## Karnataka 2nd PUC Economics Important Questions Chapter 4 Consumption and Investment Function

Question 1.
What is consumption?
Total quantity of goods bought and used by consumers during a period
Or
The process of using a good or a service by consumers to satisfy a want.

Question 2.
What is Saving?
Saving is that part of the income which is not spent on consumption.

Question 3.
What is investment?
Investment means the purchase of stocks and shares, debentures etc.,

Question 4.
State the meanings of marginal propensity to consume.
Marginal propensity to cosume is the ratio of change in consumption to the change in income.

Question 5.
What is average propensity to consume.
The ratio of consumption expenditure to income in a given period of time APC = c/y

Question 6.
What is consumption function?
The functional relationship between income and consumption expenditure.

Question 7.
What is multiplier?
The ratio of the total change in income to the initial change in investment is known as multiplier. ‘

Question 1.
What is income, according to Keynes?
Income is equal to consumption plus investment and saving is excess ofincome over consumption.

Question 2.
What is liquidity trap?
If additional money’s injected within the economy it will be used up to satiate peoples craving for money balances without increasing the demand for bonds and without lowering the rate of interest. Such situation is called a liquidity trap.

Question 3.
What is Keynes psychological law of consumption function?
According to Keynes “ when income increases, consumption also increases but by the smaller amount, part of income will be saved.

Question 4.
What is Marginal efficiency of Capital (MEC)?
If defined as the expected rate of returns over the cost expected from marginal capital asset. If depends on prospective yield and supply price.

Question 5.
Name the types of investment.

1. Private investment and public investment
2. Induced investment and Autonomous investment.
3. Ex-ante investment and Ex-post investment
4. Gross investment and Net investment.

Question 6.
How is saving equal to investment?
The equality between the savings and investment is brought through the mechanism of interest rate. When saving is less than investment, a rise in the rate of interest brings down investment and increases saving till saving equals investment.

Question 7.
Mention the factors affecting marginal propensity to consume.
The factors affecting marginal propensity to coiisume are:
(a) Disposable income
(b) Transfer of payments
(c) Fewer taxes

Question 8.
Explain the relationship between multiplier and marginal propensity to consume.
The value of multiplier is determined by MPC. IfMPC is higher, multiplier will also be higher. The converse is also true. But the value of multipher is always more than one the multiplies can be calculated by the following Formula K = 1/1-MPC

Question 9.
Distinguish between autonomous and induced investment.
Autonomous investment

1. It may be termed as public investment.
2. It made in the creation of economic and social infrastructure
3. It is income effect

Induced investment

1. It may be made by the people
2. It as a result of change in the income level
3. Investment is income inelastic

Question 1.
What is investment? Explain the types of investment.
According to Keynes, investment refers to an addition to the nation’s physical stock of capital assets like the building of new factories, new machines, new plants and equipments as well as any addition to the stock of the goods in the process of production.

In ordinary term investment means the purchase of stocks and shares, debentures, government bonds and equities.

Types of Investment:
Private Investment and Public Investment: Private investment is the investment which is undertaken by private investors,’firm holders and industrialists.
Public investments is the investment made by the government bodies. Such investment yield social benefits.

Induced investment and Autonomous investment:
Induced investment made by the people as a result of change in the income level so it is income elastic.
Autonomous investment may be termed as public investment may be termed as public investment made in the creation of economic and social infrastructure.

Ex-ante (planned) and expost (unplanned) investment:
Ex-ante investment is a planned investment that is intended to be invested
Ex-post investment is the one that has been actually made.

Gross investment and net investment: Gross investment is the total value of the asset made or required.
Net investment is gross investment minus depreciation

Question 2.
Explain Keynes consumption function.
Keynes consumption function is an important concept of general theory. It shows the relationship between income and consumption. Symbolically represented as C=f(y) where C is consumption and y is income. Consumptin function is a schedule showing various amount of consumption expenditure at different level of income. The consumption schedule given in table

Consumption Schedule

 Income(y) (in crores) Consumption C (in crores) 0 20 50 60 100 100 150 140 200 180

As shown in table consumption expenditure increases with increase in income. When income is zero during the depression, people spend out of their past saving on consumption. A rise in income to Rs.50 crores is not enough to meet consumption expenditure of Rs.60 crores. At this stage, Rs 10 crores is dis-saved when income is RS. 100 crores, consumption expenditure is also RslOO crores. After this stage, income is shown to increase by Rs.50 crores and consumption by Rs.40 cr. This implies that increase in consumption is less than increase in income.

