CIRCULAR FLOW OF INCOME

1. Introduction

The Circular Flow of Income is a fundamental concept in macroeconomics that describes

how money moves through an economy. It represents the continuous movement of
production, income, and expenditure among the different sectors of the economy.

The concept emphasizes that one person's expenditure is another person's income, and
this interconnectedness forms a complete circle where money flows through markets for
goods and services, factors of production, and financial markets.

Understanding the circular flow is crucial for grasping how economies operate, how incomes
are generated, and how national income is measured.

2. Meaning of Circular Flow of Income

The term "circular flow of income" refers to the unending circulation of money and goods
between economic agents. In a simplified economy, households supply factors of production
to firms and receive wages, rent, interest, and profits in return. The firms, in turn, use these
services to produce goods and services, which they sell to the households.

Thus, there are two major flows:

 Real Flow: Movement of goods and services (from firms to households) and factor
services (from households to firms).

 Money Flow: Payments for goods and services and factor incomes.

These two flows run simultaneously and in opposite directions, forming a closed loop.

3. Basic Assumptions

 The economy initially consists only of households and firms.

 Households spend all their income on consumption (no savings).

 Firms produce goods and services using factors provided by households.

 No government and no foreign trade in the basic model.

Later, the government and foreign sector are added to build more realistic models.
4. Two-Sector Model (Households and Firms)

The simplest form of the circular flow includes only two sectors: households and business
firms.

4.1 Structure:

 Households provide factors of production (land, labor, capital, entrepreneurship) to

firms.

 Firms provide goods and services to households.

 Firms pay factor incomes (wages, rent, interest, profits) to households.

 Households spend their entire income on goods and services produced by firms.

4.2 Diagram of Two-Sector Circular Flow:

Households ----> (Factors of Production) ----> Firms

Households <---- (Goods and Services) <---- Firms

Money Flow:

Firms ----> (Factor Payments: Wages, Rent, Interest, Profits) ----> Households

Firms <---- (Consumption Expenditure) <---- Households

4.3 Explanation:

Thus, the money flows in one direction and the real flow of goods and services flows in the
opposite direction. The economy remains in equilibrium when total production = total
income = total expenditure.

5. Three-Sector Model (Adding Government)

When government activities are included, a third sector appears in the model.

5.1 Structure:

 Government collects taxes from households and firms.

 Government provides public goods and services (education, defense, infrastructure).

 Government makes transfer payments (subsidies, pensions).

5.2 New Elements Introduced:

 Leakages: Taxes reduce household and firm spending.

 Injections: Government spending injects money back into the economy.

5.3 Diagram of Three-Sector Circular Flow:

[Households] ---Taxes---> [Government] ---Public Expenditure---> [Firms]

[Households] ---Consumption Expenditure---> [Firms]

[Firms] ---Factor Payments---> [Households]

Thus, even with government intervention, the fundamental circular flow continues, though
now part of the income is redirected to and from the government.

6. Four-Sector Model (Adding Foreign Sector)

When we add the foreign sector, the circular flow becomes globalized.

6.1 Structure:

 Exports (X): Domestic goods sold to foreigners — an injection into the flow.

 Imports (M): Foreign goods bought by domestic residents — a leakage from the
flow.

6.2 Impact:

 If exports > imports → inflow of foreign currency → increases income.

 If imports > exports → outflow of domestic currency → decreases income.

6.3 Diagram of Four-Sector Circular Flow:

[Households] ---> (Consumption Expenditure) ---> [Firms] ---> (Exports) ---> [Foreign
Sector]

[Foreign Sector] ---> (Payment for Exports) ---> [Firms]

[Households] ---> (Imports) ---> [Foreign Sector]

This model captures the reality of open economies and global trade interdependence.

7. Leakages and Injections: Conceptual Framework

The circular flow is maintained only if leakages equal injections. Otherwise, national income
will fluctuate.

7.1 Leakages:

These are withdrawals from the flow of income:

 Savings (S): Money saved instead of spent.

 Taxes (T): Money collected by the government.

 Imports (M): Money spent on foreign goods.

Leakages reduce aggregate demand.

