Consumption,

Saving and
Investment
Unit 3
Learning Objectives
On completion of this unit, students will be able to:
 define and classify the consumption function
 explain the psychological law of consumption
 explain the determinants of consumption function
 define and classify the saving function
 explain the determinants of saving function
 explain the Pardox of Thrift
 define investment and explain its types
 explain marginal efficiency of capital and derive investment demand curve
 explain the determinant of induced investment
 describe the principles of acceleration coefficient.
Introduction
• Consumption, saving and investment are very important macroeconomic
indicators.
• These three macroeconomic indicators play important role to analyse performance
of an economy.
• All these three indicators are the functions of level of disposable income.
• Higher the income, higher will be consumption, saving and investment and lower
the income, lower will be saving, consumption and investment.
Consumption Function
Meaning of Consumption
• Consumption is defined as the part of income that is devoted on goods and
services in order to derive mental or physical satisfaction.
• In other words, it is the use of economic resources to satisfy current human needs
and wants which means that consumption is the purchase of goods and service and
act of using these goods and services to satisfy human needs and wants.
Consumption Function Contd…
Concept of Consumption Function
• Consumption function refers to the functional relationship between total
consumption and total income.
• There is positive relationship between consumption and income.
• It means higher the income, higher will be consumption and vice verse.
Consumption Function Contd.
The consumption function is expressed as follow:
C = f(Yd)
where
C = Consumption
Yd = Disposable income
Yd = National income – Taxes = Y – T
The consumption function can also be written algebraically as
C = a + b Yd
where
a = Autonomous consumption
b = Marginal propensity to consume (MPC) (0 < MPC < 1)
Consumption Function Contd.
Income (Y) Consumption (C) Saving (S) (S = Y – C)
0 40 – 40
100 120 – 20
200 200 0
300 280 20
400 360 40
500 440 60
Consumption Function Contd.
Y

500 45 (C = Y)
450 C
400 Saving
Consumption

350
300
250
E
200
150
100 Dissaving
50
a
O X
100 200 300 400 500
Income
Classification/ Types or Technical Attributes of
Consumption Function
The consumption function or propensity to consume has been divided into two parts:
average propensity to consume and marginal propensity to consume, which are
explained as follows:
1. Average Propensity to Consume (APC)
Average propensity to consume is defined as the ratio of aggregate consumption and
aggregate income. It is calculated by dividing consumption expenditure by income. It
tells us the level of consumption at a given level of income. Symbolically
APC =
where
APC = Average propensity to consume
C = Consumption
Y = Level of income
Income (Y) Consumption (C)

100 100 1.00

200 180 0.90
300 260 0.86
400 340 0.85
500 420 0.84
600 500 0.83
 Y

C
c
C3
Consumption

C
b
C2
Y
a C
C1
Y
C

X
O Y1 Y2 Y3
Income
Classification/ Types or Technical Attributes of
Consumption Function Contd.
2. Marginal Propensity to Consume (MPC)
Marginal propensity to consume is defined as the ratio of change in consumption to
the change in income. It shows that by how much total consumption changes when
there is change in income by one unit. It is calculated by dividing change in
consumption by change in income.
Symbolically
MPC =
where
MPC = Marginal propensity to consume
DC = Change in consumption
DY = Change in income
 Marginal propensity to
Income (Y) Consumption (C)
consume

100 100 –
200 180 0.8
300 260 0.8
400 340 0.8
500 420 0.8
600 500 0.8
 Y

C
b
C2
Consumption

C C
a
C1
K
C Y

Y

X
O Y1 Y2
Income
Properties of MPC
1. MPC is greater than zero but less than one
2. MPC of poor is greater than MPC of the rich
3. The short-run MPC is stable
Relationship between APC and MPC
There is close relationship between APC and MPC. The relationship between APC
and MPC can be shown by help of following figure

Y Panel "A" Y Panel "B"

