Lesson Unit

Basic Propositions by Keynes

• The equilibrium level of Y and output of an economy depends on its Effective Demand or Expenditure.o If expenditure < Output, unemployment,o If expenditure > Output, inflation,o If expenditure = Output, full employment.

The economy can exist at any one of these three levels.

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The Consumption Function

• C = f(Y), where Y is disposable income.• Direct relationship, if Y, then C also ,Fundamental Psychological Law of Consumption:

o As Y, then C , o But C < Yo As Y, S, Therefore Y = C + S (prices remaining constant).

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C,S

0Y

Y=C+S

C= Ca + cY

Y =100

C=150

Y =200

C=200

Dissaving, C > Y

Y =300

C=250saving, C < Y

CONSUMPTION AND SAVING FUNCTIONS

S= - Sa +sY

S = -50

S = 0 S = 50

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Ca

Sa

Consumption Function• C-function is given by: C = Ca + cY

oWhere Ca = autonomous consumption, when Y = 0, C is not 0, there is some positive C, C > Y, and there is dissavings.

o Plus cY, where c stands for the slope of the C-function. This is equal to the Marginal Propensity to consume, MPC.

oWhen Y increases, C also increases, but less than proportionately.

o At Rs.200 Y, C = Y, and savings are zero.oWhen Y increases to Rs.300, C = Rs. 250, and

Savings are positive = Rs.50.

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APC is equal to consumption expenditure divided by income, at various Y-levels.

o APC = C/Y, it is equal to the slope of the radius vector, drawn on the C-function.

o APC falls as Y increases.• At Y = 100, APC = 125/100 = 1.25 > 1.• At Y = 200, APC = 100/100 = 1• At Y = 300, APC = 250/300 = 5/6 < 1

Average Propensity to Consume: APC:

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Marginal Propensity to Consume

• MPC is the rate at which C increases, when Y increases.

• MPC = ∆C/∆Y = slope of the C-function.• On a straight line C-function, MPC is constant.

0 < MPC < 1 (always a fraction)Based on Keynes’ Psychological Law.

(C = Ca + cY)MPC = dC/dY = c

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