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Unit – 3
Theory of Employment
Say’s Law of Market
Say’s law is the foundation of classical theory of employment. Say’s law, named after the French
Economist J.B. Say, is a classical economic proposition that the production of aggregated output creates
sufficient aggregate demand to purchase all of the output produced. In other words, Say’s law states that
supply creates its own demand and over production is impossible. In Say’s words, “It is production which
creates market for goods for selling each at the same time buying and more of production, more of
creating demand for other goods”. Every producer finds a buyer. Every supply of output creates equivalent
demand for output so that there can never be a problem of general over production. Thus, Say’s law denies
the possibility of deficiency of aggregate demand.
Assumptions of Say’s Law
a) Free Market Economy
b) No government intervention
c) Flexibility in internal prices
d) Long run phenomenon
Classical theory of Employment
The classical theory of employment was developed by the combined contribution of classical economist
like Adam Smith, J. B Say, J. S. Mill, David Ricardo etc.
The theory is based on the assumption of full employment of labour and other resources of the economy.
Full employment refers the situation when all the people who are willing to work at the existing wage rate
will get work. Thus, full employment doesn’t mean achieving zero unemployment. Zero unemployment is
impossible in any real economy.
Assumption of classical theory of employment
a) This theory assumed that closed capitalist economy.
b) Full employment level
c) Money acts as medium of exchange
d) There is the existence of perfect competition in the market
e) There is existence of wage price flexibility
1. Say’s law of market:
Same as before (not assumption)
2. Money market:
Irving Fisher states that total value of output is equal to total expenditure on final goods and
services. According to Fisher the long run rate of goods and services remains constant at full
employment level. Similarly, (V and V) velocity of money and velocity of bank money also
remains constant. Thus, price level (p) is determined by the supply of money (M and M). There is
direct relationship between money supply and price level. Hence, PT = MV + MV
3. Labour market:
Flexibility in wage rate assures labour equilibrium with full employment. Real wage rate is
determined by market forces i.e. demand and supply of labour market. Demand for labour is
negative function of real wage rate whereas supply of labour is positive function of real wage
rate. Real wage rate is determined and the level where demand and supply of labour are equal. This
level also represents level of full employment.
4. Product market (Production function):
According to classical economist total output is decreasing function of the number of workers
employed. It is due to the operation of law of diminishing returns but at the full employment level
of output remains stable.
The classical theory of employment can be shown with the help of following figures:
M1V1
Y
Y
A
B
Money Supply
Aggregate Output
y = f(N, K,T)
MV
X
O
Units of Labour
Y
P2
P1
Price Level
Y
W/P
S1
Real Wage W/P
D2
Real Wage W/P
E
S1
D2
E1
X
0
Units of Labour
X
0
P1
P2
Price Level
In figure A, DD represents demand for labour curve and SS represents supply. It intersect at point E i.e.
equilibrium.
In figure B, y = f ( N , K , T ) curve indicates total production function. It slopes upward to the right and
bends to the x-axis and after a point it becomes horizontal.
In figure C, two horizontal curve representing MV and M1V1 at corresponding level of price. It slopes
downward to the x-axis.
Thus, it indicates that total output increases at a decreasing rate initially and reaches at its maximum and
constant at full employment ON. At full employment level, corresponding output is OY.
Unemployment
Unemployment in reality is taken in sense of involuntary unemployment. Involuntary unemployment
refers to a situation when people are willing to work at the prevailing wage rate. But they are unable to
find the work.
Types of unemployment
a. Cyclical unemployment
b. Frictional unemployment
c. Structural unemployment
d. Open unemployment
e. Disguish unemployment
f. Educated unemployment
a. Cyclical unemployment:
It is associated with the downsizing and depression phases of business cycle. During the downsizing
and depression phase of business cycle income fall then aggregate demand also falls and output fall
giving rise to widespread unemployment. It is caused by deficiency in aggregate demand.
b. Fictional unemployment:
Frictional unemployment exists when there is lack of adjustment between demand and supply of
labour force. People leave job for many reason and they take time to find new jobs because of lack
of knowledge and mobility on part of the labour. This gives rise to temporary unemployment of
those workers who are moving between jobs. Unemployment caused by movements of people from
one job to another.