Income is measured along OX axis and consumption is measured along OY axis OS=A curve is in 45° It points out that at all levels, income and consumption are equal.

C is the consumption curue. it is upward sloping curue indicating that is an increasing function in income. At B, C = y or oy1 = OC1 When income increases to oy2 consumption is not equal to increase in income. In the diagram C C2 < y1y2 The income saved is SS1

Question 3.
Explain the investment function of Keynes.
Investment function is given much importance in the Keynesian. Theory of employment. Employment depends upon effective demand Effective demand decides income, output and employment. The two major constituents of effective demand are investment is more strategic variable, consumption being constant in the short period.

According Keynes investment refers to an addition to the nation’s physical stock and capital assets and stock of finished goods in the process of production.

As said above, investment is more important strategic variable. As the income of the community increases. Consumption will also increase. But, it does not increase in the same rate as income increases. There will be a gap between income and consumption. The gap must be bridged to increase employment and production. This gap is saving and it becomes investment. In other words, employment cannot increase, unless investment increases.

Question 4.
Discuss the concept of multiplier of Keynes?
The concept of multiplier is an important contribution of Keynes to economic analysis. It occupies an important place in the Keynesian model of employment. The concept of multiplier was first originated by lord R.F.Kaha Keynes has successfully implemented it in his employment theory.

According to Keynes, an initial increase in investment increases the final income by many times. Change in investment leads to changes in consumption which in turn will lead to changes in income. The ratio of the total change in income to the initial change in investment is known as multiplier.

Therefore K = y/I is increase in income, y is increase in investment and K is multiplier.
The value of multiplier is determined by MPC. If MPC is higher, multiplier will also be higher. The converse is also true. But the value of multiplier is always more than one the multiplies can be calculated by the following formula
K = 1/1-MPC

If MPC is deducted from 1, we get marginal propensity to save (MPS)
The formula is K = 1/MPS

The formula states that the multiplier is the reciprocal of MPS

Question 5.
Explain the concepts of saving and investment. Discuss the equality between saving and investment.
Investment means the purchase of stocks and shares, debentures etc. According to keynes investment refers to an addition to the nations physical stock of capital goods like buildings, machine etc. It also includes addition to the stock of goods in the process of production, inventories and fixed capital keynes states that, a country should produce equivalent to what it spends. Hence, income (y) is equal to expenditure (E). y=E. The total income, therefore includes the money earned by producing consumption goods (c) and investment goods (I).

Symbolically, y = C + 1
Therefore, I = y – C
Investment is generally influenced by marginal efficiency of capital and rate of interest. It also depends on consumption.

Saving is that part of the income which is not spent on consumption. This is the excess of income over expenditure. In short, income not consumed is income saved. This is the demand side of income.

The country as a whole spends its income on consumption and the remainder is saved.

Therefore, y = c + s where, y = income or c = consumption s = y – c s = saving

Equality between saving and Investment

According to classical economists, saving and investment are always equal in full employment economy. They opined that saving and investment are a function of rate of interest.

Symbolically S = f(r) and I = f(r) where, r = rate of interest.
Therefore S = I
When saving is less than investment, a rise in the rate of interest brings down investment and increases saving till saving equals investment.

However, keynes does not agree with the classical view of saving – investment equality. He gives two views (1) The first view is the accounting equality between saving and investment. This is used in national income accounting. It tells that actual saving and investment are always equal at all times and at any level of income keynes defines saving as excess of income over consumption. Hence, saving and investment are always equal.

Symbolically (1) S = y- c
(2) I = y – c

Since, y – c is common in equations (1) and.(2) it follows that (3) S = I

Keynes also used another method to establish this equality. According to him, income is equal to consumption plus investment and saving is excess of income over consumption.
Thus, y = c + s
y = c +1
Therefore, c + s = c +1
∴ s = I
Thus both saving and investment are the difference between income and consumption. Hence they are equal.

2. The second view of keynes is functional equality. In this sense, saving and investment are not only equal but they are also in equilibrium. Income is a function of saving and investment. When saving exceeds saving income rises. This process of changes in income, saving and investment will continue till saving and investment are not only equal but are also in equilibrium.