7.2 Injections:

These are additions to the flow of income:

 Investment (I): Business spending on capital goods.

 Government Expenditure (G): Public spending.

 Exports (X): Foreign spending on domestic goods.

Injections increase aggregate demand.

7.3 Table: Leakages and Injections

Leakages Injections (Additions)

(Withdrawals)

Savings (S) Investment (I)

Taxes (T) Government Expenditure (G)

Imports (M) Exports (X)

Equilibrium Condition:

S+T+M=I+G+XS + T + M = I + G + XS+T+M=I+G+X

If leakages > injections → National income falls.

If injections > leakages → National income rises.

8. Importance of the Circular Flow Model

 1. Understanding National Income: It helps to understand how income is generated
and distributed within an economy.

2. Basis for National Accounting: Forms the basis for measuring Gross Domestic
Product (GDP) and other aggregates.

3. Highlights Economic Interdependence: Demonstrates the mutual dependence of

households, firms, government, and foreign sector.

4. Policy Formulation: Helps governments design fiscal and monetary policies by

understanding leakages and injections.

5. Business Decision Making: Firms can forecast demand conditions and plan
production accordingly.

9. Complexities in the Real World Circular Flow

In real economies, the circular flow is highly complex due to:

 Financial Markets: Saving and borrowing between sectors.

 Government Policies: Fiscal deficits, taxation, subsidies.

 International Trade: Exchange rates, trade surpluses, and deficits.

 Black Economy: Non-recorded activities affecting flows.

 Inflation: Changes in the value of money affecting the real flow.

Thus, the basic model needs to be expanded with dynamic factors for complete accuracy.

10. Conclusion

The Circular Flow of Income gives a bird’s-eye view of the entire economy's functioning. It
explains how the different sectors are integrated and how money circulates, ensuring that
production, income, and expenditure match each other.

Any imbalance between leakages and injections leads to changes in the level of national
income, which can cause growth, recession, inflation, or unemployment.

Understanding this flow is thus essential for formulating macroeconomic policies aimed at
achieving growth, stability, and equity in an economy.
NATIONAL INCOME: CONCEPTS AND CALCULATION
1. Introduction

The concept of National Income lies at the heart of macroeconomic analysis. It represents
the total value of goods and services produced by a country during a given period (usually
a year).
It reflects the economic health of a nation and serves as a key tool for policy formulation,
international comparisons, and development planning.

However, due to the complexity of modern economies, the definition, measurement, and
interpretation of national income involve significant theoretical and practical challenges.

2. Meaning of National Income

National Income generally refers to the total monetary value of all final goods and services
produced in a country during a financial year.

As per M.L. Jhingan:

 National income may be referred to as national dividend, national output, or

national expenditure.

 It includes payments made to all factors of production: wages, rent, interest, and
profit.

Thus, it reflects the income earned by the citizens of a country for their productive activities.

3. Definitions of National Income

National income has been defined differently by various economists:

Economist Definition Focus

Alfred “The labour and capital of a country, acting on its Production-based

Marshall natural resources, produce annually a certain net
aggregate of commodities, material and immaterial,
including services of all kinds.”

A.C. Pigou “National income is that part of the objective income of Money-
the community, including of course income derived measurement
 from abroad, which can be measured in money.” based

Irving “The national dividend or income consists solely of Consumption-

Fisher services as received by ultimate consumers, whether based
from their material or human environments.”

Critical Observations:

 Marshall emphasizes net production.

 Pigou focuses on measurability in money.

 Fisher emphasizes services and consumption.

4. Concepts of National Income

Various related terms are used in national income accounting:

Concept Meaning

Gross Domestic Total value of final goods and services produced within a country
Product (GDP) in a year at market prices.

Net Domestic GDP minus depreciation (wear and tear of capital).

Product (NDP)

Gross National GDP + Net income earned from abroad.

Product (GNP)

Net National GNP minus depreciation.

Product (NNP)

Personal Income Total income received by individuals (including transfer payments

like pensions, excluding undistributed corporate profits).

Disposable Income Personal income minus direct taxes (available for spending and
saving).