c. Structural unemployment:
Unemployment in Nepal is basically structural in nature, which refers to a situation when a large
number of persons do not get work because of limited job opportunities available. This is known as
structural unemployment.
d. Open unemployment:
Open unemployment refers to a situation when there are some workers who have absolutely no work
to de. They are willing to work at the present wage rate but they are forced to remain unemployment
in the absence of work.
e. Disguish unemployment:
It refers to a situation when a person is apparently employment, but in fact is unemployed. It is not
open for everyone to see. It remains canceled or hidden. This type of unemployment prevails mostly
in villages.
f. Educated unemployment:
It refers to the unemployment among the educated. Some of these people may be unemployed in the
sense of open unemployment i.e. they are not doing any work whatever.
Keynesian theory of employment (Principle of effective demand)
British economist J. M Keynes in 1930s developed macro economics as a field of economic analysis,
different from micro-economics. Keynes propounded the theory of employment, which is also known as
principle of effective demands. According to this theory unemployment arises due to the deficiency of
effective demand and method to control unemployment is to raise effective demand. According to
Keynes the level of employment in short run will depend on aggregate effective demand for goods and
services in the country. Greater the aggregate demand greater will be the volume of employment and
vice-versa. Total employment depends on total demand and unemployment is the result of a deficiency
of total demand. Effective demand represents total money spends on consumption and investment.
Assumptions:
a. There is the existence of closed economy.
b. There is operation of law of diminishing returns.
c. Perfect competition market exists in the society.
d. Less than full employment equilibrium is possible in short run time period.
e. Labour supply in the economy is positively related to money wages.
Aggregate Demand Price / Function (ADP)
When the entrepreneur provides employment to the labour, they produce goods and services. The
entrepreneur receives certain fixed amount of money from the sale of that product. Hence, the aggregate
demand price refers to the receipt which all the entrepreneurs taken together expect from of the sale of
the output. In brief, ADP means the expected price or income when certain volume of employment is
given. The expected receipts are different to different level of employment. A schedule of receipts
expected from the sale of output from various amount of employment is called aggregate demand
function.
Aggregate Supply Price (ASP)
The entrepreneur should bear certain production cost when he gives employment to a fixed number of
labour. Hence, he should get at least a minimum amount from the sale of output while giving
employment. Therefore, ASP refers to the amount of money that the entrepreneur taken together must
receive from the sale of output as given level of employment. In brief, ASP is the production cost of
total output at a given level of employment.
The aggregate supply price is different at different level of employment. A schedule of minimum
amount of receipts required to induce various quantity of employment is called aggregate supply
function.
Determination of Equilibrium Level of Employment
The equilibrium level of employment can be determined by the interaction of aggregate demand
function and aggregate supply function as shown in the following figure:
Figure:
In the figure x-axis represents level of unemployment and y-axis represents receipts and cost. E point is
initial equilibrium where aggregate demand function (AD) intersects with aggregate supply function
(AS). Any other level of employment will reduce the profit and the economy will not be in equilibrium.
At ON, level of employment, aggregate supply function is greater than aggregate demand function
which reflects less. E1 represents new equilibrium which is obtained in the case to achieve full
employment.
Unit – 4
Theory of Multiplier
The concept of multiplier is one of the important components of Keynesian theory of employment. This
theory was propounded by a popular economist F.A. Khan in 1931. Later on J.M Keynes developed and
y
redefined this theory. Hence, K 
where K = multiplier.
I
y = Change in income
I = Change in investment
Multiplier is the ratio between change in income with change in investment at particular period of time.
In other words, it tells us how many times income increases as a result of increase in investment.
Relationship between multiplier and MPC (Marginal Propensity to Consume)
Let a two sector economy, economy is in equilibrium as follows:
Y = C + I ------------------- (i)
When investment increases them,
Y + y = C + C + I + I --------------------- (ii)
Subtract the eqn (i) from (ii)
y = C + I ------------------------ (iii)
C
Or, y = y
 I
y
C
Or, y - y
= I
y
 C 
 = I
Or, y 1 
y 





