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Ex-post Investment:. This refers to the actual investment made by all entrepreneurs in the economy during a given period. It is the outcome of actual investment. However, it cannot always be at full employment and may be less than full employment.
The quantity of real GDP that will exist when AD intersects Short Run Aggregate Supply in a short-run macroeconomic equilibrium is the amount of aggregate output produced. Closed Economy: In the framework of a two-sector model households and firms , the determination of equilibrium output will be investigated. It implies that there is no government or international sector. Self contained Investment: It is assumed that investment expenditure is self-contained, i.
Short-period analysis: This analysis is with reference to short period only. It indicates that whatever the producers intended to manufacture during the year is exactly equal to what the buyers intended to purchase during the year. To curb this situation, the producers will enhance the level of output and production such that AS could increase and become equal to AD, and the situation of equilibrium is restored.
To curb this situation, the producers will decrease the level of output and production such that AS could decrease and become equal to AD, and the situation of equilibrium is restored. Explanation of Diagram. The quantity of money removed S from the economy equals the amount of money put I into the economy at this point. Two Situations:. In order to clear the stocks, producers will cut production, resulting in a decrease in output.
As a result, the economy's income decreases. Less income means less savings, and this cycle will continue until saving equals investment. This means that AD outnumbers AS in the economy. As a result, manufacturers will increase output to compensate for the situation.
As a result, investment rises to the point where it equals investment. So, equilibrium is reached when:. Additionally, AS is the sum of consumption C and saving S :. When we substitute ii and iii into i , we get:. Full employment: This occurs when all those who are able and willing to work at the prevailing wage rate are given the opportunity to do so. Voluntary unemployment: This occurs when a person is able to work but unwilling to work at the prevailing wage rate.
Involuntary unemployment: This occurs when a worker is able and willing to work at the prevailing wage rate but is unable to find work. Under employment: It occurs when all those who can work at current wage rates are unable to find work. The multiplier shows us what the eventual change in income will be as a result of a change in investment. Changes in investment lead to changes in income.
The aggregate demand rises when the autonomous measures A rise. As a result, output and income will rise in the next round, causing consumption and the AD to rise. This is referred to as the multiplier mechanism. It is represented symbolically by:. The process of income generation is shown below. From the whole increase in income, Rs. The derivation of the sum of total increase in income is shown below.
The investment multiplier K is the ratio of the change in income Y caused by the change in investment I. The value of the investment multiplier ranges from one to infinity. It occurs when aggregate demand exceeds aggregate supply, resulting in full employment. Reasons for excess demand:. Rise in household consumption demand due to increased propensity to consume. Rise in private investment demand because of higher provision and availability of credit facilities.
Higher public government expenditure. Rise in demand for exports. Rise in supply of money. Rise in disposable income. Impact of Excess demand on:. General Price Level: General price level increases as when aggregate demand exceeds aggregate supply at a full employment level, there is a situation of inflation in the economy. Output: It has no impact on output, as the economy is already at full employment level, thus no idle capacity exists.
Hence, one cannot raise the output more than already. Employment: No impact on employment level. The economy is already operating at full employment equilibrium. It occurs when AD falls short of AS at full employment. It's referred to as deficient demand. Reasons for Deficient demand:. Fall in household consumption demand due to decreased propensity to consume. Fall in private investment demand because of lesser provision and availability of credit facilities. Reduced public government expenditure.
Fall in demand for exports. Fall in supply of money. Fall in disposable income. Impact of Deficient demand on:. General Price Level: General price level falls as when aggregate demand is less than aggregate supply at a full employment level, there is a situation of deflation in the economy.
Output: Low output levels, due to unemployment, and reduced investment. Employment: Low employment levels, as there will be a case of involuntary unemployment. The difference between actual aggregate demand and the level of aggregate demand required to achieve full employment is known as the inflation gap. It assesses the magnitude of excess demand.
As the output could not be increased beyond the full employment level, prices will rise, and there will be a situation of inflation in the economy. Deflationary gap refers to the difference between the actual aggregate demand and the level of aggregate demand required to achieve full employment. It assesses the degree of deficient demand. The area between a and b shows deflationary gap, as here the Aggregate supply is greater than that of aggregate demand.
