KEYNES THEORY

• Consumption is ‘be all’ and ‘end all’• Income is the most important determinant. • C=f(y).• Psychological Law of Consumption.• APC• MPC• Three relatively common consumption

function.

Contd….

• Constant MPC and declining APC

“Men are disposed, as a rule and on an average to increase their consumption as their income increases, but not as much as the increase in their income”

C=a+by

EMPIRICAL ESTIMATION

• Keynes did not provide statistical evidence.• Consumption function puzzle (Keynes

versus Kuznets)• Three important hypotheis. a. Relative Income Hypothesis-James

Dussenbery. He recognised the social character of the consumption. Relative income and not absolute. Demonstration effect-ratchet effect-APC

Contd…

• The permanent income hypothesis-Milton Friedman. Future as well as current income-future income consists of two streams-empirical measure is required-Transitory consumption and income-criticisms.

• Life Cycle Hypothesis-Modigliani and Ando-Planning consumption and saving over a long period of time-allocation of consumption in the best possible manner-Maximising his utility over entire life span-savings-dissavings.

Contd…

• People do not want to consume over their lifetimes at precisely the same time and amounts they earn income. Thus they save and dissave so as to consume their life time incomes in the pattern they want. They save while working, and then use the savings to finance in their retirement years.

Importance of Consumption Function

1. The concept helps to invalidate Say’s law

2. Significance of investment demand

3. It helps to derive the theory of multiplier

Multiplier

• Investment Multiplier• Algebraic derivation of multiplier• Assumptions : Instant change, excess

capacity in consumer goods industries, closed economy, increase in money as well as real terms.

Importance: Helps in understanding the business cycles, importance of fiscal policy.

CLASSICAL THEORY

• Automatic adjustment between production and consumption.

• Full employment

• Equality of saving and investment.

• Economy would continue to employ the unemployed.

• Demand and supply of labour

Contd…

• Demand depends on output and also MRP

• MRP=MPPxP

• MPP is subject to law of diminishing returns.

• Employers would continue to employ till W=MRP.

KEYNES THEORY

• Aggregate Demand: Is the total sum of money or proceeds, which is expected from the sale of the output produced when that amount of labour is employed.

• Aggregate Supply: Is a schedule of the minimum amounts of proceeds required to induce varying quantities of employment.

INFLATION-FEATURES

• It is not high prices• Coverage increases• No absolute price rise• Input Output relationship• No pre-determined set of causes and effects• Greater need for means of payment• Expectations of further rise• Holding back supplies• Change in asset preference• Increase in Interest rates initially• Growing inequalities in income

TYPES

• Demand Pull

• Cost Push

a) Wage Push b) Profit Push

They are often interwined

IS-LM MODEL

• Keynes Model: National Income and Output is determined by investment which in turn is determined by the rate of interest which in turn is determined by the demand and supply of money.

• Only one way relationship was found to be inadequate

• J.R. Hicks developed the IS-LM model.

IS-LM CURVE

• The IS curve is a graphic representation of the product market equilibrium condition that planned investment be equal to saving and it shows the level of income that will yield equality of planned investment and saving at different possible interest rates.

IS-LM CURVE

• The LM Curve is a graphic representation of the monetary equilibrium condition, and it specifies the level of income which, for different rates of interest, makes the demand for money equal to the supply of money.

IS CURVE – Increase In Govt Exp

IS CURVE –Increase in Taxes

IS CURVE – Increase in Productivity

IS CURVE Investment Senstivity

LM CURVE

LM CURVE – Interest Elasticity of Money Demand

LM CURVE (contd)

IS LM – Fiscal and Monetary Policy

Fiscal and Monetary (contd)

Fiscalist Case

Monetarist Case