y  1  
y
C 
 K 


Or,
MPC 


C 
I

I
,

y

1


y


Substituting the value,
1
Or, K =
------------------------- (iv)
1  MPC
1
K=
MPS
This equation shows that the multiplier and marginal propensity to consume have direct relationship.
When MPC increases, multiplier also increases and vice versa. This positive relationship can be shown
by the help of following table.
MPC
0
0.25
0.50
0.75
-1
Multiplier K =
1
1.33
2
4

1
1  MPC
Assumption of multiplier effect
a. The original propensity to consume remains constant during the period of multiplier process.
b. There is closed economy.
c. There are no changes in prices.
d. Consumption is function of current income
e. There are no time lags in multiplier process.
f. Consumer goods are available in response to effective demand for them.
Forward working multiplier can be shown with the help of following figure:
Figure:
In the given figure, x-axis represent income and y-axis represent saving / investment. Initial equilibrium
is E1, at point E1 the equilibrium income is OY. Now there is an increase in the investment ( I ) which
leads to an increase in the aggregate expenditure. Thus, this cause income to increase ( y ).
Reverse working multiplier
Figure:
In the given figure x-axis and y-axis represents income and saving / investment respectively. Initial
equilibrium is E1. At this point income level is OY1. Now there is decrease in investment ( I ) which
leads to decrease in the aggregate expenditure. Thus, this cause income also decrease by ( y ).
Leakage of multiplier
a. Saving
b. Undistributed profit
c. Taxation
d. Inflation
e. Hoarding of cash balance
1. Saving:
It is the most important cause for the leakage of multiplier process. Since the marginal propensity
to consume is less than one, the whole increment in income is not spent on consumption. A part
of it is saved which prefer out of the income stream and the increase in income in the next round
decline. Thus, the higher the marginal propensity to save, the smaller the size of the income
stream and vice versa.
2. Undistributed profit:
If profits acquiring to Joint Stock Company are not distributed to the shareholders in the form of
dividend but are kept in the reserve fund, it is a leakage from the income stream. If companies
tend to reduce the income and hence, further expenditure on consumption goods thereby
weakening the multiplier process.
3. Taxation:
It is also important factor in weakening the multiplier process. Progressive taxes have the effect
of lowering the disposable income of tax payers and reducing their consumption expenditure.
Thus, increased taxation reduces the income stream and lowers the size of multiplier.
4. Inflation:
When there is a raise in the price of consumption goods, a good part of the increased money
expenditure out of the increased income will be dissipated on higher prices instead of promoting
consumption, income and employment.
5. Hoarding of cash balance:
This type of leakage will be greater if business prospectuses are bad and smaller. When business
prospectus are good. Whenever new created money income is hoarded, it cannot reappear as
income in the next round and the multiplier effect will be arrested.
The principle of acceleration
The principle of acceleration was developed by J. M Clark in 1917. Later on Hicks, Samulson and
Harrod etc redefined this theory. The principle of acceleration is based on the fact that the demand for
capital goods is derived from the demand for consumer goods. In other words, acceleration is the ratio
between induced investment and initial change in consumption. Symbolically
Ii
V=
C
When, V = acceleration
Ii = change in induced investment
C = change in consumption
Hicks has broadly explained the concept of acceleration as the ratio of induced investment to change in
income or output. Thus,
Ii
Acceleration (V) =
y
Acceleration principle can be explained by the following mathematical expression:
Igt = V (Yt – Yt-1) + R --------------------------- (i)
Where,
Igt = gross investment at time period ‘t’
V = acceleration
Yt = income at time period ‘t’
Yt-1 = previous year income
R = replacement or depreciation
Or, Igt = V . y + R
After deducting depreciation from gross investment we get net investment. Hence,
Int = V y -------------- (i)
Where,
Int = net investment at time period ‘t’
I =V. y
I
Or, V =
which is the regd equation.
y
Assumption
a. Capital output ratio remains constant
b. There is permanent change in consumption demand
c. There should be no excess capacity in the capital goods
d. Technology remains constant
e. There is absence of time lag
Criticism of principle of acceleration
a. The assumption of a fixed technical coefficient and replacement demand is not valid at least in
short run changes in demand.
b. The acceleration principle does not operate in those situations in which there exist most unused
plant capacity that enables business to increase output of goods without increasing capital.
k 

