Macro-Economics

Prepared by Dr. Haider

Chapter 1
1) Introduction and definition of Macro
economics
2) Historical Background of Macro Economics.
3) What is Macro Economics?
4) Assumption of Macro Economics
5) Differences between Micro and Macro Eco
• Introduction:
Economics has been defined by different
economists in different ways. Definitions are
mainly classified into two categories.
1. Problem type definition: Economists like Adam
Smith, Marshall, Robbine, etc, have in their
definitions, highlighted problems of economics.
According to them, economics studies those
individual and social problems
Which are concerned with the maximum
satisfaction of unlimited wants by the
optimum allocation of limited means.
2. Method type definitions: Economists like J.M.
Keynes have focused on methods of
economics in their definitions. According to
them, economics is a method that helps the
economist to draw correct conclusions.
• Based on this classification of the definitions of
economics, Prof. Fisher in 1933 had divided the
study of economics into two parts:
(i) Micro economics: In it economic problems are
studied on individual level like, problems of
consumption of a consumer or the problem of
price determination of a firm, by partial
equilibrium method. Micro economics also
called Price Theory.
Partial equilibrium:
• In economics, partial equilibrium is a condition of
economic equilibrium which takes into consideration
only a part of the market (with all other parts
remaining constant) to attain equilibrium.
• As defined by Leroy lopes, "A partial equilibrium is one
which is based on only a restricted range of data, a
standard example is price of a single product, the
prices of all other products being held fixed during the
analysis."
• The supply and demand model is a partial
equilibrium model where the clearance on the
market of some specific goods is obtained
independently from prices and quantities in other
markets. In other words, the prices of all substitute
goods and complement goods, as well as income
levels of consumers, are taken as given. This makes
analysis much simpler than in a general equilibrium
model, which includes an entire economy.
Assumptions:
• Commodity price is given and constant for the
consumers.
• Consumers' taste and preferences, habits,
incomes are also considered to be constant.
• Prices of prolific resources of a commodity and
that of other related goods (substitute or
complementary) are known as well as constant.
• Industry is easily availed with factors of
production at a known and constant price
compliant with the methods of production in use.
• Prices of the products that the factor of
production helps in producing and the price and
quantity of other factors are known and constant.
• There is perfect mobility of factors of production
between occupation and places.
Applications:
• Applications of partial equilibrium discusses, when
does an individual, a firm, an industry, factors of
production attain their equilibrium points.
• A consumer is in a state of equilibrium when they
achieve maximum aggregate satisfaction on the
expenditure that they make depending on the set
of conditions relating to his tastes and preferences,
income, price and supply of the commodity etc.
• Producers’ equilibrium occurs when they
maximize their net profit subject to a given set
of economic situations.
• A firm's equilibrium point is when it has no
inclination in changing its production. In the
short run: Marginal Revenue = Marginal Cost.
• Algebraically MR=MC
• Limitations
• It is restricted to one particular portion of the
economy.
• It lacks the ability to study the interrelations of
all the parts of the economy.
• This analysis will fail if the improbable
assumptions, which disconnect the study of
specific market from the rest of the economy, are
not taken into consideration.
• It has been unsuccessful in explaining the
outcome of economic disturbance in the
market that leads to demand and supply
changes, moving from one market to another
and thus instigating second- and third-order
waves of change in the whole economy.
Difference between partial and general equilibrium

Partial Equilibrium General Equilibrium

• Developed by Alfred Marshall. • Léon Walras was first to develop it.

