Questions and Answers
If output increases at a diminishing rate, investment is decreasing and positive.
True
When the slope of the aggregate output curve becomes 0, net investment becomes 0.
True
When aggregate output starts falling, net investment becomes positive.
False
What is the acceleration principle criticized for neglecting?
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Technological changes may be:
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What factors affect the propensity to consume?
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What happens when consumers expect a rise in prices?
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Real income and aggregate consumption remain unchanged if price levels rise proportionately.
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What role does interest rate play in consumption?
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How does an increase in liquid assets impact consumption?
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What is effective demand?
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What determines the level of equilibrium employment?
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According to Keynes, full employment equilibrium is always achieved at effective demand.
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What does the aggregate demand curve represent?
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Where is the economy in equilibrium according to the provided content?
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What is the initial value of the multiplier if investment increases by Rs. 5 crores and national income rises by Rs. 20 crores?
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The value of the multiplier can theoretically reach infinity?
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What does an increase in the investment multiplier imply for employment and income?
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What is the range of the marginal propensity to consume (MPC) according to Keynes?
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What does the quantity theory of money state?
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What does the acceleration principle explain?
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According to A.C. Pigou, what will happen if the demand for labor falls?
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If investment increases, the multiplier effect on consumption and expenditure will be _____.
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What key element does the concept of the multiplier depend on?
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Keynes believed that full-employment equilibrium is a realistic assumption.
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What causes a deficiency in aggregate demand according to Keynes?
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Keynes accepted the classical view of 'laissez faire' as essential for self-adjusting full employment equilibrium.
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What is Pigou’s advocated policy to achieve full employment equilibrium?
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How is the marginal propensity to consume (MPC) defined?
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Keynes believed that _____ was a significant factor affecting the demand for money.
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What is the relationship between average propensity to consume (APC) and marginal propensity to consume (MPC) as income increases?
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In Keynesian consumption function, which assumption is NOT included?
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What happens when savings exceed investments according to Keynes?
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Study Notes
Expansion of Say’s Law and Quantity Theory of Money
- Say's Law in a monetary economy is tied to classical money theory, represented as MV = PT.
- An increase in money supply lowers the value of money, leading to higher general price levels.
- While money wages rise, real wages do not, maintaining economic equilibrium.
A.C. Pigou’s Version of Say’s Law
- Pigou relates equilibrium to the labor market, suggesting unemployment reduces wages, increasing labor demand.
- He posits wages and relative prices are flexible downward, aiding in restoring full employment.
- Modern factors like unions and minimum wage laws challenge this theory, rendering it less applicable.
Keynesian Criticism of Classical Economics
- Keynes rejected full-employment equilibrium as unrealistic; underemployment is common, with Say’s law failing due to inadequate demand.
- Savings do not automatically convert into investments; income is not fully consumed, causing aggregate demand deficiencies.
- He argued capitalist systems are not self-adjusting due to wealth inequality, necessitating state intervention.
- Classical economists viewed savings and investment as equal, but Keynes linked investment to business outlook and not just interest rates.
- Keynes emphasized speculative demand for money, contrasting with classical views focused solely on transaction purposes.
- Policy suggestions by Pigou for wage cuts were critiqued by Keynes as impractical for the entire economy.
- Keynes favored state action for economic activity to achieve full employment.
Keynes's Psychological Law of Consumption
- As income rises, consumption increases but at a diminishing rate; not all income changes translate into proportional consumption changes.
- Law is based on three main propositions regarding income, spending, and saving behaviors.
Consumption Function
- It is predicated on stable psychological behaviors and a functioning capitalist economy without government consumption restrictions.
- Consumption depends on disposable income (income after taxes).
- The function is expressed as C = f(y), indicating consumption varies with different income levels.
Marginal Propensity to Consume and Save
- MPC measures incremental consumption changes due to income shifts, typically less than 1 as income rises.
- The relationship between changes in consumption and income is expressed through MPC + MPS = 1.
- MPC tends to decline as income increases while MPS rises.
Average Propensity to Consume (APC)
- APC is the ratio of total consumption to total income; it reflects what portion of income is spent on consumption.
- APC can remain constant or vary depending on the form of the consumption function.
Factors Influencing Propensity to Consume
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Price Variables:
- Expected price changes can influence immediate consumer behavior, affecting MPC.
- General price level shifts alter real income, impacting consumption patterns.
-
Monetary Variables:
- Interest rates can influence consumption, though interpretations vary across economic theories.### Consumption and Savings
- High interest rates typically decrease present consumption while increasing savings, as per classical economic thought.
- Neo-Keynesian theory suggests individuals save to support future consumption rather than significantly cut current consumption.
- Availability and terms of credit influence consumption levels; easier access often leads to increased consumption beyond the standard marginal propensity to consume (MPC).
