ECN 202 (3 Units)

Principles of Economics II

Five topics

1. National Income Accounting.

Dr. D.O Olayungbo (2 weeks).
2. National Income Analysis.
Dr. O.T Ojeyinka (3 weeks).
3. Theory of consumption, savings and investment.
Dr. T.T Osinubi (2 weeks).
4. Money, Inflation and elements of public finance.
Dr. O.T Apanisile and Dr. P.T Ogun (2 weeks).
5. International trade and balance of payment.
Dr. O.M Oladunjoye (2weeks).

Total number of weeks (11)

Total number of weeks available in a semester (13)
Lecture commencement (week 2)

Lecture days: Tuesdays 1-3 pm CHM eng

 DEFINITION AND SOME CONCEPTS IN ECONOMICS

DEFINITION

Macroeconomics is the study of the economy as a whole. It captures the

interdependence of the various sectors and units in a given economic system.

The focus of macroeconomic analysis is usually to determine the sequence of the

consequence of a given development in one sector on another in the economy.

Therefore, to examine the overall performance of an economy, macroeconomic analysis

deals with the broad determination of economy aggregates such: National Income
(output), general price level, general level of employment, exchange rate, balance of
payment equilibrium etc.

Macroeconomics also examines factors that determine the level of these aggregates
and the structure of their components.

In summary, macroeconomics is the study of aggregates or averages covering the

entire economy, such as total employment, national income, national output, total
investment, total consumption, total savings, aggregate supply, aggregate demand,
and general price level, wage level and cost structure.

In other words, it is aggregative economics which examines the interrelations among

the various aggregates, their determination and causes of fluctuations in them.

Apart from the above definitions, macroeconomics also focuses on economic policies
and policy variables that affects the performance of an economy.

DISTINCTIONS BETWEEN MACROECONOMICS AND MICROECONOMICS

Macroeconomic theory refers to the analysis of the hypothesized relationships between

aggregate variables in the economy; such as national income, savings, consumption
employment, exports and imports. On the other hand, microeconomics study the
behaviour of individual economic decision units, the consumers, households, firms
and the way in which their decisions interrelate to determine relative prices of goods
and factors of production, and the quantities which will be bought and sold in the
market economy.
The objective of microeconomics on demand side is to maximize utility whereas on the
supply side is to maximize profits at minimum cost while the main objectives of
macroeconomics are full employment, price stability, economic growth, exchange rate
stability and favourable balance of payments.

The basis of macroeconomics is national income, output and employment which are
determined by aggregate demand and aggregate supply. On the other hand, the basis
of microeconomics is the price mechanism which operates with the help of demand
and supply forces and these forces help to determine equilibrium price and quantity in
the market.

DEFINITION OF SOME CONCEPTS

VARIABLE

This is a quantity whose magnitude or value can change i.e. a variable is a magnitude
that can take on different values. Examples of such variable frequently used in
macroeconomics include consumption, savings, investment, import, export,
government expenditure etc. And we have different types of variable. E.g. stock and
flow variables, endogenous and exogenous variables etc.

Time dimension is used to distinguish between a stock and a flow variable.

Stock variables are measured at a given point in time while flow variables are
measured over a period of time. For instance, store of cloth in a shop at a point in time
is stock while monthly income and expenditure of an individual are examples of flow
variables.

Common stock variables in macroeconomics include; wealth, debt, total bank deposit,
inventory, capital stock, savings (total saving in a day) etc. Examples of flow variables
include; national income, consumption, investment, wages, saving (by a person within
a month), imports, exports, tax payments, dividends etc.

An economic model is used also to differentiate between exogenous and endogenous

variables.
Given an economic model, a variable is exogenous within that model if its value is
determined outside the model or the system under consideration. Such variables may
affect all other variables but its own value is not explained by the model but it is given.
It is also known as “independent or explanatory variable.” On the other hand,
endogenous variables are those whose values are determined within the model and
thus explained by the model. It is also known as “dependent or explained variable.”
For example, consider a consumption model given as

C = a + bY

C (consumption) in the model is the endogenous (dependent) variable because its

value is determined within the model.

Y (Income) is an exogenous (independent) variable because its value is determined and

influenced by factors outside the model.

PARAMETERS

These are constants that are assumed at a given value in a model. They are factors
influencing a given relationship of variables in a model or system and which are not
allowed to change in response to the development in the model.