• More than one variable or economy as a

• Related to single variable
whole is taken into consideration
Based on two assumptions: • It is based on the assumption that
1. Ceteris Paribus various sectors are mutually
2. Other sectors are not affected due to interdependent. There is an effect on
change in one sector. other sectors due to change in one.
• Prices of goods are determined
• Other things remaining constant, price simultaneously and mutually. Hence all
of a good is determined. product and factor markets are
simultaneously in equilibrium.
(ii) Macro Economics: in it economic problems
are studied on aggregate level like, total
consumption of the economy as a whole,
general price level , total employment,
national income etc, by semi-general
equilibrium method. Macro economics is also
called The Theory of Income and
Employment.
• Historical Background of Macro Economics
Economists belonging to Physiocrates and Mercantilists
school of thought had laid stress on the study of the
economy as a whole. Study of historical background of
macro economics may be made in the following parts:
(1) Classical Theory: Classical economists like Adam
Smith, Malthus, Ricardo and J.B. Say had tried to study
the economics problems from a macro point of view. As
such all these economists were the votaries of Macro
Economics.
• According to classical theory, full employment is
a normal condition of a free capitalist economy.
If there is unemployment in these economies, it
is short lived because in the event of
unemployment economic forces have an
automatic tendency to move in such a way as to
remove unemployment. Classical theory is based
on Say’s law of Markets and the assumption of
flexibility of wages, rate of interest and prices.
• Say’s Law of Markets holds that “Supply creates its
own demand”. In order words, whatever quantity of
output is produced the whole of it is sold. Thus, the
producers are neither worried nor have any doubt
about the sale of their produce.
• If the demand for a commodity falls, its price will
also fall and thus its production will be reduced. If fall
in production causes unemployment, money wage
rate will be cut. As a result of it , demand for labor
will rise and become equal to its supply.
• In this way unemployment will disappear and the
condition of full employment will be re-established.
• According to classical, condition of unemployment
is possible only when people start saving more than
what they invest. If it so happens, rate of interest
will continue to fall till saving and investment
become equal once again. With increase in
investment, there will be more production and
more employment.
• Thus, unemployment is a temporary
phenomenon in a capitalist economy. Market
forces will succeed in removing it
automatically. There will be no need of
government intervention to meet this
situation.
(2) Keynesian Theory:
Keynes in his book “The General theory of
Employment, Interest and Money” in 1936 has
criticized classical theory and propounded modern
theory of Macro-Economics. Keynes views were
based on the experiences of the Great Depression of
1930. Keynes rejected the theory of Classical which
was based on Say’s Law of Markets and the
flexibility of wages, rate of interest and prices
without any interference of the Government.
• Keynes concluded that the main cause of
unemployment was the deficiency of
aggregate demand. He suggested that
unemployment could be removed by
increasing the aggregate demand. There are 3
component of aggregate demand:
(1) Demand for consumption, (2) Demand for
investment goods and, (3) Government
expenditure.
• In the short run, consumption remains more
or less constant. As such, aggregate demand
can be increased mainly by increasing
investment. During the period of depression
the possibility of profit is very less. Hence,
private sector will not feel inclined to make
any new investment. To achieve the objective
of full employment, the new investment must
be made by the government.
• Keynes was of the opinion that government
interference was very essential to remove
unemployment and achieve the condition of
full employment.
• Government interference manifests itself in
change in fiscal policy.
(3) Monetarism or New Classical Theory
Milton Friedman, has criticized Keynes’s
theory and propounded a new theory of
macro economics. It is called Monetarism or
New Classical Theory. Monetarists theory is
based on the assumption that equilibrium in
an economy cannot be established through
government interference or its fiscal policy.
• This school of thought believes that Level of
full employment can be achieved and
unemployment removed by changing the
supply of money.
• The theory assumes that velocity of money
remains constant and as such changes in the
supply of money directly influence the
aggregate demand.
• Increase in money supply causes increase in
aggregate demand. As a result in the short
run, both output and level of employment
increase and in the long run, when full
employment condition is achieved, price level
begins to rise. This theory has greater
importance to monetary policy than fiscal
policy.
(4) Rational Expectations or New Classical Theory
After 1960 a new theory of macro economics
was propounded. It is called “Rational
Expectations Theory and the Theory of Price
Movements” by Prof. Lucas.
The theory states, “ Rational expectations are
expectations about the future that people form
by using all available information of the past
and present”.
• In the words of Prof. Lucas, “Rational
expectations theory is a behavior that
assumes that people make efficient use of all
past and present relevant information in
forming expectations, implies that people’s
reactions to policy may neutralize the
intended effects of the policy”.
• On the basis of rational expectations, people make
correct assessment of the effects of the changes in
the policies of the government and adopt such
measures as render these policies ineffective. Thus,
monetary and fiscal policies of the government
make no effect on the aggregate demand. But the
events or policies which are unanticipated may
have their impact in the short run. However, these
effects may also be neutralized in the long run.
• The main cause that led to the formation of
Rational Expectations Theory was that in the
years following 1970 a situation of Stagflation
arose in the developed countries of the world. In
this situation, on the one hand prices were rising
under the impact of inflation and on the other
hand, unemployment was also on the increase.
But, according to Keynesian economists when
prices rise unemployment falls.
• However, in the above realistic situation,
unemployment was rising along with inflation. in
order to check this situation, the government
enforced both Fiscal Policy measures like reduction
in taxes and hike in public expenditure and
Monetary Policy measures like rise in the rate of
interest and contraction of credit, but in spite of all
these measures the inflation continued to increase
unabated and so also the situation of
unemployment.
• All this means that Keynes’s fiscal policy and
Friedman's monetary policy both proved ineffective.
• Prof. Lucas is of the view, that it was because of
rational expectations, that fiscal and monetary
policies failed to show results.
• The new classical theory is based on the assumption
that decisions regarding saving, consumption and
investment depend on real factors rather than
monetary factors.
• In short, this theory means that changes made in
aggregate demand influence real national income
only when the same are unexpected.
• Those policies which can be anticipated will have
their effect on prices alone. As such, new classical
economists argue that “ monetary and fiscal
policies should be aimed at maintaining low,
stable rate of inflation. They should not attempt
to alter real national income and unemployment.
• What is Macro Economics?
• The term” Macro” in English has its origin in
the Greek language term” Makros” which
means “Large”. Macro economics, therefore,
studies economic problems from the point of
view of entire economy, e.g., aggregate
consumption, aggregate employment,
national income, general price level, etc.
2.1 Definitions
- In the words of Boulding, “ Macro economics theory is that
part of economics which studies the over all averages and
aggregates of the system.”
- According to Shapiro, “ Macro economics deals with the
functioning of the economy as a whole”.
- According to M.H. Spencer, “Macro economy is concerned with
the economy as a whole or large segments of it. In macro
economics, attention is focused on such problems as the level
of unemployment, the rate of inflation, the nation’s total
output and other matters of economy-wide significance.”
2.2 Scope
Scope of Macro economics is the use of
economic resources at the national level. these
resources have their effect on the national
income, employment, effective demand,
aggregate saving, aggregate investment, price
level, economic development etc of the
country. its scope can be divided into the
following part:
(1) Theory of National Income: Macro economics studies
the concept of national income, its different elements,
methods of measurement and social accounting.
(2) Theory of Employment: macro economics also studies
problems relating to employment and unemployment.
It studies different factors determining the level of
employment, effective demand, aggregate supply,
aggregate consumption, aggregate investment,
aggregate saving, multiplier, etc.
(3) Theory of Money: Changes in demand for and supply
of money have considerable effect on the level of
employment. Macro economics therefore, studies
functions of money and theories relating to it. Banks and
other financial institutions are also part of its study.
(4) Theory of General Price level: determination of and
changes in general price level are also studied under
macro economics. Problems concerning inflation or
general rise in prices and deflation or general fall in
prices are also studied under macro economics.
(5) Theory of economic growth: Study of problems
relating to economic growth or increase in per capita
real income forms part of macro economics. It studies
the economic growth of under developed economies.
Monetary and fiscal policies of the government are
also studied therein.
(6) Theory of international Trade: Macro economics also
studies trade among different countries. theory of
international trade, tariff, protection etc, are subjects
of great significance to macro economics.
• Assumptions of Macro Economics
Main assumptions of macro economics as propounded
by Keynes are as follow:
(1) Short period: macro economics theories are
applicable in the short period. The time is too short
to increase production by installing new plants or
new machines. Thus, in the short period, production
capacity, technique, number of laborers, taste of the
consumers, their habits and fashion remain constant.
• Keynes assumed that the problem of
unemployment in developed countries is a
short term problem because “ In the long run
we are all dead”. Aggregate supply remains
constant in the short period. It is only by
increasing aggregate demand, that the volume
of employment can be increased and
unemployment can be removed.
(2) Perfect Competition: Macro economics is
based on the assumption of perfect
competition. Under the conditions of perfect
competition, there is no external interference
in the determination of prices. Prices may rise
or fall in accordance with changes in demand
and supply position.
(3) Closed Economy: it is assumed under macro
economics,, that a developed capitalist
economy is a closed economy. A closed
economy is one which is free from the
influence of foreign trade on income and
employment level. in other words, aggregate
demand will not be influenced by the
deference between import and exports.
(4) Ignores the role of the Government as a
Spender or a Taxer : macro economics
overlooks the role of the government as a
taxer or a spender. It implies that macro
economics is based on the assumption that
aggregate demand is influenced only by
consumption and investment, that is AD=C+I
Keynes has ignored the influence of
government sector on aggregate demand.
(5) Diminishing Marginal Productivity: As more and
more units of labor are employed, their marginal
productivity goes on diminishing. It means
production is subject to the operation of the law
of diminishing returns. Keynes also assumed that
under perfect competition, wages of the laborer
were equal to his marginal productivity (W=MRP).
It implies that more laborers will be employed
only when their real wages are low.
(6) Labor is the only variable factor of Production
Macro economics assumes that labor alone is a variable factor
of production in the short period and it means production
increases when the number of laborer are increased, that is
P = f (N)
(7) Labor has money illusion: laborers entertain the wrong
nation that value of money remains constant. It means that
they believe that their real wages will increase I the same
proportion in which their money wages increase. Similarly,
their real …..
Wages will decrease in the same proportion in which
their money wages decrease. Labourer ignores the
effect of change in the price level.
(8) Money also acts as a store of value: another
assumption of macro economics is that money is not
only a medium of exchange but also a store of value.
It is not necessary therefore, that people must spend
all their monetary income as soon as they get it.
(9) No time lag: macro economics assumes that
adjustment among different economic
variables takes place without any time lag. For
example, consumption expenditure of
Monday depends upon the income of Monday
or that present consumption is a function of
present income. In short, the period in which
income changes is also the period in which
consumption and investment change.
(10) Under employment equilibrium: Macro Eco
assumes that position of equilibrium is also
possible in case of under employment.
Equilibrium position is that position in which
there is no tendency to change, that is,
aggregate demand is equal to aggregate
supply (AD=AS). This equality is possible both
under the condition of full employment and
under employment.
(11) Saving and Investment Function: Macro Eco is
based on the assumption that saving depends on
income, that is, S=f(y). On the other hand, investment
depends on the rate of interest, that is, I=f(r)
(12) Interest is a Monetary Phenomenon: Macro Eco
also assumes that determination of interest depends
upon monetary factors, i.e., demand for and supply of
money. Demand for money refers to liquidity
preference. People prefer liquidity on account of
transaction, precautionary and speculation motives.
(13) Optimum Utilization of Resources: Macro Eco
also assumes that there is optimum utilization of
resources.
Differences between Micro and Macro Eco
1)Differences in the Degree of Aggregation :
Micro Eco studies economic problems relating to a
single economic unit like a firm or a small group of
economic units like an industry. Macro Eco studies
the economic problems of all firms in an economy.
2) Differences in Objectives: Aim of Micro Eco is
to study the principles, problems and policies
relating to the optimum allocation of
resources. On the other hand, aim of Macro
Eco is to study the principles, problems and
policies concerning full employment and
growth of the resources of the economy.
3)Different importance to price and Income: Main
determinant of the problems of micro economics is
price and that of macro economics is income. In
case of micro economics, economic units like
consumers, producers, factors of production etc.
take their decisions mostly on the basis of prices.
On the other hand, in Macro Eco decisions
regarding aggregate consumption, aggregate
investment, aggregate saving etc, are taken mainly
on the basis of income.
4) Differences in the Method of Study: in formulating
the principles of micro econ, we assume other things
being equal. It implies that we study only the
significant factors relating to an economic activity.
For instance, in case of law of demand we study the
relationship between demand and price, but other
factors influencing demand such as income of the
consumer, his habit, his taste, prices of related goods
etc are assumed to be constant. Such a method of
study is called Partial Equilibrium Analysis.
On the other hand, in case of Macro Eco ,
economic factors are divided into important
aggregates, such as aggregate demand,
aggregate supply, aggregate consumption,
aggregate investment, etc. Mutual dependence
of these factors is studied. Change in one
economic factor has its influence on other
factors also. this method of study is called
Quasi General Equilibrium Analysis.
5) Different Assumptions: In Micro Eco it is assumed
that there is full employment in the country, total
output and total expenditure are fixed. On the basis
of these assumptions, it is sought to know how
optimum allocation of resources takes place and how
different economic units achieve equilibrium position.
On the other hand, Marco Eco assumes that there is
optimum allocation of the resources in the country.
on the basis of this assumption it is sought to know
how full employment be provided to these resources.
6) Analytical Differences: According to Prof.
Patinkin, the main differences between Micro
and Macro Eco is that Micro eco deals with
the study of the behavior of economic variable
in equilibrium position, whereas Macro econ
deals with the study of the behavior of
economic aggregate in disequilibrium position
7) Differences relating to change: According to Prof.
Boulding, just as a forest is composed of many trees,
likewise an economy is an aggregation of innumerable
individuals. Differences between a tree and a forest are:
(a) An individual tree many die but a forest goes on forever.
(b) An individual tree has no effect on the climate of the
neighborhood but a forests does affect the climate.
The same differences are found in micro and macro
economics.
Chapter 2

Classical Theory of Employment

• Introduction
In developed capitalist economies, there are two
important theories for the determination of
the level of employment.
1) The Classical Theory of Employment
2) The Keynesian Theory of Employment.
In this chapter we shall discuss the classical
theory of employment.
• What is Classical Theory of Employment?
• Classical theory of employment is not a contribution of any
single economist. The theory has been build on the basis of the
thoughts of different classical and neo- classical economists in
respect of employment The term ‘Classical’ was associated with
economist by Karl Marx, first of all. This term is derived from
Latin language and means ‘ the best’. Keynes has used the term
classical theory in a broad sense. The term classical Theory was
used by him to denote the thoughts of classical economists like
Adam Smith, Ricardo, J.B. Say, Marx and neo classical
economists like Marshall, Pigou etc on employment .
• According to classical theory of income, full employment
is a normal feature of a capitalist economy.
• In a situation of unemployment, demand for labor is less
than their supply. Due to low demand, money wages of
the laborers will fall. Low wage rate, in its turn, will raise
the demand for laborers. As a consequence,
unemployment is removed and full employment
situation is restored. Classical theory of employment is
based on Say’s law of Markets and on the assumption of
flexibility of wages, rate of interest and prices.
• What is full employment?
• The term full employment refers to a situation in
which no one is unemployed. Demand for labor is
equal to supply of labor (DL=SL).
• According to Macro Eco, “ full employment refers to
a situation in which at any given level of real wage
demand for labor is equal to the available supple of
labor. Thus the term FE is used to signify a situation
in which all those people who are will to work at the
prevailing wage rate get work.
• Modern definition: in the word of Spencer, “full
employment is a situation in which everyone
who wants to work is working except for those
who frictionally and structurally unemployed.”
• According to modern Macro Eco, full
employment does not mean that no person is
unemployed. But it means a situation in which
there is equilibrium between the vacancies and
the eligible persons to fill them.
• Types of Unemployment Associated with full
employment:
1) Frictional Unemployment:
Frictional unemployment associated with the changing of jobs in
dynamic economy. On account of imperfections in the labor
market people are rendered unemployed temporarily. This
temporary unemployment is called frictional unemployment.
Factors account for it, such as immobility of labor, shortages of
raw material, lack of information regarding opportunity of
employment, shortage of power, bread-down of machinery,
tendency of the people to change their jobs often, search of
good job etc. this type of unemployment is temporary.
2) Structural unemployment: “SU is the
unemployment that results from the long term
decline of certain industries” it is associated with
the structure of the economy. It arises when:
i) Other factors of production, like land and
capital are in short supply
ii) when the production technique in the country
and the nature of goods produce undergo
change, some industries close down.
3) Seasonal Unemployment: this type of SU
arises due to changes in season, fashion, taste.
4)Technical unemployment: it arises due to
changes in technique of production.
5)Voluntary & involuntary unemployment
a) It is a situation when employment is available
but the worker is unwilling to work at the
prevailing rate of wage.
b) Involuntary unemployment: it is a situation in
which people have remain unemployed for want of
employment opportunities. They are ready and
willing to work at the prevailing wage rate but they
do not get any work.
According to Hansen, above types of unemployment
may be found in a state of full employment but not
involuntary unemployment. As a matter of fact, full
employment implies absence of involuntary
unemployment.
• Assumptions of Classical Theory:
1) Rational man: every man is rational. A rational
man is one who desires maximum satisfaction.
2) Laissez-fair: economy is free from any kind of
interference by the state.
3) Perfect competition: there is perfect competition
in commodity as well as labour market. All units of
labour are homogeneous. No individual buyer or
seller by his own actions can influence the price.
4) Closed economy: foreign trade has no effect on the economy.
5) Constant technology: there is no change in the short period in
the technique for production and organization of business.
6)Money is only a medium of exchange.
7) Flexibility of Price: it is assumed by the theory that wages,
interest and prices are flexible.
8)Relation between money and real wages.
9) Equality between saving and investment: equality between
saving and investment is brought about by change in the rate
of interest.
10) Law of diminishing returns .
Determination of income and employment

