DR.

VISHWANATH KARAD MIT WPU

SCHOOL OF BUSINESS
BBA - IB SEMESTER II

Unit IV
Consumption Function
and Investment
By: Prof. Mayuresh Shendurnikar
 What is
effective
demand as
pointed out
by John
Keynes?
Now that we know it is the
equilibrium between
Aggregate Demand and
Aggregate Supply, how to
determine the Aggregate
Demand?
The answer for the
question lies in the name
of this 4th unit.
Let us understand the consumption
function in more detail.
What is a
consumption?
The consumption is simply a function
of income. It depends mainly and
directly on income. A positive
relationship between income and
consumption easily states that when
income of the community rises,
consumption would also rise.
Further, Keynes put forward a psychological law of consumption, according to
which, as income increases consumption increases but not by as much as the
increase in income.
While Keynes recognized that many subjective and objective factors including
interest rate and wealth influenced the level of consumption expenditure, he
emphasized that it is the current level of income on which the consumption
spending of an individual and the society depends.

“The amount of aggregate consumption depends mainly on the amount

of aggregate income. 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 (and women, too) are disposed, as a rule and on an average
to increase their consumption as their income increases, but not by as
much as the increase in their income”

--- John Keynes

The consumption function can be
explained well with the schedule
here. It can be seen from the
schedule that how consumption is
getting reflected with an increase
in income level of the community.
The consumption function shows that as
national income increases, consumption
also increases but not as much as income,
due to savings. At an income of Rs. 1200
crores, consumption is Rs. 900 crores, and
at an income of Rs. 1500 crores,
consumption is Rs. 1125 crores. When
income increases from Rs. 1000 crores to
Rs. 1100 crores, consumption increases
from Rs. 750 crores to Rs. 825 crores, with
Rs. 25 crores saved. Similarly, when income
increases from Rs. 1100 crores to Rs. 1200
crores, consumption increases from Rs. 825
crores to Rs. 900 crores.
 Consumption depends on income and
propensity to consume. Propensity to
consume depends on various factors
such as price level, interest rate,
What determines stock of wealth and several
subjective factors. Since Keynes was
consumption? concerned with short-run
consumption function he assumed
price level, interest rate, stock of
wealth etc. constant in his theory of
consumption. Thus, with these factors
being assumed constant in the short
run, Keynesian consumption function
considers consumption as a function
of income.

Thus, C= f(Y)
 In a mathematical form, Keynesian
function can be written as:

C = a + b(Y)

Mathematical where a and b are constants.

Formula While a is intercept term of the

consumption function, b stands for
the slope of the consumption
function and therefore represents
marginal propensity to consume
(MPC). MPC refers to change in
consumption in response to
change in income.
The Keynesian consumption function is
represented by a curve (CC') in the diagram,
with national income measured along the X-
axis and consumption measured along the Y-
axis. The curve deviates from the OZ, with
consumption exceeding income at lower
income levels. As income increases,
consumption also increases but at a
diminishing rate. At the income level OY0,
consumption equals income, but beyond this
point, the gap between consumption and
income widens, representing savings. With
an increase in income, saving also increases.
It is useful to point out here that when the
consumption function of a community changes, the
whole consumption function curve changes or
shifts. When propensity to consume increases, it
means that at various levels of income more is
consumed than before. Therefore, as a result of
increase in propensity to consume of the
community, the whole consumption function curve
shifts upward as has been shown by the upper
curve C’C’ in diagram beside. On the contrary,
when the propensity to consume of the community
decreases, the whole consumption function curve
shifts downward signifying that at various levels of
income, less is consumed than before.
There are two important concepts
of propensity to consume, the one
being average propensity to
consume and the other marginal
propensity to consume.
Average Average propensity to consume is the ratio
of the amount of consumption to total
Propensity income. Therefore, average propensity to
to Consume consume is calculated by dividing the
amount of consumption by the total income.
(APC)
Thus, APC = C/Y,