Fiscal Policy:. Fiscal policy refers to the general government's expenditure and income policies used to achieve its objectives. It includes:. Change in taxation:. Taxation is used to represent revenue policy. Excess Demand: During an inflationary period, the government raises taxes, resulting in a loss in people's purchasing power.
This is due to the fact that in order to limit excess demand, the economy's liquidity must be reduced. Deficient Demand: In case of deficient demand, tax rates. Change in public expense:. The government must invest heavily in public works projects like roads, buildings, and irrigation systems. Excess Demand: During an inflationary period, the government should limit lower its expenditure on public works such as roads, buildings, and irrigation projects, therefore reducing people's money income and consumer requirements.
Deficient Demand: During deficient demand, the government should increase its expenditure on public works such as roads, buildings, and irrigation projects, therefore increasing people's money income and consumer requirements.
A Shift in public borrowing:. Excess Demand: This measure implies that the government should borrow money from the general population, which reduces people's purchasing power by leaving them with less money. As a result, during periods of high demand, the government should resort to increased public borrowing. Deficient Demand: This measure implies that the government should reduce the borrowings from the general population, which increased people's purchasing power.
As a result, during periods of deficient demand, the government should resort to reduced public borrowing. Monetary Policy:. It is the policy of a country's central bank to control the amount of money in circulation and the availability of credit in the economy. Quantitative measures:. These instruments do not direct or restrict credit flow to specific sectors of the economy. Bank Rate :. The bank rate is the interest rate at which a central bank lends money to commercial banks with no security.
Hence the aggregate demand falls down with a low credit creation and supply of money in the economy. Hence the aggregate demand increases as a result of high credit creation and supply of money in the economy. It is the minimum percentage of a bank's total deposits that it must keep with the central bank. As a matter of law, commercial banks must keep a certain percentage of their deposits with the central bank in the form of cash reserves.
It specifies the minimum proportion of net total demand and time obligations that commercial banks must retain with themselves. It consists of the central bank purchasing and selling government assets and bonds on the open market. Excess Demand: In situations of excess demand, the central bank should sell the government assets and bonds in the open market. This reduces the ability of commercial banks to provide loans, thus reducing the levels of aggregate demand.
Deficient Demand: In situations of deficient demand, the central bank should buy the government assets and bonds in the open market. This increases the ability of commercial banks to provide loans, thus increasing the levels of aggregate demand, due to higher purchasing power in the hands of people..
Qualitative measures:. Marginal requirement:. Commercial banks extend loans to businesses and dealers in exchange for the security of their commodities. The bank will never grant credit equivalent to the entire amount of the security. It is never worth more than the security.
Excess Demand: In situations of excess demand, the margin requirements are raised, as it discourages the borrowers because high margin required means less amount of loan provided to them. Deficient Demand: In situations of deficient demand, the margin requirements are reduced so as to encourage the borrowers to take loans, as low margin required means more amount of loan provided to them. Credit rationing : The central bank can use this approach to direct commercial banks not to lend for specific reasons or to lend more for specific objectives or priority sectors.
Moral suasion : Moral suasion refers to the central bank's persuasion, request, informal suggestion, advice, and appeal to commercial banks to cooperate with the central bank's overall monetary policy. Excess Demand: In cases of excess demand, the central bank requests for contraction of credit. Deficient Demand: In cases of deficient demand, the central bank requests for extension of credit.
It is defined as a situation in which people tend to save more money, and this increased saving leads to reduced consumption, resulting in a decrease in aggregate consumption. Such a savings system reduces employment levels, reduces total economic savings, and slows economic growth. This is regarded as a crucial component of Keynesian economics.
It refers to the total amount of goods and services supplied by all the producers within an economy during a year. It is also known as total output. Growth in population, increased physical capital stock and technological progress are some events that increase the aggregate supply. It is denoted by AS. Consumption C. Saving S. When capital increases, the number of goods and services increases resulting in a drop in rates.
The consumption function describes a functional relationship between total consumption and total disposable income. The consumption function assumes that when the rate of income changes then the consumption also changes. However, if the income becomes zero then consumption still takes place.
Hence, it is independent of income and so it is called autonomous consumption. The autonomous consumption is denoted by C and it represents the consumption is independent of income. The average propensity to consume APC : It is the measurement of consumption per unit of income. This can be used by any individual or an economist to understand the expenses and savings.