According to classical economists, income and

employment in an economy are determined by
production function and the equilibrium of
demand for and supply of labour. Production
function expresses the relation between factors
of production and volume of production.
P= f (L, K, N,T)
Volume of production therefore, depends on the
level of employment (L). (Page 25)
• Level of employment in an economy is known by the
equilibrium of demand for and supply of labour.
1) Demand for labour: in and economy, labour is
demanded because of productivity. Labour is
demanded up to the extent that its marginal revenue
productivity is equal to its wage, i.e.,
W= MRP=P x MPP or W/P= MPP
W=money wage, P=price level, MRP= Marginal revenue
productivity, MPP= Marginal physical productivity,
W/P= real wage
2)Supply of labour: Supply of labour refers to the
number of labourers who are willing to work at the
given rate of real wage. There is a direct relation
between supply of labour and wage. (P26)
Flexibility of wages, Interest and prices: one of the
main basis of classical theory of employment is the
flexibility of wages, interest and prices in the
economy. It implies that they can increase or
decrease to any extent in accordance with demand
and supply position.
• In case of unemployment in the economy,
demand and supply will change in such
manner as to bring the economy back to full
employment level.
• Changes in these prices during unemployment
situation and their effect on full employment
can be made clear as under:
(continue…..)
i) Flexibility of wages or change in wage:
Wage rate is determined in the labour market. Demand
for and supply of labour depend on real wages. The
same can be calculated by dividing the money wages
by the prevailing price-level.
Real wages = Money wages/price
Demand for labour increases with fall in their real wage.
Demand for labour is less that its supply when there
is unemployment in the economy, consequently there
is fall in money wage…..
• If price level remains constant or if the price
level falls less than fall in money wages, then
fall in money wages will lead to fall in real
wages as well. Fall in real wages will increase
demand for labour and remove unemployment
thereby restoring full employment situation in
the economy. Relationship between real wages
and level of employment is explained with the
help of the following equations:
Demand for labour is function of real wages
ND= f (W/P)
Demand for labor (ND) is the diminishing
function of real wages (W/P)
.Supply of labour (NS) is the increasing function of real wage
NS= f(W/P)
ND=NS
Demand for labour is inversely related to real wages ,ie.,
with rise in real wage, demand for labour falls and with fall
.in real wage, demand for labour rises
• On the other hand, supply of labour is directly
related to real wage, i.e. with fall in real wage,
supply of labour falls and with rise in real wage,
supply of labour also rises.
• Clssical economists were of the view, that if
unemployment is found in an economy then money
wages will fall. With fall in money wages thee will be
corresponding fall in real wages. As a result, demand
for labour will increase and full employment
situation be restored.
Classical theory of income or employment can be
explained with the help of Fig 3. In this figure, level
of employment is shown on OX- axis and wage rate
on OY-axis. DD is the demand curve of labour and
SS is the supply curve of labour. When wage rate is
OW, then DD demand curve and SS supply curve
will cut each other at equilibrium point E. It means
that at point E, demand for labour is equal to
supply of labour at full employment level ON.
• If wage rate increases to OR, then less number of
laboure OM will be given employment because
wage curve RR cuts demand curve DD at point A. It
also shows that at OR wage rate, supply of labour
will be OQ because wage curve SS at point B. It will
be a situation of disequilibrium. In this situation,
supply of labour OQ will be more than its demand
OM.
• Hence, there will be involuntary unemployment
equivalent to OQ-OM=MQ in the economy…..
• Unemployed labour will be willing to work at
low wages. As a consequence, wage rate will
fall from OR to OW. At this wage rate (OW) all
those labourers who are willing to work will
get work. In this way, full employment
situation in the economy will be maintained.
On the contrary, if the wage rate falls to OT,
then supply of labour will be maintained.
• On the contrary, if the wage rate falls to OT,
then supply of labour will be OM and its
demand will be OQ. In other words, MQ
demand for labour will be more than its
supply. This will tend to raise the wage rate to
OW and the equilibrium of demand and
supply will be re-established at Point E.
Explanation of Keynesian Theory of employment:

• According to Keynesian theory of Income or

Employment, in a capitalist economy, in short
period, total output or national income depends
on the level of employment because in the short
period other factors of production like capital,
technique, etc, remain constant, level of
employment depends on effective demand.
Effective demand refers to that level of aggregate
demand at which it is equal to aggregate supply.
• Thus, according to Ackley Gardner, the basic
concept of Keynesian theory is that the level of
employment in a country is determined by the
aggregate demand and aggregate supply.
Effective demand refers to the equilibrium
between aggregate demand and aggregate
supply. It means that only that level of aggregate
demand which is equal to aggregate supply in
the country, is called effective demand.
• Suppose by employing one lakh labourer in a
country at any given time the aggregate
supply is worth Rs. 100 cr, and the aggregate
demand at that very time is also Rs. 100 cr,
then in that situation aggregate demand price
will be equal to aggregate supply price.
According to Keynesian theory of employment
, in that situation aggregate demand price of
Rs. 100 cr, will be called Effective Demand.
• It can be explained in the following manner:
Y= f(N)
National Income or output (Y) is a function of level of
employment( N)
N=f(ED)
Level of employment (N) is a function of effective demand
(ED)
ED  (AD=AS)
Effective Demand (ED) expresses equality between
aggregate demand and (AS) and aggregate supply(AS)
• The theory of Keynesian can be explained as follows:
1. National Income depends on level of employment.
2. Level of employment depends on effective demand
(ED)
3. Effective demand depends on aggregate demand
and aggregate supply. That level of aggregate
demand is called effective demand which is equal
to aggregate suplly.
(i) Aggregate supply: in order to understand the
concept of aggregate supply, it is necessary to
comprehend the difference between
aggregate supply price and aggregate supply
schedule or aggregate supply. Aggregate
supply price refers to the total amount that all
the producers must receive by selling the
output produced at a given level of
employment.
• Under perfect competition, aggregate supply
price is equal to total cost of production . If
can also be called national income. On the
contrary, aggregate supply schedule or
aggregate supply refers to a schedule showing
aggregate supply price received at different
levels of employment. In the short, aggregate
supply remains constant.
(ii) Aggregate Demand: aggregate demand price
refers to that total amount which all the
producers expect to receive by selling the
output produced at a given level of
employment. On the contrary, aggregate
demand schedule or aggregate demand refers
to a schedule showing aggregate demand
price received at different level of
employment.
• According to Keynes, aggregate demand can be
divided into two parts, Consumption and
investment AD=C+I
(A)Consumption expenditure: it is an important
constituent of aggregate demand. Increase in
consumption expenditure leads to increase in
total income. Consumption expenditure
depends mainly on two factors: propensity to
consume and National Income.
(i) Propensity to consume: it refers to the ratio of
consumption expenditure to different level of
income. It is of two types:
(a) Average Propensity to consume: it is
estimated by dividing total consumption
expenditure by total income {APC= C/Y}
It is through average propensity to consume that
the share of total consumption in aggregate
demand can be known.
• Suppose, under equilibrium condition,
aggregate demand or aggregate income is Rs.
100 cr. And average propensity to consume
(APC) is 60 %. It shows that consumption
expenditure is Rs.60cr.
(b) Marginal propensity to consume: it is the
ratio of change in aggregate consumption to
change in aggregate income
{MPC= C/Y}
• Supposing total income increases from Rs.100 cr to Rs.
120 cr. And consumption expenditure increases from
Rs. 50 cr to 60 cr. Changing in income Y= Rs.120 cr –
Rs. 100 cr = Rs. 20 cr and change in consumption
C= Rs. 60cr – Rs.50 cr=10 cr.
Thus, MPC= C/Y = Rs. 10/Rs. 20=1/2
Marginal propensity to consume indicates how much
aggregate consumption expenditure increases with
increase in the income of consumers.
(ii) Size of National income: Keynes assumed that
consumption is a function of income , i. e, C=f(Y).
Increase in income causes increase in consumption.
However, the ratio of increase in consumption is
less that the increase in income. It testifies that
when national income or aggregate supply
increases then, because of less proportionate
increase in aggregate consumption than increase in
national income, aggregate demand falls short of
aggregate supply. …..
Consequently, firms reduce their output causing
unemployment. Hence, to remove unemployment,
aggregate demand must be increased. With a view
to increasing aggregate demand , it is not possible
to increase aggregate demand, it is not possible to
increase aggregate consumption © because the
latter depends on such subjective factors as taste,
fashion, habit and objective factors as distribution
of income etc, which remain constant in the short
run.
• Hence, according to Keynesian theory of
employment, there is grater scope of increasing
aggregate demand if investment is increased.
(B) Investment: it refers to that expenditure which
leads to addition in the total stock of capital
assets. it is an important constituent of aggregate
demand. According to Keynes, investment mainly
depends on two factors: (i) Rate of interest and
(i) Marginal Efficiency of Capital.
(i) Rate of Interest: According to Keynes,
investment increases with fall in the rate of
interest and decreases with rise in the rate of
interest. Rate of interest is determined by
demand for and supply of money. Demand for
money depends on liquidity preference. People
prefer to hold their money in cash for (liquid)
due to three motives (1) Transaction motive, (ii)
Precautionary motive, (iii) speculation motive.
(ii) Marginal Efficiency of Capital: MEC refers to rate
of profit. Addition made to the total profit by
applying one more unit of capital asset is called
MEC. MEC depends on two factors:
(a) Prospective Yield: the amount of profit expected
per unit of capital per annum is called
prospective yield.
(b) Supply Price: Supply Price means that price of a
machine which is paid for a similar new machine.
An entrepreneur compares the rate of interest
with the marginal efficiency of capital, at the
time of making investment. If the MEC is more
than the rate of interest, the investment will
be take place. On the other hand, if the MEC is
less than the rate of interest, no investment
will be undertaken. If both are equal, it will be
difficult for the entrepreneur to decide
whether to go for investment or not.
• In short, the above discussed testifies that according to
the theory of employment as propounded by Keynes,
developed capitalist economies can be afflicted with
unemployment and deficiency of aggregate demand
accounts for such an unemployment. Aggregate
demand is composed of consumption and investment.
In the short period, consumption expenditure remains
more or less constant, hence, there is greater possibility
of increasing aggregate demand by increasing
investment.
4. Determination of Employment

