Macro Economics Theory Solution.
Chapter- 01, 02: Nature and Scope of Macroeconomics and Circular
Flow of Income and National Income Accounting
1. Define macroeconomics. Explain the subject matter of
macroeconomics. Differentiate between Macroeconomics and
Macroeconomics. Explain the Six key economic Indicators.
Definition: Macroeconomics is the study of what
is happening to the economy as a whole, the
economy in the large.
It’s try to figure out why overall economic
activity rises and falls: the value of production,
total incomes, unemployment, inflation,
Intermediate variables like interest rates, stock
market values, and exchange rates--that play a
major role in determining the overall levels of
production, income, employment, and prices.
According to John Maynard Keynes:
Macroeconomics deals with aggregates
such as national income, total employment, and the general price level.
Subject Matter of Macro-Economics:
Theory of income and employment: Macroeconomics explains the determination of national
income and employment. In addition it also helps in analysing the cause and effect of fluctuations
in them. For this, various concepts such as consumption function, investment function, business
cycles are studied.
Theory of income and employment can be categorized into 3 section
Such as:
i.
ii.
iii.
Theory of Consumption
Theory of investment
Theory of Trade and Business Cycle
Theory of Consumption
The theory of consumption examines how
individuals and households allocate their
income to spending and saving. It is
critical for understanding aggregate
demand in an economy.
Theory of Investment
The theory of investment explores how
businesses decide to allocate resources to
capital formation, which influences
economic growth and employment.
Theory of Trade
The theory of trade examines how and
why countries exchange goods and
services and the benefits of such
exchanges.
Theory of general price level and inflation: Macroeconomics studies how the general level
prices in an economy are determined and the effects of fluctuations on them. Such study is
specifically important to understand and combat the effect of such problems as depression and
recession.
Theory of economic growth and development: Macroeconomic study helps in
understanding the causes of underdevelopment and other socio-economic problems such as
poverty and inequality in an economy. Accordingly, it helps in determining suitable policies to
combat the same. Similarly, it helps to deals with such problems as underutilization of resources,
thereby, help in working towards increasing the productive efficiency in the economy.
Macro theory of distribution: The study of macroeconomics helps in determining how the
national income would be distributed among the various sections in the economy in the form of
rent, wages, income and profit. Some of the important theories in this regard are given by Ricardo,
Karl Marx, Kalecki, and Kaldor.
Difference between Macroeconomics and Microeconomics.
Microeconomics
Macroeconomics
It is the study of Individual Units.
1
Study of the behaviour of the economy
as a whole .
Uses Partial Equilibrium technique
2
Uses General Equilibrium technique .
Price theory is the central part.
3
Income theory is the Central Part.
Deals with small parts or section of
the system.
4
It embraces the entire economic
System.
Micro-economists assume that
imbalance between demand and
supply are resolved by changes in
prices
5
Macroeconomists consider the
possibility that imbalances between
supply and demand can be resolved by
changes in quantities rather than in
prices.
Deals with Micro Variables.
5
Deals with Macro Variables.
Basically deals with the Problem of
Pricing and Distribution .
Major areas Covered – Theory of
Value and Economic Welfare.
Pertains to the problems of the size of
6
National Income, Economic Growth
and General Price Level .
7
Major areas Covered – Income and
Employment and Monetary Theory.
Provides Worm’s Eye View.
8
Provides Bird’s Eye View.
It is applied to internal issues.
9
It is applied to environmental and
external issues.
It is useful in regulating the prices
of product alongside the prices of
factors of production, (lever, land,
entrepreneur, capital and more)
within the economy.
It perpetual firmness in the broad
priced level and solves the major
10 issues of the economy like deflation,
inflation, rising prices, unemployment
and poverty as a whole.
It covers several issues like
demand, supply, factor pricing,
product pricing, economical
welfare, production, consumption
and more.
It covers several issues like
distribution national income,
11
employment, money, general price
level and more.
Indicators of Macro-Economics.
There are six key indicators of economic activity Six Key Indicators
1. Real Gross Domestic Product: The total value of production within the country either the
citizens of the country or foreigners using market prices from a specific base year to
determine the value of each unit that is produced.
2. The unemployment rate: The number of unemployed people divided by the total labor
force The unemployment rate is the best indicator of how well the economy is doing
relative to its productive potential.
3. The inflation rate: Inflation rate is the percentage increase I the price level from one year
to the next year. High inflation erodes purchasing power, while deflation signals weak
demand.
A very high inflation rate--more than 20 percent a month, say can cause massive economic
destruction, as the price system breaks down and the possibility of using profit- and-loss
calculations to make rational business decisions vanishes.
Strangely, moderate inflation rates--a little more than 10 percent a year, say--are highly
unsettling to consumers and business managers. Moderate inflation should not seriously
compromise consumers', investors', and managers' ability to determine the best use of their
financial resources or to calculate profitability
4. The interest rate: The cost of borrowing or return on savings. Central banks adjust interest
rates to control inflation, stimulate growth, or stabilize the economy.
Whenever interest rates are low--that is, when money is "cheap"--investment tends to be
high, because businesses find that a wide range of possible investments will generate
enough cash to pay the interest on borrowed money, repay the principal of the loan, and
still produce a profit.
5. The level of the stock market: Represent the aggregate value of publicly traded
companies. A rising stock market suggests investor confidence and economic optimism.
The level of the stock market is an index of expectations for the future. When the stock
market is high, investors expect economic growth to be rapid, profits to be high, and
unemployment to be relatively low.
6. The exchange rate: The value of one currency relative to another. The exchange rate
governs the terms on which international trade and investment take place. When the
domestic currency is appreciated, its value in terms of other currencies is high. Foreignproduced goods are relatively cheap for domestic buyers, but domestic- made goods are
relatively expensive for foreigners. In these circumstances imports are likely to be high;
exports are likely to be low. When the domestic currency is depreciated, the opposite is the
case.
2. "Macroeconomics is a study of aggregates"- How?
Macroeconomics is the study of aggregates or averages covering the entire economy, such as total
employment, national income, national output, total investment, total consumption, total savings,
aggregate supply, aggregate demand, and general price level, wage level, and cost structure.
Macroeconomics: analyzing the economy as a whole rather than individual units. This branch of
economics examines large-scale economic variables and their interrelations to understand the
overall functioning and performance of an economy
Aggregate Variables:
Macroeconomics deals with aggregates or averages that reflect the collective performance of an
economy. Key variables include:
Total Employment: Measures how many people are employed across the entire
economy.
National Income and Output: Indicates the economy's total earnings and production,
often measured by GDP or GNP.
Total Investment and Consumption: Reflects how much is being spent on capital
formation and goods/services.
Total Savings: Shows the economy's capacity to generate resources for future
investment.
Aggregate Supply and Demand: Represents total output available and total spending in
the economy.
Theory of general price level and inflation: Macroeconomics studies how the general
level prices in an economy are determined and the effects of fluctuations on them. Such
study is specifically important to understand and combat the effect of such problems as
depression and recession.
The exchange rate: The value of one currency relative to another. The exchange rate
governs the terms on which international trade and investment take place.
3. What is meant by saving and investment? How do they affect circular
flow of income in a free market economy?
Savings: This refers to the portion of income that is not spent on consumption. It's money set aside
for future use, typically kept in a bank account or other safe financial instruments. Savings provide
a financial cushion for emergencies, short-term goals like buying a car, or larger long-term goals
like a down payment on a house or retirement.
Investment: This involves using savings to purchase assets with the expectation of generating a
return or profit over time. Investments can take various forms, including stocks, bonds, real estate,
mutual funds, or starting a business. The goal of investing is to grow wealth and potentially earn
a higher return than what is offered by traditional savings accounts.
Affect in circular flow of income in a free market economy
Savings as a Leakage:
Reduced Spending: When households save a portion of their income, they reduce their
spending on goods and services. This reduces the flow of money from households to businesses,
acting as a leakage from the circular flow.
Impact
on
Demand:
Decreased spending can lead to
lower demand for goods and
services, potentially affecting
production and employment
levels.
Investment as an Injection:
Increased
Spending:
Businesses invest savings back
into the economy by purchasing
capital goods (like machinery,
equipment, and buildings). This
increases spending and boosts the
flow of money from businesses to
factor markets (where resources
like labor and capital are bought
and sold).
Economic Growth: Investment fuels economic growth by increasing production capacity,
creating jobs, and generating income.
Balancing Savings and Investment:
Equilibrium: For the circular flow to remain balanced, savings and investment must be equal.
This ensures that the money leaking out of the system through savings is offset by the money
injected back in through investment
Government Role: Government policies can influence savings and investment through tax
incentives, interest rate adjustments, and regulations.
Global Economy: In an open economy, savings and investment can flow across borders, affecting
the domestic circular flow.
4. Draw a flow chart of circular income flows in four sector economy with
foreign sector. How will circular income flow in an economy be affected if a
country has foreign trade transactions?
Foreign trade transactions introduce two new elements into the circular flow of income: exports
and imports. These transactions affect the flow of money and goods between the domestic
economy and the rest of the world.
Exports:
Injection: When a country exports goods or services, it receives money from foreign
countries. This inflow of money acts as an injection into the circular flow of income.
Impact:
Exports
increase
aggregate demand, leading to higher
production,
employment,
and
income levels within the domestic
economy.
Imports:
Leakage: When a country
imports goods or services, it pays
money to foreign countries. This
outflow of money acts as a leakage
from the circular flow of income.
Impact:
Imports
reduce
domestic demand for goods and
services, potentially leading to lower
production,
employment,
and
income levels.
Net Effect:
The net effect of foreign trade on the circular flow of income depends on the balance between
exports and imports.
Determines the net impact of foreign trade: Net Exports=Exports (X)−Imports (M)
A trade surplus (X > M) increases the circular flow.
A trade deficit (X < M) reduces the circular flow.
Trade Surplus: If exports exceed imports, the net effect is an injection into the circular flow,
stimulating economic activity.
Trade Deficit: If imports exceed exports, the net effect is a leakage from the circular flow,
potentially slowing down economic activity.
5. Define National Income and National Product. Discuss about different
components of national income.
National Income: The sum of all incomes of the people of a country obtained as wages, rent,
interest and profit is the national income of a country.
National Income refers to the total monetary value of all goods and services produced by the
citizens of a country, including income earned from abroad, during a specific period (usually a
year). It measures the overall economic activity and prosperity of a nation.
NI= Wages + Rent + Profit + Interest
National Product: The total value of final goods and services produced by various productive
firms and business in a year is known as national product.
NP= Total output of final goods × Market price
In two sector economy national product equal national income due to the absences of government
expenditure, depreciation, foreign trade, no indirect taxes and no subsidies and transfer payment
is grant.
Hence,
NP= Total output of final goods × Market price = Wages + Rent + Profit + Interest = NI
Concepts of National Income1) GNP (Market price, Factor cost)
a. GNP at Market Price
b. GNP at Factor Cost
2) GDP
3) NNP
4) NDP
5) Personal Income
6) Disposable Income
GNP
The total value of goods and services produced by the nationals (citizens) of a country, regardless
of whether production occurs within or outside the country.
Components of GNP