c. The acceleration principle assumes a constant incremental capital output ratio V 
 but in
I 

dynamic world the cause of fixed ICOR are rare.
d. It ignores the effect of price change which has a great role important.
e. It only studies the effect of changes in consumption but ignores the effect of an autonomous
investment.
f. According to Prof. Tinbergn, this principle does not posses practical importance.
Importance of acceleration theory
Despite of some criticism, this theory occupies a significant place in macro economics analysis:
a. It helps to understand the process of income generation more clearly and comprehensively.
b. It also explains why the fluctuation in income and employment occur so violently.
c. It demonstrates that capital goods industries fluctuate more than the consumer good industries.
d. It is more useful in explaining the upper turning point of the business cycle because what is
responsible for a fall in the induced investment is not any absolute fall in the demand for
consumer goods but only a decline in its rate of increase.
e. Harrod had used the coefficient of acceleration in the growth to show that the economic growth
in the economy depends upon the size of acceleration, higher the size of acceleration higher the
growth rate and vice versa.
Concept of super multiplier
The concept of super multiplier was developed by J. R Hicks in 1950. Super multiplier refers interaction
between acceleration and multiplier. It shows the effect on equilibrium income, output and employment.
y
Ks =
where, Ks = super multiplier
Ia
Super multiplier can be explained with the following mathematical expression. Let the economy is in
equilibrium.
Y=C+I
Or, Y = C + Ii + Ia ------------------------ (i)
When investment increase leads to increase in income and consumption.
Or, Y + y = C + C + Ii + Ii + Ia + Ia -------------------------- (ii)
Subtract the eqn (i) from eqn (ii)
y = C + Ii + Ia
C
Ii
Or, y = y .
+ y .
+ Ia
y
y
C Ii
Or, y - y .
. y = Ia
y y
 C