Under perfect competition, employment will be

determined at that level of aggregate demand
at which it is equal to aggregate supply. This
level is called equilibrium level or effective
demand. According to Keynes, “ the volume
of Employment is given by the point of
intersection between the aggregate Demand
function and aggregate supply function.”
• In the short period aggregate supply remains
constant, as such, effective demand and level of
employment can be increased by changing
aggregate demand. In a closed economy, aggregate
demand depends upon consumption, national
income and propensity to consume. Propensity to
consume depends upon many subjective and
objective factors which remain constant in the short
period. It is therefore, not possible to increase
consumption in the short period.
• The other determinant of aggregate demand is
investment. It depends upon rate of interest and
MEC. Rate of interest is determined by the
interaction of the demand for and supply of money.
Demand for money is reflected in liquidity
preference. Preference to hold wealth in cash is
called liquidity preference. People hold their wealth
in liquid form for three motives: Transaction,
Precautionary, and speculative motives. …
• Demand for cash for transaction and precautionary
motives depends on the level of income while that
for speculative motive depends on the rate of
interest. At high rate of interest people will be
willing to give more money on loan and at low rate
they will lend less. MEK in fact, refers to the rate of
profit. It (MEC) is also governed by two factors:
• (i) Supply price of capital asset, (ii) prospective
yield.
• In the short period, investment can be increased
by lowering the rate of interest. If investment
made by the private sector is not enough,
government can increase it by making
autonomous (public) investment. Hence, Keynes
in his General theory stated that unemployment
could be removed by increasing effective
demand . In order to increase effective demand,
aggregated demand must be increased.
• To increase aggregate demand, consumption
demand (C) and investment demand (I) must
increase. But in the short period, consumption
remains constant. Hence, it is by increasing
investment that aggregate demand can be
increased. As a result of it, employment will
increase. Keynes was of the opinion that due to
increase in investment, income and employment
both will increase many times on account of
multiplier effect.
• In short, the objective of full employment
could be achieved through increase in
effective demand and investment.
• Determination of level of employment is
expainded with the help of Table and Fig
below:
Table: Determination of Employment
Employment (N) Aggregate Aggregate Demand Trends in
(In Lakh) Supply (Rs. Crore) Employment
(Rs. Crore)
0 0 60 Rise
10 60 100 Rise

20 90 120 Rise

30 120 140 Rise

40 150 160 Rise

50 180 180 Equilibrium

60 210 190 Fall
70 240 200 Fall
(1) When the level of employment is Zero even
then, aggregate demand is Rs. 60 cr, and
aggregate supply is zero. It is so because even
unemployed persons do spend some amount
on consumption.
(2) As employment increases to 40 lakh, there is
increase in aggregate demand along with
increase in aggregate supply, although
aggregate demand is more than aggregate
supply. As such the producers will continue to
produce more.
As a result of it, more laborers will be employed.
(3) When 50 Lakh person get employment,
aggregate demand becomes equal to aggregate
supply, viz, Rs. 180 cr. It will be a position of
equilibrium in the economy. It is at this point
that equilibrium level of employment will be
determined. However, in the economy 70 lakh
persons are will to work. Consequently, 20 lakh
persons will remain unemployed in this position
of equilibrium. It implies that unemployment is
• Possible even when economy is in equilibrium.
Such an equilibrium has been referred to as
under- employment equilibrium in Keynesian
theory of employment.
(4) Beyond 50 lakh person, as more persons are
employed, aggregate demand falls short of
aggregate supply. Hence, it will not be worth –
while for the entrepreneurs to give work to
more than 50 lakh persons.
• It is evident from table, that equilibrium level
of employment will be determined at that
point where aggregate demand is equal to
aggregate supply. In Diagram page (58),
income and employment are shown on OX-
axis and Expenditure/Expected Receipts on
OY- axis. AS is aggregate supply curve, 50 lakh
persons get employment. Thus, point E is an
equilibrium point.
• If the level of employment is reduced to 40 lakh, then
aggregate demand as shown by point B will be Rs. 160 cr.
And aggregate supply as shown by point A will be Rs. 150
cr. In order words, aggregated demand will be more than
aggregate supply by AB. Aggregate demand being more
than aggregate supply, producers will produce more. As
a result, level of employment will go on increasing till it
reaches 50 lakh. At this level of employment, aggregate
demand will be equal to aggregate supply and this
situation will be indicative of equilibrium.
• If, however, the level of employment rises to 60
lakh, then aggregate demand as shown by point C
will be Rs. 190 cr. While aggregate supply as shown
by point D will be Rs. 210 cr. In order words,
aggregate demand will be less than aggregate
supply. It will cause loss to the producers and they
will reduce production. Less production will result
into fall in employment, till it once again comes
down to the level of 50 lakh, where AD is equal to
AS.
5. Achievement of full employment

• Equilibrium is possible in an economy even with

unemployment. It is called under- employment
equilibrium. With a view of removing
unemployment and achieving full employment,
it is essential to increase aggregate demand.
According to Keynes, in order to increase AD in
short period, investment must be increased,
because in the short run, consumption remains
more or less constant. …….
• As a result of increase in investment, the AD curve will
shift upwards. The new demand curve will intersect the
supply curve at full employment level. the equilibrium
so established will be called full- employment
equilibrium. The position of full employment
equilibrium can be explained with the help of diagram
page (59). In this diagram at point E the AD cuts AS
curve, shows economy is in equilibrium. Yet YY1 lakh
persons remain unemployed, because OY1 persons
want employment.
Hence, it is an under-employment equilibrium. If as a
result of increase in investment, there is increase in
AD, then the new demand curve will shift upwards as
shown by AD1. the new demand curve AD1 intersects
aggregate supply curve AS at point F, which will
indicate new equilibrium position. In the new
equilibrium, all OY1 workers will get employment.
Hence, it will be called full-employment equilibrium.
If investment increases still more, there will be
further upwards as shown by AD2 .
• This new demand curve intersects AS curve at
point P which will be the new equilibrium
point. In this situation there will be no
increase in employment and output. Hence,
after the attainment of full employment
situation if AD continues to increase, it will
simply lead to rise in prices. Such a situation is
referred to as over full employment situation.
5.1. Determination of Income or output

