National income

It is defined as the total volume of all goods and services produced in a country within a given period of time usually
one year expressed in monetary units or the monetary value of all goods and services produced in a country within a
given year.

Methods or Ways of Evaluating or Measuring National income. There are three main ways by which the
expenditure method.

1.THE OUTPUT METHOD. With this method the national income is determined by summing up all values added to
production in the primary, secondary and tertiary sector of the economy.

Accounting procedure.

STEP 1.THE SUM OF VALUES ADDED TO PRODUCTION IN THE PRIMARY, SECONDARY AND TERTIARY
SECTOR

=TOTAL DOMESTIC OUTPUT (TDO)

STEP 2. TDO +RESIDUAL ERRORS – STOCK APPRECIATION (or +STOCK DEPRECIATION) –ADJUSTMENTS
FOR FINANCIAL SERVICES

=GROSS DOMESTIC PRODUCT at Factor cost (GDPfc)

STEP 3. GDPfc+NET PROPERTY INCOME FROM ABROAD

=GROSS NATIONAL PRODUCT AT FACTOR COST (GNPfc)

STEP 4. GNPfc – DEPRECIATION

=NET NATIONAL PRODUCT AT FACTOR COST (NNPfc) or the NATIONAL INCOME

2. THE INCOME METHOD. With this method the National Income is determined by summing up all factor incomes
(all the rewards) paid to the various factors of production used in producing the national output. These include wages
and salaries as well as income form self employment, rents, interest and imputed charges for the
consumption of non trading capital, profits and dividends including undistributed profits of companies and
trading surpluses of public Corporations.

Accounting procedure

Step 1.SUM OF FACTOR INCOMES

=TOTAL DOMESTIC INCOME (TDI)

STEP 2. TDI +RESIDUAL ERRORS– STOCK APPRECIATION (or +STOCK DEPRECIATION)

= GROSS DOMESTIC INCOME AT FACTOR COST (GDIfc)

Step 3. GDIfc+NET PROPERTY INCOME FROM ABROAD =GROSS NATIONAL INCOME AT FACTOR COST
(GNIfc)
STEP 4. GNIfc – DEPRECIATION

=NET NATIONAL INCOME AT FACTOR COST (NNIfc) or the NATIONAL INCOME

3. The Expenditure Method

With this method the national income is determined by summing up all final expenditures made by firms, households
and governments on goods and services. Final expenditures are summarised in the aggregate money demand
equation given as C+I+G+X-M
Where
C=Consumers expenditures on goods and services,
I = Gross Investments
G = Government Expenditures on goods and services
X =Export of goods and services
M=Import of goods and Services
Note that there are 2 main components of Gross Investments;
Firstly the addition to stocks or changes in Stocks or the Value of physical increase in stocks, which is the
accumulation of Stocks over the period; that is STOCKS OF 31st December –Stocks of 1st January.

Secondly Gross Capital Formation or gross Expenditures on fixed Capital or Gross formation of fixed Capital.

Accounting procedure.

STEP 1. C+I+G =TOTAL DOMESTIC EXPENDITURES at Market price (TDEmp)

C+I+G+X = TOTAL FINAL EXPENDITURES AT market price (TFEmp)

C+I+G+X-M =GROSS DOMESTIC EXPENDITURES at market price (GDEmp)

STEP 2. (GDEmp) –INDIRECT TAXES +SUBSIDIES

=GROSS DOMESTIC EXPENDITURE AT factor cost (GDEfc)

STEP 3. GDEfc+NET PROPERTY INCOME FROM ABROAD

=GROSS NATIONAL EXPENDITURE AT factor cost (GNEfc)

STEP 4. GNEfc – DEPRECIATION

=NET NATIONAL EXPENDITURES AT factor cost (NNEfc) or the NATIONAL INCOME

NOMINAL AND REAL NATIONAL INCOME

Nominal National income is the National Income measured at current prices. It measures the national income from
one year to another based on the current prices of each year. It is the therefore the national income where no
adjustments for inflation have been made.
Real National Income is the national income measured at constant prices. It measures the National Income from
one year to another assuming that prices are constant. It is therefore the National Income where adjustments for
inflation has been made.

