Consumption, Investment and

Multiplier

1
Consumption

◼ Consumption is the act of using resources to

satisfy current needs and wants.

◼ It is seen in contrast to investing, which is

spending for acquisition of future income.

◼ Consumption is the value of goods and services

bought by people. Individual buying
acts are aggregated over time and space.

2/5/2024 2
Consumption Function

• The consumption function is an economic

formula that measures the relationship between
income and total consumption of goods and
services in the economy.
• The consumption function was introduced by
John Maynard Keynes.
• Keynes argued that the consumption function
could track and predict total aggregate
consumption spending.

2/5/2024 3
Consumption Function
The consumption demand is a major component of
aggregate demand. The level of consumption
expenditure in an economy depends on the current
level of income, current and expected price level, taste
and preference, expected future income, etc. Keynes
stated that in the short period consumption is a
function of current real income.

C = f (Y )
Consumption and income has a direct functional
relationship.
Consumption Function
According to Keynes, consumption function is
governed by the Psychological Law of
Consumption. The men are disposed, as a rule,
and on the average, to increase their consumption
as their income increases, but not by as much as
the increase in their income.''
This means that the change in consumption (ΔC)
is less than the change in income (ΔY).
Consumption function equation:
C = C + cY C  0 and 0  c  1
Attributes of Consumption Function
◼ Average propensity to consume (APC): The APC is
the ratio of consumption expenditure to the
corresponding level of income. APC diminishes as
income increases. C
APC =
Y
◼ Marginal propensity to consume: It is the ratio of
change in consumption to change in income. Following
the psychological law of consumption, MPC lies between
zero and one (0 < MPC < 1).
C
MPC =
Y
HOUSEHOLD CONSUMPTION AND
SAVING
◼ The relationship between
consumption and income
is called the
consumption function.
• For an individual
household, the
consumption function
shows the level of
consumption at each
level of household
income. 7
HOUSEHOLD CONSUMPTION AND
SAVING
C = a + bY
◼ Where y is disposable income
◼ The slope of the consumption
function (b) is called the marginal
propensity to consume (MPC),
or the fraction of a change in
income that is consumed, or
spent.
◼ MPC refers to relationship
between marginal income and
marginal consumption

0  b<1 8
HOUSEHOLD SAVING
◼ The fraction of a change in income that is
saved is called the marginal propensity
to save (MPS).

MPC + MPS  1
• Once we know how much consumption will
result from a given level of income, we
know how much saving there will be.
Therefore,
S =Y-C
S = Y – (a+bY)
9
S = -a + (1-b)Y
1-b is the MPS
MPC EQUATION

C= a +bY
C + ΔC = a + b(Y + ΔY)
ΔC = -C +a + by + b ΔY
Since C = a + bY
So ΔC = -a –bY +a +bY +b ΔY
Hence ΔC = b Δ Y and
ΔC/ ΔY = b 10
AN AGGREGATE CONSUMPTION FUNCTION
DERIVED FROM THE EQUATION C = 100 + .75Y

C = 100+ .75Y
AGGREGATE AGGREGATE
INCOME, Y CONSUMPTION
(BILLIONS OF ,C
DOLLARS) (BILLIONS OF
DOLLARS)
0 100
80 160
100 175
200 250
400 400
400 550
800 700
1,000 850
AN AGGREGATE CONSUMPTION FUNCTION
DERIVED FROM THE EQUATION C = 100 + .75Y

C = 100+ .75Y
◼ At a national income of
zero, consumption is
$100 billion (a).
◼ For every $100 billion
increase in income (Y),
consumption rises by
$75 billion (C).

12
DERIVING A SAVING FUNCTION
FROM A CONSUMPTION FUNCTION
C = 100+ .75Y
S Y−C
Y - C = S
AGGREGA AGGREGAT AGGREGAT
TE E E SAVING
INCOME CONSUMPT (Billions of
(Billions ION Dollars)
of (Billions of
Dollars) Dollars)
0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
600 550 50
800 700 100
1,000 850 150
Subjective factors for
Consumption
◼ Motive of Precaution: Generally, people save to meet
unexpected contingencies such as accidents, illness etc.

◼ Motive of Foresight: Individuals save more to provide for

anticipated requirement in future such as old age, education
of children, etc,

◼ Motive of Calculation: In order to earn income people invest

in shares, debentures. This reduces their present
consumption.

◼ Motive of Improvement: To enjoy a improved standard of

living in future, people save more.
2/5/2024 14
Subjective factors for
Consumption
◼ Motive of Independence: People want to have financial
independence and freedom, so they save more now and
consume less.

◼ Motive of Enterprise: To set up business or to expand the

business in future people save more and spend less.

◼ Motive of Pride: Individuals take pride in leaving money and

wealth for their children. So they will accumulate money by
savings.

◼ Motive of Avarice: If people are miserly by temperament they

will save more and consume less.
2/5/2024 15
Objective factors for Consumption
◼ Windfall income
◼ Fiscal policy
◼ Changes in the rate of interest
◼ The level of holding of financial assets
◼ The level of wealth
◼ Expectation of price
◼ Level of income
Investment

◼ An investment is an asset or item

accrued with the goal of generating
income or recognition.