 MPC  b 

 C Ii 
 y

 = Ia
Or, y 1 



Ii
y y 

 acceleration 

 y

Substituting the values on eqn:
y (1 – b – y) = Ia
y
y
1


 Ks 
Or,

 where,
Ia
Ia 1  b  y


Or, Ks =
1
which is our regd eqn.
MPS  V
The concept of super multiplier can be shown with the help of following figure:
Figure:
Consumption function:
In economics, consumption means the amount spent of consumption at a given level of income. There is
direct relationship between income and consumption. The consumption varies with income. The
propensity to consume or consumption functions shows the relation between income and consumptions.
In short the propensity to consume shows how the consumption expenditure varies with change in
income. Hence,
C = f( Yd) where Yd= disposable income
Consumption function can also be written as linear equations.
C = a + bYd
Where, a = autonomous consumption or Y=intercept
b = marginal propensity to consume
d = disposal income
This can be shown with the help of following table:
Income ($)
0
60
120
180
240
300
360
Consumption ($)
20
70
120
170
220
270
320
Saving ($)
-20
-10
0
10
20
30
40
This can be shown with the help of following figure:
Figure:
In the above figure, x-axis and y-axis represents the income level and consumption saving respectively.
Here, OC is autonomous consumption and OS is autonomous saving. When income increases
consumption also increased and reached at the equilibrium point E. E point shows that consumption is
equal to income or zero level of saving. When income increases consumption also increases. The
increasing rate of income is greater than the increasing role of consumption
Propensity to consume has two aspects:
1. Average propensity to consume (APC)
2. Marginal propensity to consume (MPC)
1. Average propensity to consume (APC):
It shows the ratio of aggregate consumption expenditure to aggregate income. In other words,
APC is the ratio of consumption and income. Hence,
C
APC =
Y
2. Marginal propensity to consume (MPC):
MPC shows the ratio of change in consumption and change in income. Hence,
C
MPC =
Y
Distinction between APC and MPC has been shown from the following figures.
Figures:
Properties of MPC:
1. Value of MPC is always positive and less than unity i.e. 0 < MPC < 1. It implies that
consumption expenditure increases at less proportion than income.
2. The short run MPC is stable. It is because of psychological and institutional factors.
3. MPC of the poor is higher / greater than the rich one.
The relationship between APC and MPC
1. APC means the ratio of total consumption to total income i.e. APC =
change in consumption to change in income i.e. MPC =
C
.
Y
C
and MPC is the ratio of
Y
2. If consumption functions be liner with positive expenditure at 0 income level. Its equation is C =
a + by and APC is falling while MPC is constant. And APC is always greater than MPC.
Figure:
In the above figure, slope of CC represents MPC and slope of OA and OB represents APC. Here,
slope of OA > slope of OB. This expression shows that when income of consumption increases
at constant rate APC falls but MPC remains constant.
3. If consumption function be liner passes through origin both APC and MPC are equal and
constant. This can be shown from following equation:
C = by, where b = MPC and APC
Figure:
Keynes’s Psychological law of consumption
J. M Keynes propounded the fundamental psychological law of consumption function. This law states
that there is a tendency on the part of the people to spend on consumption less than the full increment of
income. This law has three related propositions:
1. When the aggregate income increase aggregate consumption also increases but by a some what
smaller amount. The reason is that as income increases, consumer wants get more and more
satisfied with the result it is no longer necessary to spend the additional increase in income on
consumption. The expenditure on consumption is definitely increased but not in the same
proportion in which the income increases. Hence,
C = f(y) or, 0 < MPC < 1
2. An increase of income will be divided in some proportion between saving and spending i.e.
Y  C  S because the whole of increased income is not spend on consumption but
remaining is saved.
3. Increase in income always leads to an increase in both consumption and saving.
This can be shown with the help of following table:
Income
Consumption
Saving
0
50
-50
100
125
25
200
200
0
300
275
25
400
350
50
500
425
75
The three prepositions can be described with the help of following schedule:
Preposition 1: Income is increasing by 100 as from 0 – 100 – 200 – 300 and so on. In the same
consumption also increase by 75 (50 – 125 – 200). When income is increasing, consumption also
increases but the rate of increase in consumption is greater than change in consumption.
Preposition 2: At any two consecutive periods, Y  100, C  75, S  25, Hence the increased
income of Rs.100 crore in each stage is divided in same ration between consumption and saving [ or
Y  S  C
Preposition 3: As income increases from Rs.200 to 300, 400 – 500 consumption also increases from
Rs.50 – 125, 200 – 275 along with increase in saving from 0 to 25, 25, 50, 75 respectively. Hence,
consumption and saving increase with an increased income.
This can be shown with the help of following figure:
Figure:
The 450 line Y = C represents income. This also indicates that at all the point lying on this line whole of
income is consumed and nothing is saved.
Preposition 1: When income is increasing, consumption also increases but rate of increase in income is
greater than rate of increase in consumption.