The Nominal National Income can be converted to the Real National Income using the formula

Real National Income=Nominal National Income X 100

Price index 1

THE CIRCULAR FLOW OF INCOME

It is the continuous flow of income from firms to households and vice versa. The national income is in a continuous
flow moving from firms to household and vice versa as shown.

There are 2 main types of flow

1.Real flows. House holds supply factors of production to firms. Firms convert these factors of production into goods
and services which are consumed by the households.
2. Monetary flows. When households supply factors of production, they are rewarded with factor incomes like wages
interest rents and profits. They use these factor incomes to make payments for the goods and services.

TYPES OF ECONOMY, THEIR CIRCULAR FLOW AND EQUILIBRIUM INCOME

1.THE TWO SECTOR SPEND THRIFT ECONOMY. This is an economy where all what is produced is consumed.
There are no injections and there are no withdrawals or Leakages. The diagram represents the summary of the
circular flow as shown.

An injection is any addition of income into the circular flow. That is any increase in the income of Households which
is not coming from the spendings of firms or any increase in the income of firms which is not coming from household
spendings. For example when firms borrow from banks to carry out investments or when Government carry out
expenditures in the economy through firms or when firms generate revenue from exportation. Therefore typical
injections are Autonomous Investments, Government Spendings and Exports.
A Withdrawal or Leakage is any income which is not passed back into the Circular flow. For example when
household save their incomes in banks or when they pay taxes to the government or when households import goods
from other countries. therefore typical leakages are Savings, Taxes and Imports.

Determination of the equilibrium income. The equilibrium income is defined as that income level where there is no
tendency for the income to rise or fall. It can be determined in two ways that is the Aggregate money demand
approach and the injection withdrawal approach.

The Aggregate Money Demand (ADM) Approach. With this approach, for National Income to be at equilibrium, it
must be equal to the AMD. That is; Y=AMD. AMD refers to total purchasing power or spendings in an economy.

If income (Y) is greater than AMD, it implies that the output by the firms in the economy is greater than the global
demand or purchasing power of the citizens. Firms are producing but the citizen’s purchasing power is not sufficient
enough to absorb the output. The tendency will be that the firms will want to contract production. As such the national
output or income will have the tendency of falling and it will not be at equilibrium.

income (Y) is lesser than AMD, it implies that the output by the firms in the economy is lesser than the global
demand or purchasing power of the citizens. The output by the firms in the economy is not sufficient enough to
satisfy the total demand or purchasing power of the citizens. The tendency will be for the firms to expand production.
As such the national income will have the tendency of rising and will still not be at equilibrium.
The income will only be at equilibrium when it is equal to the AMD and the is no tendency for the Income to rise or
Fall.

The injection withdrawal approach. With this approach, for the national income to be at equilibrium, the sum of
injections must be equal to the sum of withdrawals. That is; Sum of J=Sum of W

If the sum of injections is greater than the sum of withdrawals, it means the addition of income into the circular flow is
greater than the income withdrawn out of the circular flow. As such the income of the system will have the tendency
of rising and will not be at equilibrium.

If the sum of Withdrawals is greater than the sum ofInjections, it means the income which is withdrawn from the
circular flow is greater than the income which is added into the circular flow. As such the income of the system will
have the tendency of falling and will still not be at equilibrium.
The income will only be at equilibrium when the sum of Injections is equal to the sum of Withdrawals and the is no
tendency for the Income to rise or Fall.