5. Methods of Measuring National Income

To estimate national income, economists use three main methods, depending on the nature
of the economy:

5.1 Product (Output) Method

Definition: It measures the market value of all final goods and services produced in a
country during a year.

Steps:

1. Classify economy into sectors: Agriculture, Manufacturing, Services, etc.

2. Estimate gross output of each sector.

3. Deduct intermediate consumption to avoid double counting.

4. Add up value-added across sectors to get GDP.

GDP = ∑ (Gross Output – Intermediate Consumption)

GDP = ∑ (Gross Output - Intermediate Consumption)

GDP = ∑ (Gross Output – Intermediate Consumption)

Diagram:

Sector 1 → Value Added → Sector 2 → Value Added → Sector 3 → Value Added

Sum = GDP

Important Point: Only final goods are considered, not intermediate goods.

5.2 Income Method

Definition: Measures national income by summing all incomes earned by factors of

production.

Components:

 Wages and Salaries (Compensation of employees)

 Rent

 Interest

 Profits (Corporate and proprietors’ income)

 Mixed Incomes (from self-employed persons)

 GDP=Wages + Rent + Interest + Profits + Mixed Income

 GDP = Wages + Rent + Interest + Profits + Mixed Income
  GDP=Wages + Rent + Interest + Profits + Mixed Income

Diagram:

Labour → Wages

Land → Rent

Capital → Interest

Entrepreneurship → Profit

Sum = National Income

5.3 Expenditure Method

Definition: Measures national income by adding up expenditures made on final goods and
services.

Formula:

 GDP=C+I+G+(X−M)
 GDP = C + I + G + (X - M)
 GDP=C+I+G+(X−M)

Where:

 C = Consumption Expenditure

 I = Investment Expenditure

 G = Government Expenditure

 X = Exports

 M = Imports

Component Meaning

C Household spending on goods and services

I Business spending on capital

G Government spending

X Export earnings
 M Import payments

6. Interrelationship Among Methods

If there are no statistical discrepancies, all three methods should give the same result:

 National Product = National Income = National Expenditure

This is because:

 What is produced (product) generates income for factors and is spent (expenditure)
to buy the output.

Thus, the circular flow of income connects all three measurements.

7. Difficulties in Measurement of National Income

Measuring national income is highly challenging due to several conceptual and practical
problems:

7.1 Conceptual Difficulties

 Non-Monetized Sector: In rural areas, goods are often bartered and self-consumed
(especially in underdeveloped countries like India).

 Imputed Values: Services like housewives’ work, unpaid family labor, etc., are
excluded, although they contribute to welfare.

 Illegal Activities: Black market transactions are not recorded but affect economic
activity.

7.2 Statistical Difficulties

 Double Counting: Intermediate goods could be counted multiple times if care is not
taken.

 Depreciation Estimation: Difficulty in accurately estimating capital consumption.

 Price Changes: Inflation/deflation complicates the comparison of national income

over time.

 Lack of Reliable Data: Especially in informal sectors, small businesses, and

agriculture.

8. Importance of National Income Data

 1. Indicator of Economic Performance: GDP growth rates are key indicators of a
country’s development.

2. Policy Making: Governments use national income data for fiscal and monetary
policies.

3. International Comparison: Helps compare the living standards across countries.

4. Business Planning: Corporations use economic growth estimates for strategic

decisions.

5. Welfare Analysis: National income gives a rough estimate of the economic welfare of
a nation.

9. Diagrams and Tables

(i) Circular Flow Linking Production, Income, and Expenditure

Production → Income → Expenditure → Production

(ii) Relation Between GDP, GNP, NNP, PI, DI

Concept Formula

GDP at market prices Value of all final goods/services produced domestically

GNP GDP + Net Factor Income from Abroad

NNP GNP - Depreciation

Personal Income (PI) NNP - Undistributed Profits - Corporate Taxes + Transfer

Payments

Disposable Income PI - Direct Taxes

(DI)

INFLATION: MEANING, CAUSES AND EFFECTS

1. Introduction

Inflation is one of the most discussed phenomena in macroeconomics. It refers to a sustained

rise in the general price level of goods and services over a period of time. M.L. Jhingan
describes inflation as a monetary phenomenon that emerges when there is excess aggregate
demand compared to the available aggregate supply of goods and services.