where APC stands for average propensity to

consume, C for amount of consumption, and
Y for the level of income.
In the above table, it can be seen that at the level of income Rs 1000 crores, consumption
expenditure is equal to Rs. 750 crores. Therefore, average propensity to consume is here
equal to 750/1000 = 0.75. Likewise, when the income rises to Rs. 1200 crores, consumption
rises to Rs. 900 crores. Therefore, the average propensity to consume will be 900/1200 =
0.75. In this schedule of consumption function, the average propensity to consume is the
same at all levels of income.
 The concept of marginal propensity to consume is
Marginal very important, because from it we can know how
much part of the increment in income is consumed
Propensity and how much saved. Marginal propensity to
to Consume consume is the ratio of change in consumption to
the change in income.
(MPC)
Thus, MPC = ΔC/ΔY

where, MPC stands for marginal propensity to

consume, ΔC for change in consumption, and ΔY
for change in income. marginal propensity to
consume is the ratio of change in consumption to
the change in income, i.e. ΔC/ΔY.
When average propensity to consume remains constant as in above table,
marginal propensity to consume is equal to it. In the above table, average
propensity to consume remains constant at 0.75 and from its 4th column it will
be seen that marginal propensity to consume is also 0.75.
 Calculate the APC and MPC for the
following:

Mathematical
The level of income in an economy rises from Rs.
20,000 crores to Rs. 70,000 crores; and as a result,

Problems
the consumption rises from Rs. 15,000 crores to Rs.
45,000 crores. Calculate the MPC.

Calculate the MPC for the following:

Now, let us understand the savings
function in more detail.
What is a saving?
Saving is that part of income which is not spent
on current consumption. The relationship
between saving and income is called saving
function.
Simply put, saving function (or propensity to
save) relates the level of saving to the level of
income. It is the desire or tendency of the
households to save at a given level of income.
Thus, saving (S) is a function (f) of income (Y).
Symbolically,
S = f (Y)
Two noteworthy features of
saving function are:

(i) Saving can be negative (-) at Features of

zero or low level of income.
Savings
(ii) As Income increases, savings
also increase.
The savings function can be
explained well with the schedule
here. It can be seen from the
schedule that how saving is
getting reflected with an increase
in income level of the community.
The savings function shows that as
national income increases, saving also
increases. At an income of Rs. 1200
crores, saving is Rs. 300 crores, and
at an income of Rs. 1500 crores,
saving is Rs. 375 crores. When
income increases from Rs. 1000
crores to Rs. 1100 crores, saving
increases from Rs. 250 crores to Rs.
275 crores. Similarly, when income
increases from Rs. 1100 crores to Rs.
1200 crores, saving increases from
Rs. 275 crores to Rs. 300 crores.
In this Fig., we show the savings curve. The
saving curve SS shows the gap between
consumption curve CC and the income
curve OZ in the upper panel of Fig. It will be
seen that up to income level OY1,
consumption is more than income, that is,
there is dissaving. Beyond income level
OY1, there is positive saving. As average
propensity to consume (APC) falls with the
increase in income in the upper panel,
average propensity to save (APS) rises as
income increases. Thus, in Fig. with the
increase in income not only the absolute
amount of saving increases, the average
propensity to save also increases.
There are two important concepts
of propensity to save, the one
being average propensity to save
and the other marginal
propensity to save.
Average Average propensity to save is the proportion of
income that is saved (i.e. not consumed).
Propensity
to Save Mathematically,
APS= Savings/Income = S/Y
(APS)
Like the average propensity to consume (APC)
average propensity to save also changes as income
increases. According to Keynes, average propensity
to consume (APC) falls as income increases. This
implies that average propensity to save (APS) will
increase as income rises.
In the above table, it can be seen that at the level of income Rs 200 crores, saving is
equal to Rs. 30 crores. Therefore, average propensity to save is here equal to 30/200
= 0.15. Likewise, when the income rises to Rs. 400 crores, saving rises to Rs. 90
crores. Therefore, the average propensity to consume will be 90/400 = 0.225. In this
schedule of savings function, the average propensity to save is the increasing at all
levels of income.
 Marginal propensity to save represents how much
Marginal of the additional income is devoted to saving.