Marginal Propensity to Consume MPC : Marginal Propensity to consume is the ratio of change in consumption expenditure to change in total income. For example: Suppose, your income increases from Rs. This shows that the entire income is not spent but saves a fraction. Different people plan to consume a different proportion of their additional income.
Therefore, MPC is defined as a measure of the rate at which aggregate consumption expenditure changes as income changes. Example — If income and consumption values are. Income Y Consumption expenditure C. If the consumption function is given on the presumption of the constant marginal propensity to consume. It is called linear consumption. The saving function or propensity to save establishes a functional relationship between total saving and total income.
Total income. Average Propensity to save is a term that refers to the total amount of income saved instead of spending on goods and services. It represents the percentage of total household disposable income. Marginal Propensity to save refers to the small increase in income that is saved instead of spending on goods and services. It represents the change in savings per unit change in income. In the same example above:. Investment refers to the addition to the existing stock of physical capital like machines, buildings, etc.
The producer decides on the additional investment depending largely on the market rate of interest. We assume that producers plan to invest the same amount every year. Where, I is a positive constant representing the autonomous investment in the economy in a given period.
Induced Investment: Induced investment refers to the investment that is influenced by the profit expectations and level of income. In other words, multiple increment in income as a result of a given net increase in investment does not only take place in money terms but also in terms of real output, that is, in terms of goods and services. When incomes increase as a result of investment and these increments in income are spent on consumer goods, the output of consumer goods is increased to meet the extra demand brought about by increased incomes.
Therefore, real income or output increases by the same amount as the increment in money incomes, since the prices of goods have been assumed to be constant. Of course, we have assumed, that there exists excess productive capacity in the consumer goods industries so that when the demand for consumer goods increases, their production can be easily increased to meet this demand. However, if due to some bottlenecks output of goods cannot be increased in response to increasing demand, prices will rise and as a result the real multiplier effect will be small.
Th e level of national income is determined by the equilibrium between aggregate demand and aggregate supply. With such a diagram we can explain the multiplier. The multiplier is illustrated in Fig. In this figure C represents marginal propensity to consume.
Therefore, the slope of the curve C of marginal propensity to consume curve C has been taken to be equal to 0. It will be seen from Fig. If investment increases by the amount EH we can then find out how much increment in income occur as a result of this. On measuring it will be found that Y 1 Y 2 is twice the length of EH. The multiplier can be illustrated through savings investment diagram also.
The multiplier can be explained with the help of savings investment diagram, as has been shown in Fig. In this figure SS is the saving curve indicating that as the level of income increases, the community plans to save more. II is the investment curve showing the level of investment planned to be undertaken by the investors in the community. The investment has been taken to be a constant amount and autonomous of changes in income. This investment level OI has been determined by the marginal efficiency of capital and the rate of interest.
Investment being autonomous of income means that it does not change with the level of income. Keynes treated investment as autonomous of income and we will here follow him. With this increase in investment, the investment curve shifts to the new dotted position TF. This new investment curve II intersects the saving curve at point F and a new equilibrium is reached at the level of income OY 2 A glance at Fig.
On measuring these increments in income and investment it will be found that the increment in income Y 1 Y 2 is two times the increment in investment II. We have seen above that as a result of increase in investment, the level of income increases by a multiple of it. In our above analysis, saving is a leakage in the multiplier process. Had there been no saving and as a result marginal propensity to consume were equal to 1, the multiplier would have been equal to infinity. In that case as a result of some initial increase in investment, income would go on rising indefinitely.
Since marginal propensity to consume is actually less than one, some saving does take place. Therefore, multiplier in actual practice is less than infinity. But besides saving, there are other leakages in the process of income generation which reduce the size of the multiplier. Therefore, the increase in income as a result of some increase in investment will be less than warranted by the size of the multiplier measured by the given marginal propensity to consume.
We explain below the various leakages that occur in the income stream and reduce the size of multiplier in the real world. The first leakage in the multiplier process occurs in the form of payment of debts by the people, especially by businessmen. In the real world, all income received by the people as a result of some increase in investment is not consumed.