Consumption

Consumption
C2 C C
C1
K
C
C

O X O X
Y1 Y2 Y1
Income Income
Relationship between APC and MPC
1. APC is the ratio of total consumption to total income at the particular point of
time. MPC is the ratio of change in total consumption to the change in total
income. It means that MPC is the rate of change in APC.
2. In the Panel "A" of the Figure, the consumption curve CC is straight line with
positive consumption expenditure at zero level of income or autonomous
consumption. In this situation, APC is always higher than MPC. The slope of
consumption curve CC is MPC which is constant at all level of income but APC
is falling. The APC is the slope of line CC from the origin O to any point on CC.
3. The Panel "B" of the Figure, shows long-run consumption curve (OC) which is
passing through the origin. It means that in the long-run APC equals to MPC.
4. If consumption function is non-linear or curve linear, both MPC and APC
decline with increase in income, but decline in MPC is more than decline in
APC, i.e. MPC < APC
Psychological Law of Consumption
• The psychological law of consumption was propounded by J.M. Keynes.
• The main basis of the law is the relationship between income and consumption.
• According to this law, people have tendency to spend more on consumption when
their income increases but not to the same extent as the increase in income because
a part of income is saved.
Assumptions
1. No change in institutional and psychological factors
2. Normal situation
3. Existence of a Laissez-fair capitalist economy
Psychological Law of Consumption Contd.
Propositions
The Keynesian psychological law of consumption contains following three
interrelated propositions:
1. When total income increases, total consumption also increases but by a some
what smaller amount.
2. The increased income will be divided in some ratio between saving and
consumption i.e., what is not spent is saved.
3. With increase in income both saving and consumption will increase.
Psychological Law of Consumption Contd.

Income (Y) Consumption Saving (S)

(C) (S = Y – C)
100 100 0
200 180 20
300 250 50
400 310 90
500 360 140
600 400 200
 Y

45 (Y = C)

Saving C
Consumption

E
C

A Dissaving

X
O Y
Income
Determinants of Consumption Function
1. Subjective Factors
a. Psychology of human nature
i. To build the reserve for unforeseen contingencies such as death, diseases, etc.
ii. To provide for anticipated future need such as retirement, future higher
studies of children, etc.
iii. To enjoy an enlarged future income by investing funds out of current income,
iv. To enjoy a sense of independence or not to depend on others,
v. To possess power or to get higher social or political status,
vi. To secure enough funds to carry out speculation because speculation is an
essential part of money market,
vii. To satisfy purely miserly nature.
Determinants of Consumption Function
Contd.
b. Institutional arrangements
i. Enterprise, i.e., the desire to do big things or to expand business,
ii. Liquidity, i.e., the desire to face emergencies successfully,
iii. Rising income, i.e., the desire to demonstrate successful management,
and
iv. Financial care, i.e., the desire to ensure adequate financial provisions
against depreciation and obsolescence and discharge debt.
Determinants of Consumption Function
Contd.
2. Objective Factors
a. Changes in wage level
b. Distribution of income
c. Windfall gains and losses
d. Fiscal policy
e. Changes in expectations
f. Financial policies of corporations
g. Holding of liquid assets
Determinants of Consumption Function
Contd.

h. Dusenberry hypothesis
 Past living standard
 Demonstration effect
i. Attitude towards thrift
j. Social security
k. Installment buying
l. New products
Saving Function
Meaning of Saving
Saving is defined as the part of income that is not spent on consumption. In other
words, the portion of disposable income not spent on consumption of consumer
goods and services is called saving.
S=Y–C
where
S = Saving
Y = Income
C = Consumption expenditure
Saving Function Contd.
Concept of Saving Function
Saving function states the relationship between income and saving. There is positive
relationship between saving and income. It means that the higher the income, the
higher will be saving and vice-versa. Symbolically,
S = f(Y)
Since,
S=Y–C
or, S = Y – (a + bY) [∵ C = a + by]
or, S = Y – a – bY
or, S = – a + Y – bY
or, S = – a + (1 – b)Y
or, S = – a + sY [∵ 1 – b = s]
Saving Function Contd.