• According to Keynes, Income or Output depends on the

level of Employment. Income or output can be determined
with the help of following equation:
Y= C+I
C= Co + bY
I=I
Y= Co + bY + I
Y= income, C= consumption, I= investment,
Co = Autonomous consumption, b=MPC or C/Y
Y= Income in initial stage, I=Autonomous Investment.
• Supposing, in an economy in the initial stage there is
the following situation:
Y=0
C0= Rs. 25 cr
b= 0.75
I= Rs. 75 cr
If in the beginning there is no income and people are spending
their old savings on consumption and investment then income
can be determined on the basis of above equation as follows.
Y=25+(0.75x0)+75=Rs. 100 cr
• When income increases to Rs.100 cr and
autonomous investment remaining Rs. 75 cr then
the second stage income will increase according to
the following formula:
Y=25+(0.75x100)+75= 25+(3/4)x100+75=Rs.175 cr
In this situation, consumption will be of Rs. 100 cr. In
the third stage of income expansion, income can be
calculated as:
Y= 25+(0.75x175)+75=Rs. 231.25 cr
• Thus, when income reaches to Rs. 400 cr passing
through different stages then AD will also be Rs.
400 cr and saving will also be Rs.75 cr which is
equal to investment. Therefore,Rs.400 cr will be
called as equilibrium income, because at this
stage two conditions are fulfilled:
(1) AS is equal to AD or AD=AS
(2) Ex-ante Investment and Ex-ante saving are equal
S=I
Equilibrium level of (Y) in terms of Equality
between desired (S) and desired (I)
Income Consumption Saving Investment
(Y) (C) (Y-C) (I)
0 25 -25 75
100 100 0 75
175 156 19 75
300 250 50 75
350 287.5 62.5 75
400 325 75 75
450 362.5 87.5 75
500 400 100 75
Equilibrium is struck when: S=I=75
Equilibrium level of ------ Y= 400
In Fig (P.61), income is shown on OX- axis and
.consumption, saving and investment on OY
SS is Saving-line. It begins from below point “O”,
which means in the beginning saving is negative.
after this, it starts moving upward and equals
investment point at “F” . Thus, Point “F” is an
equilibrium point of saving and investment. Line
.. ,CC is consumption curve, it begins from above
the point “O”, i.e., in the beginning when income
is zero consumption (OC) is still thee. Line II
shows investment curve. This curve is parallel
to OX- axis, it proves that quantity of
investment will remain constant OI. AD shows
aggregate demand curve. It is the sum of
consumption and investment. AS shows
aggregate supply curve which reveals different
points of Income. At point E, curve AD and AS
• Intersect each other. therefore, this point is an
equilibrium point. Equilibrium income will be
determined at point “E”,. In the situation of
equilibrium;
• AD = AS and (ii) Ex-ante S = Ex-ante (I)
•
6. Keynesian Model of Employment and
Income
• Keynesian Model of employment and income can be
explained with the help of the following formulas:
Y=f(N) …….(1)
(Output (Y) is the direct function of employment (N) i.e.,
output depends on employment. Total output
increases with increase in employment.)
NS= f(W) …….(2)
Supply of labour is a function of wage money(W)
It means, supply of labour increase with increase with
money wages.
• ND =f(W/P) ……(3)
• Demand for labour (ND) is a function of real wages
(W/P)
• (It means demand for labour increases as his real wage
falls and decreases as his real wage rises. According to
Keynes, increase in employment will lead to fall in real
wages)
• ND=NS…..(4)
• labour market will be in equilibrium when demand for
labour is equal to its supply.
• According to Keynes, money market will be in equilibrium
when demand for money is equal to supply of money, that
is,
• MS=MD …..(5)
• Keynes believe that, MD=L1(Y)+L2(r) ….. (6)
• it means, demand for money (MD) for precautionary and
transaction motives depends on liquidity preference (L1).
Liquidity preference (L1) depends on income (Y). Besides,
demand for money for speculative motive also depends on
liquidity preference (L2). Liquidity preference (L2) depends
on rate of interest (r)
• Keynes also assumed that in equilibrium,
investment and saving will be equal.
• I=S ……(7)
• where,
• I=f(r) …..(8)
• and S=f(Y)….(9)
• Saving (S) is a direct function of income (Y).
Saving increases with increase in Income.
10. Differences between Keynesian theory
and classical theory of employment
(1) Concept of Unemployment: according to classical,
an involuntary unemployed person is one who is
willing to work at the existing rate of money wage
but does not get work. On the contrary, according
to Keynes, an involuntary unemployed person is
one who is willing to work at less than existing rate
of real wage. Thus, there are millions of
unemployed person who are not covered with the
classical concept of involuntary unemployment.
(2) Concept of Equilibrium: as per classical,
equilibrium refers to situation in which demand for
a commodity is equal to its total supply. Thus, under
the situation of equilibrium, there is full
employment in the economy. On the contrary,
Keynes believe that equilibrium refers to a situation
having no tendency to change. it is not necessary
that there should be full employment when the
economy is in equilibrium. For instance, …..
according to Keynes, labour market will be in
equilibrium if there is no tendency to make
any change in wage rate and level of
employment, even though at the existing real
wage rate, demand for labour is less than its
supply. Hence, according to Keynes,
equilibrium can be possible even when there
is under-employment in the economy.
(3) Relative Importance of Demand and Supply:
The classical, laid relatively more stress on AS in
determination of income and employment.
According to them, supply creates its own
demand to maintain the level of equilibrium in
economy. On the other hand, Keynes laid
relative more stress on AD in the
determination of income and employment and
treated AS to be fixed.
(4) Function of money: as per classical theory “ the
function of money is to serve as a medium of
exchange”. On the contrary, according to Keynes, in
addition to being a medium of exchange, money also
serves as a “ store of value”. People demand money in
order to hold it in liquid form. People prefer this
liquidity because of three motives:
1. Transaction motive
2. Precaution motive
3. Speculative motive
5. Rate of Interest: classical economists asserted
that rate of interest is determined by real
factors. On the contrary, Keynes held the view
that it is determined by monetary factors.
Further, classical economists believed that rate
of interest is determined at the level where
saving and investment are equal.
• On the contrary, Keynes maintained that rate
of in interest is determined at that level where
demand for money is equal to supply of
money. Classical economists believed that
rate of interest could rise or fall to any extent
but Keynes maintained that rate of interest
could not fall below a given limit called
Liquidity Trap.
6. Saving and Investment: According to calssical
economists, saving and investment are governed by
the rate of interest; i.e.,
S = f(r)
I = f(r)
S=I
Equality between saving and investment can be
established by changing the rate of interest. On the
contrary, according to Keynes, saving depends on
income and investment on rate of interest.
S=f(Y) saving is a function of Income.
I=f(r) Investment is a function of interest rate.
According to Keynes, equality between saving
and investment can be brought about by
changing the level of income.
[Link] level and output: classical economists
assumed that under full employment situation
AS curve will be parallel to OY- axis, it will be a
vertical line and AD curve will be a rectangular
hyperbola. Equilibrium will be established at
point where both these curves intersect each
other. if AD increases in the economy, it will
not stimulate more production . In that case
price level alone will rise.
• On the other hand, Keynes was of the view
that AS curve will be an upward rising curve
till full employment level is attained, whereas
demand curve will be a downward sloping
curve. Hence, with increase in AD, there will
be increase both in output and price level till
full employment is reached.
8. Theory of Money: Classical believed in quantity
Theory of Money which asserts direct and
proportional relation between quantity of money
and price level. the price level increases in the
same proportion as the quantity of money dose
and vice versa. On the contrary, Keynes, believed
that there was no direct and proportional relation
between quantity of money and price level. there
is an indirect relation between the two.
9. Adjustment of Price and output: classical held
that as a result change in AD, change in price will
be quicker than change in output. It is because ,
full employment is the normal situation of the
economy. On the contrary, Keynes asserted that
due to change in AD, change in output will be
quicker than change in price. The reason being
that less than full employment is the normal
condition of the economy.
10. Cut in money wages: classical like Pigou held
the view that full employment could be
achieved by lowering the money wage.
Keynes, believed that any reduction in money
wage was likely to cause fall in effective
demand. This in turn will lead to fall in
employment rather increasing it. Keynes
prescribed cut in real wage, price level must
be raised.
11. Necessity of state Interference: according to
classical, free market economy is automatic.
Government should not interfere in the
economic affairs. Keynes did not share this
view. According to him, economy is not
automatic. Its proper functioning requires
government interference.
12. Saving is a Social Vice: classical treated
saving as a private and social virtue. According
to them, saving was the basis of capital
formation. Keynes treated saving as a social
vice. With a view to increasing employment,
spending should be given more importance
than saving. If everybody indulged in more
saving there will be a fall in effective demand
causing corresponding fall in employment.
13. Integration between the Theory of Money and Theory
of Value:
Classical were unable to integrate the theory of money and
the theory of vale. They divided the study of real and
monetary sectors into two parts. Called Classical
Dichotomy. Keynes made a significant integration of the
theory of money and the theory of value. According to
him, supply of money has a great impact on the prices
and output of the commodities. According to Keynes
there is a mutual dependence between real and monetary
sectors.
14. Dynamic: classical analysis is static. It has no
significance for the study of expectations. Keynes
has accorded special importance to the study of
expectations. These expectations play an
important role in the determination of marginal
efficiency of capital (MEC) and marginal
efficiency of capital, in its turn, determines the
level of employment. Hence, expectations render
Keynesian Theory, dynamic to some extent.
15. Practical: classical has contributed very little in
solving thee practical problems, but Keynes theory is
more pragmatic. While formulating its economic
polices, government seeks lot of guidance from
Keynesian economic theories. According to
Schumpeter, the importance of Keynesian economic
lies in the fact that it helps in finding out solutions to
the exiting economic problems. Robinson is of the
view that the greatest success of Keynes lies in
relating academic economics to state economies.
16. Classical and Keynesian Models of Income
and Employment:
Similarities and differences between classical
theory of Income and Employment and
Keynesian theory of Income and Employment
are clarified with the help of the following
equations: (Next slide)
Classical Keynesian
M=LPY M=LPY+L (r )
Y= f(N) Y= f(N)
NS= f(W/P) NS= W0
ND= f(W/P) ND= f( W/P)
S=f(r) S=f(y)
I=(r) I= f(r, MEC)
S=I S=I
1. According to Classical, money is demanded
for transaction motive (LPY) alone. On the
contrary, Keynes maintained that money is
demanded for transaction motive as well as
speculation motives; i.e., (LPY+ L (r )
2. Both Classical and Keynesian theory are
based on the assumption that in the short
run , total output (Y) is a function of
employment (N), that is depends on
employment.
3. According to Classical, supply of labour (NS)
depends on real wage (W/P). On the contrary,
Keynes believe that it depends on money
wage (W0).
4. Both Classical and Keynes agree to the fact
that demand for labour (ND) depends on real
wage.
5. According to Classical , saving (s) is a function
of rate of interest (r ). Keynes is of the view
that (s) is a function of income (Y).
6. Classical believed that investment (I) depends on
the rate of interest (r ). According to Keynes,
investment depends on rate of interest and
marginal efficiency of capital (r, MEC).
7. According to Classical , any discrepancy between
saving and investment can be corrected by
change in the rate of interest. On the contrary,
Keynes believes that any differences between
saving and investment can be corrected by
change in the level of income.
Chapter 5
Effective Demand
1. What is effective demand?
2. Determinants of effective demand.
3. Relative Importance of Aggregate Demand
and Aggregate Supply
4. Determination of effective demand
5. Importance of effective demand
1. What is Effective Demand?
In economics, the term “demand” is used in as sense
different from desire. Human has many desires, but
only those desires are called demand that he has the
capacity to fulfill and that he is prepared to fulfill at a
given price.
Thus, only effective desire is called demand.
Keynes has used the term demand in the sense of
aggregate demand found in and economy at different
level of employment.
• At different level of employment, AD can be
different, but there is a level of AD at which it
is equal to AS. It is in order to emphasis this
level of AD, that Keynes has used the adjective
‘effective’ . According to Keynes’ theory of
employment, level of employment depends
on that level of AD at which it is equal to AS, is
called equilibrium position.
• Effective demand is that level of AD at which it
is equal to AS.
• Only that AD which is equal to AS is called
effective demand. Effective demand refers to
that amount of aggregate expenditure which
being equal to AS or national income proves
to be effective. Thus, it represents short run
equilibrium position.
• Explanation: The concept of effective demand
tells that like other economic factors, level of
employment is also determined by demand
and supply. AD of an economy tell as to how
much money is expected to be received by all
the entrepreneurs by selling the output
produced at different levels of output.
• When entrepreneurs of an economy make
more investment there is increase in AS.
Increase in AS, leads to increase in the volume
of employment. Increase in the employment
level leads to increase in AD. Position of
equilibrium between AD and AS signifies
effective demand. With increase in effective
demand there is increase both in AD and AS.
Hence, level of employment also increases.
• On the contrary, with fall in effective demand
there is fall in AD and AS. Consequently, level of
employment also falls. (Fig 1 p 83) explains the
concept of AD.
• In this figure, level of employment is shown on
OX-axis and receipts on OY- axis. AS and AD
curves intersect each other at point E. thus, point
E indicates the level of employment that will
finally be determined. Supposing, AS is equal to
AN. in this situation, ON number of labour get
employment . At ON level of employment, AD will
be ND. In this way, by employing ON number of
labours, the entrepreneurs will receive ND amount
of money and spend AN amount by way of cost of
production. Thus, they will receive AD amount as
surplus. It means that entrepreneurs will receive
more money than their expectations they will
increase their production. They will go on
Employing more and more labours till they reach
equilibrium position as shown by point E. in
this position, AD will be equal to AS . If the
entrepreneurs employ more than OM labours,
i.e., OQ labours, then AD will be less than CQ
aggregate supply BQ. In this case, the
entrepreneurs will not be able to sell all their
output. Fall in the sale of output will force the
entrepreneurs to reduce employment to the
Extent that the level of equilibrium OM is re
established. In short, level of employment,
according to Keynes, is determined by the
level of effective demand.
2. Determinants of Effective Demand: Two main
determinants of effective demand are:
1. Aggregate Demand
2. Aggregate Supply
According to Keynes, AD refers to AD of expenditure in an
economy while AS refers to the total value of the output
of an economy at any give time or the national income. It
will be of advantage to know at this juncture the
difference between the concepts of AD and AS as used in
macro economics and the concept of demand and supply
as used in micro economics.
2.1. Aggregate Demand:
With a view to having a detailed study of the concept of
AD, it is essential to know about the two related
concepts: (1) AD Price (2) AD schedule or AD function.
1. AD price: Aggregate demand price refers to the total
sale proceeds that all the producers of an economy do
expect from the sale of the goods and services
produced by a given number of laboures
corresponding to a particular level of employment,
during the period of one year.
(i). Definitions: “the Aggregate Demand Price at any
level of employment is the amount of money which
all the entrepreneurs in an economy taken together
really do expect that they will receive if they sell the
output produced this given number of men”.
(ii). Aggregate Demand Schedule: AD Price is different
at various level of employment. The relation
between employment and expected receipts can also
be expressed in the form of a schedule. Such a
schedule is called AD schedule or AD function.
Definition: according to Peterson,” AD function
is a schedule of the various amounts of money
which the entrepreneurs in an economy
expect from the sale of their output at varying
levels of employment.
The Aggregated demand Schedule is explained
with the help of Table
Table: Aggregate Schedule
Level of Employment (In Lakh ) Aggregate Demand Price (In crore)