A part of the increment in income is used for paying back the debts which the people have taken from moneylenders, banks or other financial institutions. The incomes used for paying back the debts do not get spent on consumer goods and services and therefore leak away from the income stream.
This reduces the size of the multiplier. Of course, when incomes received by the moneylenders, banks or institutions are again lent back to the people, they come back to the income stream and enhance the size of multiplier. But this may or may not happen. If the people hold apart of their increment in income as idle cash balances and do not use it for consumption, they also constitute leakage in the multiplier process.
As we have seen, people keep part of their income for satisfying their precautionary and speculative motives, money kept for such purposes is not consumed and therefore does not appear in the successive rounds of consumption expenditure and therefore reduces the increments in total income and output. In our above analysis of the working of the multiplier process we have taken the example of a closed economy, that is, an economy with no foreign trade.
If it is an open economy as is usually the case, then a part of increment in income will also be spent on the imports of consumer goods. The proportion of increments in income spent on the imports of consumer goods will generate income in other countries and will not help in raising income and output in the domestic economy.
Therefore, imports constitute another important leakage in the multiplier process. We, therefore, see that the size of multiplier instead of being equal to 4, as it would have been in the case of a closed economy, is equal to 2 in the open economy with — as the marginal propensity to import. Taxation is another important leakage in the multiplier process. The increments in income which the people receive as a result of increase in investment are also in part used for payment of taxes.
Therefore, the money used for payment of taxes does not appear in the successive rounds of consumption expenditure in the multiplier process, and the multiplier is reduced to that extent. However, if the money raised through taxation is spent by the Government, the leakage through taxation will be offset by the increase in Government expenditure.
But it is not necessary that all the money raised through taxation is spent by the Government as it happens when Government makes a surplus budget. No doubt, if the Government expenditure increases by an amount equal to the taxation, it would not have any adverse effect on the increases in income and investment and in this way there would be no leakage in the multiplier process. Price inflation constitutes another important leakage in the working of the multiplier process in real terms.
The multiplier works in real terms only when as a result of increase in money income and aggregate demand, output of consumer goods is also increased. When output of consumer goods cannot be easily increased, a part of the increases in the money income and aggregate demand raises prices of the goods rather than their output. Therefore, the multiplier is reduced to the extent of price inflation. In developing countries like India the extra incomes and demand are mostly spent on food-grains whose output cannot be increased so easily.
Therefore, the increments in demand raise the prices of goods to a greater extent than the increase in their output. Besides, in developing countries like India, there is not much excess capacity in many consumer goods industries, especially in agriculture and other wage-goods industries. Therefore, when income and demand increase as a result of increase in investment, it generally raises the prices of these goods rather than their output and therefore weakens the working of the multiplier in real terms.
Thus, it was often asserted in the past that Keynesian theory of multiplier was not very much relevant to the conditions of developing countries like India. The above various leakages reduce the multiplier effect of the investment undertaken. If these leakages are plugged, the effect of change in investment on income and employment would be greater. In our above analysis of multiplier with aggregate demand curve, it is assumed that price level remains constant and the firms are willing to supply more output at a given price.
How much national income or GNP increases as a result of any autonomous expenditure such as government expenditure, investment expenditure, net exports is determined by a shift in aggregate demand curve by the size of simple Keynesian multiplier when price level is fixed.
This implies a horizontal short-run supply curve. However, as studied above, short-run aggregate supply curve slopes upward as the firms are willing to supply additional output in the short run only at a higher price level. With short-run aggregate supply curve sloping upward, a rightward shift in aggregate demand curve raises new equilibrium GNP level not equal to the horizontal shift in the aggregate demand curve but less than it.
Consequently, the size of multiplier is smaller than that of simple Keynesian multiplier with a given fixed price level. This is because a part of expansionary effect of GNP of the increase in autonomous government expenditure is offset by rise in the price level. The multiplier effect in case of upward sloping curve is shown in Fig.
To begin with, in the top panel of Fig. In the panel at the bottom of Fig. Now suppose autonomous investment expenditure which is independent of changes in price level increases by AI. As will be seen from the lower panel b of Fig. Now, with this rise in price level to P 1 , aggregate expenditure curve in the upper panel a will not remain unaffected but will shift downward. This fall in aggregate expenditure curve is due to the adverse effects on wealth or real balances, interest rate and net exports.