◼ In an economic outlook, an investment

is the purchase of goods that are not
consumed today but are used in the
future to generate wealth.

2/5/2024 17
Investment Function

◼ A strategy or concept of economics that

helps in identifying the connection between
shifts in the investment patterns of people
and other variable factors affecting
investment in an economy is known
as Investment Function.

2/5/2024 18
Types of Investment

◼ The expenditure incurred to create new capital

assets is known as Investment. These capital
assets include buildings, machinery, raw
material, equipment, etc. The expenditure on
these assets results in an increase in the
economy’s productive capacity. The investment
expenditure can be classified under the heads:
• Induced Investment
• Autonomous Investment

2/5/2024 19
Induced Investment

◼ The investment which depends upon the

profit expectations and has a direct influence
of income level on it is known as Induced
Investment. Induced Investment is income
elastic. It means that the induced investment
increases when income increases and vice-
versa.
◼ Induced investment is caused by the increase
in the income and decrease in the interest
rate
2/5/2024 20
Autonomous Investment

◼ The investment on which the change in income level

does not have any effect is known as Autonomous
Investment.
◼ Autonomous Investment is income inelastic. It means
that if there is a change in income (increase/decrease),
the autonomous investment will remain the same.
◼ Autonomous investment is the investment caused by
the factors other than level of income and interest
rates. Such exogenous factors are innovation, future
expectations etc

2/5/2024 21
2/5/2024 22
Investment function and Marginal Efficiency
of capital
◼ Investment implies the addition to the capital
stock i.e. plant and equipment.

◼ Investment demand depends on two factors

namely,
❑ Marginal Efficiency of Capital (MEC or e)
❑ Rate of Interest (i)
Net Present Value

Net present value (NPC): PV-C

Where net present value is the present value of
future income

Present value of future income: discounted value

of income expected at a future date.
The future income is discounted at market rate of
interest
Question: why discount future income- because
money has a time value
Net Present Value

◼ Compare INR 100 today and INR 100 after

one year. Are they same
◼ If interest rate is 10%, you will get INR 110
next year, so INR 100 today is equal to INR
110 next year
◼ So present value after a year is obtained by
discounting formulae
◼ PV= R/(1+i) where R is net cash flow in time
(one year) and I is rate of interest
2/5/2024 25
Net Present Value

◼ PV of INR 110 = 110 (1+ .01)= 110/1.10= 100

◼ For many years as time the formulae is
◼ PV of Rn= Rn/ (1+i)n
◼ IN NPV (PV-C) is greater than zero= invest
◼ Otherwise don’t invest

2/5/2024 26
Marginal Efficiency of capital

◼ Marginal Efficiency of Capital =The MEC

refers to the profitability of the capital
asset. It is the expected rate of return over
cost or the expected profitability
◼ It is also known as internal rate of return
◼ MEC is the rate of interest which makes
NPV=0

2/5/2024 27
◼ NPV = 0
◼ NPV= PV-C; PV=C
◼ R/1+i= C
◼ R= C(1+i)
◼ R/C= 1+I
◼ R/C-1 = i
◼ Implies i= R/C-1

2/5/2024 28
MEC decision making
◼ If MEC is greater than market interest rate (I)
- invest
◼ If MEC=I May not
◼ I MEC is less than i= Reject the project

2/5/2024 29
Factors Affecting Investment Function
1. Short run factors
a) Nature of demand, prices and cost
b) Propensity to consume
c) Changes in liquid asset
d) Business outlook
2. Long run factors:
a) Population
b) Techniques
c) Development of backward areas
Multiplier

◼ In economics, a multiplier broadly refers to an

economic factor that, when increased or changed,
causes increases or changes in many other related
economic variables.
◼ In terms of Gross Domestic Product, the multiplier
effect causes gains in total output to be greater than
the change in spending that caused it.
◼ The term multiplier is usually used in reference to
the relationship between government spending and
total national income.
2/5/2024 31
Multiplier

• A multiplier refers to an economic factor that,

when applied, amplifies the effect of some other
outcome.

• A multiplier value of 2x would therefore have the

result of doubling some effect; 3x would triple it.

2/5/2024 32
Static and Dynaimc Multiplier

◼ Depending on the purpose of analysis

sometimes a distinction is made between the
static multiplier and the dynamic multiplier.
◼ The static multiplier is also called
comparative static multiple simultaneous
multiplier, logical multiplier, timeless
multiplier, legless multiplier and instant
multiplier

2/5/2024 33
Static Multiplier

◼ The concept of static multiplier implies that

changes in investment causes change in income
instantaneously.

◼ It means that there is no time lag between the

change in investment and the change in income.
It implies that the moment a rupee is spent on
investment project, society's income increases by
a multiple.

2/5/2024 34
Dynamic Multiplier

◼ Dynamic multiplier also known as period and sequence multiplier.

