Questions and Answers
What is the formula to calculate the Average Propensity to Consume (APC)?
If the consumption function is C = a + bY, what is the formula to derive the saving function?
What is the relationship between MPC and MPS in the consumption and saving functions?
What is the aggregate supply based on?
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If the consumption function is C = 200 + 0.75Y, what is the saving function?
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What is the formula to calculate the MPC if the consumption function is C = a + bY?
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What is the relationship between the aggregate supply and national income?
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If APC = b, what can be concluded about the consumption function?
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What is the effect of an increase in national income on saving?
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What is the purpose of the saving function?
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Study Notes
Aggregate Demand
- Aggregate Demand = Consumption of goods and services + Investment (Demand for capital goods)
- Investment is the sum of spending made by business firms per unit of time (one year) to build stock of capital
- Capital is the stock of productive assets: machinery, equipment, residential land, buildings, and inventories
Investment
- Investment is a flow concept: measured per unit of time, generally one year
- Investment refers to the addition to the physical stock of capital
- Types of Investment:
- Induced Investment: caused by the increase in income and decrease in interest rate (I = f(Y, i))
- Autonomous Investment: caused by exogenous factors such as innovation, invention, expansion plans, and discovery of new markets
- Autonomous investment is largely made by the government in areas such as physical infrastructure, human infrastructure, and public goods
Consumption
- Consumption is based on various factors: income, wealth, interest rate, expected future income, consumer credit, age, and sex
- Income is the primary determinant of consumption and saving
- Consumption Function: C = f(Y) (consumption is a positive function of income)
- Consumption increases with increases in income
- Keynes' "Psychological Law": with an increase in income, consumption does not increase in the same proportion
- Marginal Propensity to Consume (MPC): relationship between marginal income and marginal consumption
- MPC = ΔC/ΔY
Linear Consumption Function
- Applicable to the economy as a whole or at the aggregate level: C = a + bY
- a = positive constant (intercept), denotes autonomous consumption
- b = positive constant, represents the slope of the linear consumption function
- Average Propensity to Consume (APC): APC = C/Y
- APC = a + bY / Y
Saving Function
- Saving function is the counterpart of the consumption function: S = f(Y)
- Saving rises at an increasing rate at the upward movement of national income
- If consumption function is given as C = a + bY, then saving function can be derived as S = Y - C or S = Y - (a + bY) = -a + (1 - b)Y
- 1 - b gives MPS (Marginal Propensity to Save) where b = MPC
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Description
Understand the concept of aggregate demand, its components, and investment as a flow concept in economics. Learn how investment adds to the physical stock of capital.