Much of wealth is held in the form of bank deposits, bonds and shares of companies and other assets. With the rise in price level, real value or purchasing power of wealth possessed by the people declines. This induces them to spend less. As a result, consumption expenditure declines due to this wealth effect. Given the demand function for money M d , the decline in the real money supply will cause rate of interest to rise.
Now, the rise in interest will induce private investment expenditure to decline. Lastly, rise in price level in the domestic economy will adversely affect exports of a country causing net exports to fall. Thus, as a result of negative effects of rise in price level on real wealth, private investment and net exports, in the upper panel a of Fig. Thus with the upward sloping short-run aggregate supply curve SAS, the effect of increase in autonomous investment expenditure or for that matter increase in any other autonomous expenditure such as Government expenditure, net exports, autonomous consumption on the GNP level can be visualized to occur in two stages.
First, increase in investment expenditure shifts aggregate expenditure curve AE upward in the upper panel a of Fig. However, as shall be seen from Fig. It may be further noted that steeper the slope of the short- run supply curve, the greater is the increase in the price level and smaller is the effect on real GNP.
Multiplier is one of the most important concepts developed by J. Keynes to explain the determination of income and employment in an economy. The theory of multiplier has been used to explain the cumulative upward and downward swings of the trade cycles that occur in a free-enterprise capitalist economy. When investment in an economy rises, it has a multiple and cumulative effect on national income, output and employment. As a result, economy experiences rapid upward movement.
On the other hand, when due to some reasons, especially due to the adverse change in the expectations of the business class, investment falls, then backward working of the multiplier causes a multiple and cumulative fall in income, output and employment and as a result the economy rapidly moves on downswing of the trade cycle.
Thus, Keynesian theory of multiplier helps a good deal in explaining the movements of trade cycles or fluctuations in the economy. The theory of multiplier has also a great practical importance in the field of fiscal policy to be pursued by the Government to get out of the depression and achieve the state of full employment. To get rid of depression and remove unemployment, Government investment in public works was recommended even before Keynes.
But it was thought that the increase in income will be limited to the amount of investment undertaken in these public works. But the importance of public works is enhanced when it is realised that the total effect on income, output and employment as a result of some initial investment has a multiplier effect.
Thus, Keynes recommended Government investment in public works to solve the problem of depression and unemployment. The public investment in public works such as road building, construction of hospitals, schools, irrigation facilities will raise aggregate demand by a multiple amount. The multiple increase in income and demand will also encourage the increase in private investment.
Thus, the deficiency in private investment which leads to the state of depression and underemployment equilibrium will now be made up and a state of full employment will be restored. If the multiplier had not worked, the income and demand would have risen as a result of some public investment but not as much as they rise with the multiplier effect. Inspired by the Keynesian theory of multiplier, expansionary fiscal policy of increase in Government expenditure and reduction in income tax have been adopted by President John Kennedy and President George W.
Bush in the United States of America to remove involuntary unemployment and depression. Suppose the level of autonomous investment in an economy is Rs. The size of multiple is determined by the value of marginal propensity to consume. Thus, with increase in investment by Rs.
Suppose in a country investment increases by Rs. How much increase will there take place in income? An interesting paradox arises when all people in a society try to save more but in fact they are unable to do so. The multiplier theory of Keynes helps a good deal in explaining this paradox. According to this paradox of thrift, the attempt by the people as a whole to save more for hard times such as impending period of recession or unemployment may not materialize and in their bid to save more the society in-fact may not only end up with the same savings or, even lower savings but also in the process cause their consumption or standard of living to decline.
Thrift i. Further, according to classical economists, savings determine investment which plays a crucial role in accelerating the rate of economic growth. However, the paradox of thrift shows that the efforts to. It goes to the credit of Keynes that with his multiplier theory he was able to resolve the paradox of thrift. Keynesian explanation of paradox of thrift has been shown in Fig. Keynes has showed that if all people in a society decide to save more, they may actually fail to do so but nevertheless reduce their consumption.
This is because, according to Keynes, the effort to save more by all in a society will lower the aggregate demand for goods and services resulting in a drop in the level of national income. At the lower level of national income, the savings fall to the original level but consumption will be less than before which implies that the people would become worse off. Consider Fig. It will be seen that saving and investment curves intersect at point E and determine level of income equal to K, or Rs.