Question 6.
Explain keynes consumption function. Discuss the properties of consumption function.
The value of multiplier is determined by MPC. IfMPC is higher, multiplier will also be higher. The converse is also time. But the value of multiplier is always more than one the multiplies can be calculated by the following formula, K = $$\frac{1}{1-M P C}$$

Properties or Technical Attributes of consumption function:
The relationship between income and consumption is measured by two technical properties. They are, –

1. Average propensity to consume
2. Marginal propensity to consume

The diagram, income is measured along ox axis and consumption is measured along oy axis. PC is propensity to consume. As income increases from to y2, consumption also increases from to C2. But consumption does not increase proportionately to the increase in income. RQ is change in income and NQ is change in consumption. RQ is greater than NQ.

Question 3.
What is investment function? Explain the types and determinants of investment
Keynes consumption function is an important concept of general theory. It shows the relationship between income and consumptioa Symbolically represented as C = f(y), where C is consumption and y is income. Consumption function is a schedule showing various amounts of consumption expenditure at different levels of income. The consumption schedule is given in table.

Consumption Schedule

 Income(y) (in crores) Consumption C (in crores) 0 20 50 60 100 100 150 140 200 180

As shown in table consumption expenditure increases with increase in income. When income is zero during the depression, people spend out of their past saving on consumption. A rise in income to Rs.50 crores is not enough to meet consumption expenditure of Rs.60 crores. At this stage, Rs. 10 crores is dis-saved. When income is Rs. 100 crores, consumption expenditure is also Rs. 100 crores. After this stage, income is shown to increase by Rs.50 crores and consumption by Rs.40 cr. This implies that increase in consumption is less than increase in income.

Income is measured along OX axis and consumption is measured along OY axis. OA curue is in 45°. It points out that at all levels, income and consumption are equal.

C is the consumption curue. It is upward sloping curue indicating that is an increasing function in income. At B, C = y or oy, = OCr When income increases to oy2, consumption increases to OC2. But, increase in consumption is not equal to increase in income. In the diagram C1C2<y1y2 The income saved is SS1. According to keynes, investment refers to an addition to the nation’s physical stock of capital assets like the building of new factories, new machines, new plants and equipments as well as any addition to the stock of the goods in the process of production.

In ordinary term investment means the purchase of stocks and shares, debentures, government bonds and equities.

Types of Investment:
Private Investment and Public Investment:
Private investment is the investment which is undertaken by private investors, firm holders and industrialists.
Public investments is the investment made by the government bodies. Such investment yield social benefits.

Induced Investment and Autonomous investment:
Induced investment made by the people as a result of change in the income level so it is income elastic.
Autonomous investment may be termed as public investment made in the creation of economic and social infrastructure.

Ex-ante (planned) and Expost (unplanned) investment:
Ex-ante investment is a planned investment that is intended to be invested.
Ex-post investment is the one that has been actually made.

Gross Investment and Net Investment:
Gross Investment is the total value of the asset made or required.
Net Investment is gross investment minus depreciation.

Determinants of investment:
Investment depends on two factors.

They are:

1. Marginal efficiency of capital (MEC)
2. Rate of interest

1. Average Propensity to consume (APC)
It is the ratio of consumption expenditure to income in a given period of time.

Symbolically, APC = $$\frac{\mathrm{C}}{\mathrm{y}}$$
Where C is consumption and y is income.

Thus APC gives the proportion of income consumed. As income increases, the proportion of income spent on consumption decreases. APC declines. On the other hand, average propensity to save (APS) increases with an increase in income.

2. Marginal propensity to consume (MPC)
It is the ratio of change in consumption to the change in income. In other words, it is an increase in income (Δy)
MPC = $$\frac{\Delta \mathrm{C}}{\Delta \mathrm{y}}$$
Generally, the relationship between income and consumption is such that when income rises, consumption also rises, but by less than the rise in income. It is always positive but less than once.

Now it is easy to find out Marginal propensity to save (MPS). The earned income should be spent or saved, y = c + s. Therefore, increase in y = MPC + MPS. So MPS = 1 – MPC.

According to Keynes MEC plays a major role in determining the level of investment than the rate of interest. MEC refers to the expected yield from new capital assets. It depends on prospetive yield & supply price.

Prospective yield is the total net return expected from the asset over its lifetime.
Supply price is the cost of producing a new asset. It also called replacement cost.

If the prospective yield is more than the supply price, MEC will become greater and investment will also be greater. MEC will be greater when supply price is smaller.