Consumption =C
Gross Private Investment = I
Govt. Purchase of Goods and services = G
Net Export (Export – Import) = Xn
Net factor Income from Abroad = NFIA
Calculation of Net Factor Income and its Components
Net Factor income= Factor Income received from abroad by the resident of the country
Minus (-)
Factor income paid to the foreign country
Components of Net Factor Incomea. Net compensation of employees: The wages, salaries, and other benefits earned by
residents working abroad minus similar earnings of foreign workers in the domestic
economy.
Example:

A citizen working in a foreign country and sending wages back to their home
country.

A foreign worker earning wages within the domestic economy.
b. Net income from property: Income received from investments abroad (e.g., interest,
dividends, rents, and royalties) minus similar payments made to foreign entities for their
investments in the domestic economy.
c. Net retained earnings of the residents companies working in foreign countries:
Profits retained by domestic companies from their operations abroad minus profits
retained by foreign companies operating within the domestic economy.
GDP(MP) = C+I+G+Xn
GNP(MP) = GDP(MP)+ NFIA
Net National Product (NNP) at Market Price
Net National Product at market price is the money value of all final goods and services of a country
after deducting depreciation.
Thus, NNP(MP) = GNP(MP) – Depreciation
NNP= C + I+ G + Xn + NFIA - D
GDP
The total value of goods and services produced within a country’s borders in a specific time
period with respective of countries residents as well as non- residents but does not include net
factor income from abroad (NFIA)
GDP= C+I+G+Xn
GDP= GNP(MP) - NFIA
Net Domestic Product (NDP) at Market Price
Net Domestic Product (NDP) is the total value of all goods and services produced within a
country's borders in a specific time period, after accounting for depreciation (or wear and tear) of
capital goods.
NDP= GDP- Depreciation
Net National Product at Factor Cost or National Income
National Income at Factor Cost is the total income earned by the factors of production (land,
labor, capital, and entrepreneurship) within a country during a specific period, measured at the
cost of factors of production. It excludes any taxes or subsidies on products and is focused on the
income generated by economic activities.
It reflects the earnings of workers, rent to landlords, interest to capital providers, and profits to
entrepreneurs without the influence of market prices distorted by taxes or subsidies.
National Income at Factor Cost= NNP at Market Prices −
Indirect Taxes + Subsidies
GNP at Factor Cost = GNP at Market Price – Indirect taxes +
Subsidies
GDP at Factor Cost= GDP at Market Price – indirect tax+
Subsidies
Relationship between NDP at market price and NDP at factor Cost
Had there been no government intervention in the economy, both NDP at market price NDP at
factor Cost would have been equal to each other. As the government interferes with the economy
through imposition of indirect taxes on goods and services, and provision of subsidies to
productive enterprises, these cause market prices of output to be different from the factor income
resulting from it. Hence, there arises difference between NDP at market price and NI (NDP at
factor cost).
Distinction between GDP and GNP
Aspect
Gross Domestic Product (GDP)
Gross National Product (GNP)
Definition
The total value of goods and services
produced within a country’s
borders in a specific time period.
The total value of goods and services
produced by the nationals (citizens) of
a country, regardless of whether
production occurs within or outside the
country.
Scope
Focuses on domestic production,
including output by foreign residents
or companies within the country.
Focuses on national production,
including output by citizens or
companies abroad but excludes income
earned by foreigners in the country.
GDP=C+I+G+(X−M)
Formula
where:
- C: Consumption
- I: Investment
GNP=GDP + Net Income from Abroad
where:
- Net Income from Abroad = Income
- G: Government Spending
- X−MX : Net Exports
earned by nationals abroad − Income
earned by foreigners domestically
Key
Difference
Measures what is produced within
the country's geographic boundaries.
Measures what is earned by the
country's citizens and businesses,
regardless of location.
Relevance
Indicates the economic strength of
the domestic economy.
Highlights the income-generating
capacity of a nation’s residents.
Example
If a foreign company operates within
the country, its output counts in GDP
but not GNP.
If a domestic company operates abroad,
its output is included in GNP but not
GDP.
Illustration

GDP Example: A car produced in a factory located in Country X by a foreign company is
included in Country X’s GDP because it was produced within its borders.

GNP Example: If a citizen of Country X earns income from working or investing abroad,
this income is included in Country X’s GNP but not its GDP.
Personal Income and Disposable Income
1. Personal Income (PI):

The total income received by individuals and households before paying taxes.

It includes all earnings, such as wages, salaries, rents, interest, dividends, and
transfer payments (e.g., pensions, unemployment benefits).

PI=National Income−Undistributed Corporate Profits – Corporate Taxes
+Transfer Payments=NFIA + Profit + Interesst + Rent + Wages
2. Disposable Income (DI):

The income remaining after deducting personal taxes (e.g., income tax, social
security contributions) from personal income.

It represents the amount individuals have available to spend or save.

DI=PI−Personal Taxes = Consumption + Savings
Differences between Personal Income and Disposable Income
Aspect
Personal Income (PI)
Disposable Income (DI)
Definition
Total income earned by individuals and
households before taxes.
Income available to individuals after
paying taxes.
Components Includes wages, rent, interest,
dividends, and transfer payments.
Excludes personal taxes; focuses on
net income.
Purpose
Indicates gross earnings of individuals.
Reflects purchasing power and
savings capacity.
Usage
Provides insight into total income
received in an economy.
Measures income available for
consumption or saving.
Calculation
PI=National Income−Undistributed
Corporate Profits – Corporate Taxes
+Transfer Payments= NFIA + Profit
+Interest + Rent + Wages
DI=PI−Personal Taxes=
Consumption + Savings
6. Discuss about the measurement of National Income
VALUE ADDED METHODS:
The Value-Added Method is a way to calculate national income by summing the value added
by all production units in an economy during a specific period. This method focuses on the
contribution of each production stage to the final value of goods and services, avoiding double
counting by considering only the net value added at each stage of production.
STEPS IN THE VALUE-ADDED METHOD
STEP-01: Identify the Production Sectors and Its Gross Value of Domestic Output
Estimating the gross value of domestic output in different sectors of the economy by divide the
economy into primary, secondary, and tertiary sectors:

Primary Sector: Agriculture, forestry, fishing, and mining.

Secondary Sector: Manufacturing and industrial production.

Tertiary Sector: Services like banking, healthcare, and education.
STEP-02: Determine the value of Intermediate consumption of goods like raw materials and
other costs related in the production period and also the depreciation of physical goods used in the
process of production.
STEP-03: Calculating the NI using Value added method by considering the gross value of final
goods from different sector at market price by deducting the Intermediate goods.
Value Added=Gross Value of Output (GVO)−Intermediate Consumption (IC)
FACTOR INCOME METHOD:
The Factor Income Method, also known as the Income Method, calculates national income by
summing up all the income earned by the factors of production (land, labor, capital, and
entrepreneurship) within an economy during a specific period. This method focuses on the
payments made to the owners of the factors of production for their contribution to the production
process.
STEPS IN THE FACTOR INCOME METHOD
STEP-01: Identify and classify the different sectors and their production unit by dividing the
economy into primary, secondary, and tertiary sectors:

Primary Sector: Agriculture, forestry, fishing, and mining.

Secondary Sector: Manufacturing and industrial production.

Tertiary Sector: Services like banking, healthcare, and education.
STEP-02: Classification of factor income earned by each factor separately in different sector of
the economy.
Factor incomes includes





Income from work which includes wages and salaries in kind, contribution to social
security
Income from ownership which includes rents, royalties and interests
Income from control of property i.e. profits which includes dividends and
undistributed profits
Mixed incomes of self employed
Net factor income from abroad ( NFIA)
STEP-03: Estimation of national income.