Now suppose that expecting hard times ahead all people try to save more by the amount of Rs. This downward shift in the consumption function brings about an upward shift by Rs. It is important to note that level of income does not drop only by the amount E 1 A or RS. With marginal propensity to save MPS being equal to 0.
Further, the decline in consumption due to more saving would cause the multiplier to work in reverse, that is, the multiplier would operate to reduce the level of consumption and income by a magnified amount. The decline in consumption expenditure of the people by Rs. But the reverse process will not stop here. Given the marginal propensity to consume being equal to 0. It will be observed from Fig. Thus the attempt by all people to save more has led to the decline in the equilibrium level of income to Y 2 or Rs.
This is clearly depicted in Fig. With the decrease in planned saving by Rs. This sets in motion the operation of the multiplier in the reverse and as will be seen from the It is important to observe that the saving which had risen to Y 1 A Rs.
In other words, the increases in saving by Rs. This explains the paradoxical feature of an economy gripped by recession. This is paradoxical because in their attempt to save more the people have caused a decline in their income and consumption with no increase in the saving of the society at all. In our analysis we have assumed that the planned investment is fixed, that is, determined outside the model.
In other words, the investment has been assumed to be autonomous of income, that is, it does not vary with income. Paradox of thrift holds good when a free market economy is in the grip of recession or depression and investment demand is inadequate due to lack of profit opportunities. However, it has been pointed out by some economists that paradox of thrift can be averted if the extra savings that the people do for a rainy day are somehow channeled into additional investment through financial markets.
Indeed, the classical economists argued that the increase in the supply of savings would lead to the fall in the rate of interest which would induce increase in planned investment. In Fig. In this way the paradox of thrift has been averted. However, according to the modern economists, especially the followers of Keynes, the empirical evidence does not support the above argument of averting the paradox of thrift. This is because at times of recession or depression, the prospective yields from investment are so small that no possible reduction in the rate of interest will induce sufficient increase in investment.
Thus, according to them, in a free-market and private enterprise economy without Government intervention paradox of thrift cannot be averted. Of course, if the Government intervenes as it does even in the present- day predominantly private enterprise economies of the USA and Great Britain, it can mobilise the extra savings of the people and invest them in some worthwhile projects and thus prevent aggregate demand and income from falling.
This can happen because the Government undertakes investment because it is not motivated by profit motive but by the considerations of promoting social interest and economic growth. It is because of this that the role of the Government has greatly increased for overcoming recession in the capitalist countries.
During the s the capitalist economies experienced severe depression which caused widespread involuntary unemployment, substantial loss of output and income and crushing hunger and poverty among the working classes. The classical economists attributed this unemployment and depression to the higher wage rates maintained by the trade unions and the Government. However, this explanation did not prove to be valid. It was English economist J. Keynes who radically departed from the classical thought and put forward the view that it was the large decline in investment that caused the depression and substantial increase in involuntary unemployment.
According to Keynes, the investment was highly volatile and it was a drastic decline in it due to the pessimistic expectations of the entrepreneurs about the prospective profits from investment that brought about a decline in aggregate demand expenditure which through working of the multiplier in the reverse caused a magnified fall in income output and employment.
For example, during the first four years of depression in the USA the unemployment which was only 3. The huge decline in national income and the emergence of unemployment in the USA, UK and other industrialized capitalist countries during the period of depression is graphically shown in Fig. The important point made by Keynes was that income would not fall merely equal to the decline in investment but by a multiple of it.
In fact, during the depression period of s, it actually happened so and is evident from Table It will be seen from Figure Y F Y 1 is twice that of HT.
|Forex forms sheets||Second, the MPI is the slope of the investment linewhich makes it important to the slope of the aggregate expenditures lineas well. How to Calculate AVC? What Is the Multiplier Effect? Accounting costs, while very important to accountants, company CEOs, shareholders, and the Internal Revenue Service, is only minimally important to economists. Check Out These Related Terms|
|Marginal propensity to invest||215|
|Marginal propensity to invest||670|
|Marginal propensity to invest||Market value invested capital|
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