Note that since in the 2 sector spend thrift economy all what is produced (Y) is consumed (C) that is Y=C it implies
the income equal the aggregate demand and hence the economy is at equilibrium following the AMD approach.
Also since there are no injections and there are no Withdrawals, it implies the economy is at equilibrium following the
injection withdrawal approach.
2.THE TWO SECTOR FRUGAL ECONOMY. This is similar to the two sector spend thrift economy but in addition,
there are financial institutions or banks where household save and firms borrow to carry out investments. The circular
flow diagram is shown below.
Since there are 2 components of spending or AMD that is consumption (C) and Investments (I), it implies at
equilibrium, with the AMD approach,
Y=C+I
With the injection withdrawal approach, since the is only one injection Investments (I) and only one leakage Savings
(S), it implies at equilibrium,
I=S
3. THE THREE SECTOR GOVERNED ECONOMY. This is similar to the 2 sector frugal economy but in addition,
government activity is introduced into the system where households are taxed and the government carry out
expenditures in the economy through firms as shown.

At equilibrium, with the AMD approach, Y=C+I+G

With the injection withdrawal approach, I+G=S+T
4. THE FOUR SECTOR OPENED ECONOMY. This is similar to the three sector governed economy but in addition
the economy is now opened up to international trade with the rest of the world where firms export (X) and households
Import (M) as shown.
At equilibrium, with the AMD approach, Y=C+I+G+X-M
With the injection Withdrawal approach, I+G+X =S+T+M

GRAPHICAL REPRESENTATION OF THE EQUILIBRIUM INCOME.

The equilibrium income can be represented graphically using the AMD approach and the injection withdrawal
approach.
With the AMD approach, a graph of income on the X-axis and AMD on the Y-axis is plotted. A 45 degree line is
included. This is a line showing equality between income and AMD. Where the AMD curve cuts the 45 degree line,
the equilibrium income is attained because at this point the income equal the AMD as shown.

Assume a 2 sector economy where AMD IS C+I and there is only one injection I and only one leakage S. Clearly the
equilibrium income is Ye where the AMD curve (C+I) cuts the 45 degree line because at this point the income will be
exactly equal to the AMD.

If the full employment output was at Yf1, the income OYf1 or BYf1 will be lesser than the AMD AYf1. This creates an
INFLATIONARY GAP given by the distance AB which is defined as the amount by which AMD exceeds national
output or income at full employment. An Inflationary gap tends to exist because prices will have the tendency of rising
since aggregate demand is greater than aggregate supply or National output. Also the income will have the tendency
of rising and will not be at equilibrium.

If the full employment output was at Yf2, the income OYf2 or CYf2 will be greater than the AMD DYf2. This creates a
DEFLATIONARY GAP given by the distance CD which is defined as the amount by which national output or
income exceeds AMD at full employment. A Deflationary gap tends to exist because prices will have the tendency of
falling since aggregate supply or National output is greater than aggregate demand. Also the income will have the
tendency of falling and will not be at equilibrium.

Beneath this, the graph of injection investment (I) and withdrawal savings (S) is plotted. The equilibrium income is
equally attained where the injection (I) equal the withdrawal (S).
At Yf1, injection (I) is greater than withdrawal (S) as such the income will have the tendency of rising and will not be
at equilibrium. This equally creates an INFLATIONARY GAP given by the distance A’B’, which can also be defined
as the amount by which Injections exceed Withdrawals at full employment.
At Yf2, Withdrawals (S) is greater than Injections (I) as such the income will have the tendency of falling and will still
not be at equilibrium. This equally creates a DEFLATIONARY GAP given by the distance C’D’ which can also be
defined as the amount by which Withdrawals exceed Injections at full Employment

CONSUMPTION
It is the usage of commodities for the satisfaction of human wants. Consumption spendings are spendings carried out
by households on consumer goods and services, both durable and non durable.
The propensities to Consume
Marginal propensity to consume. It is the change in consumption resulting from a given change in income or the
proportion of additional income which is consumed.

MPC=Change in Consumption =C2-C1

Change in Income Y2-Y1

The Average propensity to consume. It is the fraction of income which is spent on consumption.