In respect of the consumption function above, b is a parameter which represents the

marginal propensity to consume (MPC).

FUNCTIONS AND EQUATIONS

Functions are relationships that exist between two or more variables such that a
change in the value of one variable is related to a change in the values of some other
variables in some regular and predictable manner. For instance, if two variables C and
Y are so related that for a value assigned to Y, one or more values of C are determined,
then, C is said to be a function of Y. It is symbolically given as

C = f(Y)

C = a + bY
Equations are statements that show that what is on the left hand side is equal to what
is on the right hand side. Equality sign (=) are always used:

X=2

X+Y=3

e.t.c.

DEFINITIONAL EQUATION OR IDENTITIES

These are equations which define one variable in terms of the other variable. If the
equality is true at all times and for all values of the symbols for which the numbers
are defined, then such equation is an identity or a definitional equation.

For example, aggregate income (Y) is the sum of aggregate consumption (C) and
aggregate savings (S) i.e.

Y=C+S

Total profit is the difference between total revenue and total cost

π = TR − TC

BEHAVIOURAL EQUATION OR FUNCTIONAL RELATIONSHIP

These equations, as the name implies explain the behaviour of economic agents. It
shows the manner in which some variables depend on the other, or are explained by
the other. The consumption function, C = f(Y) ; C = a + bY is a behavioural equation
because it is specified that consumption (C) of the consumer depends on income (Y),
all other things being equal.

EQUILIBRIUM CONDITION / EQUATION

At equilibrium, the variables in a system have values such that there is no inherent
tendency for them to change. Thus, an equation which describes the pre-requisite for
the attainment of equilibrium is called an equilibrium condition/equation.
For instance, in the money market, the equilibrium condition is that money demand is
equal to money supply i.e.

Md = Ms

In the goods market, the equilibrium condition states that quantity demanded equals
quantity supplied i.e.

Qd = Qs

CONCEPT OF EQUILIBRIUM

A system or a model is in equilibrium when all its significant variables has no inherent
tendency to change i.e. they show no change and there are no pressures for change
that will produce subsequent changes in the variables. There are three types of
equilibrium analysis:

1. STATICS EQUILIBRIUM ANALYSIS

The word ‘statics’ is derived from the Greek word ‘statike’ which means bringing
to a standstill. It implies a state characterised by movement at a particular level
without any change. Therefore, statics equilibrium analysis tells us the
relationship between economic variables at a time but says nothing about the
process by which the system adjusts before or after the time of equilibrium.

2. COMPARATIVE STATICS ANALYSIS

As the name indicates, it compares equilibrium corresponding to two or more
sets of external circumstances. This concentrates mainly on equilibrium
positions. It is neither concerned itself with the time it takes for an equilibrium
position to be achieved nor with the path through which the equilibrium is
attained. It only accounts for the process by which the economic system moves
from one equilibrium position to another.

3. DYNAMICS EQUILIBRIUM ANALYSIS

 Dynamics is the study of change and movement. It studies models or systems
involving relationships that hold overtime i.e. relationships in which the current
values of an endogenous variable will depend not only on the current values of
exogenous variables but also the previous values of the same variables. It is the
analysis of the process of change which continues through time.

MACRO INTERACTION

Two types of interactions are very important in the analysis of macroeconomic

problems. These are offsets and feedbacks

OFFSETS

Offsets are effects produced by economic actions and policies to counteract other
effects/consequences of previous policy actions. For example, if increases in tax rates
apply to firms in one sector of an economy causes a decline in employment in the
sector and within the same tax, a reduction in tax rate is applied in another sector of
the same economy causing a rise in employment. Then, we call these offsets because
an increase in employment generated by tax reduction clears the decline in
employment suffered in the first sector.

FEEDBACKS

These are the secondary economic effects of one policy action that may reinforce
primary effects. For instance, in an attempt to increase government revenue, tax is
increased in all corporations which lead to reduction in employment. The primary
effect of the action is a proportion of the workforce that will become unemployed.

This primary effect will bring about a reduction in the income of those who lost their
jobs and as a result, will lead to a reduction in demand for goods and services. The
reduction in the demand will further make the corporations to reduce their
employment level.
Therefore, the feedback (secondary) effect which manifests in the reduction in the
demand for goods and services leads to further decline in employment (which is the
primary effect).