Income (Y) Consumption (C) Saving (S)

(S = Y – C)
0 40 –40
100 120 –20
200 200 0
300 280 20
400 360 40
500 440 60
 Y

500 45 (C = Y)
C
Saving and Consumption

400

300 Saving

200
Dissaving
Saving
100
S
C K
X' X
O 200 300 400 500 600
S 100
–100 Dissaving

Y' Income
Classification/ Types or Technical Attributes of
Saving Function
There are two technical features in
connection to the relationship between
saving and income, average propensity
to save (APS) and marginal propensity
to save (MPS).
1. Average Propensity to Save (APS)
The APS is the ratio of total saving to
total income. It is expressed as,
APS =
where
S = Saving
Y = Income
Classification/ Types or Technical Attributes of
Saving Function
 
Classification/ Types or Technical Attributes of
Saving Function Contd.
2. Marginal Propensity to Save (MPS)
MPS is the ratio of change of saving
resulting from one unit change in
income. It is expressed as the ratio of
change in total saving to the change in
total income. It can be expressed as
MPS =
where
ΔS = Change in saving
ΔY = Change in income
MPS is always between 0 to 1.
0 < MPS <1
Classification/ Types or Technical Attributes of
Saving Function Contd.
 
Types of Savings
1. Personal or individual saving
2. Corporate saving
3. Compulsory saving
4. Forced saving
5. Government saving
Determinants of Saving or Saving Function
1. Level of income
2. Rate of interest
3. Distribution of wealth and income
4. Demographic factors
5. Price level
6. Fiscal policy
7. Development of banking and financial institutions
8. Social security
 Paradox of Thrift (Saving is a Vice, not a Virtue)
• J.M. Keynes does not accept the concept of savings given by the classical economists.
• According to Keynes, savings in the form of hoarding would decrease the consumption at the
national level.
• Thus, decrease in consumption will lead to fall in effective demand and as a result, there will
be over-production and unemployment in the economy.
• The fall in aggregate demand would ultimately reduce investment in the economy.
• If all persons in an economy increase savings, it will directly push the total effective demand
below.
• The deficiency of demand for consumer goods also reduces the demand for capital goods,
which is a derived demand.
• This will reduce price, profit, and discourage investment consequently, income, output,
employment and saving itself will decline.
• Hence, the private virtue like saving may be a public vice (unemployment). The thriftiness or
saving produces poverty not wealth. This is the 'paradox of thrift'.
Paradox of Thrift (Saving is a Vice, not a Virtue)
Contd.
• In this way, if the amount of saving is increased in the beginning, assuming income
constant, all the consumption expenditure, production, employment, income, etc. start
to fall and finally the amount of savings itself starts to fall.
• On the other hand, if the amount of saving is decreased in the beginning, it increases
all the consumption expenditure, production, employment, income, etc.
• Finally, the saving starts to increase.
• This is the paradox of thrift, the situation of final reduction in saving from the habit
of not spending income.
 Paradox of Thrift (Saving is a Vice, not a Virtue)
Contd.
Y

S1
Saving/ Investment

S
I
S
E
S1
E1
I

X' X
O Y1 Y
S1
Income
S

Y'
Investment
• In general, investment means buying old shares, bonds or property.
• But in economics, such activities are only known as transfer of ownership because this sort
of investment does not increase the aggregate income and employment.
• This is also known the financial investment.
• Thus, in economics, investment is defined as the part of income, which is devoted on
purchase on those goods, which are used for further production of other goods or earning
income.
• Such type of investment is known as the real investment.
• There are different opinions regarding investment function.
Investment Contd...
According to classical economists, investment is the negative function of rate of interest.
I = f(i)
where
I = Investment
i = Rate of interest
But Keynesian concept is different. According to him, investment is the function of rate
of interest (i) and marginal efficiency of capital (MEC).
I = f(MEC, i)
Classification/ Types of Investment
1. Gross investment and net investment
Gross investment: The total amount of expenditure made in new capital
goods during a year is known as gross investment, which includes the
depreciation value.
Gross investment (GI) = Net investment + Depreciation
Net investment: If depreciation is deducted from the gross investment, then
net investment will be obtained. Thus,
Net investment (NI) = Gross investment – Depreciation
Classification/ Types of Investment Contd...
2. Induced investment and autonomous Investment
Induced investment: The investment that varies with the change in national income
is called induced investment. Induced Investment is the function of income, I = f(Y).
Y

