Macroeconomics

Dr.S.Amuthan
Assistant Professor
Department of Economics
Kebri Dehar University, Kebri Dehar, Somali Region
Ethiopia
 The Keynesian consumption Function

• Keynes propounded the fundamental

psychological law of consumption which forms
the basis of the consumption function
• a prior from our knowledge of human nature
and from the detailed facts of experience
• there is a tendency on the part of the people
to spend on consumption less than the full
increment of income.
Propositions of the Law
• When income increases, consumption
expenditure also increases but by a smaller
amount
• The increased income will be divided in some
proportion between consumption expenditure
and saving.
• Increase in income always leads to an increase
in both consumption and saving.
• A.H. Hansen developed the theory of secular
stagnation for the mature capitalist economies.
• This secular stagnation theory is based upon the
assertion that investment opportunities in a capitalist
economy will be exhausted soon due to the absence
of the possibilities of increasing consumption demand.

• The meager opportunities of increasing investment in

the mature capitalist economies, according to them,
are partly due to the stability of consumption function
and declining average propensity to consume which
cause the marginal efficiency of capital to decline.
Kuznets’s Consumption Function
• Keynes’ consumption function (C = a + bY) and Kuznets’
consumption function (C = bY) are different.
• There was no tendency for the average propensity to
consume to decline as disposable income rises
• Whereas in Keynes’ consumption function APC falls as
income rises, in Kuznets ‘consumption function it
remains constant over a long period
• Propensity to consume: dC/dY (Disposable Y)
Propensity to consume, in economics the proportion of
total income or of an increase in income that
consumers tend to spend on goods and services rather
than to save.
• The reconciliation between two types of
consumption functions has been made by
some economists by pointing out that
whereas Keynes’ function is short-run
consumption function, ‘Kuznets’ function is
concerned with long run and is referred to as
long-run consumption function
 Irvin Fischer’s Model
• The quantity theory of money states that the
quantity of money is the main determinant of the
price level or the value of money.
• Any change in the quantity of money produces an
exactly proportionate change in the price level
• Irving Fisher, "Other things remaining unchanged,
as the quantity of money in circulation increases,
the price level also increases in direct proportion
and the value of money decreases and vice versa.
Fisher has explained his theory in terms of his
equation of exchange:
PT = MV + M' V‘
• P = price level, or 1/P = the value of money;
• M = the total quantity of legal tender money;
• V = the velocity of circulation of M;
• M' = the total quantity of credit money;
• V' = the velocity of circulation of M';
• T = the total amount of goods and services
exchanged for money or transactions performed
by money.
• PT is ΣPQ. In other words, price level (P)
multiplied by quantity bought (Q) by the
community (Σ) gives the total demand for
money.
• Thus the total value of purchases (PT) in a year
is measured by MV+M'V'. Thus the equation of
exchange is PT=MV+M'V'. In order to find out
the effect of the quantity of money on the
price level or the value of money
Fisher's quantity theory of money is explained quantity of money is M1, the price level is
P1. When the quantity of money is doubled to M2, the price level is also doubled to P2.

Panel B of the figure, the inverse relation between the quantity of money and the
value of money When the quantity of money is M1, the value of money is 1/P. But
with the doubling of the quantity of money to M2, the value of money becomes one-
half of what it was before, 1/P2
Assumption :
 P is a passive factor in the equation of exchange which is
affected by the other factors.
 The proportion of M' to M remains constant.
 V and V' are assumed to be constant and are independent of
changes in M and M'.
 T also remains constant and is independent of other factors
such as M, M', V and V'.
 It is assumed that the demand for money is proportional to the
value of transactions.
 The supply of money is assumed as an exogenously determined
constant.
 The theory is applicable in the long run.
 It is based on the assumption of the existence of full
employment in the economy.
THE PERMANENT INCOME HYPOTHESIS: FRIEDMAN’S
THEORY OF CONSUMPTION –
• The absolute income hypothesis relates
household consumption to the current absolute
income
• And the relative income hypothesis relates it to
the current relative income.
• Both Ho consumption to current income
• Milton Friedman: rejected the ‘current income
hypotheses - permanent income Hypothesis
• Absolute-income theory of consumption hypothesizes -
current consumption expenditure depends on the
current and absolute level of income
C = f (Y)

• The relative income hypothesis links the consumption

level of a household with the income and expenditure
level of the households of the comparable income
groups

All the incomes anticipated by the households in the long

run
Its Assumptions
Given these, Friedman gives a series of assumptions
concerning the relationships between permanent and
transitory components of income and consumption.

1. There is no correlation between transitory income and

permanent income.
2. There is no correlation between permanent and
transitory consumption.
3. There is no correlation between transitory
consumption and transitory income.
4. Only differences in permanent income affect
consumption systematically.
CL is the long-run consumption
function which represents the long-run
proportional relationship between
consumption and income of an
individual where APC = MPC

CS is the nonproportional short-run

consumption function where
measured income includes both
permanent and transitory components

OY income level where CS and CL

curves coincide at point E, permanent
income and measured income are
identical
 RANDOM-WALK THEORY
Robert E. Hall, - Incorporating the element of
uncertainty of income to life-cycle and permanent-
income hypothesis.