By summing up of factors income paid out by all the industries sectors NDP at
factor cost
And adding the NFIA with NDP at factors cost we can find the national income
NDP at Factor cost of Domestic Factor Income = Compensations of Employees + rent +
interest + profit + Mixed income
NNP at factor cost or National Income= NDP at factor cost+ NFIA
FINAL EXPENDETURE METHOD
The Expenditure Method calculates national income by summing up all expenditures incurred in
an economy on final goods and services during a specific period. This method focuses on the
spending side of the economy and measures the total demand for finished goods and services.
STEPS IN FINAL EXPENDETURE METHOD
STEP-I: Identification and classification of economic units into household sector, producer sector,
government sector and rest of the world sector.
STEP-II: Classification of final expenditure. Final expenditure are classified as




Final consumption expenditure by household sector
Gross domestic capital formation by producer sector
Government final expenditure
Net exports =Export –Import
STEP-III: Estimation of Gross Domestic Expenditure (GDE) and Gross National Expenditure
(GNE). Final expenditures are summed up to arrive at GDE. GDE is equivalent to GDP at market
price.
GDE= GDP at market price = Private final consumption expenditure + Gross domestic
private capital formation + Government final expenditure + Net Exports
GNE= GNP at market price = GDE + NFIA
7. Explain the difficulties of calculating national income in Bangladesh.
8. Distinguish between economic statist and economic dynamics.
9. Justify the statement "Macroeconomics is both science and art".
Chapter-3, 4
The Classical Full-Employment Model
&
Keynes’s Theory of Employment
1. Explain the basic two assumptions of classical theory of employment.
The classical economist did not propound any particular theory of employment. Classical theory
of employment was based upon two main assumptions.
1. Assumption of full employment
2. Assumption of flexibility of price and wages
Assumption of Full Employment
Classical economists believed that full employment is the normal state of an economy.
This means that all those willing and able to work at the prevailing wage rate will find
employment.
Even if unemployment exists, it is considered temporary and voluntary, arising due to:
 Frictional Unemployment – Workers switching jobs.
 Structural Unemployment – Mismatch between skills and job
opportunities.
According to Say’s Law, "Supply creates its own demand," meaning that any goods produced
will generate enough income to ensure their purchase, leading to full employment.
Assumption of Flexibility of Prices and Wages
Classical economists believed that wages, prices, and interest rates are flexible and will adjust to
restore equilibrium in the economy.
If unemployment exists, the following adjustments will occur:
 Wage Reduction: Unemployed workers will accept lower wages, making labor more
affordable for firms.
 Price Reduction: Lower wages reduce production costs, leading to lower product prices,
which increases demand.
 Interest Rate Adjustment: If people save more, interest rates will fall, encouraging
businesses to invest and create jobs.
2. Explain the Say's Law of employment. Explain the assumptions of Say's law.
How did classical economists use this law to show that there could not be
involuntary unemployment in the economy?
Explain the two assumptions of the classical theory of income and employment.
Explain Consumption and Savings Theories
Say’s Law of Markets: "Supply Creates Its Own Demand"
Say’s Law, formulated by Jean-Baptiste Say, states that production itself generates demand.
This means that when goods and services are produced, they create income for workers and
businesses, which is then used to purchase other goods and services. Thus, there can be no
general overproduction or demand deficiency in the economy.
Principles of Say’s Law:
No Demand without Supply


Production automatically creates demand for goods.
When firms produce goods, they pay wages, rent, and profits, which become the income
that consumers use to purchase products.
Production is the Source of Demand

The ability to buy goods comes from one’s own productive efforts (labor or assets).
Wealth is created by production, not consumption.

Higher productivity increases purchasing power, allowing people to demand more goods
and services.
Assumptions of Say’s Law:
No Saving or Hoarding


Households immediately spend all their income on goods and services.
There is no leakage of money from the circular flow.
Savings Convert to Investment


If people save, those savings are automatically invested due to flexible interest rates.
No money remains idle; all savings turn into productive investments.
No Government Intervention


The economy is entirely free-market-based.
There are no taxes, subsidies, or government expenditures.
Closed Economy

No foreign trade—only domestic production and consumption exist.
Acceptance of Full Employment in a Free Enterprise Economy: Two Key
Assumptions
Classical economists believed that full employment is the normal state of a free-market
economy, based on the following two assumptions:
1. No Deficiency of Aggregate Demand (Say’s Law)
Say’s Law of Markets states that supply creates its own demand.
When production occurs, it not only generates goods and services but also creates
income for workers and business owners.
This income is then used to purchase the produced goods, ensuring that there is never a
general deficiency of demand.
Since products are exchanged for products, there is no possibility of a general
overproduction or under consumption leading to unemployment.
2. Wage and Price Flexibility Ensures Market Correction
Even if there is a temporary shortfall in aggregate demand, wages and prices are flexible
in a free-market economy.
If unemployment rises, wages will fall, making labor cheaper and encouraging businesses
to hire more workers.
Lower wages also reduce production costs, making goods more affordable, which
increases demand.
Similarly, interest rates adjust in financial markets—if people save more, interest rates
fall, encouraging investment and boosting employment.
This automatic adjustment eliminates unemployment in the long run.
3. "Keynes challenged Say's law"- how and why? (Criticism of classical theory of
employment)
Keynes’s Critique of Say’s Law
The Impossibility of Full Employment in Reality

Say’s Law assumes that the economy naturally moves toward full employment.

Keynes argued that demand must equal supply to ensure full employment.

However, no country has a completely free market, meaning supply and demand are
rarely in perfect balance.
The Misconception of "Supply Creates Its Own Demand"
Say claimed that all production generates equivalent demand.
Keynes countered that full employment requires aggregate demand to match aggregate supply.
In a modern economy, producers must assess demand before determining supply.
The Fallacy of Wage, Price, and Interest Rate Flexibility
Classical economists assumed that wages, prices, and interest rates are fully flexible.
Keynes pointed out that:


Wages and prices can adjust, but interest rates are controlled by governments.
Individuals cannot easily change interest rates, making the assumption invalid.
Not All Income Is Spent on Goods and Services
Say’s Law assumes that all income is either consumed or invested.
Keynes highlighted that:


People save a portion of their income instead of spending it all.
Some savings remain idle (not invested), reducing overall demand.
Savings Do Not Always Translate into Investment
Classical economists believed that household savings are reinvested by businesses.
Keynes argued that:


Not all business firms reinvest household savings.
Some savings never enter the economy, leading to demand shortages.
The Limitation of Wage and Price Cuts in Restoring Employment
Say’s Law suggests that reducing wages, prices, and interest rates will restore full employment.
Keynes disputed this, stating:


Wage and price cuts can cause overproduction and lower profits.
Unemployment may rise instead of decreasing, as firms reduce production.
The Necessity of Government Intervention
Say’s Law assumes no need for government intervention in the economy.
Keynes emphasized the role of government in:



Regulating interest rates.
Storing surplus goods to prevent market crashes.
Managing the economy during deflation or financial crises.
The Impact of Unemployment on Economic Stability
If full employment is not ensured in economy, then the affordability of consumers of products will
be declined. That means, the firm will not get their expected profit. As a result there will be
disequilibrium in income, saving and consumption expenditure.
For this the firms will reduce their production amount and wages of labor. As a result
unemployment will be arise.
4. What is meant by involuntary unemployment? Explain Keynes' theory of
involuntary unemployment.
Involuntary unemployment is a situation where people are willing to work at the prevailing wage
rate but fail to find work.
Keynes’ Theory of Involuntary Unemployment
Keynes challenged the classical theory, which assumed that free markets naturally lead to full
employment. His theory of involuntary unemployment is based on the following key ideas:
(i) Deficiency of Aggregate Demand
According to Keynes, unemployment arises when aggregate demand (total spending in the
economy) is insufficient to purchase all the goods and services produced.
If demand falls, businesses reduce production, leading to job cuts and unemployment.
(ii) Rigidity of Wages and Prices



Classical economists believed that wages and prices are flexible and will adjust to restore
full employment.
Keynes argued that wages are often "sticky downward", meaning that workers resist wage
cuts.
Since wages do not decrease easily, businesses reduce employment instead, leading to
involuntary unemployment.
(iii) Savings and Investment Imbalance
Classical theory assumed that all savings are automatically converted into investment.
Keynes pointed out that:



Households save money, but businesses may not always invest it.
If investment demand is low, savings remain idle, reducing overall demand.
This leads to a shortfall in employment.
(iv) Importance of Government Intervention
Keynes emphasized that government intervention is necessary to stimulate demand and reduce
unemployment.
Policies to tackle involuntary unemployment include:



Public spending (investment in infrastructure, jobs programs, etc.)
Monetary policies to lower interest rates and encourage borrowing.
Welfare programs to support unemployed individuals and boost demand.
5. Explain Keynesian theory of employment.
According to Keynes’ own theory of income and employment:
"In the short period, level of national income and so of employment is determined by aggregate
demand and aggregate supply in the country. The equilibrium of national income occurs where
aggregate demand is equal to aggregate supply. This equilibrium is also called effective demand
point"
6. Describe the concept of Effective Demand. How equilibrium level of
employment is determined? Graphically show the effective demand.
Or, Determination of Level of Employment and Income
Effective Demand and its PrinciplesEffective demand represents that aggregate demand or total spending (consumption expenditure
and investment expenditure) which matches with aggregate supply (national income at factor cost).




Effective demand is the equilibrium between aggregate demand (C+I) and aggregate supply
(C+S).
This equilibrium position (effective demand) indicates that the entrepreneurs neither have a
tendency to increase production nor a tendency to decrease production.
It implies that the national income and employment which correspond to the effective
demand are equilibrium levels of national income and employment.
Unlike classical theory of income and employment, Keynesian theory of income and
employment emphasizes that the equilibrium level of employment would not necessarily be
full employment. It can be below or above the level of full employment.
Equilibrium level of employment:
According to Keynes, the equilibrium levels of national income and employment are determined
by the interaction of aggregate demand curve (AD) and aggregate supply curve (AS).
The equilibrium level of income determined by the equality of AD and AS does not necessarily
indicate the full employment level. The equilibrium position between aggregate demand and
aggregate supply can be below or above the level of full employment as is shown in the curve
below

In the above figure, the aggregate demand curve (C+l), intersects the aggregate supply curve
(OS) at point E1 which is an effective demand point. At point E1, the equilibrium of national
income is OY1

Let us assume that in the generation of OY level of income, some of the workers willing to
work have not been absorbed. It means that E1(effective demand point) is an under
employment equilibrium and OY1is under employment level of income.

The unemployed workers can be absorbed if the level of output can be increased from
OY1to OY2 which we assume is the full employment level.

We further assume that due to spending by the government, the aggregate demand curve
(C+I+G) rises. As a result of this, the economy moves from lower equilibrium point E1to
higher equilibrium point E2 the OY is now the new equilibrium level of income along with
full employment. Thus E2 denotes full employment equilibrium position of the economy.