0 100

10 360

20 420

30 480

40 540

50 600

50 640 Full Employment

• The table indicates that even when level of
employment is zero, AD is Rs. 100 crore. It implies
that unemployed laboures are expected to spend
at least Rs. 100 crore on their consumption.
Therefore, as the level of employment increases,
AD also increases. AD includes both consumption
expenditure and investment expenditure. The
table is based on the assumption that at each level
of employment and investment of Rs.60 crore is
being made and consumers spend one half of the
increase in their income on expenditure……
• As the level of employment goes on
increasing, AD is also increasing. But on
reaching full employment situation AD tends
to stabilize. It is son because ordinarily AD
does not increase in the same proportion as
the increase in income or employment in
other words, AD is the function of level of
employment
AD=f(N)
(iii) Aggregate Demand Curve: AD curve is a curve
that expresses relationship between AD price and
employment. AD curve is shown by Fig 2,3. (p. 85)
In Fig 2, employment is shown on OX-axis and
expected receipts or AD price on OY-axis. The AD
curve slopes upward to the right. It shows that with
increase in employment, AD also increases. Fig 3
shows that AD curve starts not from the point of
origin “O” it implies that even at zero level of
employment, some money will be spent on
consumption.
(iv) Determinants of AD:
According to Keynes, two main determinants of
AD are (1) Consumption expenditure and
(2) Investment expenditure.
AD= C+I
Followers of Keynes refer to four components of
(1) Consumption (2) government expenditure (3)
Foreign investment (4) export – Import
AD= C+I+G+(X-M)
2.2. Aggregate Supply
The concept of Aggregate supply is also used in
the sense of two related concepts:
A) Aggregate Supply Price
B) Aggregate Supply Schedule
AS Price refers to that minimum amount of
money which all the entrepreneurs have to
spend in order to produce the output at a
given level of employment. In other words, it
is the cost of production.
Definitions: “At any given level of employment of
labour, aggregate supply price is the total
amount of money which all the entrepreneurs in
the economy, taken together, must expect to
receive from the sale of the output produced by
that given number of men, if it is to be worth
while to employ them”.
According to Keynes, “ AS Price of the output of a
given amount of employment is the expectation
of proceeds which will just make it worthwhile
for the entrepreneur to give that employment”.
B) Aggregate Supply Schedule or function:
ASF is a schedule of various amounts of money
which all the entrepreneurs in an economy
must receive from the sale of output at
varying levels of employment.
Definition: “ the ASF is a schedule of the
minimum amount of proceeds required to
induce varying quantities of employment”.
Aggregate Supply Schedule
Level of Employment (Lakh) Aggregate Supply Price( crore Rs)