BUSINESS CYCLE/FLUCTUATIONS

It is an irregular movement in the general economic activities along its long-run path.
Business cycle is divided into some segments or phrases which are:

1. EXPANSION PHASE: This is the phase in which the GDP is generally rising.
2. CONTRACTION PHASE: This explains the phase of business cycle where the
real GDP is generally falling.
3. BUSINESS CYCLE PEAK: It is the point at which expansion phase ends and
contraction phase begins.

The trough is the point at which contraction phase ends and expansion begins.

year

0 GDP

ECONOMIC RECESSION

This refers to a period of prolonged decline in GDP (period through contraction phase)
often associated with high level of unemployment.

ECONOMIC INDICATORS
These are economic variables that can be used to measure the level of business
activity in an economy or that can be used as signals of development in an economy.
For example, GDP serves as an indicator for economic growth, price index serves as an
indicator of the inflation level etc.

Recap

Macroeconomics is the study of the aggregate economy. It is the study of the whole
economy.

There are 5 major objectives of macroeconomics

1. Economic growth: increase in GDP

2. Price stability
3. Full employment (No unemployment, when unemployment is less than 3%)
4. Favourable balance of payment/ balance of payment equilibrium
5. exchange rate stability

Concepts in Macroeconomics

a. Variable: any quantity or magnitude that is capable of change. It is either

exogenous or endogenous, stock or flow.
Classification according to model (exogenous or endogenous)
Classification according to time (stock or flow)

A stock variable is measured at a point in time. E.g. at the end of the year,
inventory, savings. A flow variable is measured over a period of time e.g.
consumption, saving. Endogenous variable also referred to as independent
variable.
A variable is endogenous if its value can be determined within a given model
and exogenous variable if its value cannot be determined within a given model.
C = a + bY
C- Consumption (endogenous)
Y- Income (exogenous)
b. Parameter: value of a parameter is constant and most times unknown.
It helps to get the value of a variable C = a + bY ; b = MPC
c. Functions and Equations: Function is a relationship between two variables
while equation is an identity.
Q d = a − bP ; Q s = −c + dP −Functions
At equilibrium Q d = Q s −Equation

Three (3) types of equation

1. Identity or definitional equations
Y = C + S ; π = TR − TC i.e. Profit = Total revenue – Total cost
2. Behavioural equation or Functional equations
3. Equilibrium condition: A state where there is no tendency for a change or
a place of rest Q d = Q s

Concept of Equilibrium
Static equilibrium: equilibrium at a point
Comparative equilibrium: comparing equilibrium
Dynamic equilibrium: subject to change over time

Macro Interactions
Concepts of Macro Interactions
Offsets
Feedback

Offsets refers to an action taken by the government and central bank to cancel
out the effect of an economic objective.

Business Cycle
This is an irregular movement in the general economic activities along its long
run growth path. Ups and Downs in economic activities.

peak
 trough
0

There are four (4) phases

Expansionary Phase: increase in economic activities and growth.
Peak Phase: the highest point at which expansion ends and contraction begins.
Trough Phase: phase at which contraction ends and expansion begins.
Contractionary Phase: the lowest point of low economic growth.

The economy is in recession when there is negative growth in GDP for two
consecutive quarters.
The economy is in depression when there is a prolonged recession.
 1.0 NATIONAL INCOME ACCOUNTING
(Dr. D.O Olayungbo)

Introduction
One of the basic questions facing economies centers on whether the total output of
goods and services is growing from year to year or it remains static. This question is
very important because countries are keenly interested in the performance of their
economy. National income estimates enable countries to calculate the total production
of goods and services in a year.

The lecture also focuses on the measurement of national income and their problems,
uses and limitations of national income statistics and elementary theory of income
determination.

Meaning of National Income

National income can be defined as the monetary value of all the final goods and
services that are produced in a country within a given period of time, usually a year.

Final goods are goods that are ultimately consumed rather than used in the
production of another good. For example a car sold to a consumer is a final good; the
components such as tires sold to the car manufacturer are not; they are intermediate
goods used to make the final good. If the same intermediate goods were included too,
this would lead to double counting. For example, the value of the tires would be
counted once when they are sold to the car manufacturer, and again when the car is
sold to the consumer.