Thus government spending can help to achieve full employment. In case the equilibrium
level of national income is above the level of full employment, this means that the output
has increased in money terms only. The value of the output is just the same to the national
income at full employment level.
7. What is a principle (Determinants) of effective demand, aggregate demand price
and aggregate supply price?
Explain the determinants of effective demand (equilibrium level of national
income and employment).
Effective Demand and its PrinciplesEffective demand represents that aggregate demand or total spending (consumption expenditure
and investment expenditure) which matches with aggregate supply (national income at factor cost).




Effective demand is the equilibrium between aggregate demand (C+I) and aggregate supply
(C+S).
This equilibrium position (effective demand) indicates that the entrepreneurs neither have a
tendency to increase production nor a tendency to decrease production.
It implies that the national income and employment which correspond to the effective
demand are equilibrium levels of national income and employment.
Unlike classical theory of income and employment, Keynesian theory of income and
employment emphasizes that the equilibrium level of employment would not necessarily be
full employment. It can be below or above the level of full employment.
The determinants of effective demand and so of equilibrium level of national income and
employment are the aggregate demand and aggregate supply
Aggregate Demand (C+I):
 Aggregate demand refers to the sum of expenditure households, firms and the government
is undertaking on consumption and investment in an economy
 The aggregate demand price is the amount of money which the entrepreneurs actually expect
to receive as a result of the sale of output produced by the employment of certain number 2
of workers
 An increase in the level of employment raises the expected proceeds and a decrease in the
level of employment lowers it.
 The aggregate demand curve AD (C+I) would be positively sloping signifying that as the
level of employment increases, the level of output also increases, thereby increasing of
aggregate demand (C+l) for goods.
 The aggregate demand (C+l) depends directly on the level of real national income and
indirectly on the level of employment.
(2) Aggregate Supply (C+S):
 The aggregate supply refers to the flow of output produced by the employment of workers
in an economy during a short period.
 In other words, the aggregate supply is the value of final output valued at factor cost.
 The aggregate supply price is the minimum amount of money which the entrepreneurs must
expect to receive to cover the costs of output produced by the employment of certain number
of workers.
 The aggregate supply is denoted by (OS) because a part of this is consumed (C) and the
other part is saved (S) in the form of inventories of unsold output.
 The aggregate supply curve, (C+S) is positively sloped indicating that as the level of
employment increases, the level of output also increases, thereby, increasing the aggregate,
supply. Thus, the aggregate supply (C+S) depends upon the level of employment through
the economy's aggregate production function
Importance of effective Demand:
The importance of the principle of effective demand in macro economics, in brief,
is as under:
(i) Determinant of employment. Effective demand determines the level of employment in the
country. As effective demand increases employment also increases. When effective demand falls,
the level of employment also decreases.
(ii) Say's Law falsified. It is with the help of the principle of effective demand that Says Law of
Market has been falsified. According to the concept of effective demand whatever is produced in
the economy is not automatically consumed. It is partly saved. As a result, the existence of full
employment is not possible.
(iii) Role of investment. The principle of effective demand explains that for achieving full
employment level, real investment must equal to the gap between income and consumption. In
other words, employment cannot expand, unless investment expands. Therein lies the importance
of the concept of effective demand.
(iv) Capitalistic economy. The principle of effective demand makes clear that in a rich
community, the gap between income and expenditure is large. If required investment is not made
to fill this gap, it will lead to deficiency of effective demand resulting in unemployment.
Criticism of Keynesian Theory
From mid-1970 onward, the Keynesian theory of employment came under sharp criticism from
the monetarists. The monetarists believed that J. M. Keynes laid more emphasis on the
determinants of aggregate demand and to a greater extent ignored the determinants of aggregate
supply. The 'General Theory of Keynes is applicable to the developed economies. The Keynesians
concepts are not very useful for policy purposes in less developed countries.
8. Distinguish between economic laws and economic theories.
Short Notea. Aggregate demand
Chapter- 06
Consumption Function (149–169)
1. Define the consumption function. Explain the factors influencing or
determining it.
Definition
The consumption function represents the relationship between aggregate consumption and
aggregate income. Keynes introduced this concept in his General Theory, asserting that
consumption depends primarily on the current level of disposable income, with a functional form
expressed as:
C=a+bY
Where:

C: Total consumption

a: Autonomous consumption (consumption when income is zero)

b: Marginal propensity to consume (MPC, the increase in consumption per unit increase
in income)

Y: Disposable income.
Factors Influencing Consumption Function
Keynes categorized these into Objective Factors and Subjective Factors:
Objective Factors

General Price Level: High inflation reduces real purchasing power, causing a
downward shift in the consumption function (real balance effect). Deflation has
the opposite effect.

Fiscal Policy: Taxation and government spending influence disposable income.
Reduced taxes increase consumption, whereas increased taxes reduce it.

Rate of Interest: Higher interest rates encourage savings, reducing consumption,
though the effect varies across individuals.

Stock of Wealth: Greater accumulated wealth leads to higher consumption, while
wealth losses (e.g., stock market crashes) reduce it.

Income Distribution: Unequal income distribution lowers aggregate
consumption since the marginal propensity to consume is higher for the poor.

Windfall Gains and Losses: Unexpected gains or losses significantly alter
consumption.
Subjective Factors

Desire for Security: Individuals save to prepare for future uncertainties like
illness or unemployment.

Future Needs: Savings for education or retirement reduce current consumption.

Demonstration Effect: People imitate higher-income groups, increasing their
propensity to consume.

Desire for Social Status: Accumulating wealth for status reduces consumption.
Key Features of Keynesian Consumption Function
 Dependence on Current Income: Consumption is a positive function of income, with
the marginal propensity to consume (b) between 0 and 1.
 Stability: Consumption function remains stable in the short run due to institutional and
psychological factors.
 Declining Average Propensity to Consume (APC): As income increases, APC (C/Y)
decreases, reflecting that a smaller proportion of additional income is consumed
2. Explain the Keynesian linear consumption function with a graph.
Keynesian Linear Consumption Function
Definition
The Keynesian linear consumption function establishes a direct relationship between
consumption and income. The function is expressed as:
C=a+bY
Where:

C: Total consumption expenditure

a: Autonomous consumption (consumption at zero income)

b: Marginal propensity to consume (MPC), representing the change in consumption due
to a change in income (ΔC/ΔY\Delta C / \Delta Y)

Y: National income
(Table 6.1)
Income (YYY,
in ₹ crores)
Consumption (CCC,
in ₹ crores)
APC
(C/YC/YC/Y)
MPC (ΔC/ΔY\Delta C /
\Delta YΔC/ΔY)
1000
950
0.950
-
1100
1020
0.927
0.70
1200
1090
0.908
0.70
1300
1160
0.892
0.70
1400
1230
0.878
0.70
The schedule given in Table 6.1 reflects the consumption function of a community i.e., it indicates
how the amount of consumption changes in response to the changes in income. From the schedule
given in
Table 6.1 it will be seen that at the level of income equal to 1200 crore, the amount of consumption
is 1090 crore. As the national income increases to 1500 crore, the amount of consumption rises to
1300 crore. Thus, with a given consumption function, amount of consumption is different at
different levels of income.
Constant Marginal Propensity to Consume (MPC):


In the table, MPC remains constant at b=0.70b = 0.70b=0.70, signifying that for every
additional unit of income, consumption increases by 70%.
This constant MPC ensures that the consumption function is linear, with the slope of the
consumption curve remaining uniform across all income levels.
Falling Average Propensity to Consume (APC):

APC, calculated as APC=C/Y, declines as income increases.

This indicates that consumption grows less than proportionately compared to income,
highlighting a diminishing reliance on consumption as income rises.
Short-Run Assumptions
The fall in average propensity to consume with the increase in income has an important
implication that increase in consumption is not proportional to increase in income. Besides, as
will be seen from Table 6.1 in Keynesian consumption function, MPC < APC at various levels of
income.
Consumption demand depends on income and propensity to consume. Propensity to consume
depends on various factors such as price level, interest rate, stock of wealth and several
subjective factors. Since Keynes was 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 current income. Thus
C = f (Y)
In a specific form, Keynesian linear consumption function can be written as:
C = a + bY
Where a and b are constants. While a is intercept term of the consumption function, b stands for
slope of the consumption function and therefore represents marginal propensity to consume and
Y represents the level of current income.
Autonomous Consumption (a):

Even at zero income, some consumption occurs, financed through savings or borrowing.
Marginal Propensity to Consume (MPC, b):

Represents the slope of the consumption function and is constant in the linear model.

MPC is always between 0 and 1 (0<b<1), signifying that a portion of additional income is
saved.
Average Propensity to Consume (APC):

Calculated as APC=C/Y.

APC declines as income increases because autonomous consumption (a) becomes a
smaller part of total consumption
Graphical Representation of Consumption Function
Keynesian consumption function, namely, C = a + bY has been depicted by CC′ curve in 6.1 in
which along the X -axis national income and along the Y-axis the amount of consumption are
measured. In this figure, a line OZ making 45° angle with the X-axis, has been drawn. The 45°
line represents the points where consumption equals income.
At Low or Zero Income Levels:
The consumption curve (CC') starts at a on the Y-axis, indicating autonomous consumption.
Even at zero income, some consumption occurs, financed through past savings or borrowing.
At Break-even Income (𝑌0):
As income increases, consumption also increases and at the national income level OY0,
consumption is equal to income, and savings are zero.
At High Income Levels:
With the increase in income, consumption increases but less than the increase in income and
therefore, consumption function curve CC′ lies below the 45° line OZ beyond Y0 The curve lies
below the 45° line, indicating that income exceeds consumption, resulting in positive savings
The slope of the curve, b, reflects the MPC.

At low-income levels, the curve lies above the 45° line (consumption > income).