APC=Consumption =C
Income Y

THE CONSUMPTION FUNCTION. The typical consumption function is written as

C=aY+Co where a is the MPC, Y is Income , Co is autonomous Consumption and aY is induced consumption.
According to the Keynesian, Consumption is made up of two components; that is autonomous consumption and
induced consumption. Induced consumption is consumption which depends on income while Autonomous
consumption is consumption which does not depend on income. Even if income is zero; that is even if an economy
is not producing, its consumption will not be zero. Such autonomous consumption is possible due to de-savings or
deepening into past savings, through borrowing and through foreign aid.

Change in consumption and a shift of the consumption function. A change in consumption is a movement along the
same consumption function or curve and it is due to changes in income.

When income increases from Y1 to Y2, Consumption increases from C1 to C2, and when income falls from Y2 to Y1,
Consumption falls from C2 toC1.
A shift of the consumption function is a complete displacement of the whole consumption function or curve either
upward which represents an increase in consumption or downward which is a decrease in consumption. It is not due
to changes in income but it is due to changes in those factors influencing consumption.

Even at the same income level Y*, Consumption can increase from C* to C1 or can reduce from C* to C2.

Factors influencing consumption (Determinants of Consumption)

Even though the main determinant of consumption is the level of income, there are other factors that affect
consumption even if income does not change which include
1. The level of disposable income. Disposable income is income left after subtracting direct taxes but including
transfer payments. When direct taxes are reduced or when transfer payments like pension, family allowance etc are
increased, disposable will increase which will increase consumption. When direct taxes are increased or when
transfer payments are reduced, disposable income will increase which increase consumption.
2.The distribution of income. If income is more evenly distributed amongst the citizens, the impact on consumption
will be greater than if it is concentrated in the hands of a few rich. Generally, the poor or low income earners tend to
have a greater propensity to consume than the rich or high income earners. That is poor people tend to spend a
greater proportion of their income on consumption than the rich. Therefore if income is evenly distributed to benefit
the poorer mass, consumption will be greater than if the income is mostly in the hands of the few rich.
3. The availability of credit facilities. When credit facilities like hire purchase, credit sales etc are available,
consumption tends to increase especially for durable consumer goods like cars ,TV, etc. in most developed
countries, consumption tends to be high for such durable commodities since they have a lot of credit facilities.
4. The distribution of wealth. This affects consumption in the same way as income distribution. If wealth is more
evenly distributed amongst the citizens, the impact on consumption will be greater than if the wealth is concentrated
in the hands of a few rich.
5.The rate of interest. If interest rates are low, people will be encouraged to take loans from banks which will increase
consumption. If interest rates are high, people are discouraged to take loans which will reduce consumption.
6. The spending habit of the community. In spend thrift societies consumption tends to be high. But in thrifty societies
where people consider savings as a good moral habit, consumption tends to be low.
7. Expectation of future price changes. When people are expecting a general rise in future price level they tend to
increase their consumption because they want to avoid the higher prices in future. When they are expecting a fall in
the general price level, consumption tends to reduce because people want to wait for the prices to eventually fall
before they can buy.
8. Changes in population size and structure. Generally when population size increases, global consumption tend to
increase and vice versa. Changes in population structure also affects consumption. Generally a youthful population
has a greater effect on consumption than an ageing population.

SAVINGS
Savings is that part of income which is not consumed but is kept aside for future use.
The propensities to save.
The marginal propensity to save. It is the change in savings resulting from a change in income or the proportion of
additional income which is saved.

MPS=Change in savings = S2-S1

Change in income Y2-Y1
Average propensity to Save. It is the fraction or proportion of income which is saved.
APS=Savings =S
Income Y