I
Investment

O I X
Income
Classification/ Types of Investment Contd...
Autonomous investment: Autonomous investment is not affected by the change in
income. Therefore, it is called income inelastic. This investment does not depend
upon the profit motive.
Y
Investment

I I

O X
Income
Classification/ Types of Investment Contd...
3. Ex-ante investment and ex-post Investment
The planned or anticipated investment is known as ex-ante investment. On the
other hand, the actually realized investment is known as ex-post investment.
The ex-ante and ex-post investment may not be equal.
4. Private investment and public investment
The investment made by an individual, private investor, private enterprise or
businessman with the motive of earning profit is known as private investment.
The investment made by the government or various bodies of the government
is known as public investment.
Marginal Efficiency of Capital (MEC)
• Profit is one of the important factors affecting private investment.
• Business firms and private enterprises undertake investment in the purchase of
capital asset with the anticipation of earning profit.
• The expected rate of return from the purchase of capital asset is called marginal
efficiency of capital (MEC).
Determinants of Marginal Efficiency of Capital
1. Prospective Yield
• The prospective yield is what an entrepreneur expects to obtain from the output of
its capital asset during its lifetime.
• These yields take the form of a flow of money income over a period of time.
• The returns in each year are called a series of annuities represented by Q 1, Q2, Q3, .
. ., Qn.
• To arrive at the prospective yield of the capital asset, we have to add the expected
returns from the capital asset during its lifetime.
• Hence, the prospective yield of a new capital asset is the sum of the expected
returns from the capital asset during its lifetime.
Determinants of Marginal Efficiency of Capital
Contd.
2. Supply Price
• Supply price is the cost of producing a new asset, but not the supply price of the
existing asset.
• In simple sense, the amount of money that any investor invests on a new capital
asset (such as machine and equipments) which produces goods is known as supply
price.
• It is also known as the replacement cost.
• After estimating the value of annuities and the cost to produce necessary capital,
asset, the investor compares the expected returns with supply price.
• This comparison will give a rate, which is called the marginal efficiency of capital.
• In short, the marginal efficiency of capital is the rate at which the prospective yield
of a capital asset is discounted to equal the supply price of that asset.
Determinants of Marginal Efficiency of Capital
Contd.
Supply price = Discounted prospective yields
or, SP = + + … +
where
Sp = the supply priceof the new capital asset
Q1, Q2, . . . Qn = the prospective yield in different years 1, 2, . . . and n, and
r = the marginal efficiency of capital or the rate of discount.
Investment Demand Curve
•The investment behaviour of entrepreneur can be shown by the help of schedule.
•This is known as the marginal efficiency of capital schedule or investment demand
schedule.
•It shows the functional relationship between the marginal efficiency of capital and
the amount of investment.
•There is an inverse relationship between MEC and the amount of investment.
Investment Demand Curve Contd...
There are mainly two reasons for the diminishing MEC of capital, which are as
follows:
1. As volume of investment increases, expected annual returns from capital assets
falls due to the operation of the law of diminishing returns.
2. As volume of investment increases, the supply price of capital assets will rise
because of the increased demand for machineries and equipment and the
consequent rise in their prices.
Investment Demand Curve Contd.

Investment Marginal Efficiency of Capital (in

(Rs. in Billion) Percentage)
5 10
10 9
15 8
20 7
25 6
 Y
MEC/ Rate of Interest

R1

R2

MEC

X
O I1 I2

Investment
Determinants of Investment
Short-run Factors
1. Expected demand
2. Cost and prices
3. Change in income
4. Propensity to consume
5. Current state of expectations
6. Liquid assets
7. Government policy
8. Waves of optimism and pessimism
 Determinants of Investment Contd...
Long-run Factors
1. Growth of population
2. Development of new areas
3. Technological progress
4. New product
5. Development of industrial
infrastructure
6. Industrial policy
7. Rate of current investment
8. Rate of interest
Principle of Acceleration Coefficient
Thus, the principle of acceleration
coefficient is the numerical value of relation
between the increase in investment resulting
from the increase in consumption. The
acceleration principle explains the process
by which change in demand for consumer
goods leads to change in investment on
capital goods.
Symbolically
V=
or, I = V . C … (i)
where
I = Net change in investment
C = Net change in consumption
V = Coefficient of acceleration principle
Principle of Acceleration Coefficient Contd...