At higher incomes, the curve lies below the 45° line (consumption < income).
Shifts in Consumption Function:
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 any given level 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 Fig. 6.2.
On the contrary, when the propensity to consume of the community decreases, the whole
consumption function curve shifts downward signifying that at any given level of income, less is
consumed than before
Average and Marginal Propensity to Consume:
Average and Marginal Propensity to
Consume- The Average Propensity to
Consume (APC) is defined as the ratio of
total consumption (C) to total disposable
income (Y), expressed as APC=C/Y. It
measures the proportion of income that is
spent on consumption. For example, if a
household's income is $1,000 and its
consumption expenditure is $900, the APC
would be 0.9, indicating that 90% of the
income is spent on consumption. One
important feature of APC is that it tends to
decline as income increases. This is because
as income rises, people save a larger portion
of their income, and consumption does not
increase proportionally.
The Marginal Propensity to Consume
(MPC) - on the other hand, measures the
change in consumption resulting from a
change in income. It is calculated as MPC=ΔC/ΔY where ΔC Delta C is the change in
consumption, and ΔY Delta Y is the change in income. For instance, if an individual's income
increases by $1,000 and their consumption rises by $700, the MPC would be 0.7. Unlike APC,
which declines as income grows, MPC remains constant in the Keynesian linear consumption
function. This constant nature of MPC reflects the idea that consumption changes at a fixed rate
with respect to income changes.
Average propensity to consume at a point on the consumption function curve can be obtained by
measuring the slope of the ray from the origin to that point. For example, in Fig. 6.3 at income
level OY1, corresponding point on the consumption function curve CC′ is A. Therefore, at OY1
income level, average propensity to consume (APC) is the slope of the ray OA. Similarly, at
income level OY2, average propensity to consume is the slope of the ray OB. It will be observed
from Fig.6.3 that slope of OB is less than that of OA. Therefore, average propensity to consume
at income level OY2 is less than that at income level OY1. In other words, average propensity to
consume has declined with the increase in national disposable income. However, marginal to
consume (MPC) which measures the slope ∆C/∆Y of the consumption function curve CC′
remains constant with the increase in income throughout.
APC and MPC Relationship;
MPC remains constant, as it measures the slope of the consumption function. It indicates
the proportion of additional income that is spent on consumption and does not vary with
changes in income.
APC declines as income increases, because APC is calculated as APC=C/Y rises, the term
“a” which represents the share of autonomous consumption in total consumption, decreases.
As a result, APC falls, even though MPC stays the same.
At lower levels of income, APC>MPC, as autonomous consumption (a) constitutes a
significant portion of total consumption, causing the average propensity to consume to be
higher than the marginal propensity to consume.
As income increases, APC approaches MPC, but it never equals or falls below MPC. This is
because the autonomous consumption (a) ensures that the average propensity to consume
always remains slightly higher than the marginal propensity to consume.
Thus, the key relationship is that while MPC is constant in the Keynesian framework, APC
decreases with rising income, and APC>MPCAPC > MPCAPC>MPC at all positive levels of
income.
Non-Linear Consumption Function: Average and Marginal Propensity to
Consume
Definition: In a non-linear consumption function, the relationship between consumption (C) and
income (Y) is not a straight line, unlike the linear consumption function. The marginal
propensity to consume (MPC) decreases as income increases, leading to a diminishing slope of
the consumption curve.
Key Characteristics
Average Propensity to Consume (APC):

APC is defined as: APC=C/Y

In a non-linear consumption function, APC decreases as income increases
because the proportion of income spent on consumption declines.
Marginal Propensity to Consume (MPC):

MPC measures the change in consumption (ΔC\Delta C) with a change in income
(ΔY\ Delta Y):
MPC=ΔC/Δ

In a non-linear consumption function, MPC decreases as income rises, reflecting a
diminishing additional consumption for every additional unit of income.
Table: Relationship between Income, Consumption, APC, and MPC
Income
(YYY)
Consumption
(CCC)
APC
(C/YC/YC/Y)
MPC (ΔC/ΔY\Delta C/\Delta
YΔC/ΔY)
1000
900
0.90
-
2000
1700
0.85
0.80
3000
2400
0.80
0.70
4000
3000
0.75
0.60
5000
3500
0.70
0.50
Observations:

APC decreases as income rises.

MPC also declines, showing diminishing increments in consumption with rising
income.
Significance of Non-Linear
Consumption Function

Realistic Representation:
Reflects actual consumer
behavior where the proportion of
income spent on consumption
decreases with higher income
levels.

Policy Implications: Helps in
understanding savings behavior
at different income levels, which
is crucial for fiscal and monetary
policy planning.
3. What is the consumption function puzzle? How has it been resolved?
Distinction between Keynes' Consumption Function and Kuznets' Consumption
Function
1. Keynes' Consumption Function
Short-Run Perspective: Keynes focused on the short-term relationship between income
and consumption.
Key Assumptions:

Psychological Law of Consumption: As income increases, consumption also
increases but by a smaller proportion.

Declining Average Propensity to Consume (APC): APC decreases as income
rises because a larger proportion of additional income is saved.

Marginal Propensity to Consume (MPC): MPC is less than one and remains
constant in the short run for a linear consumption function.
Linear Model: Keynes' consumption function is expressed as: C=a+bYC = a + bYC=a+bY
Where aaa represents autonomous consumption and bbb (MPC) is constant.
2. Kuznets' Consumption Function
Long-Run Perspective: Kuznets derived his findings from long-term data on income and
consumption across multiple countries.
Empirical Observations:

Constant APC: Contrary to Keynes, Kuznets observed that APC remained stable
over long periods despite rising income.

Economic Growth: Kuznets attributed constant APC to structural factors in
economic growth, such as increased consumption opportunities and diversification
of goods and services.
Non-Linear Model: Kuznets' data suggests a non-linear relationship between income and
consumption in the long run.
Key Differences
Aspect
Keynes' Consumption
Function
Kuznets' Consumption
Function
Time Frame
Short-run analysis
Long-run analysis
Behavior of
APC
APC decreases as income
increases
APC remains constant over time
Focus
Psychological factors affecting
consumption
Structural and societal changes
in the economy
Approach
Theoretical
Empirical (based on long-term
data)
Reconciliation of Keynes and Kuznets
Difference in Time Frames:

Keynes analyzed short-run behavior where APC decreases due to limited
immediate adjustments in consumption habits.

Kuznets examined long-run trends where economic and structural factors stabilize
APC.
Role of Structural Changes:

In the long run, structural changes like urbanization, education, technological
progress, and diversification of consumption patterns offset the declining APC
observed in the short run.
Blended Perspective:

Keynes' theory applies to short-term fluctuations in income, while Kuznets'
findings provide a broader view of consumption behavior in a growing economy.

Together, they illustrate how consumption adapts over different time horizons.
Modern Insights:

Modern economists recognize that consumption behavior evolves dynamically.
Short-term variations align with Keynes' theory, while long-term trends align with
Kuznets' observations.
By integrating Keynes’ psychological insights with Kuznets’ empirical findings, the
reconciliation highlights the complementary nature of short-run and long-run consumption
analyses. Let me know if you'd like further clarifications!
4. What is the saving function? Derive a savings function from the
consumption function, C= a + bY.
Chapter 7: Post-Keynesian Theories of Consumption
1. What is the relative and absolute income hypothesis? How does it differ from
Keynes' absolute income hypothesis? Explain the demonstration and ratchet
effects in the relative income hypothesis. Explain the shortcomings of relative
income hypothesis
Relative Income Hypothesis
The Relative Income Hypothesis, developed by James Duesenberry, posits that an individual's
consumption behavior is influenced not only by their absolute level of income but also by their
income relative to others in society. This theory emphasizes the social context of consumption.
The figure illustrates Duesenberry's
Relative Income Hypothesis, which
emphasizes that a family’s consumption
depends on its relative income in
comparison to others in the community,
rather than just its absolute income.
Initial Income Level (Y1):
At income level Y1 family A′ consumes
Y1A′. This indicates that the average
propensity to consume (APC = C/Y)
remains high at lower income levels.
Increase to Income Level (Y2):
When income rises to Y2, the family A′
does not merely consume Y2 B (as would
be expected under simple proportional
income increases). Instead, its
consumption rises to Y2A′, which lies on
the same ray from the origin as the earlier point A.
This shows that the family adjusts its consumption proportionally to its past standard of living,
maintaining a constant APC despite the increase in income.
Further Increase to Income Level (Y3):
For family B at Y2 with consumption Y2B, a rise in income to Y3 leads to an increase in
consumption to Y3B′, again maintaining proportionality to its earlier consumption level.
This implies that consumption behavior adapts in such a way that APC does not decline with
rising income.
Community-Level Dynamics:
When incomes rise across society, the consumption function curve shifts upwards from CC to
C′C′. This adjustment reflects that the relative income hypothesis ensures a stable APC across
different income levels for the community, unlike Keynes’ original theory, where APC declines
with rising income.
Key Implications:
Duesenberry’s hypothesis explains that consumption habits are sticky due to social comparisons
(demonstration effect). Families aim to maintain or improve their relative consumption level.
The upward shift of the consumption function (from CC to C′C′) ensures that average propensity
to consume remains constant over time as income increases.
Key Features:
Demonstration Effect:
Individuals compare their consumption to that of others in their social group or society.
This "keeping up with the Joneses" effect leads people to adjust their consumption to match
higher-income groups, even if it means reducing savings.
Ratchet Effect:
Consumption habits adjust slowly to changes in income, especially when income decreases.
Once a certain standard of living is
achieved, individuals are reluctant to
reduce consumption, even if their
income declines.
This is illustrated in Figure 7.2 where
on the X-axis we measure disposable
income and on the Y-axis the
consumption and savings. Starting
with disposable income of zero, we
assume that there is steady growth of
disposable income till it reaches Y1.
The linear consumption. Function CLR
is the long-run consumption function.
It will be seen from the figure that at
Y1 level of disposable income, the
consumption expenditure equals
Y1C1. Now suppose with initial income level Y1, there is recession in the economy with the result
that disposable income falls to the level Y0. According to Duesenberry, consumption would not
fall greatly to the level Y0C0 as the long-run consumption function curve CLR would suggest. In
their bid to maintain their consumption level previously reached people would now save less and
reduce their consumption level only slightly to Y0C′0whereas point C′0 is on the short-run
consumption function curve CSR.
APC and MPC:
In the relative income hypothesis, the average propensity to consume (APC) remains constant
over time because consumption depends on social comparisons rather than absolute income
growth.
The marginal propensity to consume (MPC) may vary but is influenced by social and habitual
factors.
Implications:
Consumption is more stable in the long run because individuals adjust spending based on
relative, not absolute, income.
Explains why APC may remain constant in the long term, aligning with Kuznets' findings.
Absolute Income Hypothesis
The Absolute Income Hypothesis was proposed by John Maynard Keynes in his General
Theory. It asserts that an individual's consumption depends solely on their absolute level of
income in a given period.
Key Features:
Direct Relationship:
Consumption increases as income rises but at a decreasing rate.
A portion of additional income is saved, leading to a declining APC as income increases.
Linear Function:



Keynes expressed the relationship as: C=a+bY
a: Autonomous consumption (consumption when income is zero).
b: Marginal propensity to consume (MPC), which is constant.
Short-Run Focus:
Keynes emphasized short-run consumption behavior, where psychological and institutional
factors determine the propensity to consume.
Implications:
APC declines as income rises because savings become a larger fraction of income.
Consumption patterns are directly linked to current income levels, with little consideration for
relative societal factors.
Comparison
Aspect
Key Determinant
APC Behavior
Focus
Reaction to
Income Changes
Relative Income
Hypothesis
Income relative to
others in society
APC remains stable
over time
Long-term social and
habitual influences
Slower adjustment due
to the ratchet effect
Absolute Income
Hypothesis
Absolute level of
income
APC declines as income
increases
Short-term individual
income effects
Immediate adjustment
based on current income
Social Context
Emphasizes societal
and peer comparisons
Ignores social
influences
Shortcomings of the Relative Income Hypothesis
Focus on Social Comparison: Overemphasizes peer comparisons (demonstration effect) and
ignores individual preferences or goals.
Rigid Consumption Behavior: The ratchet effect assumes consumption doesn’t decrease
with income, which isn’t always true.
Limited to Developed Economies: Does not apply well to developing countries, where basic
needs drive consumption.
Neglect of Absolute Income: Underestimates the role of absolute income, especially for
low-income groups.
Fails to Explain Long-Term APC Stability: Struggles to justify stable APC during rapid
income growth.
Ignores Intertemporal Choices: Does not consider long-term consumption and savings
planning, unlike newer theories.
2. Explain the life cycle theory of consumption.
The Life Cycle Theory of Consumption, developed by Franco Modigliani and his collaborators,
explains how individuals allocate income to consumption over their lifetime. The theory suggests
that individuals plan their consumption and savings behavior based on their expected lifetime
income rather than their current income. It emphasizes the role of intertemporal decision-making,
where people aim to maintain a relatively stable consumption level over their lifetime.
Key Features of the Life Cycle Theory of Consumption:
Income and Lifecycle Phases:
The income of an individual varies across different phases of life. Typically:



In the early years (youth), income is low, and individuals borrow or rely on savings to
maintain consumption.
In the middle years (working life), income increases, and individuals save to prepare for
retirement.
In the later years (retirement), individuals rely on savings and dis-savings to maintain
consumption as income diminishes.
Consumption Smoothing:
The theory assumes that individuals prefer to smooth their consumption over their lifetime rather
than have it fluctuate with their income. This means they borrow when income is low, save when
income is high, and use their savings during retirement.
Savings Behavior:
Savings are influenced by the difference between current income and desired consumption:


If income is higher than planned consumption, individuals save.
If income is lower than planned consumption, individuals borrow or spend their savings.
Wealth Accumulation and Dissaving’s:
Wealth accumulation occurs during the high-income earning phase, while dissipation occurs in
the retirement phase to fund consumption.
Graphical Representation of Life Cycle Theory of Consumption:
The provided diagram, Fig. 7.3: Life Cycle Theory of Consumption, illustrates the income and
consumption pattern of an individual over their lifetime based on the Life Cycle Hypothesis.
Here is the explanation of the figure based on the given description:
Income Curve (YY′):
The curve represents the individual's
income over their lifetime.
Income starts increasing when the
individual enters the workforce,
peaks during their prime working
years, and declines sharply after
retirement.
Consumption Curve (CC′):
The consumption curve represents
the planned consumption of the
individual, which increases slightly
over time due to lifestyle changes
and higher needs as they grow older.
The curve is smoother compared to
the income curve, reflecting the
assumption that individuals prefer stable consumption over their lifetime.
Dissaving Periods (CYA and BC′Y′):
Before Age 25 (CYA):
At this stage, income is less than consumption, so the individual dissaves (spends more than they
earn). This could be funded by borrowing or support from others (e.g., family or loans).
After Age 65 (BC′Y′):
Post-retirement, income decreases sharply and falls below consumption levels. The individual
dissaves again, utilizing their accumulated savings from earlier years.
Savings Period (Area AHB):
Between the ages of 25 and 65, income exceeds consumption, leading to savings.
This is the period during which the individual builds wealth or assets to prepare for retirement and
repay any earlier debts.
Net Savings = Zero:
The Life Cycle Hypothesis assumes that the individual's total savings over their lifetime (shaded
area AHB) exactly balance out the total dissavings (areas CYA and BC′Y′).
This means that the individual uses all their accumulated wealth during their retirement, leaving
no assets or liabilities at death.
Critical Points on the Graph:
Point A: Marks the age (25 years) when income starts exceeding consumption, transitioning into
the savings phase.
Point B: Represents the age of retirement (65 years), after which dissaving begins.
Explanation of the Behavior:




In the early years (15–25 years), the individual relies on borrowing or financial support
since their income is insufficient to meet their consumption needs.
During the prime earning years (25–65 years), income surpasses consumption, allowing
the individual to save and build wealth.
In the post-retirement years (65–75 years), the individual uses their accumulated savings
to fund consumption as income falls drastically.
The shaded areas indicate the balance between savings and dissavings, aligning with the
hypothesis that lifetime net savings are zero unless the individual intends to leave a bequest.
Assumptions:

The individual plans their consumption to ensure stable living standards throughout life.

No assets are left behind at death unless explicitly planned.

Interest on assets and debts is assumed to be zero for simplicity.
Equation of Life Cycle Consumption Function:
How the consumption of an individual in a period depends on these factors highlighted by life
cycle theory can be expressed in the form of an equation. To do so let us consider an individual of
a given age with an additional life expectancy of T years and intends to retire from working after
serving for N years more. Then suppose that in the current period and thereafter in his life span
the individual will consume a constant proportion, 1/T of his life-time income in equal instalments
per year.
ThusIt will be observed from the
above equation that life cycle
hypothesis
suggests
that
consumption in any period does
not depend only on current
income but also on expected
income over his entire working
years. Besides, consumption in
any period also depends on his presently owned wealth or assets which are built up during the
prime working years of one’s life when income exceeds savings
Criticisms of the Theory:

It assumes perfect foresight regarding lifetime income, which may not be realistic.

Borrowing constraints and unexpected life events can disrupt the predicted consumptionsmoothing behavior.

It assumes individuals are rational planners, ignoring behavioral biases.
3. Explain the permanent income hypothesis. How does it differ from Keynes'
absolute income hypothesis? How is permanent income measured?
PERMANENT INCOME THEORY OF CONSUMPTION
Permanent income theory of consumers’ behaviour has been put forward by a well-known
American economist, Milton Friedman. , according to Friedman, consumption is determined by
long-term expected income rather than current level of income. It is this long-term expected
income which is called by Friedman as permanent income on the basis of which people make their
consumption plans.
To make his point clear, Friedman gives an example which is worth quoting. According to
Friedman, an individual who is paid or receives income only once a week, say on Friday, he would
not concentrate his consumption on one day with zero consumption on all other days of the week.
He argues that an individual would prefer a smooth consumption flow per day rather than plenty
of consumption today and little consumption tomorrow. Thus consumption in one day is not
determined by income received on that particular day. Instead, it is determined by average daily
income received for a period. People plan their consumption on the basis of expected average
income over a long period which Friedman calls permanent income.
It may be noted that permanent income or expected long-term average income is earned from both
“human and non-human wealth”. The income earned from human wealth which is also called
human capital refers to the return on income derived from selling household’s labor services, that
is, efforts and abilities of its labor. This is generally referred to as labor income. Non-human wealth
consists of tangible assets such as saved money, debentures, equity shares, and real estate and
consumer durables.
The Permanent Income Hypothesis (PIH)
Definition:
The Permanent Income Hypothesis (PIH) was developed by economist Milton Friedman. It posits
that an individual’s consumption decisions are not based solely on their current income but rather
on their permanent income, which represents their expected average long-term income.
According to this hypothesis, people distinguish between permanent income (income expected
to persist over time) and transitory income (temporary or short-term deviations from the expected
income). Consumption primarily depends on permanent income, while transitory income has a
smaller impact.
Key Features of the Permanent Income Hypothesis
Consumption Smoothing:


Individuals prefer a stable consumption pattern over time. They adjust their savings to
smooth consumption, regardless of short-term income fluctuations.
For example, a temporary bonus is more likely to be saved than fully spent, as it is
considered transitory income.
Role of Expectations:

People form expectations about their future income based on past income trends and other
economic factors. Consumption decisions are aligned with these expectations rather than
current income alone.
Permanent and Transitory Income:


Permanent Income (Yp): Represents the stable, expected income over a long period. It
forms the primary determinant of consumption.
Transitory Income (Yt): Represents short-term, unexpected deviations from permanent
income, such as bonuses, temporary pay cuts, or windfall gains.
Total income (Y) can be expressed as:
Y=Yp+Yt
Consumption is a function of permanent income:
C=kYp
Where k is the marginal propensity to consume from permanent income.
Friedman's Formula for Measuring Permanent Income:
Milton Friedman proposed a method to estimate permanent income (Yp) by accounting for the
current year's income (Yt), the previous year's income (Yt-1), and the fraction of the change in
income deemed permanent (a):
Yp= aYt + (1 — a) Yt-1
Where:




Yp: Permanent income
Yt: Current year's income
Yt−1: Last year's income
a: Weight given to the current income (0 < a < 1)
Explanation of the Formula
Role of a:
• a measures how much of the change in income is perceived as permanent.
• A higher a (closer to 1) indicates greater confidence in current income being permanent.
• A lower a (closer to O) implies more reliance on past income trends.
Income Stability:
• If Yt =Y—I, Yp = Yt, as the income trend is stable.
• If Yt > Y—I, Yp is less than Yt, as part of the increase is viewed as temporary.
Example Calculation
Suppose:



Current income (Yt) = ₹85,000
Last year's income (Yt−1) = ₹80,000
a=0.6
Using the formula:
Yp= 0.6×85,000 + (1 - 0.6)×80,000
=51,000 + 32,000
=83,000
Here, permanent income (Yp) is ₹83,000, slightly below the current income due to cautious
adjustment.
Difference between Keynes' Absolute Income Hypothesis and Friedman's
Permanent Income Hypothesis
The table below highlights the key differences between these two theories:
Aspect
Keynes' Absolute Income
Hypothesis
Core Idea
Consumption is primarily
determined by current disposable
income.
Consumption
Function
Time Frame
C=a+bY C = a + bY C=a+bY where
a is autonomous consumption, b is
the marginal propensity to consume
(MPC), and YYY is income.
Focuses on short-run consumption
behavior.
Role of Past
Income
Does not account for past income or
expectations about future income.
Marginal
Propensity to
Consume
MPC is constant in the short run.
Impact of
Transitory
Income
Behavior of APC
Transitory income increases
consumption proportionally in the
short run.
APC decreases as income rises,
reflecting diminishing consumption
relative to income.
Adjustment to
Income Changes
Consumption adjusts immediately to
changes in income.
Empirical Basis
Based on short-term observations of
consumption behavior.
Policy
Implications
Short-term fiscal policies like tax
cuts or subsidies are effective in
influencing consumption.
Friedman's Permanent Income
Hypothesis
Consumption is determined by
long-term (permanent) income
expectations rather than current
income alone.
Cp=kYp where Cp is
consumption, k is the proportion
of permanent income consumed,
and Yp is permanent income.
Focuses on long-term
consumption patterns.
Considers past income and future
income expectations in
determining permanent income.
Short-run MPC is lower than
long-run MPC, as adjustments to
income changes occur gradually
over time.
Transitory income has minimal
impact on consumption as it is
often saved rather than spent.
APC remains stable in the long
run as permanent income aligns
with consumption.
Consumption adjusts cautiously to
changes in income unless the
income change is perceived as
permanent.
Developed using long-term data
and empirical observations.
Policies that affect long-term
income growth, such as education
or investment, are more effective
in influencing consumption.
Comparison: Life Cycle Hypothesis vs. Permanent Income Hypothesis
The table below outlines the differences between the Life Cycle Hypothesis (LCH) proposed by
Franco Modigliani and the Permanent Income Hypothesis (PIH) developed by Milton
Friedman:
Aspect
Core Idea
Key Focus
Role of Wealth
Time Horizon
Treatment of
Income
Role of Savings
Behavioral
Assumptions
Impact of
Transitory
Income
Empirical Basis
Consumption
Stability
Permanent Income Hypothesis
(PIH)
Consumption is determined by
Consumption is determined by
permanent income, representing
lifetime resources (current income,
long-term average income
wealth, and future expected income).
expectations.
Examines income and consumption
Emphasizes distinguishing
patterns over an individual’s life
between permanent and
cycle (youth, working years,
transitory income components.
retirement).
Wealth plays a significant role;
Wealth is considered indirectly;
individuals draw on savings and
consumption depends primarily on
accumulated wealth to smooth
income expectations.
consumption.
Focuses on long-term income
Focuses on lifetime consumption
expectations, abstracting from
patterns based on the stages of life.
specific life stages.
Consumption depends on
Current income is less critical than
permanent income, with
lifetime resources (wealth + future
transitory income having minimal
income).
effect.
Savings are used to smooth
Savings occur as a response to
consumption across life stages (e.g.,
transitory income changes, not
saving during working years,
necessarily linked to life stages.
dissaving in retirement).
Rational individuals plan
Rational individuals base
consumption and savings to maintain consumption on long-term income
a stable standard of living
expectations and adjust savings
throughout life.
accordingly.
Transitory income may temporarily
Transitory income is typically
increase savings but is incorporated
saved and does not significantly
into overall lifetime resources.
influence consumption.
Derived from observations of
Based on the relationship between
lifetime consumption and savings
income components (permanent
patterns.
vs. transitory) and consumption.
Consumption stability is tied to
Consumption is relatively stable
lifetime planning, with fluctuations as it reflects long-term income
across life stages (e.g., higher during rather than temporary income
retirement).
changes.
Life Cycle Hypothesis (LCH)
Policy
Implications
Policies affecting wealth (e.g.,
pensions, retirement savings)
significantly impact consumption.
Policies promoting long-term
income growth are more effective
in influencing consumption.
Comparison of Life Cycle Theory, Permanent Income Theory, and
Keynesian Theory of Consumption
The table below summarizes the key aspects of the Life Cycle Theory of Consumption, the
Permanent Income Theory of Consumption, and how they differ from Keynesian Theory of
Consumption:
Aspect
Core Idea
Time Frame
Consumption
Function
Role of Wealth
Adjustment to
Income
Changes
Role of
Expectations
Permanent Income
Theory of
Consumption
Consumption depends
Consumption is based
on lifetime resources
on permanent income,
(current income,
which is the long-term
wealth, and future
average expected
income).
income.
Focuses on lifetime
Emphasizes long-term
consumption patterns, income expectations
including savings and
and the distinction
dissavings at different
between permanent and
life stages.
transitory income.
Life Cycle Theory of
Consumption
C=aW+bY where W is
wealth and Y is
income.
Wealth is a critical
determinant, as it
provides resources for
smoothing
consumption.
Income changes are
incorporated into
lifetime planning,
affecting savings and
consumption.
Includes expectations
about future income
and retirement
planning.
Keynesian Theory of
Consumption
Consumption depends
on current disposable
income, with no role
for future expectations.
Focuses on short-run
consumption behavior
and immediate income
changes.
Cp=kYp_ where Yp is
permanent income.
C=a+bY where a is
autonomous
consumption and b is
the MPC.
Wealth plays an indirect
role through its effect
on permanent income.
Wealth is not
explicitly considered.
Gradual adjustment to
income changes unless
they are perceived as
permanent.
Immediate adjustment
to income changes.
Focuses on long-term
income expectations
rather than short-term
income.
No role for future
income expectations;
consumption depends
only on current
income.
Behavior of
APC
Behavior of
MPC
APC may vary across
life stages but is stable
over an individual's
lifetime.
MPC depends on
lifetime resources and
varies with income and
wealth levels.
Savings occur during
working years and are
drawn down in
retirement (life stage
planning).
APC remains stable in
the long run as
permanent income
aligns with
consumption.
Short-run MPC is lower
than long-run MPC, as
consumption adjusts
gradually.
APC declines as
income rises due to the
psychological law of
consumption.
MPC is constant and
less than 1 in the short
run.
Savings are primarily
influenced by transitory
income changes.
Savings increase as
income rises because
consumption does not
grow proportionally.
Empirical
Basis
Based on observations
of consumption and
savings patterns across
different life stages.
Based on the distinction
between permanent and
transitory income
components.
Derived from shortterm observations of
income and
consumption
relationships.
Policy
Implications
Policies affecting
wealth (e.g., pensions,
retirement savings)
significantly impact
consumption.
Policies promoting
long-term income
growth are more
effective.
Short-term fiscal
policies (e.g., tax cuts)
directly influence
consumption.
Savings
Behavior
Summary



The Life Cycle Theory incorporates lifetime planning, emphasizing savings and
dissavings across life stages (e.g., saving during working years and dissaving in
retirement).
The Permanent Income Theory focuses on long-term income expectations, treating
temporary income changes as having little effect on consumption.
The Keynesian Theory is a short-term model, where consumption depends primarily
on current disposable income, with no consideration for future expectations
or wealth.
5. Explain permanent income hypothesis. How does it differ from
Keynes' absolute income hypothesis? How is permanent income
measured?
6. Explain the cyclical relationship between aggregate consumption
and national income in terms of the relative income hypothesis.
Chapter-08: Investment Demand
1. Define investment. Discuss about different types of investment. What are
the determinants of investment? Explain the factors that influence the level
of investment in the economy. Distinguish between autonomous investment
and induced investment. Draw and explain the investment demand curve.
Definition:
The term Investment means purchasing of different kinds of shares and stocks and investing
capital in such activities as are likely to yield income.
According to Keynes: The term Investment is used to mean real investment. It means addition
made to the existing capital asset which results in an increase in employment. Thus, investment
is the expenditure incurred for real capital formation.
It includes 3 kinds of items:
a) Building of new machines & capital equipment
b) Construction of new buildings
c) Increase in stocks.
In words of KEYNS, “ Investment, thus defined included therefore the increment of capital
equipment.”
Classification of Investment:
Based on income investment may be classified into two categoriesi.
ii.
Induced Investment
Autonomous investment
Based on ownership investment can be classified into two typesi.
ii.
Private Investment
Public Investment
Investment may be also two types on the basis of calculationi.
ii.
Gross Investment
Net Investment
Induced InvestmentIt is governed by income & amount of profit. Induced by changes in income and profit. Induced
investment is found in private sector.
In words of prof. keiser,” When an increase in investment is due to increase in current level of
income & production, it known as investment.”
Induced investment is expressed in fig.1, income is shown on OX- axis & investment is shown
on OY-axis. II curve represent induced investment. It slopes upward signifying that investment
increases when there is increase in income.
Autonomous Investment:
It is that investment which is independent of level of income or profit or output. It is not induced
by income.
Fig.2 explains the concept of autonomous investment.
Factors or determinants of Investment in economyInterest Rates