0 0
10 12
20 240
30 360
40 480
50 600
60 720 Full employment
The table shows that as the level of employment
increases, AS also increases. After reaching full
employment situation, there will be no change in
the level of employment but AS Price will increase.
Increase in employment by a given number of
accompanied with an increase in AS by a given
amount. When the level of employment is zero, AS
is also zero. If employment increases to 10 Lakh, AS
increases to Rs. 120 Crore. As employment
increases, AS doubles than before.
AS is a function of employment AS= f(N)
AS Price and AS F are different concepts. AS P
refers to producer’s minimum expected
receipts (= cost of production), from the sale
of their output corresponding to a specific
level of employment.
ASF refers to the entire table showing
producer’s minimum expected receipts from
the sale of their output corresponding to the
various levels of employment.
C) Aggregate Supply Curve: ASC is a curve that
expressed relationship between ASP and level of
employment. Fig (4 p88). In this figure, AS curve
shows ASF. This curve is sloping upwards up to point
and thereafter it becomes a vertical line parallel to
OY-axis. Point “F” represents full employment. As
long as the economy is in less than full employment
position, ASP and level of employment are
increasing in the same proportion. That is why AS
curve is sloping upwards up to point ‘F’ but after
point ‘F’ as a result of full employment position, ASC
becomes a vertical line parallel to OY-axis.
Supporters of Keynes have attempted to
establish the relationship between real
income and total receipts through ASC. They
have shown income instead of employment
on OX-axis, because AS and Aggregate income
are equal in an economy. Thus ASC can be
represented by line drawn on 45 degree angle.
It is shown in (Fig. 5 p).
• In this figure, income is shown on OX-axis and
total receipts on Oy-axis. AS is Aggregate
supply curve. It is situated at equal distance
from OX and OY-axis. It forms 45 degree angle,
signifying that each point on it expresses
equal value of income and receipts. For
instance, point A shows that if aggregate
income is Rs. 100 crore then aggregate
receipts are also Rs. 100 crore.
3. Relative Importance of AD and AS:
Keynes has given more importance to AD than AS. Keynes
assumed AS to be constant in the short run. It is so
because change in AS is influenced by capital, productivity
of labour and technical factors. It is not possible to change
these three factors in the short run. Keynes was also of the
view that under condition of unemployment or depression
in the economy if attempts are made to lower the total
cost of production by introducing technical reforms, then
instead of increase in employment there might be
decrease in unemployment.
In short run, changes are possible in the AD alone, as
such Keynes has given more importance to AD.
After full employment situation is reached, any
increase in production leads to rise in prices. In this
situation, any change in AS may prove helpful in
lowering the prices. Before the achievement of full
employment situation, AD is more important than
AS. However, after full employment and in the
situation of inflation, AS becomes relatively more
important.
4. Determination of Effective Demand: in any
economy, effective demand depends on two factors:
1)AD Price (ADP) , 2) AS Price (ASP)
Both these factors together determine effective
demand. The level of employment at which AD
becomes equal to AS (AD=AS) is called equilibrium
level. at this level of equilibrium, the effective
demand is determined. Thus, effective demand is
determined at that level where AD is equal to AS.
Determination of Effective Demand
Employment AD in (crore AS in (crore Equilibrium
in (Lakh) Rs) Rs)
0 100 0 Disequilibrium
10 360 120 AD>AS
20 420 240 AD>AS
30 480 360 AD> AS
40 540 480 AD> AS
50 600 600 Effective
Demand
50 640 720 AD< AS
Above table indicates that when level of
employment is 50 lakhs, then both AD and AS
are equal at Rs. 600 crore. It is an equilibrium
situation. The AS under this situation (Rs.600
crore) is called Effective Demand. Any situation
before or after AD=AS does not represent the
situation of Effective Demand.
Point E shows that in equilibrium situation, level of
employment is OQ and expected receipts OP.
• If the level of employment is less than OQ , i.e.
OQ1, then employment will ultimately increase
to OQ. It is so because at OQ1 level of
employment, AD price OP2 is more than ASP
OP1 entrepreneurs earn large profits. They will
be induced to increase production which will
lead to increase in the level of employment. If
the level of employment is OQ2, then at this level
of employment, ADP will be less than ASP.
• It means the entrepreneurs will not be able to
meet their cost of production. They will reduce
production, causing fall in employment. Hence,
level of employment will come down from OQ2 to
OQ. Thus, effective demand is determined under
equilibrium situation of employment, because in
this situation, as is clear from E, Aggregate
demand is equal to aggregate supply.
In Fig 6. p 89, employment is shown on OX-axis
and expected receipt on OY-axis. Both AD and
AS curves intersect each other at point E. AD
at point E is called equilibrium point. It is
corresponding to this point that AD becomes
Aggregate Effective Demand (AED).
4.1. Equilibrium not Necessarily at Full Employment:
it is clear from the above discussion that equilibrium is
established at that point where AS curve intersects AD curve.
However, it does not mean that full employment is necessary
under equilibrium situation. As a matter of fact, equilibrium
can be possible even in case of under employment. It is
shown in (Fig. 7 p 90). In this figure, E is equilibrium point
signifies under employment equilibrium because in this case,
AD curve and AS curve intersect each other at point E and
economy is in equilibrium at OQ level of employment. In this
situation
QQ1, number of labourers are still unemployed. It
means that in this equilibrium position there is no
optimum utilization of factors of production.
Economy will have full employment equilibrium
only when OQ1 number of labourers get
employment. It can happen only when AD increases
AD1 and intersect AS curve at point E1
corresponding to full employment level. in this case,
at E1 point, OQ1 full employment equilibrium will
be established and factors of production
including labourers will be fully utilized. If
demand curve rises to AD2 , the new
equilibrium point E2 will indicate over-full
employment equilibrium. In this situation,
neither employment nor output increases. It is
the AS price that increases due to inflation.
• “In the short-run, the economy can achieve
equilibrium of income and employment at
levels that represent full employment, less
than full employment or over full employment.
Not one level is inherently more ‘normal’ than
any other level. it al depends up on the
relationship existing at any given time interval
between AS and AD”.
• Many important conclusions can be drawn
from the above discussion:
1)Equilibrium need not coincide with full
employment. It can be possible even under
less than full employment. Hence, the concept
of effective demand repudiates the
assumption of classical theory of employment
that equilibrium is possible only under full
employment situation.
2) Principle of effective demand is concerned
only with involuntary unemployment. It does
not take into consideration frictional
unemployment and technological
unemployment.
3)Equilibrium indicated by effective demand is
only a temporary equilibrium because it
changes with change in aggregate demand.
6. Criticism of the concept of Effective Demand:
1). The theory of effective demand does not
apply to under developed economies. In these
economies, there is no increase in
employment with increase in AD , rather there
is increase in price level alone. The theory is
valid in the context of determination of
employment in developed economies only.
2) Keynes’ concept of effective demand is a
narrow concept. It is based on the assumption
of closed economy. It also ignores the income
and expenditure of the government. Thus,
according to Keynes, AD includes only
consumption expenditure (C) and investment
(I ). It ignores government expenditure and
net export (X-M).
Chapter 6
Consumption Function
1. What is consumption function?
2. Propensity to Consume.
3. Kinds or Technical Attributes of the
Propensity to Consume.
4. Propensity to save and saving function.
5. Determinants of Propensity to consume.
6. Psychological Law of Consumption.
7. Cyclical and Secular consumption function.
1. What is consumption function?
Consumption and investment are two vital
components of AD in the Keynesian theory of
Income and employment. The amount of
money that people spend out of national
income on the purchase of goods and services
for the direct satisfaction of their wants in
called Aggregate Consumption Expenditure
or consumption.
• Supposing the total income of an economy is Rs.
5000 crore, of it, people spend Rs. 4000 cr or
the purpose of consumption goods and services.
Thus, Rs. 4000 cr will be the total consumption
expenditure of the economy. Consumption
expenditure depends on many factors like
income, price level, fashion etc. Keynes held the
view that total consumption of and economy
depends on income or can be written as C=f(Y)
[Link] to Consume: consumption
expenditure expresses the relation between
total consumption and national income.
Keynes has used the term Propensity to
Consume for consumption function.
Propensity to consume refers to schedule that
shows the relationship between different level
of income and different level of consumption.
• According to Keynes, quantity of a good
demanded shows its functional dependence
on price, likewise, quantity of goods
consumed shows its definite functional
dependence on income. It can be expressed in
the form of following equation:
C= f(Y)
2.1 Definition: “The schedule that relates
consumption to disposable income is called
the propensity to consume or the consumption
function”. or
“Consumption function shows what expenditure
consumers will wish to make on consumer’s
goods and services at each possible level of
income”.
2.2 Explanation: According to Dillard, “ A
schedule showing the various amounts of
consumption which correspond to different
levels of income is the schedule of propensity
to consume, which for the sake of brevity is
referred to simply as the propensity to
consume. This may be explained with the
help of Table and Figure.
Table 1. Propensity to Consume
Income Consumption Saving
0 10 -10
100 100 0
200 190 10
300 280 20
400 370 30
500 460 40
• The table shows that when income is zero,
people spend Rs. 10 cr on consumption. This
expenditure is met either from their past
savings or by borrowing. When income
increases to Rs. 100 cr, consumption also
increases to Rs.100 cr. Saving , therefore, is
zero. As income is rising, consumption and
saving are also rising, but increasing in
consumption is less than increase in income.
• In Fig, 1 p 99, income is shown on OX-axis and
consumption and saving on OY-axis. The AS curve is
drawn on 45 degree angle. This curve represents
equality of aggregate income and aggregate
expenditure of an economy. CC curve is aggregate
consumption curve and SS curve is saving curve.
Consumption curve has constant slope. It shows
that at different levels of income, propensity to
consume remains constant. Consumption curve
does not start
• From point of origin ‘O’. It is so because when
income is zero even then consumption is Rs. 10 cr,
as is shown in table 1. consumption curve CC slopes
upward from left to right. It implies that with
increase in income there is also increase in
consumption. At point P, income and expenditure
are equal because consumption curve is
intersecting AS. At this point, saving will be zero,
that is why SS saving curve is touching OX-axis at
point M. to the left of point P, consumption curve
CC is above AS curve. It means that consumption
expenditure is more than income, that is the reason
why saving is negative, it also explains why saving
curve SS is below OX-axis before OM level of income.
SM part of the saving curve expresses negative
saving. At the right of point P, consumption curve CC
is below AS curve. It means that consumption is less
than income and saving is positive. MS part of the
saving curve SS expresses positive saving.
2.3 Different shapes of consumption curve:
1) Linear consumption curve which does not
start from the point of origin: consumption
curve can be linear as shown in Fig. 2.p 100.
this curve does not started from the point of
origin ‘O’. It shows that even when the income
of the consumers is zero, they are spending OC
amount on consumption. That is.
C= C0+bY
Here C0 = minimum consumption, which must
be incurred, even when the income of the
consumer is zero, ‘b’ refers to marginal
propensity to consume or the slope of CC
curve. Marginal Propensity to consume is the
ratio of change in consumption as a result of
change in income ,i.e., MPC= C/ Y
CC curve also shows that when income increases
From OY to Oy1, then consumption expenditure
increases from OA to OB. But AB increase in
consumption is less than YY1, increase in income.
Slope of consumption curve CC that is, marginal
propensity to consume (MPC) is constant, but it is
not equal to average propensity to consume (APC).
Because APC is the ratio of consumption to total
income, i.e., APC=C/Y. In this case, APC is
diminishing but it is more than MPC (APC> MPC)
Such a consumption curve is found in the short run.
2) Linear consumption curve which starts from the point
of Origin: in (Fig.3.p100), consumption curve starts
from the point of origin ‘O’. It shows that consumption
increases or decreases in the same proportion as the
income increases or decreases. When income is zero,
consumption is also zero, C=bY . Here MPC remains
constant. OC consumption curve shows that Marginal
and Average propensity to consume are equal to each
other (APC= MPC),i.e., APC is also constant. Such a
consumption curve is found in the long run.
3) Non—linear consumption curve: as shown in
(Fig.4.p101). Consumption curve can be non-
linear. In this figure, AC curve is a non-linear
consumption curve and BS curve is a non-
linear saving curve. In this case, MPC does not
remain constant, rather it goes on falling with
increase in income. According to Keynes,
consumption curve must conform to this
shape, but most of the followers of Keynes
recognize only linear consumption curve. Non- linear
consumption curve which does not start from point
of origin ‘O’ is a short run consumption curve.
2.4 Features or Characteristics of Propensity to
consume:
(1) Psychological Concept: Propensity to consume is a
psychological concept. It is influenced by many
subjective factors like tastes of a man, his habits etc.
these factors remain constant in the
• short run.
(2) Unequal Propensity to Consume: propensity
to consume of the poor class is greater than the
propensity to consume of the rich class. The
reason being, that due to low income of the
poor they are forced to spend their entire
income on consumption, whereas the income of
the rich class being more they meet their entire
consumption by spending only a part of it.
3) Income and employment depend on propensity
to consume: income and employment are directly
related to propensity to consume. With increase
in propensity to consume, thee is increase in total
consumption, as a result of it there is increase in
income and employment. Contrarily, with
decrease in propensity to consume there is
decrease in total consumption, as a result, there is
decrease in income and employment.
4) Consumption in the short-run: consumption
expenditure in the short run depends on
autonomous consumption and MPC.
Autonomous consumption means that
minimum consumption that an individual must
make even when his income is zero. Hence, C =
C0+bY (C= consumption expenditure, C0=
autonomous consumption,
b= MPC, Y= income)……..
• In the short run, consumption increases less than
increase in income. Hence, propensity to consume
goes on falling with increase in income.
5) Long run consumption Function: in the long run,
consumption depends entirely on MPC. It is so
because in the long run, no individual can spend
without income. As such, there is no autonomous
consumption in the long run. Hence, in the long run,
propensity to consume does not fall with increase in
income. It remains constant.
3. Kinds or Technical Attributes of the Propensity to
consume: consumption function or propensity to
consume is of two kinds:
1) Average Propensity to Consume (APC)
2) Marginal Propensity to Consume (MPC)
3.1 Average propensity to Consume: supposing the
national income of Afghanistan is Rs.1000 cr. Of it
Rs.800 cr were spent on consumption it means that
Afghanistan spent 800/1000 percent of its income on
consumption. It will be called
APC. It explained what part of its total income
will people spend on consumption.
Definition: “ The average propensity to consume
is the ratio of consumption expenditure to any
particular level of income”.
“ The APC is the proportion of the income which
is spent on consumption”.
2) Explanation: APC can be explained with the
help of the following formula:
APC = C/Y
For instance, if out of a total income of Rs. 100cr
A sum of Rs. 80cr is spent on consumption, then
APC= C/Y= 80/100= 0.8
APC can be expressed in the form of a table:
Table 2. Average Propensity to Consume
Income (Rs) Consumption Expenditure APC=C/Y