Factors influencing savings

1.The level of income. When level is high, savings will be high but when income levels are low, savings tend to be
low.
2.The rate of interest. When interest rates on savings are high, people are encouraged to save but when interest on
savings are low, people are discouraged to save.
3. The availability of savings institutions. When savings institutions such as banks, Njangi houses etc are available,
savings tend to increase and vice versa.
4. The level of taxes. Governments policies on taxes tend to affect people’s savings. When the government increase
direct taxes the disposable income of the citizens will fall which will reduce savings. When direct taxes are reduced,
disposable income increase which increase savings. High indirect taxes also increase expenditures making people to
have less for savings and vice versa.
5. The spending habit of the community. In thrifty societies where savings is considered as a good moral habit,
savings tend to be high. But in spend thrift societies, savings are generally low.
6. The purpose of the savings. When people have a particular objective to achieve in future like to purchase a Car or
to further their education, they tend to increase their savings irrespective of their level of income.
7. Contractual savings. A greater volume of savings are on contractual bases. Such savings are not influenced by
interest rates or income levels. For example savings on life insurance policies.
8. political stability also affects savings. If a country is politically stable and people are generally optimistic about the
economy, they will be encouraged to save.
9. The population structure. Savings will be higher for an ageing population than for a young population.
Also the government can increase or mobilise savings by instituting compulsory savings schemes.

The Relationship Between Income Consumption And Savings.

The relationship in a 2 sector economy. In a 2 sector economy, part of the income is consumed and part is saved
therefore Income equal Consumption plus Savings at all levels of income; that is
Y=C+S at all income levels.
At equilibrium, we know that Y=C+I also
Therefore at equilibrium C+S=C+I which implies I=S, which satisfies the injection withdrawal condition.
Also since part of the income is consumed and part is saved, it implies
MPC+MPS =1. Also APC+APC +1
From this relationship, the savings function can be easily deduced.
Y=C+S
S=Y-C. C=aY +Co
S=Y-(aY+Co)
S-Y-aY-Co
S=(1-a)Y-Co
S=bY-So where 1-a=b and So =Co.

Graphical representation of the relationship

At Yo, income equal consumption hence savings is 0. At Y1, Consumption is greater than income by the distance AB
following the 45 degree line hence savings is negative given by the distance A’B’.
At Y2, Income is greater than consumption by the distance CD following the 45 degree line hence savings is positive
given by the distance C’D’.
The relationship in a three sector economy. In a three sector economy, part of the income is consumed, part is
saved and part is taxed. Therefore Income equal Consumption plus Savings plus Taxes at all levels of income; that is
Y=C+S+T at all levels of income.
Note that at equilibrium, Y=C+I+G also
Therefore at equilibrium C+I+G=C+S+T
This implies I+G=S+T which satisfies the injection withdrawal equilibrium.
The relationship in a four sector economy. In a four sector economy, part of the income is still consumed, part is
saved and part is taxed. Therefore Income equal Consumption plus Savings plus Taxes at all levels of income; that is
Y=C+S+T at all levels of income.
At equilibrium, Y=C+I+G+X-M
Therefore at equilibrium C+I+G+X-M=C+S+T
It implies I+G+X-M=S+T which implies I+G+X=S+T+M which satisfies the injection withdrawal equilibrium.

INVESTMENTS.

It is the creation of capital or the process of adding to our existing stock of capital.

TYPES OF INVESTMENTS.

1. Addition to stocks or value of physical increase in stocks. It is the accumulation of stocks over the period; that is,
stocks of 31st December minus stocks of 1st January. The stocks of goods produced by a firm constitute part of the
firm’s investment. It is the most volatile aspect of investment since it can easily increase and can easily decrease.

2. Investments in Plants and Equipments. This refers to the purchase of machines, and equipments such as tractors,
generators, computers etc. This type of investment is highly subjected to depreciation since machines and
equipments have the tendency to wear and tear over time.

3. Investments in building and construction. This refers to investments in building and construction of houses,
factories, warehouse etc.

4. Replacement investment. This is investments to replace worn out capital.

5. Public investments. This referes to all forms of investments carried out by the public sector such as construction of
roads, bridges, schools hospitals, public administrative buildings etc. The main aim of public investments is not to
maximise profits but it is to maximise the socio economic welfare of the citizens by providing goods and services at
moderate prices.

Public investments should be distinguished from private investments which refers to all forms of investments carried
out by the private sector. The aim of private investments is to maximise profits.