Preposition 2: When income increases, it is divided in same proportion between consumption and
saving respectively as shown in figure.
Preposition 3: Increase in income leads to increase in consumption and increase in saving. It is show
by gap between income and consumption line is increasing.
Assumption of psychological law of consumption function
1. The psychological and institutional factor remains constants in the same period.
2. It assured the existence of lassiez-faire.
3. It assumes the existence of normal circumstances.
Factor affecting consumption function (Determinant)
1. Subjective factor
a. Individual motive
b. Business motive
2. Objective factor
a. Income
b. Price and wage level
c. Taste and fashion
d. Distribution of wealth
e. Windfall gain or loss
f. Holding of liquid assets
g. Fiscal policy
h. Rate of interest
1. Objective factor:
Keynes stated that the objective factors which cause shifts in consumption function are described
below:
a. Income:
Consumption function is also affected by the nature of income distribution. Greater the
inequality of income distribution lower will be the propensity to consume and it will shift
downward and vice versa. This is because propensity to consume of rich people is low of
poor people is high.
b. Price and wage level:
When wage level increases and price decrease consumption level also increase because
purchasing power increases. But proportionate increase in price level should be greater than
increase in wage level.
c. Taste and fashion:
Taste and fashion also lead in increase in consumption function.
d. Distribution of wealth:
e. Windfall gain or loss:
It is sudden or unexpected gain of loss. This has also great effect on consumption functions.
f. Holding of liquid assets:
If people have large amount of liquid assets like cash balances, saving accounts, government
bond share etc they will tend to spend more out of their current income and thus their
propensity to consume will increase.
g. Fiscal policy:
Heavy indirect taxation like VAT, excise duty etc rationing and price control adversely affect
on propensity to consume. If government imposes progressive taxation, consumption
function shifts upward by bringing about more equitable distribution of income.
h. Rate of interest:
2. Subjective factor:
Subjective factor which determine the slope and position of the consumption function includes of
those psychological motives which include people to increase their consumption. They include
psychological characteristics of human and include individual and business motive.
a. Individual motive:
They are the security motive. People want to save for unforeseen contingencies such as
illness, unemployment, accident etc. People are motivated to save more to get higher social
status etc.
b. Business motive:
Business enterprises save the income to expand the business. They save for the financial
prudence that is to provide adequate financial resources against department or repayment of
debt.
Measure to raise propensity to consumer
a. Income re-distribution
b. Advertisement
c. Credit facilities
d. Urbanization and development of means of transport
e. Social security
f. Increased wages
1. Income – redistribution:
Redistribution of NI is favour of the poor people has been suggested as one of the methods for
raising the propensity to consume. As we know that propensity to consume of poor people is
higher than that of rich people, if NI is distributed in their favour, then MPC can be raise. But the
problem is how to redistribute the NI, in favour of poor people and the methods are:
a. Increasing the productivity of lower income group so that they can spend more on
consumption. It involves the adoption of certain measures to improve employment
opportunity.
b. Increasing the purchasing power by reducing cost or providing subsidies in goods and
commodities.
c. Transferring purchasing power from the higher to lower income group through such
measures as progressive taxation, death-duties, capital gains etc.
Saving function:
That part of income not spends on current consumption is known as saving. In the other words, saving is
defined as access of income over consumption expenditure.
Saving function establishes the functional relationship between current income and saving.
Symbolically, S = f(y)
Saving function can also be derived as linear form. Hence,
S=Y–C
Or, S = Y – (a + by)
Or, S = Y – a – by
Or, S = -a + y – by
Or, S = -a + (1 – b)y where –a = autonomous saving, 1-b = MPS
Saving function can be shown with the help of following table:
Income
Consumption
Saving
0
25
-25
50
50
0
100
75
25
150
100
50
200
125
75
Figure:
Y
C
S
a
450
-a
Technical attributes of saving:
1. Average propensity to save (APS):
It is the ratio between total saving and total income in a particular period of time. Symbolically,
S
APS = .
Y
2. Marginal propensity to save (MPS):
It is the ratio between changes in saving with the change in income. Symbolically,
S
MPS =
.
Y
Types of saving
1. Personal saving
2. Corporate saving
3. Government saving
4. Forced saving
1. Personal saving:
Saving done or made by individual is personal saving. The reason for the personal saving is to
meet sudden emergencies in future. Personal saving is done after the consumption on current
income.
2. Corporate saving:
It is the saving made by companies as a form of retained earnings and depreciation or it can also
be described as ploughing back profits into business and so reducing the amount of profit
distributed to shareholder.
3. Government saving:
It is the difference between net government receipts minus government consumption
expenditure.
4. Forced saving:
Forced saving which occur in a mild inflation because it will bring about a reduction in the
demand for consumer goods. People make their decisions about saving and consumptions
simultaneously. All income which is not consumed is saved.
Determinants of saving
1. Level of income
2. Rate of interest
1. Level of income:
A Keynes stresses, saving is basically a function of income. There is direct relationship between
saving and income. The amount of personal saving depends primarily on the disposable income.
 S 
It has been observed that propensity to save 
 tends to high in high income group sector of
 Y 
community, indeed in developing countries where PCI is high, the saving income ratio is high.
2. Rate of interest:
According to classical economist, saving is the direct function of the rate of interest. To put it
ds
symbolically, S  f (i ),  0 , it clarifies that saving tends to increase with increase in rate of
di
interest. Keynes however didn’t agree with this view. He asserted that saving is a positive
function of current income.
Paradox of Thrift
The concept of paradox of thrift is a paradoxical because it contradicts with popular saying “A penisaved is peni-earned”. This may be true for individual but not for the society. According to classical
economist saving is a private virtue because every individual should save something for his difficult
days. Saving is positive function of rate of interest and investment is negative function of rate of interest.
Rate of interest is determined by the interaction between saving and investment. Therefore, according to
classical economist saving is both private as well as social virtue.
But Keynes rejected the idea of classical economist and he claimed that ‘saving is a vice not a virtue’.
Saving is increasing function of current income. In other words, saving varies positively with current
income. Since one man’s expenditure is other’s income. Increased saving means less consumption and
hence less of effective demand which leads the reduction in income, output and employment in the
economy. Hence, according to Keynes, “saving is a big social vice not a virtue”.
The paradox of thrift can be shown with the help of following diagram:
Y
Saving & Investment
Figure:
S2
S1
I1
E1
M1
E
M2
I
X
Y2
Income
Y1
S2
S1
In the above figure E is the initial equilibrium where investment (II1) intersects saving curve (SS1). This
equilibrium shows that income equilibrium is OY1. At this level of income equilibrium saving and
investment is Y1E1, when saving is the society increases. The saving curve shifts upward from S1S1 to
S2S2. It leads to decrease in consumption, investment and income. As a result new equilibrium is formed
i.e. E, which S2S2 intersects with investment curve II1. This equilibrium level of income and equilibrium
saving and investment are OY2. It implies that saving in current period leads to decrease in both saving
and income in future.
Investment
In general sense, investment is that part of capital which is spent on productive use. In other words,
investment refers the expenditure on capital goods. The word investment is applied to the spending
money on capital goods. Investment can be classified into three types:
a. Autonomous and induced investment
b. Planned, unplanned and actual investment
c. Gross investment and net investment
1. Autonomous and induced investment:
Autonomous investment is the regular of compulsory investment and it is not guided by profit
motive. It is income inelastic. In the words of Peterson, “The autonomous investment is
generally associated with such factors as the introduction of new technology or product, the
development of new resource on the growth of population or labour force”.
When an increase in investment is due to the increase is the current level of income. It is done
with the profit motive. It varies positively with the level of income.
2. Planned, unplanned and actual investment:
If investment is made intentionally to achieve pre-defined goal, then it is planned investment. If
investment if made due to sudden changes or unexpected changes in economic and other factor
then it is called unplanned investment.
Actual investment is the sum of planned and unplanned investment.
3. Gross and net investment:
Gross investment is the sum total of net investment and depreciation. It refers to the total
expenditure on capital goods in a period of time.
Net investment is difference of depreciation from gross investment. It occurs due to increase in
capital stock.
Investment function:
Investment function refers to inducement to invest or investment demand. Classical economist
considered investment demand simply as a decreasing function of interest rate. Hence,
I  f (r ) , where I = induced investment, r = rate of interest
Keynes state that the volume of investment undertaken by private entrepreneurs in the economy depends
on two factors i.e. marginal efficiency of capital and rate if interest. Hence, I  f (e, r )
Marginal efficiency of capital (MEC)
The concept of MEC was introduced by Iriving Fisher. This concept was fully developed or re-defined
by J. M. Keynes. It is one of the important contributions made by Keynes. The MEC refers to the
expected profitability of capital assets. It is related to real investment not financial investment. It may be
defined as the higher rate of return over cost expected from the marginal or additional unit of capital
Q
 C ………………….. (i)
assets. Hence, MEC =
1 r
Where, Q = expected yields of capital assets
r = rate of interest
C = supply price of the assets
The value of r is equal to MEC. It can be obtained by re-arranging the term in equation (i)
Q
r  1
C