 
Principle of Acceleration Coefficient Contd.
Assumptions
The principle of acceleration coefficient is based on the following assumptions:
 There is constant capital output ratio.
 There is no excess production capacity.
 Factors of production are homogeneous and perfectly divisible.
 There is no financial constraint and funds are easily available.
 Firms produce with the lease cost combination of inputs.
 Technology remains constant.
 There is absence of time lag.
 Factor market is competitive and factor prices are given.
 Firms' demand forecasting is accurate.
Principle of Acceleration Coefficient Contd.
Equational Model
The principle of acceleration coefficient can be expressed in the equation form given
as below:
Igt = V(Yt – Yt – 1) + R
or, Igt = VY + R …(iii)
where
Igt = Gross investment during period 't'
Yt = Output during period 't'
Yt – 1 = Output during period (t – 1)
Y = Change in output
V = Coefficient of accelerator
R = Replacement investment
Principle of Acceleration Coefficient Contd.

 
 Principle of Acceleration Coefficient Contd.
Total Output Replacement Net Gross
Required
Period (Total Income Investment Investment Investment
Capital
'Y') (R) (Int) (Ig)
0 100 200 20 0 20
1 100 200 20 0 20
2 105 210 20 10 30
3 115 230 20 20 40
4 130 245 20 30 50
5 140 280 20 20 40
6 145 290 20 10 30
7 140 280 20 –10 10
8 130 260 20 –20 0
9 125 250 20 –10 10
Principle of Acceleration Coefficient Contd.
Importance of Acceleration Principle
 It is useful to understand the process of income generation more clearly and
comprehensively.
 It is useful to understand the causes of fluctuation in income and employment.
 It is useful to explain the cause of higher economic growth.
 It is useful to demonstrate why capital goods industries fluctuate more than the
consumer goods industries.
 It is useful to explain the upper turning point of business cycle.
Principle of Acceleration Coefficient Contd.
Criticisms/ Limitations of Acceleration Principle
• The assumption of constant capital output is not realistic.
• This principle is based on the assumption of no excess capacity in the capital
goods industries. But if excess capacity exists, an increase in demand for
consumer goods will not lead to any induced investment because increase in
demand will be met from the existing capital and machinery.
• This principle ignores the role of technological changes on investment. Some
technological changes take the form labour saving and increase the volume of
investment.
• If the economy is at the full employment, the capital goods industries will fail to
expand because of non-availability of required reserves or resources.
• This principle assumes that increases output leads to a simultaneous rise in
investment. But in reality, a rise in demand takes a long time to produce its
impact on investment level.
Numerical Example 1
Complete the following table and answer the given question.

Y C S APC MPC APS MPS

0 50        
Rs. 100 125
Rs. 200 200
Rs. 300 275
Rs. 400 350
Rs. 500 425
Rs. 600 500

From the above table explain relationship between APC and MPC.
Solution
Y C (S) APC= MPC = APS = MPS =
=Y–C
0 50 – 50 - - - -
Rs. 100 125 – 25 1.25 0.75 – 0.25 0.25
Rs. 200 200 0 1 0.75 0 0.25
Rs. 300 275 25 0.92 0.75 0.08 0.25
Rs. 400 350 50 0.88 0.75 0.13 0.25
Rs. 500 425 75 0.85 0.75 0.15 0.25
Rs. 600 500 100 0.83 0.75 0.17 0.25

 APC is declining.
 MPC is constant.
 The cause of declining APC and constant MPC is constant slope of
consumption function.
Numerical Example 2
Consider the following consumption schedule.