6. Portfolio investments. This is investments in the purchase of bonds and securities. Keynes considers investments
mainly in terms of portfolio investments. It is different from real investments like plants and equipments, building and
construction etc.

Investment Ex-ante and Investment Ex-post. Ex-ante investments refers to planned investments. This is the
investments that enterprise and planners in the economy wish to make at the start of a period. Ex-post investments is
the investment which firms end up realising at the end of the period. It includes both the planned and unplanned
investments like unsold stocks of goods that accumulate at the end of the year.

FACTORS INFLUENCING INVESTMENTS.

1. The level of income. This is one of the most important factors influencing investments. Investments which depends
on income is known as induced investments and its working is explained by the accelerator principle. In summary
when income increases, the demand for consumer goods and services increases. As a result, entrepreneurs
producing the consumer goods will be motivated to carry out more investments.
2. Expected profitability. This is the most important factor influencing private investments. When the profits which the
entrepreneur hopes to earn over the life span of the investment project is very high, he will be motivated to carry out
the investments. But if the expected profits are low, he will be discouraged.

3. The nature of demand. If the demand for the product of the investment is high and permanent the entrepreneur will
be motivated to carry out the investments. But if it is temporal or short lived or very low, he will be discouraged.

4. Government policies on taxation. When the government impose high taxes on investors, they will be discouraged
to carry out investments, but when taxes are reduced, they will be motivated to invest. Also a favourable investment
code in a country will encourage investors and vice versa.

5. The rate of interest. Interest is the price or cost of capital. When interest rates are high, firms will be discouraged to
borrow to carry out investments but when interest rates are low they are motivated to borrow and Carry out
investments.

6. The growth of population. This increases investments in two ways. Firstly increase in population will lead to
increase in the demand for goods and services which will motivate the entrepreneurs to carry out more investments.
Secondly, population growth increases investments in building and construction of houses since more people will
need accommodation.

7. The rate of depreciation. This influences replacement investment. When equipment and machines are depreciating
too fast, the will be the need for more replacement investment to be carried out to replace the worn out capital.

8. Political stability. When a country is socially and politically stable, it will encourage investors especially foreigners
to invest. But if the is a high degree of political stability, people will be discourage to invest.

CHANGES IN THE EQUILIBRIUM INCOME

This can be brought about by changes in the components of AMD. Assume a two sector economy where AMD is C+I
and there is only one Injection Investment (I) and one Leakage Savings (S).
The initial equilibrium income is Ye where the AMD curve (C+I) cuts the 45 degree line and where I=S. An increase
in Investments from I to I’ will shift the AMD Curve upward from C+I to C+I’. This causes the equilibrium income to
increase from Ye to Ye’. We observe that the increase in income is far greater than the increase in investments. This
is due to the action of the multiplier.

THE MULTIPLIER
It is the process which explains how small changes in spending causes a more than proportionate change in income.
Any initial injection in an economy such as investments or government spendings tends to generate a series of
spending with the overall effect on income being far greater than the initial spendings. The multiplier coefficient is the
coefficient by which we multiply the change in investment to bring about the change in income that is; ϪY=KϪI
where k is the multiplier.
To explain the multiplier, we assume the following
-the economy is a two sector closed economy and is not affected by foreign influence
-the economy exhibits a constant propensity to consume
-the economy is operating below full employment; that is there are idle resources to expand output if expenditures or
demand increases.
Injections are autonomous while withdrawals are induced.
-households positively reacts to changes in income same as output.
Suppose that the MPC is constant at 0.75 and there is an initial injection of 100 million into the economy worth
investment spendings. The firm that receives this initial investment spending will experience a rise in their income by
the 100 million. With the MPC constant at 0.75, this firm will proceed to spend 0.75 of this income to buy goods and
services from other firms such as its raw materials, payment of workers etc. The firms receiving this second round of
spendings will therefore experience a rise in their income by 0.75 of the 100 million. With the constant propensity to
consume of 0.75, they to will proceed to spend 0.75 of this income to buy goods and services from other firms.
Therefore the firms receiving this new round of spendings will therefore experience a rise in their income by 0.75 of
0.75 of the 100 million. These other firms receiving this new round of spendings will also proceed to spend 0.75 of
this income to buy goods and services from other firms and the process goes on and on. The series of spendings or
income that will be generated is given as