7500
1
5000
= 1.5 – 1
r = 0.5
This shows that MEC = 5%.
MEC is measured with the help of two elements:
a. Prospective Yield:
It means aggregate net return from asset during its life time. Net return refers to the net yearly
proceeds obtained from the sales of output produced by the capital assets.
b. Supply Price:
The cost of capital goods is called the supply price. The investor while purchasing a new plant or
establishing a new factory he does not only see the expected return from it but also supply price
of it. Hence, we can obtain the MEC in the following way.
n
Qn
, where Qn = expected rate of return, r = rate of discount / MEC
Sp  
n
n 1 (1  r )
Sp = supply price
Investment demand curve:
The MEC falls as investment increases. There are two reasons for this. They are:
a. The installation of large number of similar machine leads to a reduction in their perspective
yields just as consumption of more units leads to a decrease in marginal utilities.
b. The price of such machine will go up as their demand increases. This will add to the cost. Thus
cost will go up on one hand and the market price of their product goes down as production
increases. Hence MEC goes down as investment increases. This is because with more investment
the productive capacity of the economy will increase and this will decrease expected rate of
profit.
This can be shown with the help of following diagram:
Investment (in million)
MEC
$10,000
12%
$12,000
10%
$14,000
8%
$16,000
6%
$18,000
4%
$20,000
2%
Figure:
Y
MEC / rate of return
I
MEC
I
X
0
Investment
Determinants of MEC (induced invest)
a. Level of income
b. Liquid assets
c. Taxation
d. Business optimism and pessimism
e. Economic policies
f. Political climate
1. Level of income:
If the level of income raises in the economy through rise in wage rates and other factor prices,
the demand for goods will rise this will give rise to MEC and on the contrary, the inducement to
invest or MEC will fall with the lowering of income level.
2. Liquid assets:
The amount of liquid assts with the investor also influences the inducements to investment. If
they posses large liquid assets, the inducement to invest is high and vice-versa.
3. Taxation:
MEC is also affected by the rates if taxation. Heavy doses of direct and indirect tax adversely
affect the MEC. On the other hand low rates of taxation tend to raise MEC and encourage
investment.
4. Business optimism and pessimism:
Business psychology plays on important past in determining the MEC. If the business person is
optimistic then the majority of entrepreneur would estimate a high MEC and pessimism a low
MEC is estimated.
5. Government policy:
If the government levis heavy progressive tax the MEC is low and vice-versa. If the government
sector regarding private sector is liberal (in terms of credit facilities and other necessary legal
environment, the private sector participation will be enhanced and MEC will increase.
6. Political climate:
If there is political instability in the country, the inducement to investment is adversely affected.
Measures to raise induced investment
a. Low rate of interest
b. Tax reduction
c. Public expenditure (government expense)
d. Price policy
e. Promotion of research
f. Economic planning
a. Low rate of income:
Since inducement to invest depends on MEC and rat of interest, it is obvious that under the given
state of MEC, lowering of the rate of interest would enhance the probability of investment. Thus,
it is suggested that the rate of interest should be lowered down by the monetary authorities to
encourage private investors.
b. Tax reduction:
Direct and corporate should be lowered so that the disposable income of the community
increases. Again a reduction in profit tax would increase corporate saving which may induce
more investment.
c. Public expenditure:
Public expenditure may be of two types:
i. Pump-priming and ii) Compulsory spending
Deliberate public expenditure undertaken by the government with a view of initiating recovery
by injecting the circulation of new money into depressed economy is called pump-priming.
Public expenditure designed to compensate the deficiency in private investment is referred to as
compulsory expenditure.
A little expenditure by the government in the form of pump-priming encourages private
investment.
d. Price policy:
Instability in private sector investment is caused by price fluctuations which cause variations in
the expected rate of profitability. Price stability is an essential condition. A host of Keynesian
and post Keynesian economist believes that a rising price policy has favourable impact on
investment and growth.