Higher interest rates make borrowing more expensive, discouraging investment.
Lower interest rates reduce borrowing costs, making investment more attractive.
Investment is negatively related to interest rates.
Availability of Credit and Financial Resources


If banks and financial institutions provide easy access to loans, businesses can invest
more.
Tight credit policies or financial crises restrict investment due to lack of funds
Exchange Rates


Depreciation of currency makes exports cheaper and can increase investment in exportoriented industries.
Appreciation of currency makes imports cheaper but may reduce investment in domestic
production.
Global Economic Conditions


If the global economy is growing, exports and foreign investment increase, leading to
more investment.
Trade restrictions, global recessions, or currency fluctuations reduce business
confidence and investment.
Technological Advance & Innovation



Technological progress plays a crucial role in increasing productivity and efficiency.
Innovations in machinery, production processes, and automation reduce costs and
enhance output.
Higher productivity attracts more investment as businesses seek to capitalize on
advancements
Discovery of Natural Resources



The availability of resources like oil, minerals, and fertile land boosts economic
activities.
Countries rich in natural resources tend to attract foreign direct investment (FDI).
Resource discoveries can lead to increased employment and industrial development.
Government Policies



Fiscal policies (taxation, subsidies) and monetary policies (interest rates, inflation
control) influence investment decisions.
Business-friendly policies such as tax breaks and incentives encourage private sector
growth.
Regulatory frameworks affect the ease of doing business and investment climate.
Foreign Trade



International trade expands markets, enabling firms to achieve economies of scale.
Export-oriented economies experience rapid growth due to foreign exchange earnings.
Trade agreements and tariffs impact cross-border investments and economic growth.
Political Environment



Political stability ensures a secure investment climate, attracting both domestic and
foreign investors.
Corruption, bureaucratic inefficiencies, and policy unpredictability can deter investment.
Strong legal institutions and governance foster economic confidence.
Expectations



Business and consumer confidence influence investment decisions.
Positive expectations about future demand and profitability encourage firms to expand.
Economic uncertainty or fear of recession leads to reduced investment.
Rate of Population Growth



A growing population increases labor supply, boosting economic activity.
High population growth can create a large consumer market, encouraging investment.
However, excessive population growth without employment opportunities can strain
resources.
Territorial Expansion



Expansion of land or infrastructure development can stimulate investment.
Urbanization and industrial expansion create opportunities for businesses.
Access to new markets through expansion leads to increased economic activity.
The Price Level



Inflation and deflation affect the purchasing power of consumers and businesses.
High inflation discourages long-term investment due to uncertainty.
Stable prices create a predictable economic environment, fostering investment.
The Market Structure



Competitive markets encourage efficiency and innovation, leading to more investment.
Monopolies and oligopolies can either drive or hinder investment depending on
regulations.
The structure of industries determines the level of competition and market opportunities.
Infrastructure and Business Environment


Well-developed transport, power supply, and communication systems make
investment more attractive.
Poor infrastructure and bureaucratic delays discourage investors.
Investment Demand Curve
The investment demand curve represents the relationship between the rate of interest and the
level of investment in an economy. According to Keynesian economics, investment demand is
determined by the marginal efficiency of capital (MEC) and the rate of interest.
Understanding the Investment Demand Curve

The marginal efficiency of capital (MEC) refers to the expected rate of return from
additional investment in capital goods.

The rate of interest represents the cost of borrowing funds for investment.

Investment occurs when MEC is greater than or equal to the rate of interest.

As investment increases, MEC declines due to diminishing returns on capital.
Graphical Representation
In the graph:

The X-axis represents the level of investment.

The Y-axis represents both the marginal efficiency of capital (MEC) and the rate of
interest.

The investment demand curve slopes downward, indicating that lower interest rates
encourage more investment.
Explanation of the Graph

When the rate of interest is i₁, the equilibrium investment level is OI₁ (where MEC = i₁).

If the interest rate falls to i₂, the investment level increases to OI₂, as the cost of
borrowing decreases.

A further decline in the interest rate to i₃ leads to an increase in investment to OI₃.
Thus, the investment demand curve is downward-sloping, showing that as interest rates fall,
investment increases. However, the elasticity of the curve determines how responsive investment
is to interest rate changes.
Distinguishing between Autonomous Investment and Induced Investment.
Aspect
Definition
Influencing
Factors
Dependence
on Income
Purpose
Examples
Nature of
Investment
Graphical
Representatio
n
Autonomous Investment
Investment that is independent of
income or profit levels.
Determined by government
policies, technological
advancements, or long-term
growth needs.
Not influenced by changes in
national income.
Aimed at essential infrastructure,
public welfare, or long-term
economic stability.
Government spending on roads,
bridges, hospitals, and education.
More stable and does not fluctuate
with business cycles.
Induced Investment
Investment that depends on income,
profit, and economic conditions.
Influenced by business expectations,
consumer demand, and economic
cycles.
Directly depends on changes in
national income and GDP.
Focused on profit maximization and
responding to demand fluctuations.
Investment in factories, machinery, and
business expansions based on demand.
Highly volatile and fluctuates with
economic conditions.
2. What are the determinants of induced investment? Define marginal
efficiency of capital. How is it calculated? How does it determine the
volume of investment? What are the factors that determine marginal
efficiency of capital in the economy?
Determinants of Induced Investment
“The inducement to invest is determined in Keynes’ analysis by the businessmen’s estimation of
the profitability of investment in relation to the rate of interest on money for investment. The
expected profitability of new investment is called the marginal efficiency of capital”
It is induced by following two factors in private sector:
 1) Marginal efficiency of capital (Expected Rate of Return)
 2) Rate of interest/Rate of investment/Rate of discount
Marginal efficiency of capital (MEC):
It refers to the expected profitability using one more unit of capital. The marginal efficiency of
capital (MEC) refers to the expected rate of return on an additional unit of capital investment in
the production process. It measures the ability of an investment to generate additional income,
considering all relevant factors, such as market conditions, competition, and technological
advancements.


If MEC is high, businesses will invest more because they expect higher profits.
If MEC is low, investment will decline as firms anticipate lower returns.
Rate of Interest (Cost of Investment Financing)
The rate of interest refers to the cost of borrowing money for investment. It represents the
opportunity cost of using financial resources for capital investment rather than saving or
spending elsewhere.
Higher interest rates increase borrowing costs, discouraging investment. Lower interest rates
make loans cheaper, encouraging more investment.
When interest rates are high, investors may prefer saving rather than investing in capital assets.


If interest rates fall, borrowing becomes cheaper, increasing investment.
If interest rates rise, borrowing becomes expensive, reducing investment.
3. Define investment. What are the factors that determine investment of a country like
Bangladesh? Explain.
4. What are the main components of the national savings and investment identity?
5. What is the difference between foreign direct investment and portfolio investment?
6. What is accelerator theory of investment? Is it good representation of investment behavior?
Chapter-26
Inflation and Hyperinflation: Causes, Effects and Curve
1. Define inflation. What are the main causes of inflation, Distinguish between demand-pull
inflation and cost-push inflation?
2. Discuss the different methods to control inflation.
3. What is deflation?
4. Define stagflation. Discuss the factors that cause stagflation in an economy.
5. What are the main causes of inflation in developing countries like Bangladesh? What
measures would you suggest to control it?
6. State the monetary measures of Bangladesh Bank to control inflation.
7. "Monetary policy is far more effective in controlling inflation than fiscal policy." Explain.
8. Does a higher inflation rate in an economy, other things being equal, affect the exchange rate
of its currency? If so, how?
Chapter-11
Unemployment, Full Employment and Wage-Employment Relationship
1. Define unemployment full employment. Explain different types of unemployment.
Differentiate among frictional, structural and cyclical unemployment.
2. What does employment policy in the economy include?
3. Distinguish between fiscal policy and monetary policy. How is monetary policy helpful
in generation of employment opportunities in the economy?
4. Explain the causes of unemployment and underemployment in developing countries like
Bangladesh. What policy measures would you suggest to solve the unemployment
problem in these countries?
5. Discuss the nature of unemployment in developing countries like Bangladesh. Explain
the limitations of Keynesian policy prescription, namely, defect functioning to increase
aggregate demand, to solve the problem of unemployment.
6. What is meant by wage-price flexibility? How did Pigou show that given a free enterprise
competitive economic system flexibility of wages and prices always ensures full
employment?
Additional Questions
1. Briefly explain the instruments of monetary policy. How does expansionary monetary
policy work? Explain the monetary policy measures that should be adopted for curing
recession and reviving the economy.
2. If countries reduced trade barriers, would the international flows of money increase?
3. Suppose a country has an overall balance of trade so that exports of goods and services
equal imports of goods and services. Does that imply that the country has balanced trade
with each of its trading partners?
4. "The objective of achieving price stability through monetary policy clashes with its
objectives of economic growth"- Do you agree? Discuss.
5. What do you mean by goods market equilibrium and money market equilibrium?
6. What are the motives that arise the desire for liquidity? Explain.
7. What do you mean by money illusion?
8. Why do people have demand for money?
9. Explain Keynes's liquidity preference theory of interest
Short Notes
a. Disposable income
b. Absolute income hypothesis
c. Stagnation
d. Demand pull inflation
e. Cost push inflation
f. Consumer Price Index
g. PPP
h. Marginal efficiency of capital
i. Structural unemployment
j. Balance of trade and balance of payment
k. Liquidity trap
l. Demand pull and cost push inflation
m. Introduction to Macroeconomics
n. Disguised unemployment
o. Expansionary monetary policy vs. Tight monetary policy
p. Balance of payments
q. Aggregate demand
r. Frictional unemployment