Inflation erodes the purchasing power of money, affects income distribution, impacts savings
and investment, and influences the overall economic environment.

2. Meaning of Inflation

Inflation means a persistent and appreciable rise in the general level of prices.

According to M.L. Jhingan:

 Inflation implies that "too much money chases too few goods."

 It leads to a fall in the value of money.

Thus, inflation does not refer to a temporary rise in prices of individual goods but a
generalized and continuing increase across most goods and services.

3. Measurement of Inflation

Inflation is usually measured using the following indices:

Index Meaning

Consumer Price Index Measures the average change in retail prices paid by consumers.
(CPI)

Wholesale Price Index Measures the change in prices at the wholesale level.
(WPI)

GDP Deflator Ratio of nominal GDP to real GDP, reflecting price level
changes across the entire economy.

Inflation Rate is generally calculated as:

4. Types of Inflation

Inflation can be classified on various bases:

Basis Type Meaning

 Speed Creeping, Walking, Running, Galloping, Based on the rate of price
Hyperinflation increase.

Cause Demand-Pull, Cost-Push, Structural Based on reasons for inflation.

Contro Open Inflation, Suppressed Inflation Based on government

l intervention.

4.1 On the Basis of Speed

Type Description

Creeping Slow and mild (less than 3% per year). Considered manageable.
Inflation

Walking Moderate (3–10% per year). May become dangerous if unchecked.

Inflation

Running Rapid increase (>10% per year).

Inflation

Galloping Very high inflation, often > 20–30% per year.

Inflation

Hyperinflation Extremely rapid (prices rising several times a day). Example:

Germany (1923), Zimbabwe (2000s).

5. Causes of Inflation

According to M.L. Jhingan, inflation arises mainly due to two broad reasons:

5.1 Demand-Pull Inflation

Definition: Inflation caused by an excess of aggregate demand over aggregate supply at full
employment level.

Causes:

 Increase in money supply.

  Increase in government spending.

 Increase in private investment.

 Tax reductions raising disposable income.

 Export boom raising demand for domestic products.

Diagram:

Aggregate Demand (AD) shifts right → Higher price level

Graphically, in the Aggregate Demand-Aggregate Supply (AD-AS) model, an outward shift

of AD causes inflation if supply is inelastic.

5.2 Cost-Push Inflation

Definition: Inflation caused by rising costs of production independent of demand.

Causes:

 Increase in wages (without productivity rise) — Wage-push inflation.

 Increase in raw material prices (like oil shocks).

 Higher taxes on production.

 Currency depreciation increasing import costs.

Diagram:

Aggregate Supply (AS) shifts left → Higher price level

Thus, cost-push inflation reduces output and raises prices simultaneously, leading to
stagflation (inflation + stagnation).

5.3 Structural Inflation

In developing countries, inflation may occur due to structural bottlenecks:

 Agricultural supply rigidity.

 Poor transport and storage.

 Administrative inefficiencies.

 Industrial underdevelopment.
Thus, in India, inflation is often structural along with demand-pull elements.

6. Effects of Inflation

Inflation has far-reaching consequences across all sections of society and sectors of the
economy.

6.1 Effects on Distribution of Income and Wealth

Group Effect

Fixed Income Groups (salaried Adversely affected as real income falls.

persons, pensioners)

Debtors and Creditors Debtors benefit, creditors lose (repayment in

cheaper money).

Businessmen Generally gain due to rising prices of

inventories and better profits.

Speculators Benefit by buying goods cheaply and selling at

higher prices.

6.2 Effects on Production

Aspect Effect

Production Incentive Initially increases profits, encouraging production.

Resource Resources may be diverted towards speculative activities.

Misallocation

Uncertainty Discourages long-term investment due to unpredictable future

costs and returns.

6.3 Effects on Economic Growth

 Mild inflation may stimulate growth by raising profits and investments.

 Hyperinflation disrupts planning, reduces savings, increases uncertainty, and harms

long-term growth.

6.4 Social and Political Effects

  Widening inequality between rich and poor.

 Social unrest and instability.

 Pressure on governments to implement populist measures.