The national income of a country can be measured in three different ways, viz the
Income Approach, the Output Approach and the Expenditure Approach.

The use of any of these approaches produces the same result if carefully implemented.
The measurement and analysis of the total output produced in an economy is known
as social accounting.
National income Concepts
In national income accounting, economists and planners are usually interested in
various national income concepts such as, Gross Domestic Product (GDP), Gross
National Product (GNP), Net National Product (NNP), and Disposable Income (Yd).
These concepts are considered in turn.

i. Gross Domestic Product:

The gross domestic product of a country is the monetary value of all the final goods
and services produced within the domestic territory of a country in a specific period,
usually a year, irrespective of whether those who produced them are citizens or
foreigners.

ii. Gross National Product:

This is the main measure of the total output. It is at times; simply referred to as
National Income (NI).

The Gross National Product of a country is the money value of all the final goods and
services produced by nationals or citizens of a country (in a specific period, usually a
year) irrespective of where they reside.

Taking Nigeria as a specific example, the GNP of Nigeria in a particular year, say 1990
is the money value of all finished goods and services produced by Nigerians living in
Nigeria and those in other countries in 1990.

The gross national product can simply be regarded as the gross domestic product plus
the net property income from aboard, i.e. GNP = GDP + NPA. where, GDP is as
previously defined and NPA stands for Net Property Income from abroad.

The net income earned from abroad is the difference between the income which
citizens, firms or the government of a country earn abroad and income payable to
foreigners on account of their investment in the domestic country.

If NPA is positive then GNP > GDP but if NPA is negative, then GNP < GDP.
iii. Net National product (NNP):
The net national product of country is equal to the gross national product minus
capital consumption allowance or depreciation.

In order to provide for the wear and tear in the value of capital goods used in
production of the national output, the amount used up, of the wear and tear of
productive assets is usually set aside by deducting it from the value of the national
output produced.

The amount used up or the wear and tear of assets is what an accountants referred to
as depreciation while an economist, on the other hand, refers to it as capital
consumption allowance.

iv. Disposable Income (Yd):

This can be defined as the national income plus transfer earning minus taxes i.e
Yd = Y+ TE – t, where Y is the national income, TE stands for transfer earnings and t
denotes taxes.

VALUATION OF NATIONAL INCOME

The national income or output of a country can be valued in different ways. First in
current prices i.e. the prices ruling at the time of measurement.

When national income is valued at current prices it is known as nominal national

income.

If we want to compare the volume of output produced in a particular year with those
of other years, we need to make adjustment for changes in price of goods and services
produced. To achieve this objective, we need to re value the national output in terms
of fixed prices.

When the national output is valued in terms of fixed prices, this is technically referred
as national income at constant prices or real national income.
National Income at Market Prices and Factor Costs

(i) GDP (MP) = GDP (FC) + indirect taxes - subsidies;

(ii) GNP (MP) = GNP (FC) +indirect taxes - subsidies; or GDP (MP) + NPA

(iii) NNP (MP) = NNP (FC) +indirect taxes - subsidies; or GNP (MP) – Depreciation

Measurement of National Income

The national income of a country can be measured in three ways, these are, the
income approaches the output approach; and the expenditure approach. These
approaches are discussed as follows:

The income approach

Under the income approach, the national income of a country is obtained by summing
all income earned by all factors of production employed in the economy during a
particular period of time usually a year.

These incomes are in the form of wages, salaries, rents, interests, profits, dividends
etc. When the national income is measured in this way, we arrive at national income
at factor cost which can be defined in symbols as:

Y= Yw + Yr+Yrp+Yi

Where Yw= income received by individuals in form of wages salaries, commissions,

bonuses, and other forms of employee earnings before deduction of taxes,

Yr = net income from rentals and royalties,

Yrp = retained profits of business enterprises,

Ydp = disbursed profits of business enterprises,

Yi = interest income. In using this approach, however, care is taken to avoid double
counting.

Consequently, all forms of transfer payments must be excluded because they are not
rewards economic activities.

Transfer payment are money paid to an individual by the government, firms or other
non-governmental organizations for which there is no quid pro quo (i.e. no
corresponding service or good exchange) example of transfer payments include:
pensions, unemployment benefits, students grants etc.