Propensity The marginal propensity to save is therefore

to Save change in savings induced by a change in the
income.
(MPS)
Thus, mathematically, MPS = ΔS/ΔY

For example, if disposable income increases from

rupees 10,000 to 12,000 and this causes planned
savings to increase by Rs. 500 crores, marginal
propensity to save is: MPS = 500/2000 = 1/4 =
0.25
When average propensity to save shows an increasing trend as in above table,
marginal propensity to save remains constant. This constancy in MPS is due to
the assumption of same change in the level of income all the time i.e. 100. In
real life, change in income is not same all level, thus, MPS does not remain same
accordingly.
 Relationship between APC and APS

The sum of the Average Propensity to Consume (APC) and Average Propensity to Save (APS) is equal to one.

Proof:
We already know that Y = C + S.
Now dividing both sides by Y, we get
(Y/Y) = (C/Y) + (S/Y) ===> 1 = APC + APS

Also, APC + APS = 1 because the income is either used for consumption or for saving.
 Relationship between MPC and MPS

The sum of the Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS) is equal to
one.

Proof:
We already know that dY = dC + dS.
Now dividing both sides by dY, we get
(dY/dY) = (dC/dY) + (dS/dY) ===> 1 = MPC + MPS

Also, MPC + MPS = 1 because total increment in income is either used for consumption or for saving.
 From the following schedule, compute
APS and MPS.

Mathematical The level of income in an economy falls from Rs.

70,000 crores to Rs. 65,000 crores; and as a result,

Problems the saving falls from Rs. 25,000 crores to Rs. 22,000
crores. Calculate the MPS.

Calculate the MPS for the following:

What is investment exactly? How does it get determined?

Is it so important? What is investment multiplier?

 The term investment means purchase of stocks and shares,
debentures, government bonds and equities. According to
Keynes, it is only financial investment and not real investment.
This type of investment does result in an addition to the stock of
real capital of the nation. In the views of Keynes, Investment
includes expenditure on capital investment.

Meaning of Real investment refers to investments in productive capital stock

Investment that increase the demand for human and physical resources,
leading to an increase in employment. It includes the building of
new machines, factory buildings, roads, bridges, and an increase
in inventories. On the other hand, financial investment, which
involves the exchange of money from one person to another,
does not affect the level of employment in an economy.
Investment is a flow variable, and its counterpart is a stock
variable called capital.
In Keynesian economics, the level of income, output, and
employment in an economy depends on effective
demand, which is influenced by consumption and
investment expenditures. Consumption is considered
stable in the short term, so changes in effective demand
are traced through fluctuations in investment. Investment
plays a crucial role in determining the level of income, Importance of
output, and employment because it must bridge the gap
between an increase in income and consumption caused Investment
by the psychological law of consumption. According to
this law, consumption increases less than the increment in
income, which means that some income is saved. If this
gap is not plugged by an increase in investment, the result
could be an unintended increase in inventories leading to
depression and mass unemployment.
The investment which depends upon
the profit expectations and has a direct Induced Investment
influence of income level on it is
known as Induced Investment. Induced
Investment is income elastic. It means
that the induced investment increases
when income increases and vice-versa.

The graph on the side shows that the

induced investment curve II has an
upward slope from left to right. It
indicates that as the income increases
from OY to OY1, the investment also
increases from OM to OM1.
The investment on which the change in income level
does not have any effect and is induced only by
profit motive is known as Autonomous Investment. Autonomous Investment
Autonomous Investment is income inelastic. It
means that if there is a change in income
(increase/decrease), the autonomous investment will
remain the same. In general, autonomous
investments are made by the Government in
infrastructural activities. However, a country’s level
of autonomous investment depends upon its social,
economic, and political conditions. Therefore, the
investment can change when there is a change in
technology, or there is a discovery of new resources,
etc.

