced by interest rate, business expectations

and technology development.
Induced investment

• Induced investment depends on the national income.

• It increases with increase in national income.

Factors influencing investment
• Rate of interest
• Rate of return
• Government policies
• Technological changes
• Expectation of the future
 Keynes theory of investment

• According to Keynes investment demand depends upon two factors:

a. Marginal Efficiency of Capital
b. Rate of interest.
• A person having an amount of savings has two alternatives before him. Either he
should invest his savings in machines, factories, etc., or he can lend his savings to
others at a certain rate of interest.

• If investment undertaken in machines or factories is expected to fetch 25% rate of

profit, while the current rate of interest is only 15%, then it is obvious that the
person would invest his savings in machinery or factory
Marginal efficiency of capital

• Marginal efficiency of capital refers to the rate of profit expected to be made from
investment in certain capital assets. The rate of profit expected from an extra unit of a
capital asset is known as marginal efficiency of capital.

• Now, the question is how the marginal efficiency of capital is measured.

• To estimate the marginal efficiency of capital, the entrepreneur will first take
into consideration how much price he has to pay for a particular capital
asset. The price which he has to pay for the particular capital asset is called
its supply price or cost of capital.
• The second thing which he will consider is that how much yield he expects
to obtain from investment from that particular capital asset. A capital asset
continues to produce goods and yield income over a long period of time.
Therefore, an entrepreneur has to estimate the prospective yield from a
capital asset over his whole life period.
• The supply price and the prospective yields of a capital asset determine the
marginal efficiency of capital.
• According to Keynes, marginal efficiency of capital is the rate of discount which
renders the prospective yields from a capital asset over its whole life period equal
to the supply price of that asset.
• Suppose it costs 3000 rupees to invest in a certain machinery and the life
of the machinery is two years, that is, after two years it becomes quite
useless, having no value. Suppose further that in the first year the
machinery is expected to yield income of ` 1100 and in the second year `
2420/-. By substituting these values in the above formula, we can calculate
the value of r, that is, the marginal efficiency of capital.

•
Rate of Interest and Investment Demand
Curve
Government sector
• Government spending can effect the national income of the country.

• Government spending can be classified into two categories

a. Purchase of goods and services

b. Transfer payments

Government can effect the national income of the country through

taxes.
Foreign sector (Export and Import)

• Foreign sector involves the exports and imports of goods and services.
• Exports are goods and services that are sold to foreign countries
• Imports of goods and services that are purchased from other countries.
 Investment Multiplier- Keynes
• The concept of multiplier was first of all developed by F.A. Kahn in the
early 1930s.
• Kahn’s multiplier is known as ‘employment multiplier- The concept of
Employment Multiplier was introduced by R.F. Kahn in 1931 as a ratio
between the total increase in employment and primary employment
• Keynes, propounded the concept of multiplier with reference to the
increase in total income, as a result of an initial increase in investment
and income.
• Keynes’s multiplier is known as investment or income multiplier.
Equilibrium Level of National Income

AE = GDP = Y
 Marginal Propensity to Consume

• In economics, the marginal propensity to consume (MPC) is defined

as the proportion of an aggregate raise in pay that a consumer spends
on the consumption of goods and services, as opposed to saving it.
• Marginal propensity to consume is a component of Keynesian
macroeconomic theory and is calculated as the change in
consumption divided by the change in income.

• Formula= ΔC / ΔY
 Value of Multiplier
• The multiplier effect comes about because injections of new demand for
goods and services into the circular flow of income stimulate further
rounds of spending – in other words “one person’s spending is another’s
income”
• This can lead to a bigger eventual final effect on output and employment
• The Keynesian Multiplier is an economic theory ,asserts that an increase
in private consumption expenditure, investment expenditure, or net
government spending (gross government spending – government tax
revenue) raises the total GDP by more than the amount of the increase.
Therefore, if private consumption expenditure increases by 10 units, the
total GDP will increase by more than 10 units.
Conti…..

• The value of MPC allows us to calculate the size of the

multiplier using the formula:

• Formula for multiplier (K)={ 1 / (1 – MPC)}

• The multiplier is the ratio of the change in income to change in
investment.
• The multiplier is, the ratio of increment in income to the increment in
investment.
• K= ∆Y/ ∆I
• K= 1/1-MPC
• K=1/MPS
• why the increase in income is many times more than the initial increase in
investment????
• Suppose Government undertakes investment expenditure equal to 100
crore on some public works, say, the construction of rural roads.

• For this Government will pay wages to the labourers engaged, prices
for the materials to the suppliers and remunerations to other factors
who make contribution to the work of road-building.

• The total cost will amount to 100 crore.

• This will increase incomes of the people equal to 100 crore. But this is not all.
• The people who receive 100 crore will spend a good part of them on consumer
goods. Suppose marginal propensity to consume of the people is 4/5 or 0.8.
• Then out of 100 crore they will spend 80 crore on consumer goods, which
would increase incomes of those people who supply consumer goods equal to
80 crore.
• But those who receive these 80 crore will also in turn spend these incomes,
depending upon their marginal propensity to consume.
• If their marginal propensity to consume is also 4/5, then they will spend 64
crore on consumer goods.
• Higher the MPC higher will be the value of multiplier.
 Value of multiplier
• The value of multiplier lies between one and infinity.
• Higher the MPC higher will be the value of multiplier.
 Inflationary gap
• Inflationary gap occur when national income exceeds the
full employment level.

• Full employment is achieved when country’s resources are

fully used with maximum efficiency.

• Inflationary gap may be due to an increase in aggregate

expenditure.

• To reduce the inflationary gap, government can use

contractionary fiscal policy.
 Deflationary gap
• Deflationary gap occurs when national income is below full employment.
• Resources are not fully utilized.
• To reduce the deflationary gap the government can use the expansionary fiscal
policy.