100 80 80/100=0.8

200 120 120/200=0.6

• It is clear from the above table that APC can
be calculated by dividing total consumption
expenditure by total income. APC is also
expressed diagrammatically, as shown in (Fig.5
p 103) in this figure, income is shown on OX-
axis and consumption on OY-axis. CC is
consumption curve. This curve indicates that
at point A , APC= C/Y= 80/100=0.8 and at
point B, APC=120/200=0.6
As this curve is sloping upwards, APC is falling.
3.2. Marginal Propensity to Consume:
supposing the national income of Afghanistan
increases from Rs.1000 cr to Rs.1200 cr and
consumption expenditure increases from Rs.
800 cr to Rs. 900 cr, then the ratio of change in
consumption by Rs. 100 cr as a result of
change in income by Rs.200 cr will be called
MPC. Thus, Afghanistan’s MPC will be
100/200=0.5 or 50%
• Definition: “The MPC is the ratio of a change
in consumption to a change in income”.
• The MPC many be defined as the change in
consumption expenditure, divided by the
change in income that causes it.”
• Explanation: MPC is explained with the help
of the following formula:
MPC= C/Y (= change)
• For example, if income increases from Rs.100 cr to
Rs. 200 cr, then change in income is of Rs.100 cr.
(Y= Rs.200cr-Rs.100cr). On account of change in
income, consumption increases from Rs. 80cr to Rs.
120 cr. Thus, change in consumption is of Rs. 40 cr.
(C=Rs.120 cr - Rs.80 cr). Hence,
MPC= C/ Y=40/100=0.4 %
Table 3. Marginal Propensity to Consume

Income Y Consumption C MPC= C/ Y

100 80

200 200-100=100 120 120-80=40 40/100=0.4

300 300-200=100 150 150-120=30 30/100=0.3

• In (Fig. 6.p 104), income is shown on OX-axis and
consumption on OY-axis. CC is consumption curve.
MPC shown by point ‘A’ on this
curve=C/Y=40/100=0.4
3.3. Characteristics of MPC:
Main characteristics of the concept of MPC are as
follows:
1) It is always Positive: it means that consumption
expenditure must increase when there is increase in
income. It is not possible that increase in income may
lead to fall in consumption expenditure.
2)Generally MPC is greater than zero and less
than unity: it is so because with an increase in
income there must be some increase in
consumption. However, only a part of the
increased income will be spent on
consumption. The entire income is not spent
on consumption, hence MPC is less than Unity
,it can be expressed in the form of an equation
as follows: C/Y>0; C/Y< 1
3) MPC of the poor class is Higher: MPC of the
poor class is higher than MPC of the rich class.
it is so because the income of the poor class is
low and it spends a large part of increased
income on consumption. Likewise, MPC in the
underdeveloped countries I higher than in the
developed countries.
4) Falling MPC in the short run: MPC tends to
fall with increase in income in the short run. It
means that ratio of increase in consumption in
the short run is less than increase in income.
5)Constant MPC in the Long run: MPC tends to
remain constant in the long run. It means that
change in income is followed by change in
consumption almost in the same ratio.
6) MPC can be greater than Unity in Abnormal
conditions: those who are extremely poor,
their consumption is more than income. So
their MPC is greater than unity (>1 or =1).
They are forced to borrow.
3.4. Causes of the Fall in MPC with the Increase in
Income:
1) Fulfillment of Basic and Important Wants: when
the basic and important want of the people like
housing, clothing, fuel etc are fulfilled, their
expenditure is restricted largely to the satisfaction
of ordinary daily needs. Consequently, when their
income increases, they begin to save more and
spending less and less out of increased income.
2) Constant habit in the short run: Ordinarily,
there is no change in the habits of the people
in the short run, although income tends to
increase. Increase in income accompanied by
not change in habits, in short period, results
into less proportionate increase in
consumption.
3) Consumption and level of Income in the Past:
consumption expenditure does not depend
upon existing income alone, but is also
influenced by the level of income enjoyed by
the people in the past. Hence, when existing
income increases, consumption does not
increase in the same proportion.
4) Uncertainty of Future: because of uncertainty
of future, people do save in the present so as
to face future crises or to meet the
unforeseen requirements arising in future.
Thus, rise in consumption tends to lag behind
the rise in income.
3.5 Difference and Relation between APC and MPC:
1) APC is the ratio of total consumption to total
income (APC = C/Y). MPC is the ratio of change
in consumption to change in income
(MPC=C/Y).
2) In the short run, when C=C0+by, average
propensity to consume goes on falling but MPC
remains constant. So that in the short run APC
tends to be more than MPC.
3) In the long run, when C = bY , both APC and MPC
tend to remain constant and APC tends to be equal
MPC, (APC=MPC)
4. Propensity to Save and Saving Function:
Propensity to save is a schedule showing relation
between income and saving at different levels of
income. According to Keynes, saving is also a
function of income. Saving increases with increase
in income and decreases with decrease in income.
Saving is income elastic. S=f(Y)
• Definition: “ Saving function or propensity to
save may be defined as schedule showing
amounts that will be saved at different level of
income”.
• Kinds of Propensity to Save: it is of two kinds:
1) Average Propensity to Save: APS is the ratio
of to disposable income at a given level of
income. APS= S/Y
• Income (Y) is either consumed (C) or saved (S)
{C+S=Y } , {C/Y+S/Y=Y/Y=1} , { APC+ APS=1}
it is clear that at each level of income, sum of APC
and APS is =1. supposing APC=0.8, then APS must
be 0.2.
APC + APS= 0.8+0.2=1
2) Marginal propensity to Save: MPS is the ratio of
change in saving to change in income.
MPS= S/Y
4.1. Relation between MPC and MPS:
MPC is less than unity. It means that part of increase in
income which is not spent on consumption, is equal to
saving. Thus, the total of MPC and MPS is equal to unity. Or
S+C= Y
S+ C= y
S/ Y+ C/ Y= Y/ Y=1
MPS+MPC=1
Or MPS= 1-MPC
Or S/ Y=1- C/ Y
• If one-half of the increase in income is spent
on consumption, then MPC= ½
As such MPS=1-MPC=1-1/2=1/2
[Link] of Propensity to Consume:
Determinants of PC are broadly classified as:
1. Subjective factors
2. Objective factors
1. Subjective factors: Are those factors which
relate to psychological characteristics of
human nature and social practices and
institutions. These factors relate to the
circumstances when individuals and business
institutions would consume less and save
more. These factors determine the position
and slope of consumption curve. These factors
are divided into two parts:
(i).Individual Factors: following factors influence
consumption and saving of an individuals:
1. Farsightedness: future is uncertain. Hence
individuals gifted with far sight always save in
order to fulfill their anticipated future needs,
cutting down their consumption.
2. Economic Independence: some individuals
spend less and save more so that they may not
depend on other financially.
3. Enlarged Income in Future: People also save
more and consume less so that they many
invest their saving and earn more wealth or
lend it and earn interest.
4. Occupational Motive: In order to start a new
occupation , people save more and spend less.
5. Bequeathing a Fortune: some people save
more and spend less in order to bequeath a
fortune for the progeny.
6. Miserliness: some people are niggardly by nature.
Hence, they tend to save more and consume less.
7. Status in the Society: in the present day world,
man’s status in the society is governed by the
wealth he possesses. No wonder, people amass
wealth by saving more and spending less.
[Link] Motive: people save to meet
unforeseen contingencies and consume less.
(ii) Business Factors: subjective factors influencing
saving and consumption of business sector are as
under:
1. Extension of Business: business firms effect savings
in order to accumulate capital for the extension of
their business.
2. Liquidity Preference: In order to face future
contingencies, business firms prefer to hold their
wealth in cash form and curtail their consumption
expenditure.
3. Change in the Distribution of income:
propensity to consume is also influenced by the
change in the distribution of income. If the
distribution of income is equal, propensity to will
be more. On the contrary, if the distribution of
income is unequal, rich people will have a large
chunk of nation income. Hence, propensity to
consume will be less because the rich have less
propensity to consume than the poor.
4) Windfall Gains and losses: propensity to
consume increases as a result of windfall gains
and decreases as a result of windfall losses.
5) Financial Policy of the Corporations:
propensity of consume is also influenced by
the financial policy of the corporations. If the
policy of the corporation is to distribute the
entire profit among the shareholders then
propensity to consume will increase
On the other hand, if the entire profit is not distributed
among the shareholders and a part of it is kept as a
reserve then the income of the shareholders will remain
restricted, limiting their propensity to consume.
6) Change in Expectations: people’s expectations
regarding future events also influence their propensity
to consume. If people apprehend war or shortage of
goods in future, they will start stock -piling of the goods
in the present, with the result that propensity to
consume will increase.
7) Fiscal Policy: if the government adopts such a
policy as levying of progressive taxes or long
scale spending on social security schemes
then there will be a tendency for more
equitable distribution of income. Equitable
distribution leads to higher propensity to
consume.
8) Changing in the Rate of Interest: rise in the rate of
interest may induce the people to save more and
consume less. Fall in the rate of interest may serve
as a disincentive to save and encourage
consumption.
9) wages: on account of wage cut, income of the
labourers and the poor goes down and distribution
of income goes in favor of the rich whose propensity
to consume is low, propensity to consume falls on
the whole.
10) Liquid Assets: according to Prof. Pigou,
when prices fall, real balances of those who
possess large amount of liquid assets ( such as
cash, saving accounts, government bonds or
shares) tends to increase. As such, they will
spend more and their propensity to consume
will increase.
6. Psychological Law of consumption: according
to this law when income increases,
consumption also increases but increases in
consumption is less than increase in income.
In the words of Keynes, “ the Psychology of
the community is such that when Aggregate
real income is increased, aggregate
consumption is also increased, but not by so
much as income.”
Definition: “The fundamental psychological law,
upon which we are entitled to depend with
great confidence both a priori from our
knowledge of human nature and from the
detailed facts of experience, is that 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 the income.”
• Assumptions:
Keynes’ Psychological Law is based on the
following three assumptions:
1)No change in Psychological and Institutional
Complex: it implies that except change in
income, there is no change in psychological and
institutional complex, such as population,
habits of the people, tastes, fashion, custom,
distribution of income, prices etc.
2) Normal Conditions: it implies that there is no danger of
war or cold war, depression, boom, political upheaval,
revolution etc. in other words, this law applies under
normal conditions alone.
3) Prosperous Capitalist Economy based on Laissez-faire: the
law applies to free and prosperous economy. It means that
the law does not hold good in case of socialist and under
developed economies. In a free economy , people can
consume goods according to their needs and desires.
There is no government interference in the economic
affairs.