◼ The concept of dynamic multiplier recognizes the fact that the overall
change in income as a result of the change in investment is not
instantaneous. There is a gradual process by which income change as a
result of change in investment or other determinants of income. The
process of change in income involves a time lag.
◼ The multiplier process works through the process of income generation
and consumption expenditure. The dynamic multiplier takes into account
the dynamic process of the change in income and the change in
consumption at different stages due to change in investment.
◼ The dynamic multiplier is essentially a stage-by stage computation of the
change in income resulting from the change in investment till the full
effect of the multiplier is realized

2/5/2024 35
KEYNESIAN MULTIPLIER
❑ Keynes chose to ignore long-run tendencies toward full
employment.
❑ In his view the problems of unemployment could be
solved only if people and government would buy more
goods and services.
❑ Consumption spending is about 70% of GDP, and it
motivates investment spending.
❑ The Keynesian model is based around understanding
how much spending is likely to occur at different levels of
spending, and how government can influence that
spending to ensure full employment.

36
THE MULTIPLIER MODEL
◼ The multiplier model explains how an initial
shift in expenditures changes equilibrium
output when the price level is fixed.
◼ An initial expenditure shift causes additional
induced (multiplier) effects.
◼ The multiplier is the ratio of changes in output
to changes in spending. It measures the
degree to which changes in spending are
“multiplied” into changes in output.
37
AGGREGATE DEMAND
◼ Aggregate Demand = the total amount of
spending on final goods and services in the
economy:
❑ Consumption (C)– spending by consumers.

❑ Investment (I)– spending by business.

❑ Spending by government (G).

❑ Net foreign spending on goods (X)– the

difference between exports and imports.

38
EXPENDITURES FUNCTION
◼ Aggregate expenditures is the sum of the
components of expenditures:
AE0 = C0 + I0 + G0 + (X0 – M0)
Initially, taking two-sector model with
components of aggregate demand ‘C’ and ‘I’
Where I is assumed to be determined exogenously
and to remain constant in the short run. So
AD = C + Ic
So, AD is short run depends largely on aggregate
consumption expenditure 39
AGGREGATE EXPENDITURE (AE)

◼ Aggregate
expenditure is
the total amount
the economy
plans to spend in
a given period. It
is equal to
consumption plus
investment.
AE  C + I 40
EQUILIBRIUM LEVEL OF
NATIONAL INCOME
Y= C +I
Y= a + bY + Ic
Y-bY = a+Ic
Y(1-b) = a+Ic
Y= 1 (a + Ic)
(1-b)
41
EQUILIBRIUM AGGREGATE
OUTPUT (INCOME)
(1) Y = C+ I Y = 100+ .75Y + 25
(2) C = 100+ .75Y There is only one value of Y for which
this statement is true. We can find it by
(3) I = 25 rearranging terms:

By substituting (2) and (3) into (1)

we get:
Y − .75Y = 100 + 25
Y = 100+ .75Y + 25 Y − .75Y = 125
.25Y = 125
125
Y= = 500 42

.25
CLASS EXERCISE

If C= 100 + .75Y and Ic = 200

1. Calculate equilibrium level of Income (Y) from

consumption and savings approach
2. Give consumption and Savings levels at equilibrium
level of income

43
THE MULTIPLIER EFFECT

The multiplier is multiplied by a change in

autonomous spending to reveal the change in
equilibrium GDP.
There must be some idle resources for the
multiplier effect to occur.
Keynesian multiplier analysis assumes a
constant price level.

44
MULTIPLIER
I=I+ΔI
So Y + Δ Y = C + Δ C + I + Δ I
ΔY=ΔC+ΔI
Given C = a + by
Hence Δ C = b Δ y (as a is constant)
ΔY=bΔy+ΔI ΔY-bΔy = ΔI
Δ Y (1-b) = Δ I Δ Y = 1/(1-b) Δ I
Δ Y / Δ I = 1/(1-b)
m = 1/1-MPC = 1/MPS
45
ALTERNATIVE METHOD TO
OBTAIN MULTIPLIER
Y = C +I
Y = a + by +I
Y1 = 1/ (1-b) (a +I)
Y2 = C + I + Δ I
Y2= a + bY2 + I + Δ I
Y2 = 1/ (1-b) (a +I Δ I)
Y2-Y1 = [1/ (1-b) (a +I +Δ I)] - [1/ (1-b) (a +I)]
Δ Y = 1/ (1-b) Δ I
Δ Y / Δ I = 1/ (1-b)
46
THE MULTIPLIER

• After an increase in
planned investment,
equilibrium output is
four times the
amount of the
increase in planned
investment.
• Paradox of Thrift

47
Limitations of the Multiplier

◼ Leakages
◼ Payments of the past debts
◼ Purchase of existing wealth
◼ Imports of goods and services
◼ Non-availability of resources
◼ Full-employment situation

48
E-Content on Multiplier

◼ https://www.youtube.com/watch?v=sfNYbZS
RTRo

2/5/2024 49