On the other hand, the investment is also determined by the rate of interest. Investment is low when the rate of interest is high as people compare rate of interest with MEC and vice versa. Thus, investment will depend on the prevailing rate of interest.

Exercises

Question 1.
What is marginal propensity to consume? How is it related to marginal propensity to save?
Marginal propensity to consume refers to the ratio of change in the consumer’s expenditure due to the change in disposable income (income after deducting taxes). In other words, MPC measures how consumption will vary with the change in income.
So,
MPC = $$\frac{\Delta \mathrm{C}}{\Delta \mathrm{Y}}$$
Where,
y = Change in income
ΔC = Change in consumption

For example, if income increases from Rs 200 crores to Rs 250crores and consumption increases fromRs 20 crores to Rs 40 crores, it implies that 0.4 is the MPC or 40% increase in the income is being consumed.

This can further be explained with the help of a table and a diagram.
If income and consumption are:

 Income in Rs (Y) Consumption Expenditure in Rs (C) 200 20 250 40

Then MPC = $$\frac{\Delta \mathrm{C}}{\Delta \mathrm{Y}}=\frac{20}{50}$$ = 0.4

Also, MPC can be explained with the given diagram.

In the diagram, x-axis represents national income and y-axis represents consumption level.
So, MPC = $$\frac{\mathrm{BC}}{\mathrm{AC}}$$

The relationship between MPC and MPS can be explained as
Y = C + S (Assuming that the income earned is either consumed or saved)
Or, ΔY = ΔC + ΔS
Dividing both sides by ΔY
Or, MPC = 1 – MPS
Or, MPS = 1 – MPC
So, the sum of MPC and MPS is always equal to unity.

Question 2.
What is the difference between ex ante investment and ex post investment?

 Ex-ante Investment Ex-post Investment 1. It refers to the planned or intended investment during a particular period of time. 1. It refers to the actual level of investment during a particular period of time. 2. It is imaginary (intended), in which a firm assumes the level of investment on its own. 2. It is factual or original that signifies the existing investment of a particular time. 3. It is planned on the basis of future expectations. 3. It is the actual result of variables.

Question 3.
What do you understand by ‘parametric shift of a line’? How does a line shift when its:
(i) slope decreases, and
(ii) its intercept increases?
Considering the equation of a straight line as b = ma + ε
Where m = slope of straight line, m> 0
ε = intercept on vertical axis, ε >0

Also, when a increases by 1 unit, the value of b increases by m units.
As the value of m increases, the straight line rotates upward around the same vertical intercept. This movement is an example of parametric shift of the graph.

1. A straight line rotates downward around the same vertical intercept as its slope decreases.
2. A straight line shifts parallelly upward when its intercept increases.

Question 4.
What is ‘effective demand’? How will you derive the autonomous expenditure multiplier when price of final goods and the rate of interest are given?
Effective demand refers to a situation in which equilibrium output is determined solely by the level of aggregate demand. This is because of the assumption that the supply is infinitely elastic and if there exists any inequality between the Aggregate Demand (AD) and the Aggregate Supply (AS), then the equilibrium output will only be influenced by AD. The concept of effective demand can be explained with the help of the given diagram.

The x-axis represents income/output level and y-axis represents the level of aggregate demand. E is the equilibrium point where the two curves AS and AD meet. EG is the effective demand and output level is determined by AD (assuming the elasticity of supply to be perfectly elastic).
Autonomous expenditure multiplier is derived as
Y = A + c Y [Where AD = A + c Y]
Y – cY = A
Y(1 – c) = A
Y = $$\frac{A}{1-c}$$
A = Autonomous expenditure c = MPC
Y = level of income
$$\frac{1}{1-c}$$ = autonomous expenditure multiplier

So, the autonomous expenditure multiplier is dependent on the income and MPC.

Question 5.
Measure the level of ex-ante aggregate demand when autonomous investment and consumption expenditure (A) is Rs 50 crores, and MPS is 0.2 and level of income (Y) is Rs 4000 crores. State whether the economy is in equilibrium or not (cite reasons).
Consumption expenditure (A) = Rs 50 Crores
MPS = 0.2
So, MPC = 1 – MPS = 1-0.2 = 0.8
Y = 4000 Crores
We know that AD = A + cY………….(1)
Putting the values in equation………..(1)
AD = 50+ 0.8 x 4000
= 50 + 3200
= Rs 3250 Crores
But, Rs 3250 < Rs 4000