 Credibility of economic institutions declines.

7. Measures to Control Inflation

M.L. Jhingan outlines the following anti-inflationary policies:

7.1 Monetary Measures

 Control over Money Supply through:

o Higher interest rates.

o Increased Cash Reserve Ratio (CRR).

o Selective credit controls.

 Central Bank uses monetary tightening to reduce liquidity.

7.2 Fiscal Measures

 Reduction in public expenditure.

 Increase in taxes to siphon off excess purchasing power.

 Public borrowing to absorb extra money from the economy.

7.3 Direct Measures

 Price controls on essential commodities.

 Rationing of scarce goods to prevent hoarding and black marketing.

However, direct controls are often temporary and hard to implement over long periods.

8. Special Concepts Related to Inflation

Concept Explanation

Inflationary Excess of aggregate demand over aggregate supply at full employment.

Gap
Phillips Curve Inverse relationship between inflation and unemployment (short-run).

Stagflation Simultaneous occurrence of inflation and stagnation (low growth + high

unemployment).

Cost of Shoe leather costs, menu costs, uncertainty costs.

Inflation
EMPLOYMENT: CLASSICAL AND KEYNESIAN THEORIES
1. Introduction

The determination of the level of employment has been one of the fundamental concerns of
macroeconomic theory.

Historically, two major approaches dominate this field:

 The Classical Theory of Employment

 The Keynesian Theory of Employment

Both theories differ significantly in their assumptions, analytical frameworks, and policy
implications.

M.L. Jhingan carefully explains the evolution, principles, and critiques of these two
landmark theories.

2. The Classical Theory of Employment

2.1 Overview

The Classical Theory of Employment was developed by economists such as Adam Smith,
David Ricardo, J.B. Say, Pigou, and others.

They assumed that:

 The economy is self-adjusting.

 Full employment is the normal situation.

 Any unemployment is temporary and will be corrected by the free working of market
forces.

2.2 Main Assumptions of Classical Theory

Assumption Description

Full Employment The economy normally operates at full employment.

Wage-Price Wages and prices adjust freely to eliminate unemployment or

Flexibility inflation.
 Say's Law of "Supply creates its own demand"; there cannot be general
Markets overproduction or unemployment.

Money Neutrality Money is only a medium of exchange and has no effect on real
variables like output or employment.

Perfect Competition Exists in both product and factor markets.

Rational Economic All individuals aim to maximize utility and firms maximize
Agents profits.

2.3 Explanation of Classical Model

 Labour Market: Labour demand (based on marginal productivity) equals labour

supply (based on real wage preferences).

 Goods Market: Production creates income equivalent to value of goods produced.

 Savings and Investment: Flexible interest rates ensure that savings equal investment,
maintaining aggregate demand.

Thus, if any unemployment appears, it is voluntary — due to the unwillingness of workers to

accept lower wages.

2.4 Diagrammatic Representation

Labour Market Equilibrium: Intersection of LD and LS at real wage (W/P) determines full
employment level.

2.5 Say’s Law of Market

 "Supply creates its own demand."

 Production of goods generates income equivalent to the value of goods, ensuring that
all goods produced are sold.

Thus, there can never be general overproduction or deficient aggregate demand in an

economy.

2.6 Criticisms of Classical Theory

Criticism Explanation

Unrealistic Assumptions Perfect competition and wage-price flexibility are

 rarely found.

Ignoring Money’s Role Money is not just a medium of exchange but also
affects saving and investment decisions.

Overemphasis on Supply Demand factors ignored; effective demand matters.

Voluntary Unemployment Myth In reality, involuntary unemployment exists.

Wrong Saving-Investment Investment decisions are not always responsive to

Equality Mechanism interest rate changes.

3. The Keynesian Theory of Employment

3.1 Overview

John Maynard Keynes revolutionized macroeconomic thought with the publication of The
General Theory of Employment, Interest, and Money (1936).

He challenged the classical view by asserting that full employment is not automatic, and
effective demand determines employment levels.

3.2 Main Assumptions of Keynesian Theory

Assumption Description

Economy Can Be in Full employment is a special case.

Underemployment Equilibrium

Importance of Aggregate Demand Employment depends on the level of effective

demand.