Problems Associated with the Income Approach

The main problems associated with the income approach include:

1. Problem of how to estimate the rent of owners – occupied house: If a person

rents a house, such individual pays rent to the owner of the house. The rent paid, in
this case, serves as an income to the owner, the rental value of the house must be
included in the national income. However, since data on rents of owner’s occupied
houses is not available in the Nigeria setting, it poses a lot of problem to statisticians
when estimating rent.

2. Problem of retained earnings: the accounting Principle of companies usually

make provision for retained earnings. This implies that not all profits after tax are
shared as dividends to shareholders. In measuring the national income using the
income approach the amount retained by companies needs to be added back to the
personal income of individual shareholders so as arrive at the gross national income at
factor costs. This exercise, however, creates some difficulties

3. Problem of how to estimate the income of self- employed: In developing

countries, Nigeria inclusive, statistical information on the income of those that are
self-employed or in the subsistence sector of the economy are not available.
This problem causes a lot of problem when estimating the gross national income.
4. Problem in estimating the net property income from abroad. To arrive at the
gross national income, the net property income from abroad has to be added to the
gross domestic income. The net property income from abroad is the difference between
the income paid to foreigners and the income received from abroad as a result of
ownership of productive assets in other countries. In developing countries the net
property income may be positive or negative. If negative, it implies that foreigners on
account of their investment in the domestic economy is greater than the income
receipt from abroad with respect to domestic investments abroad. The reverse holds if
the net property income from abroad is positive.

5. Problem of making provision for capital allowance or depreciation: To arrive at

the net income; capital consumption allowance or depreciation has to be subtracted
from the gross national income. This exercise however creates some difficulties since
statisticians and economists may be faced with the problem of which method of
depreciation to adopt.

6. Problem of the black or underground economy: The underground or black

economy refers to all unrecorded economic transactions conducted In order to evade
taxes in the economy. In Nigerian, for instance, a lot of activities are done in
underground or black economy. This implies that some income earned are seldom
recorded, this has the effect of underestimating the national income of an economy,

7. Problem of double counting: In measuring the national income via the income
approach different are usually encountered when accounting for transfer payment. To
avoid double counting, transfer payments or earnings have to be excluded under this
approach.
The Output Approach
To calculate the national income through the output approach, we sum the values of
all the final goods and services produced by firms in the economy at a given period of
time usually a year.

Assuming that only four final goods are produced in an economy in a particular year,
the values of these final products can be derived using the formula:

Y = PA Q A + PB Q B + PC Q C + PD Q D

where PA Q A + PB Q B + PC Q C + PD Q D is the sum of the products of the price and quantities

of commodity A, B, C and D respectively.

It should be noted that this approach emphasized the inclusion of only final goods
and services whether they are sold to consumers or to the government or sold abroad
as export or to other firms. In this regard, all intermediate goods must be excluded
when using this approach, so as to avoid double counting. The main problem usually
encountered when measuring the national income through this approach is that what
is a final good to one industry may be an intermediate good to other industries. In a
way to eliminate the problem of double counting, economists and statisticians always
resort to the value-added basis when using the output approach.

Under the value added basis, the national income is computed by adding the valued
added of various firms at each stages of production. The value added (VA) at every
stage of production is defined as the value of output (VQ) minus the value of input (VI)
i.e VA = VQ-VI.

Problems associated with the approach

1. Difficulty in measuring the value of goods consumed by producers: In Nigeria
and other West Africa countries, several small-scale farmers consume part of what
they produced without accounting for them. Since all the output of the subsistence
sector of the economy have to be included in calculating the national output, sample
survey which are not usually reliable are often used when calculating the national
income through the income approach.

2. Difficulty in assessing the value of services rendered by housewives: Services

rendered by house wives such as cooking, taking care of the children, shopping for the
family etc.; are productive activities which ought to be included in national income
figure. However, as a result of lack of statistical data on these services and the
difficulty that might arise in an attempt to estimate them, they are usually excluded
from national Income figures.

3. Problem in assessing the value of self-done activities: In measuring the national

income of a country through the output approach, the value of self-done activities
ought to be included; however, as a result of lack of information on these activities,
they are usually excluded from national income figures. These activities under normal
situation, would have been paid for if someone was employed to render them.