Period t1 t2 t3 t4 t5
Disposable Income (Yd) 0 8,000 16,000 24,000 32,000
Consumption (C) 4,000 10,000 16,000 22,000 28,000
Saving (S)          

Answer the following questions:

a. Complete the above schedule
b. Derive consumption and saving function
c. Does it explain three propositions of psychological law of consumption?
Explain.
SOLUTION
a.
Disposable Income (Yd) 0 8,000 16,000 24,000 32,000
Consumption (C) 4,000 10,000 16,000 22,000 28,000
Saving (S) – 4,000 – 2,000 0 2,000 4,000

b. For consumption function,

Autonomous consumption (a) = 4,000
b = MPC
= = = 0.75
Consumption function,
C = a + bY
or, C = 4,000 + 0.75Y
 For saving function,
S=Y–C
or, S = Y – (4,000 + 0.75Y)
or, S = Y – 4,000 – 0.75Y
or, S = – 4,000 + 0.25Y
Alternatively,
S = –a + (1 – b)Y
or, S = – 4,000 + (1 – 0.75)Y
or, S = – 4,000 + 0.25Y
c. The above consumption schedule proves three proportions of psychological law
of consumption.
First Proposition: When income increases, consumption also increases but by
a smaller proportion than income. This propositions is justified because income
increase by Rs. 8,000 but consumption increase by Rs. 6,000.
Second Proposition: The increased income is divided in some ratio between
saving and consumption. This proposition also becomes justified because in the
above schedule increased income is being divided into both consumption and
saving.
Third Proposition: With increase in income, both saving and consumption
will increase. This is also justified by the above consumption schedule because
with increases in income, both saving and consumption are increasing.
Numerical Example 3
Consider the following consumption schedule of the Shakya family.
Period t1 t2 t3 t4 t5 t6
Disposable Income (Rs) 0 4,000 8,000 12,000 16,000 20,000
Consumption (Rs) 2,000 5,000 8,000 11,000 14,000 17,000

a. Derive the family's linear consumption and saving functions.

b. Consider that there is 2 million households in Nepalese economy; each of
which has the same consumption function as the Shakya family. Re-compute
the consumption schedule and explain three propositions of psychological law
of consumption function.
c. Suppose, Nepal government imposes 25% income tax to all households. Derive
the economy's linear consumption function (i) before tax and (ii) after tax [TU,
BBA, 2010]
SOLUTION
a. Autonomous consumption (a) = 2,000
b (MPC) = = = 0.75
Consumption function:
C = a + bY
 C = 2,000 + 0.75Y
Saving function;
S=Y–C
or, S = Y – (2,000 + 0.75Y)
or, S = Y – 2,000 – 0.75Y
 S = –2,000 + 0.25Y
b. If there are two millions households in the Nepalese economy, then, the
autonomous consumption will be 2,000 × 2 million = Rs. 4,000 million.
Assuming two million household in the Nepalese economy, we can recomputed
consumption schedule as follows:

Period Disposable Income (Rs.) (Rs Consumption (Rs in

in Million) Million)
t1 0 4,000
t2 8,000 10,000
t3 16,000 16,000
t4 24,000 22,000
32,000 28,000
t5
40,000 34,000
t6
On the basis of above schedule, we can explain three propositions of
psychological law of consumption function as follows:
First Proposition: There is increase in both total income and total
consumption but increase in consumption is proportionately less than the
increase in income. Therefore, first proposition is fulfilled.
Second Proposition: The increased income is being divided into consumption
and saving, it satisfies second proposition of the psychological law of
consumption.
Third Proposition: Since, with increase in income, both saving and
consumptions are increasing. It satisfies the third proposition of the
psychological law of consumption.
c. After tax
i. Before Tax When government imposes 25%
In the above schedule income tax to all households, then,
Autonomous consumption (a) = 4,000 C = a + bYd
b (MPC) = or, C = a + 0.75(Y – T)
= = 0.75 or, C = 4,000 + 0.75(Y – T)
Consumption function: or, C = 4,000 + 0.75(Y – 25% of Y)
C = a + bY or, C = 4,000 + 0.75
or, C = 4,000 + 0.75Y or, C = 4,000 + 0.75(Y – 0.25Y)
or, C = 4,000 + 0.75Y – 0.1875Y
 C = 4,000 + 0.56Y
Numerical Example 4
Let, saving function (S) = –80 + 0.2Y and investment function (I) = 50 + 0.1Y.
a. Compute the equilibrium national income, saving and investment.
b. What will be effect on equilibrium income, saving and investment when saving
function increases by 20 units?
c. Does it satisfy concepts of paradox of thrift?
SOLUTION
a. Given
S = – 80 + 0.2 Y I = 50 + 0.1Y
For equilibrium national income,
S=I
or, –80 + 0.2Y = 50 + 0.1Y
or, 0.2Y – 0.1Y = 50 + 80
or, 0.1Y = 130
or, Y = 1,300
 Equilibrium national income (Y) = Rs. 1,300
Putting value of Y in saving and investment functions,
S = – 80 + (0.2 × 1,300)
or, S = – 80 + 260
or, S = 180
 