Wage Rigidity Money wages are sticky downward.

Investment is Volatile Investment decisions are based on business

expectations ("animal spirits").

Active Role for Government Fiscal policy needed to manage demand.

3.3 Effective Demand

Keynes introduced the concept of Effective Demand — the point where aggregate demand
equals aggregate supply.
  Aggregate Demand Function (ADF): Shows expected receipts from the sale of
output at different employment levels.

 Aggregate Supply Function (ASF): Shows minimum expected proceeds to induce a

given level of employment.

Point of Intersection of ADF and ASF determines equilibrium employment.

3.4 Diagrammatic Representation of Effective Demand

Equilibrium employment at the point where ADF and ASF intersect.

3.5 Reasons for Unemployment under Keynesian Model

 Deficiency of Aggregate Demand: Lower demand leads to lower output and

employment.

 Liquidity Preference: High preference for liquidity hampers investment.

 Volatility of Investment: Business pessimism reduces capital formation.

 Wage Rigidity: Wages are sticky, preventing automatic adjustment.

Thus, unemployment is involuntary, not voluntary.

3.6 Role of Fiscal Policy

Keynes advocated:

 Government spending to boost demand.

 Budget deficits during depressions.

 Direct government intervention to stabilize the economy.

Thus, state intervention is necessary to achieve and maintain full employment.

4. Classical vs Keynesian Models: A Comparison

Basis Classical Theory Keynesian Theory

Employment Full employment is normal. Underemployment equilibrium is

normal.
 Cause of Voluntary (wage rigidity). Deficiency of effective demand.
Unemployment

Role of Money Neutral. Influences real variables.

Market Mechanism Self-correcting. Requires government

intervention.

Wage Flexibility Wages flexible. Wages sticky downward.

Investment Responsive to interest rate Influenced by expectations.

changes.

Policy Laissez-faire. Active fiscal policy.

Recommendation

5. Criticism of Keynesian Theory

Criticism Explanation

Neglect of Supply Side Focus too much on demand; supply bottlenecks ignored.

Short-Run Focus Less emphasis on long-run growth.

Inflationary Bias Excessive emphasis on demand stimulation risks inflation.

Dependence on Overreliance on fiscal policy can create budgetary

Government imbalances.

6. Modern Developments: Post-Keynesian and New Classical economists have tried to

synthesize Classical and Keynesian insights:

 Neo-Classical Synthesis: Accepts Keynesian short-run and Classical long-run

(Samuelson).

 New Keynesians: Explore wage and price rigidities more deeply.

 Monetarists (like Friedman): Emphasize the role of money supply in inflation and
employment.

7. Diagrams and Tables Summary

(i) Classical Labour Market Equilibrium Diagram

(ii) Keynesian Effective Demand Diagram
CONSUMPTION FUNCTION AND INVESTMENT FUNCTION
1. Introduction

Two critical determinants of aggregate demand in macroeconomics are:

 The Consumption Function

 The Investment Function

These two concepts form the basis of Keynesian income determination models and are
essential to understanding how output and employment levels are established in an economy.

M.L. Jhingan provides a clear and systematic explanation of both these functions in
macroeconomic theory.

2. The Consumption Function

2.1 Meaning

The Consumption Function shows the relationship between consumption expenditure

and income.

It explains how much households are willing to consume at different levels of disposable
income.

According to Keynes:

 Consumption is a function of current disposable income.

 As income increases, consumption also increases but by less than the increase in
income.

Mathematically: C=f(Y)

where,

 C = Consumption expenditure

 Y = Income

2.2 Keynes' Psychological Law of Consumption

Keynes’s law states:

  When income increases, consumption increases, but by a smaller amount.

 That is, Marginal Propensity to Consume (MPC) < 1.

Thus, with an increase in income:

 Part is spent on consumption.

 Part is saved.

2.3 Features of Consumption Function

Feature Description

Positive Relationship Consumption rises with income.

MPC < 1 Increase in consumption is smaller than the increase in

income.

Existence of Autonomous Even at zero income, there may be some consumption

Consumption (basic needs).