The graph on the side shows that the amount of

investment remains the same, i.e., OI, no matter
whether the income level in the economy is OY or
OY1.
 Private investment is influenced by the marginal efficiency

Determinants of of capital and the rate of interest. However, the marginal

efficiency of capital depends on future expectations, which
Investment are unpredictable, causing private investment to be volatile
and often low. Entrepreneurs only invest when the marginal
efficiency of capital is higher than the rate of interest.
Classical economists believed that investment was regulated
by the rate of interest, but this view was challenged during
the Great Depression. Keynes also believed in the
importance of the rate of interest initially but later realized
that investment was more influenced by psychological
factors, such as the marginal efficiency of capital.
Nonetheless, both the marginal efficiency of capital and the
rate of interest determine investment.
Determinants of
Public investment is crucial in times of economic depression
as it is independent of the profit motive and can guide more

Investment investment. A steady investment is necessary for the

investment multiplier to have a positive effect on income,
output, and employment. The government can prevent
public investment from leaking out of the spending stream
and time it to let the multiplier have its full and free play.
Public investment can create wealth and generate
employment, and its adverse tertiary effects can be offset
by the beneficial effects of the multiplier on private
consumption. Therefore, it is important to analyze measures
that stimulate investment.
Investment Multiplier

The term investment multiplier refers to the concept that any increase in public or private
investment spending has a more than proportionate positive impact on aggregate income and
the general economy. It is rooted in the economic theories of John Maynard Keynes.

The multiplier attempts to quantify the additional effects of investment spending beyond those
immediately measurable. The larger an investment’s multiplier, the more efficient it is in creating
and distributing wealth throughout the economy.
The investment multiplier measures the
economic impact of public or private
investment by considering the increase in
income for workers and suppliers. John
Maynard Keynes suggested that
governments can stimulate economic
growth by using multipliers like the
investment multiplier. The formula for the
investment multiplier depends on the
marginal propensity to consume and the
marginal propensity to save.
 Investment Mathematical
Multiplier
= Formula
1 / (1 - MPC)
Examples

Consider the road-construction workers in our

Like individuals, businesses must “consume” a
previous example. If the average worker has
significant portion of their income by paying
an MPC of 70%, that means they consume Rs.
for expenditures such as employees’ wages,
0.7 out of every Rupee they earn, on average.
facilities’ rents, and the leases and repairs of
In practice, they might spend that Rs. 0.7 on
equipment. A typical company might consume
items such as rent, gasoline, groceries, and
90% of its income on such payments, meaning
entertainment. If that same worker has an
that its MPS—the profits earned by its
MPS of 30%, that means they would save Rs.
shareholders—would be only 10%.
0.3 out of every Rupee earned, on average.
Examples

The Investment Multiplier for the example The Investment Multiplier for the example
about workers in the previous slide will be: about businesses in the previous slide will be:

1 / (1-MPC) 1 / (1-MPC)
= 1 / (1-0.7) = 1 / (1-0.9)
= 1 / 0.3 = 1 / 0.1
= 3.3333 = 10
 1
Calculate the Investment Multiplier
when the MPC is 0.6

2
The level of income in an economy rises from Rs.

Mathematical 20,000 crores to Rs. 70,000 crores; and as a result,

the consumption rises from Rs. 15,000 crores to
Problems Rs. 45,000 crores. Calculate the Investment
Multiplier.

3
The level of income in an economy falls from Rs.
80,000 crores to Rs. 75,000 crores; and as a result,
the saving falls from Rs. 25,000 crores to Rs.
22,000 crores. Calculate the Investment Multiplier.
From the entire presentation of this unit, I am somehow hoping that the
readers and learners are now somewhat done with the conceptual clarity
about those economic activities which they are always keeping doing since
a very long time viz. Consumption (always), Savings (mostly) and
Investment (maybe).

It is very easy to keep doing all the economic activities rationally, but very
difficult to explain them and that too rationally. So, keep studying and keep
learning!

All the best! Thanks for your patient reading!

--- Prof. Mayuresh Shendurnikar