I = 50 + 0.1Y
or, I = 50 + 0.1 × 1,300
or, I = 180
Hence, Saving (S) = Rs. 180
Investment (I) = Rs. 180
b. When saving function increases by 20 units, the new saving function will be,
S = – 80 + 0.2Y + 20
or, S = – 60 + 0.2Y
I = 50 + 0.1Y
For equilibrium income,
S=I
or, –60 + 0.2Y = 50 + 0.1Y
or, 0.2Y – 0.1Y = 50 + 60
or, 0.1Y = 110
or, Y = = Rs. 1,100
 Putting value of Y in new saving function,
S = – 60 + 0.2Y
= – 60 + 0.2 × 1,100
= Rs. 160
Putting value of Y in investment function,
I = 50 + 0.1 Y
= 50 + 0.1 × 1,100
= Rs. 160
Hence, new equilibrium national income, saving and investment are Rs. 1,100,
Rs. 160 and Rs. 160 respectively.
c. Yes, it satisfies the concept of paradox of thrift because due to increase in
saving by Rs. 20, equilibrium national income, investment and saving itself are
decreasing.
Numerical Example 4
Consider the following schedule.

Period t1 t2 t3 t4 t5 t6
Yd 0 100 200 300 400 500
C … … 200 … … …
S … … … … … …

a. Complete the table at MPC = 0.8 and also compute APC and APS.
b. Derive linear consumption and saving functions.
c. Draw a graph showing the saving curve and explain APS and MPS.
SOLUTION
We know that
MPC =
or, C = MPC . Y
Ct = Ct – 1 + C
= Ct – 1 + MPC . Y
Consumption of period t2 = 200 – MPC × Y
= 200 – 0.8 × 100
= 200 – 80
= 120
Consumption of period t1 = 120 – MPC × Y
= 120 – 0.8 × 100
= 120 – 80
= 40
Consumption of period t4 = 200 + MPC × Y
= 200 + 0.8 × 100
= 200 + 80
= 280
Consumption of period t5 = 280 + MPC × Y
= 280 + 0.8 × 100
= 280 + 80
= 360
Consumption of period t6 = 360 + MPC × Y
= 360 + 0.8 × 100
= 360 + 80
= 440
Period Yd C S APS MPS
t1 0 40 –40 - -
t2 100 120 –20 –0.5 0.2
t3 200 200 0 0 0.2
t4 300 280 20 0.06 0.2
400 360 40 0.1 0.2
t5
500 440 60 0.12 0.2
t6
b. Autonomous consumption (a) = 40
b(MPC) = 0.8

We know that
Consumption Function
C = a + bY
 C = 40 + 0.8Y
Again
We know that
Saving Function
S=Y–C
or, S = Y – (40 + 0.8Y)
or, S = Y – 40 – 0.8Y
or, S = – 40 + 0.2Y
 Y
c.
From the table, it is clear that S
APS is negative below 60
income Rs. 200 crore. At 50
income Rs. 200 crores, APS is

Saving
zero. When income is above 40
Rs. 200 crore, APS is positive 30
and increasing. MPS is
constant at all levels of 20 Saving
income. 10

X' X
O 100 200 300 400 500 600
–10 Dissaving
–20

–30
–40 S Income

Y'
Thank You