Stability in Short Run Consumption behavior is stable unless disturbed by

extraordinary factors.

2.4 Diagram of Consumption Function: The consumption curve lies below the 45° line
beyond a point, showing that not all income is consumed.

2.5 Marginal Propensity to Consume (MPC)

 Definition: Change in consumption resulting from a change in income.

MPC=ΔC/ΔY

 0 < MPC < 1.

 Higher in low-income groups; lower in high-income groups.

2.6 Average Propensity to Consume (APC)

 Definition: Ratio of consumption to income at a given level of income.

APC=C/Y

 APC generally declines as income rises.

3. Theories of Consumption Function (Beyond Keynes)

3.1 Absolute Income Hypothesis (Keynes)

 Consumption depends only on current absolute level of income.

 Criticized for ignoring other factors like expectations and wealth.

3.2 Relative Income Hypothesis (Duesenberry)

 Consumption depends on income relative to others.

 Individuals try to maintain a consumption level comparable to their reference group.

3.3 Permanent Income Hypothesis (Milton Friedman)

 Consumption depends on permanent income, not current fluctuating income.

 People base consumption on long-term expected income.

3.4 Life-Cycle Hypothesis (Modigliani)

 People plan their consumption and saving behavior over their entire lifetime.

 Save during earning years and dissave during retirement.

4. Factors Influencing Consumption Function

Factor Effect

Income Distribution More equal distribution raises consumption.

Wealth More wealth encourages higher consumption.

Expectations Optimism boosts consumption; pessimism reduces it.

Interest Rates Higher interest rates encourage saving.

Social Customs Cultural habits influence spending behavior.

5. Importance of Consumption Function

 Forms basis for multiplier theory.

 Determines level of effective demand.

 Crucial for designing fiscal policies like taxation and social security.
  Helps understand causes of economic fluctuations.

6. The Investment Function

6.1 Meaning

Investment refers to addition to the capital stock of the economy — such as buying new
machines, building factories, or constructing infrastructure.

According to M.L. Jhingan:

 Investment creates productive capacity.

 It depends on profit expectations and the interest rate.

6.2 Types of Investment

Type Description

Gross Investment Total addition to capital assets.

Net Investment Gross investment minus depreciation.

Induced Investment that responds to income or output levels.

Investment

Autonomous Investment independent of current income/output, often driven by

Investment technological innovations or government policies.

6.3 Factors Determining Investment

(i) Marginal Efficiency of Capital (MEC)

 MEC is the expected rate of return on an additional unit of capital.

 Higher MEC encourages more investment.

Investment Rule: Investment occurs until MEC = r, where r = interest rate.

(ii) Rate of Interest

 Investment is inversely related to the interest rate.

 Lower rates make borrowing cheaper and encourage investment.

(iii) Expectations
  Business expectations regarding future profits heavily influence investment.

(iv) Technological Innovations

 New technologies can stimulate waves of investment.

(v) Government Policies

 Tax incentives, subsidies, and public infrastructure investments encourage private

investment.

6.4 Diagram of Investment Function

 Negative relationship between investment and interest rate.

7. New Theories of Investment

Theory Explanation

Accelerator Theory Investment is related to the rate of change of output.

Flexible Accelerator Investment adjusts slowly towards desired capital stock.

Tobin’s q Theory Investment depends on the ratio of market value of capital to

its replacement cost.

Financial Theory of Firms’ financial positions and liquidity affect investment

Investment decisions.

8. Relation Between Consumption, Investment, and National Income

In the Keynesian model: Y = C+I

where:

 Y = National Income

 C = Consumption

 I = Investment

Thus, consumption and investment together determine the aggregate demand, which in
turn determines output and employment.

9. Diagrams and Tables Summary

(i) Keynesian Consumption Function: C curve above origin showing positive autonomous
consumption.

(ii) Investment Demand Curve

(iii) Summary Table

Concept Consumption Investment Function

Function

Relation with Direct and positive Indirect via interest rate and
Income expectations

Primary Disposable Income Expected Returns (MEC), Interest Rate

Determinant

Short-run Behavior Relatively stable Highly volatile

Policy Implications Tax cuts to stimulate Interest rate reduction to stimulate