ϪY=100+0.75(100)+0.75(100)(100)+0.75(100)(100)(100)+………
ϪY=100+0.75(100)+0.75(100)2+0.75(100)3 +………+0.75(100)∞

This is the sum to infinity of a convergent geometric series which is given as

ϪY=1st term
1-common ratio
ϪY=100 =100 =1 X100 =4X100=400 million
1-0.75 0.25 0.25

Clearly the multiplier value is 4 which is 1

0.25

Since 0.75 is the mpc it implies the multiplier is

1 = 1
1-MPC MPS
Since Savings is the only leakage in a two sector economy, it implies the general formula for the multiplier is

K= 1
Marginal rates of leakages

Therefore in

Two sector k= 1
MPS

Three sector K= 1
MPS+MRT

Four sector K = 1
MPS+MRT+MPS

THE PARADOX OF THRIFT

Its states that under certain circumstances, an attempt to increase the level of savings may instead lead to a fall in
total savings. For an individual who attempts to increase his savings, he will end up realizing an increase in his total
savings but for the society as a whole, an attempt to increase the level of savings will instead lead to a fall in total
savings. This is because savings is a leakage with a negative multiplier effect on income. An attempt to increase
savings actually means a reduction in Consumption. When Consumption falls, firms will contract output leading to a
fall in income, when income falls , it becomes difficult to save out of the reduce income as such savings falls.
The paradox is explained based on the following assumptions
-the economy is closed
-the is only one leakage which is savings
-the economy operates below full capacity
-savings are not re injected into the economy as investments
-the economy is depressed such that increasing savings does not make more funds available for investments.
The paradox can be explained when investment is autonomous and when investment is induced. Autonomous
investments is investment which does not depend on income as shown.

The initial equilibrium income is Ye where I =S. An attempt to increase savings will push the savings curve upward
from SS to S’S’. This causes the equilibrium income to fall from Ye to Ye’, due to the negative multiplier effect which
savings have on income. But since investments is autonomous ie it does not depend on income, the fall in income
leaves savings unchanged and at equilibrium since savings must be equal to investments, savings remain
unchanged. In this case, an attempt to increase savings leaves savings unchanged.

The paradox is clearly seen when investment is induced. Induced investment is investment which depends on
income as shown.

The initial equilibrium income is Ye where I=S. An attempt to increase savings will push the savings curve upwards
from SS to S’S’. This causes the equilibrium income to fall from Ye to Ye’ due to the negative multiplier effect which
savings have on income. Since investments depend on income, the fall in income causes investments to fall from I to
I’ and at equilibrium since savings must be equal to investments, savings falls from S to S’. In this case an attempt to
increase savings actually leads to a fall in total savings.

THE ACCELERATOR PRINCIPLE.