His theory is known as the modern version of Life-

Cycle (LC ) and Permanent Income (PI ) hypothesis
(abbreviated to LC -PI hypothesis) and also known as
random walk theory of consumption.

Households make expectations about their future

income with certainty and behave rationally
• Under the condition of certainty, consumers rationality
means that they maximize their lifetime utility
• lifetime utility is defined as
Lifetime Utility = u (Ct) + u(Ct +1) + … + u(CT–1) + u(CT)

• lifetime utility is maximized with the condition that

lifetime utility equals their lifetime resources, the
income.
• The utility maximization condition is equalizing
marginal utility gained in each period of time.
• The utility maximization condition
MU (Ct – 1) = MU(Ct) = MU (Ct+1)
• rational expectations theory to explain consumer
behaviour under the condition of uncertainty
• Is to equalize marginal utility in period t with
expected marginal utility in period t + 1.
• the theory is very close to Friedman’s permanent
income hypothesis. But marginal utility functions
cannot be specified reliably. But,
• Accordings to Hall, one thing is fairly reliable that
total utility (U) depends on total consumption (C)
• uncertainty about future income – it may increase
or decrease over time. Accordingly consumers
adjust their consumption level
 Life cycle Hypothesis model

• Ando and Modigliani have formulated a

consumption function which is known as the
Life Cycle Hypothesis*. According to this
hypothesis, consumption is a function of
lifetime expected income of the consumer -
Resources
The life cycle hypothesis is based on the following assumptions:
1. There is no change in the price level during the life of the consumer.
2. The rate of interest paid on assets is zero.
3. The consumer does not inherit any assets and his net assets are the
result of his own savings.
4. His current savings result in future consumption.
5. He intends to consume his total lifetime earnings plus current assets.
6. He does not plan any bequests.
7. There is certainty about his present and future flow of income.
8. The consumer has a definite conscious vision of life expectancy.
9. He is aware of the future emergencies, opportunities and social
pressures which will impinge upon his consumption spending.
10. The consumer is rational.
The Y0YY1 curve shows the individual consumer's income stream during his
lifetime T. During the early period of his life represented by T1 in the figure.,
he borrows or dissaves CY0B amount of money to keep his consumption level
CB which is almost constant. In the middle years of his life represented by
T1T2, he saves BSY amount to repay his debt and for the future. In the last
years of his life represented by T2T, he dissaves SC1Y1 amount.
 Chapter II
Investment
Investment is defined as the commitment of current
financial resources in order to achieve higher gains
in the future.
Investment means acquiring the assets that will give
returns on the Invested amount after a certain
period of time. The investment is made with the
goods or services, it is not consuming today but it
will be used in the future to create wealth. The
main goal of the investment is to generate more
income or increase wealth
• When a person buys shares, bonds or debentures of a public
limited company from the market, it is generally said that
he has made investment. But this is not the real investment
which determines income and employment in the country
and with which we are here concerned.

• Investment is the new addition to the stock of physical

capital such as plant, machines, trucks, new factories and so
on that creates income and employment. Therefore, by real
investment we mean the addition to the stock of physical
capital. Thus, in economics, investment means the new
expenditure incurred on addition to the stock of capital
goods such as machines, buildings, equipment, tools, etc
1. Business fixed investment 
Business fixed investment means investment in the machines, tools
and equipment that businessmen buy for use in further production of
goods and services. The stock of these machines or plant equipment
etc. represents fixed capital 
2. Residential investment
Residential investment refers to the expenditure which people make
on constructing or buying new houses or dwelling apartments for
the purpose of living or renting out to others. Residential investment
varies from 3 per cent to 5 per cent of GDP in various countries 
3. Inventory investment
Firms hold inventories of raw materials, semi-finished goods to be
processed into final goods. The firms also hold inventories of
finished goods to be sold shortly. The change in the inventories or
stocks of these goods with the firms is called inventory investment.
4. Financial Investment
Financial Investment means buying new shares, bonds, or debentures that
will be considered as a financial investment. the buying of old bonds,
shares or debentures will not be considered the financial investment. the
financial investment directly impacts on the growth of the economy.
 5. Planned Investment
Planned Investment means when the investor invests money to calculate
every aspect of the investment, which is called planned investment.
Most of the time, the planned investment gives positive results to the
investors and it also helps the investors to make faith in the company.
 6. Induced Investment
Induced Investment means the investment which depends on the income
level of the people when the income increases then Entrepreneurs starts
to invest more. When the income level starts to decreasing then
Entrepreneurs start investing less.
Neoclassical Model

• To explain investment behaviour with regard to fixed

business investment.
• This theory is called neoclassical theory of investment
behaviour because it is based on the neoclassical
theory of optimal capital accumulation which is
determined by relative prices of factors of production
• It may be recalled that fixed business investment
refers to the purchase of machines, construction of
new factories, ware houses, office buildings
• According to this neoclassical theory,
investment, that is, addition to the stock of
capital in an economy is determined by
marginal product of capital (MPK) and user cost
of capital which is also called real rental cost of
capital.
• Desired stock of capital by using the
neoclassical production function which is
popularly known as Cobb Douglas production
function
Y = A KaL1–a
 Marginal product of capital can be obtained by differentiating the production function

Marginal product of capital is diminishing as there is increase in the stock of capital.