Stock Variables
- An increase in the stock of consumer durables leads to a reduction in their consumption in the short term.
- The effect of wealth on consumption varies; Pigou posits that rising wealth reduces its marginal utility, prompting increased current consumption over wealth accumulation.
- As wealth increases, households might opt to save or invest more, resulting in a declining MPC and rising marginal propensity to save (MPS).
Social, Psychological, and Philosophical Variables
- Consumption motivations include enjoyment, short-sightedness, generosity, and extravagance.
- Saving motivations can be driven by independence, precaution, and enterprise, influencing overall consumption patterns in subjective ways.
Long-Run Variables
- Liquid assets correlate positively with current consumption levels; more liquid assets lead to higher consumption.
- Past living standards influence consumption behavior, often leading to less than proportional declines in consumption when current income decreases.
- Relative income impacts consumption; families may maintain higher consumption levels despite lower income due to peer standards.
Other Factors
- Increased advertising expenditures can encourage consumer spending beyond traditional income or saving metrics.
- Government fiscal policies, such as increased public spending and tax reductions, typically enhance disposable income and may raise MPC.
Effective Demand and Underemployment Equilibrium
- Employment levels are directly tied to effective demand; effective demand drives output, income, and subsequently employment.
- Effective demand is determined by total expenditures in an economy: consumption and investment.
- The equilibrium of effective demand occurs when aggregate demand equals aggregate supply—a situation where entrepreneurs can recover costs.
Aggregate Demand and Supply Functions
- Aggregate demand functions relate to expected receipts; at different employment levels, demand prices fluctuate.
- Aggregate supply prices must meet or exceed demand prices for sustained employment; mismatched expectations lead producers to adjust employment.
Determination of Effective Demand
- Effective demand is established where aggregate demand price meets aggregate supply price.
- Supernormal profits occur when demand exceeds supply, incentivizing firms to hire more until reaching effective demand.
Multiplier and Accelerator Concepts
- The investment multiplier measures the relationship between changes in investments and subsequent changes in income and employment.
- The multiplier effect indicates that an increase in investment leads to a greater proportional increase in national income.
- The value of the multiplier is largely influenced by the MPC, with higher MPC resulting in a greater multiplier effect.
Process of Income Generation via Multiplier
- Initial investments, such as in public infrastructure, generate primary income that circulates through the economy, leading to further economic activity and income growth.### Secondary Generation of Income
- Initial construction expenditure of Rs. 4 crore leads to a primary income generation of Rs. 8 crore.
- With a Marginal Propensity to Consume (MPC) of 0.5, subsequent spending creates a cycle of income generation.
- Secondary income generation formula: Rs. 4 crore + Rs. 2 crore + Rs. 1 crore and so on results in a total of Rs. 16 crore.
Multiplier Effect
- Multiplier effect can be diagrammatically represented to illustrate income changes in the economy.
- Equilibrium income is determined where the total expenditure curve meets the45° line indicating income (Y).
- Government investment of Rs. 8 crore shifts the consumption plus investment curve, increasing output to Rs. 16 crore due to the multiplier effect (MPC = 0.5, multiplier = 2).
Importance of Multiplier
- Useful in analyzing fluctuations in investment, consumption, and predicting economic activity.
- Public investments should be strategically conducted where leakages are minimized for significant effects on employment and income.
Criticisms of Multiplier
- Effectiveness varies between developing and developed economies due to different investment outputs.
- High levels of unemployment in developing countries result in a greater initial employment response to investments.
- Developing countries often face limitations in substantial investments and production elasticity affecting multiplier outcomes.
Acceleration Principle
- Introduced by J.M. Clark in 1917, explaining the relationship between consumption demand increases and capital goods investment.
- The accelerator coefficient (β) is the ratio of induced investment to changes in consumption expenditure.
- Investment requirements are proportionate to changes in output, with a higher accelerator value indicating more required investment.
Investment Dynamics
- Gross investment comprises both replacement and net new investments, with variations according to output levels.
- Example calculations show required capital stock is four times the output, indicating the significance of the accelerator in economic growth.
Slope of Investment and Output Change
- When output and demand for goods rise, net investments increase; conversely, when demand falls, net investment becomes negative.
- Investment patterns vary based on output growth rates and can become zero when output stabilizes or declines.
Role of Technology
- Acknowledges that the acceleration principle may overlook technological impacts on investment decision-making.
- Technological developments can either increase or decrease the volume of required investments based on whether they are capital-saving or labor-saving.
Conclusion
- Understanding the principles of multiplier and acceleration enhances comprehension of economic dynamics and investment strategies.
- Investment policies should consider the feedback effects on income and employment to maximize the benefits of economic growth.
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Description
This quiz explores the concepts of the acceleration principle, the effects of technological changes, and the factors influencing the propensity to consume. Test your understanding of how these economic factors interact within investment and output scenarios.
