- In a two-sector economy (no government), Aggregate Demand (AD) = C + I.
- Equilibrium occurs when planned output (Y) = planned AD.
- Autonomous expenditure (A) = C̄ + Ī; income depends on A and MPC (c).
- If AD < Y, inventories increase; if AD > Y, inventories fall.
- With no government and taxes, GDP = National Income (Y).
Definitions [5]
Average propensity to consume
\[APC=\frac{C}{Y}\]
This means APC = consumption ÷ income.
Marginal propensity to consume
\[MPC=\frac{\Delta C}{\Delta Y}\]
This means MPC = change in consumption ÷ change in income.
Marginal propensity to save
\[MPS=\frac{\Delta S}{\Delta Y}\]
-
Since any extra income is either consumed or saved,
MPC + MPS = 1 -
If MPC is denoted by cc, MPS is often denoted by ss, and
s = 1 − c
Average propensity to save
\[APS=\frac{S}{Y}\]
-
Because total income is either consumed or saved,
APC + APS = 1
Definitions: Investment
- "Investment refers to the increment of capital equipment." — J.M. Keynes
- "By investment we do not mean the purchase of existing paper securities, bonds, debentures or equities, but the purchase of new factories, machines and the like". — Stonier and Hague
- "Investment expenditure includes expenditure for producer’s durable equipment, new construction and the change in inventories." — Peterson
Formulae [4]
Formula for aggregate demand
Aggregate demand (AD) is the total planned spending on domestically produced final goods and services in an economy during a given period.
AD = C + I + G + (X − M)
Where:
- AD: Aggregate demand or aggregate expenditure (total planned spending).
- C: Desired consumption expenditure by households.
- I: Desired investment expenditure by firms.
- G: Desired government expenditure on goods and services.
- X: Exports of goods and services (what foreigners buy from us).
- M: Imports of goods and services (what we buy from other countries).
- (X – M): Net exports (exports minus imports).
Consumption Function
C = F(Y)
The algebraic expression of consumption function is:
𝐶 = \[\overline{C}\] +𝑏𝑌
Where, C = Consumption
\[\overline{C}\] = Autonomous consumption,
i.e. consumption at zero level of income
b = Marginal Propensity to Consume
Y = Disposable income, i.e. income after tax
Formula: Propensity to Invest
PI = `I / Y`
PI = Propensity to invest, I = Aggregate Investment, Y = Aggregate Income
Formula: Investment Function
The relationship between investment and the rate of interest can be written as:
I = f(r)
Here:
- I = Investment, the planned amount of investment; it is the dependent variable.
- r = Rate of interest; it is the independent variable that influences investment.
This notation means that the level of investment depends on the rate of interest.
Key Points
Key Points: Aggregate Demand and Its Components
- AD determines income levels through its four components, each with unique drivers like income for C and rates for I.
- Policy can boost AD by increasing G or lowering interest rates to stimulate growth.
- Understanding planned vs actual demand explains inventory adjustments and equilibrium.
- For exams, memorize the AD formula and one key driver per component.
Key Points: Investment
- Economic investment = addition to physical capital + change in inventories — NOT buying shares/bonds
- Autonomous investment is income-inelastic, welfare-driven, mostly by government; drawn as a horizontal line
- Induced investment is income-elastic, profit-driven, mostly private; drawn as an upward-sloping line
- Gross Investment = Net Investment + Depreciation; net investment positive means capital accumulation
- Ex-ante = planned; Ex-post = actual; equilibrium requires ex-ante S = ex-ante I
- Investment function I = f(r) is downward-sloping — higher interest means less investment
- Invest when MEI > Rate of Interest; stop when MEI = Rate of Interest
Key Points: Determination of Income in Two-Sector Model
Key Points: Effect of an Autonomous Change in Aggregate Demand on Income and Output
- Equilibrium income depends on aggregate demand (AD).
- Increase in autonomous consumption or investment shifts AD upward.
- Rise in investment increases income by more than the initial change.
- This happens due to the multiplier effect.
- New equilibrium is at the intersection of new AD and 45° line.
Key Points: The Multiplier Mechanism
- An increase in autonomous expenditure leads to a more than proportionate rise in income.
- Extra income generates additional consumption based on MPC.
- This creates repeated rounds of income and consumption.
- Multiplier = 1 / (1 − MPC).
- Higher MPC → larger multiplier effect.
Key Points: Paradox of Thrift
- When people try to save more, national income falls.
- Fall in income leads to lower consumption and output.
- As income falls, total saving remains same or falls.
- Thus, higher thrift does not increase total savings.
- This outcome is called the Paradox of Thrift.
Important Questions [15]
- Statement 1: In a two sector economy, consumption expenditure and investment expenditure are the two components of Aggregate Demand.
- Read the following statements carefully: Statement 1: The induced consumption shows, the direct relation between consumption and income. Statement 2: With a certain increase in income,
- Given the Following Data, Find the Missing Value of 'Government Final Consumption Expenditure' and 'Mixed Income of Self Employed'.
- State the meaning of the following: Autonomous Consumption
- At the break-even point level of incomes for the economy is ₹ 10,000 crores and if the people tends to save 20 per cent of their additional income, then calcualte the value of autonomous consumption.
- "In an economy, the autonomous consumption is ₹ 100 and Marginal Propensity to Consume (MPC) is 0.6. If the equilibrium level of Income is 2,000,
- In an economy, the value of Marginal Propensity to Save (MPS) is 0.25, what will be the value of increase in income, if investments increased by ₹ 200 crores?
- If in an economy, the Investment Multiplier is 4 and Autonomous Consumption is ₹ 30 crore, the relevant consumption function would be ______.
- On the basis of following schedule, answer the given questions: Income (in ₹ crores) Savings (in ₹ crores) 0 -20 50 -10 100 0 150 30 200 60
- Distinguish Between Revenue Receipts and Capital Receipts. Give an Example of Each.
- Distinguish between 'Fixed Investment' and 'Inventory Investment'.
- "In an economy ex-ante Aggregate Demand is more than ex-ante Aggregate Supply." Explain its impact on the level of output, income and employment.
- Answer the Following Question. "Indian Rupee (₹) Plunged to an All-time Low of ₹ 74.48 Against the Us Dollar ($)". − the Economic Times in Light of the Above Report, Discuss the Impact of the
- 'Investment multiplier and Marginal Propensity to Consume are directly related to each other'. Explain with the help of numerical example.
- "The Government has raised the exemption limit for the payment of Income tax from ₹ 2 lakh to ₹ 2.5 lakh." If the situation of deficient demand is prevailing in the economy,
Concepts [11]
- Aggregate Demand and Its Components
- Consumption
- Consumption and Saving Propensities
- Investment
- Determination of Income in Two-sector Model
- Determination of Equilibrium Income in the Short Run
- Macroeconomic Equilibrium with Price Level Fixed
- Effect of an Autonomous Change in Aggregate Demand on Income and Output
- The Multiplier Mechanism
- Paradox of Thrift
- Equilibrium Output and Employment