The principle explains how small changes in income cause a more than proportionate change in investments. When
income increases, the demand for consumer goods and services will increase. This in turn provokes entrepreneurs to
carry out more investments. For example if income increases, it will increase the demand for Ice Cream. This in turn
will make entrepreneurs to buy more machines to produce the Ice cream. The principle therefore explains how small
changes in demand in one sector of the economy that is the consumer goods sector is magnified and spread to other
sectors, that is the capital goods sector. The accelerator coefficient is the coefficient by which we multiply the change
in income to bring about the change in investment.
that is ϪI=βϪY where β is the accelerator coefficient.
To explain the principle, we assume the following
-the Consumer goods industries should be operating at full capacity because if they operate with excess capacity,
then they will simple use the idle resources to increase output as such the will be no need for any additional
investments.
-the Capital goods industries should be operating with excess capacity because if they operate at full capacity, they
will be unable to increase the supply of the capital when needed. As such the price of capital may instead increase
which will discourage the investors.
-the workers of the consumer goods industries should not be made to work over time since over time work can be
used to increase output without necessarily increasing or carrying out more investments.
-the increase in demand should be permanent because if it is temporal or short lived, it will not motivate the investors
to carry out the investments.
-firms maintain a constant capital output ratio; that is the ratio of the capital stock to the output remains constant.
-firms carry out a constant replacement investment yearly.
For example, suppose that a firm has a Capital output ratio of 2:1. That is, it takes 2000frs worth of capital to produce
1000 frs worth of output. Also the firm carries out a constant replacement investment yearly of 2000 frs. The table
below shows how changes in income or demand affects the firms total investments.
year Ϫ in Income Existing Required Net Replacement Total
Ϫ in demand Capital Capital Investment Investment Investment
Ϫ in investment (mfrs) (mfrs) (mfrs) (mfrs) (mfrs)
(mfrs)
1 10000 20000 20000 - 2000 2000
2 12000 20000 24000 4000 2000 6000
3 13000 24000 26000 2000 2000 4000
4 13500 26000 27000 1000 2000 3000
5 13800 27000 27600 600 2000 2600
6 14000 27600 28000 400 2000 2400
7 14000 28000 28000 0 2000 2000
8 13000 28000 26000 -2000 2000 0

In year 1, the firm’s existing capital equal the required capital of 20000 hence there is no need for any net or
additional investment and with the constant replacement investment of 2000 ,total investment in year 1 is 2000.
In year 2, the firm needs to increase its output to 12000 due to increase in income or demand. This new output now
requires a capital of 24000 since the capital output ratio is 2:1. As such there is the need for a net or additional
investment of 4000 and with the constant replacement investment of 2000, total investment in year 2 is 6000; that is
Net plus Replacement Investment.
In year 3, the firm needs to increase its output to 13000 due to increase in income or demand. This new output level
now requires a capital of 26000, but the existing capital is the capital stock that was built in year 2 which is 24000. As
such there is the need for a Net or additional investment of 2000 and with the constant replacement investment of
2000, total investment in year 3 is 4000 that is net plus replacement and so on.
The percentage changes in income and the percentage changes in total investments can be used to explain the
accelerator at work. For example from year 1 to year 2, income increase by 20% that is

12000-10000 X100 =20%. This causes total investment to increase by 200%; that is
10000
6000-4000 X100 =200%.
4000

From year 2 to year 3, the percentage increase in output drops from 20% to 8.3%;

that is 13000-12000 X100 =8.3%.

12000
This causes a deceleration effect on investments with total investments falling by -33.3%.

This shows that small changes in income cause more than magnified changes in total investments revealing the
accelerator at work. The accelerator coefficient is the coefficient by which we multiply the changes in income to bring
about the changes in investments; that is ϪI=βϪY where β is the accelerator coefficient.
Therefore β=ϪI =I2-I1
ϪY Y2-Y1
For example the accelerator coefficient from Y1 to Y2

Β =6000-2000 =4000 =2
12000-10000 2000
The oscillator.
It is the chain reaction between the multiplier and the accelerator. The multiplier and the accelerator do not act in
isolation. There is a chain reaction between the two. When small changes in investments causes more than
proportionate change in income through the multiplier, the change in income in turn causes a more than
proportionate change in investment through the accelerator. This chain reaction is known as the Oscillator and it can
be used to explain trade cycles. For example during a Boom, a small cut in investments will bring about a more than
proportionate fall in income through the multiplier. The fall in income will in turn cause a more than proportionate fall
in investments through the accelerator. This chain reaction continues until the economy eventually reaches a Slump.
From a Slump, any small increase in income or investments will propagate a series of such chain reactions upward
until the economy eventually recovers back to a boom.
Note that apart from the Oscillator, trade cycles can also be caused by
-an outburst of technology
-an unexpected increase in money supply
-unexpected changes in export and import prices (External shocks).