Thus the firm will continue adding to the stock of capital (i.e. continue making
investment) until the marginal product of capital (MPK) is equal to the rental price of
capital
 TOBIN'S Q THEORY OF INVESTMENT
• proposed the q theory of investment which
links a firm's investment decisions to
fluctuations in the stock market.
• When a firm finances its capital for investment
by issuing shares in the stock market, its share
prices reflect the investment decisions of the
firm.
• Firm's investment decisions depend on the
following ratio, called Tobin'sq
• Tobin's q theory explains net investment by
relating the market value of firm's financial
assets (the market value of its shares) to the
replacement cost of its real capital (shares).
Rise in the firm's new investment. It shows that an increase in
the demand for shares raises their market value which raises
the value of q and investment.
THE ACCELERATOR THEORY OF INVESTMENT

• Increase in the rate of output of a firm will

require a proportionate increase in its capital
stock
• Desired or optimum capital stock
• Assuming that capital-output ratio is some
fixed constant, v, the optimum capital stock is a
constant proportion of output so that in any
period t,
• Kt* is the optimal capital stock in period t,
• v is a positive constant,
• Yt is output in period
• Any change in ouput will lead to a change in
the capital stock

naive accelerator
Y and Y1 are the two isoquants.
The firm produces Y output with K* optimal
capital stock.
If it wants to produce Y1 output, it must
increase its optimal capital stock to K*t .

Y, Y1 and Y2 are the firms’s isoquants

C, C1 and C2 are the isocost lines
If the firm decides to increase its ouput from Y
to Y1, it will have to increase the
units of labour from L to L1 and of
capital from K* to K1* and so on

investment to be proportional to the change in

output when capital is optimally adjusted
between the iosquants and isocosts
Money can be defined as any commodity that is
generally accepted as a medium of exchange
and a measure of value
'money stock', 'stock of money', 'money supply'
and 'quantity of money'.
The supply of money at any moment is the total
amount of money in the economy
money supply is defined as currency with the
public and demand deposits with commercial
banks. Demand deposits are savings and current
accounts of depositors in a commercial bank
About Money and Liquidity

Yinager Dessie 
• The central bank of a country—National Bank
of Ethiopia is the main source of money supply
in the country. The money supplied by the
central bank is known as ‘high power money’.
• Another Way: Banks create money supply in
the process of borrowing and lending
transactions with public
• The high power money and the credit money
M1
 THE KEYNESIAN THEORY OF DEMAND FOR MONEY

• Keynes built his theory of demand for money, i.e.,

his ‘liquidity preference theory, on the Cambridge
cash-balance approach to the demand for money.
It is, in fact, an extension of the
• Cambridge theory of money. According to Keynes,
money is demanded for three motives.
• (i) Transaction motive,
• (ii) Precautionary motive, and
• (iii) Speculative motive.
Transaction motive
People hold money to meet day to day expenditure
Income is received periodically—weekly, monthly or
annually—whereas it is spent on goods and
services almost regularly as and when need arises.
The transaction demand for money is positively
related to the level of income
Mt = f (Y )
• Interest-inelastic because, whatever the rate of
interest, people cannot stop paying grocer’s bill,
house-rent, electricity and telephone bills, school
fees, and medical bills
The Precautionary Demand for Money
• households and business firms hold some money in
excess of their transaction demand to provide for
unforeseen contingencies
• Transaction demand for money, precautionary demand
for money is also closely and positively related to the
level of income. The higher the level of income, the
higher the demand for money for precautionary
motive.
• transaction and precautionary demands for money are
a function of the income
• money demanded for precautionary motive also
becomes interest-elastic
 The Speculative Demand for Money
• people hold a part of their income also in the
form of idle cash balance for speculative
purpose. The desire to hold idle cash balance
for speculative purpose arises from the
• Desire to take advantage of the changes in the
money market, specifically, the asset market.
In Keynes’ view, it is rational to hold idle cash
balance instead of holding a bond if the rate of
interest is expected to rise in future.
It implies that the speculative demand for money becomes infinitely large
or elastic when the rate of interest goes below a ‘critical’ minimum level
—a level below which people prefer to hold idle cash balance and banks
pull down their shutters. Keynes called this kind of a situation as
‘liquidity trap
MONETARY EXPANSION AND THE MONEY MULTIPLIER: A
SIMPLIFIED MODEL
Assumption
• The commercial banks provide only demand deposit
facility.
• Commercial banks hold their assets only in the form
of commercial loans and advances.
• The deposit-currency ratio (c), and the cash-reserve
ratio (r) remain costant.
• There is no demand or capacity constraint. That is,
there is a large demand for commercial bank loans,
and banks have ample funds of loans and advances.
• R = r * DD