4. Problem of making provision for capital allowance or depreciation: Like in the

income approach, to arrive at the net national product, capital consumption allowance
or depreciation has to be deducted from the gross national output.
This exercise however creates some difficulties.

5. Problem of defining of what a final good is or intermediate good: In developing

economy like Nigeria, there are at times, problem of definition of what is a final good or
intermediate good, when compiling national income figures. For example could a
bicycle be regarded as a final good or intermediate good? This question becomes
necessary since in the subsistence sector of the economy bicycles are usually the most
convenient way of transporting heavy farm products to the market. When viewed from
this perspective, bicycle could be regarded as an intermediate good that aid the
production of other goods.

6. Problem of double counting: When measuring the national income via the output
approach the value added on productive activities has to be included in the national
output. However in Nigeria and other West Africa countries, most businessmen hardly
distinguish between the value-added in and total revenue realized on account of
production. This has the effect of overestimating the national output since total
revenue includes some element of cost of production.

The Expenditure Approach

The expenditure approach to the measurement of the national income of a country
entails summing up the total expenditure on final goods and services by private
individuals, firms and the government since no country operates in autarchy or
without any relation with other countries, we also add the value of expenditure by
foreigners on domestic production (exports) and deduct the value of domestic
expenditure on foreign production (imports).

Using expenditure approach, the gross national expenditure or aggregate demand

which is a measure of the national income can be expressed as

𝑌 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀)

where,
C = Household expenditure on consumer goods
I = investment expenditure by firms
G = government expenditure
X = exports
M = imports
X-M= net exports

In computing national income using the expenditure approach, only expenditure on

final goods and services should be included, all expenditure on intermediate goods
have to be excluded.

Problem of the expenditure approach

1. Problem of definition of what is final good: To be able to measure the national
income of a country accurately using the expenditure approach, knowing what is a
final good or service is important. It is only when a final good or service is known and
identified that a statistician or economists would know what to include or exclude.
Therefore, when there is a problem of product definition, double counting occurs.

2. Problem of unsold stock: All inventories are usually included in the GNP. The
procedure is to take positive or negative changes in physical units of inventories and
multiply them by current prices. Then the figure is added to total current production
of the firm. But the problem is that firms recorded inventories at their original costs
rather than at replacement costs. When prices rise there are gains in the in the book
value of inventories. Contrariwise, there are losses when prices fall. So the book value
of inventories overstates or understates the actual inventories. Thus for correct
imputation of GNP, inventory evaluation is required. A negative valuation adjustment
is made for gains and a positive valuation adjustment is made for losses. But
inventory valuation is a very difficult and cumbersome procedure.

3. Conversion of market prices to factor costs: When national income is estimated

using the expenditure approach, some adjustments have to be made so as to ensure
the equality of national expenditure with national income and national output. This
adjustment becomes important because under the expenditure approach the national
expenditure is computed at market prices which are distorted by taxes and subsidies.
Therefore to convert national expenditure to national income at factor cost, indirect
taxes have to be deducted while subsidies have to be added.

4. Adjustment for net property income from abroad: To derive the gross national
expenditure, adjustment has to be made for net property income from abroad. This
exercise involves adding all incomes from overseas and deducting all incomes accruing
to foreigners. This is a complex process.

5. Adjustment for exports and imports: When goods and services are produced in
the domestic country, some of these goods are consumed locally while others are sold
abroad. In the same vein, some goods consumed within the country are bought from
abroad, therefore, exports have to be added to domestic expenditure while imports
deducted.
Note: It could be observed that if the three approaches are carefully adopted they
result to the same thing this implies that:

National Income = National Expenditure = National Output.

Numerical Example:
The following are the items of the income statement of the economy for a particular
year (in billions of Naira). Determine the Gross National Product using
a) Expenditure approach and b) income approach.
Items (N)’b
Rents 24
Personal consumption expenditure 1,080
Corporate income taxes 65
Undistributed corporate profits 18
Net exports 7
Dividends 35
Capital consumption allowance 180
Interest 82
Indirect business taxes 163
Gross private domestic investment 240
Compensation of employees 1,028
Government purchases of goods and services 365
Proprietors’ income 97
Solution:
Using the Expenditure approach:

Y = C + I + G + (X-M)

C = 1080; I = 240; G = 365; X = 7.

Hence; Y = 1080 + 240 + 365 + 7 = 1692.

Using the income approach

Capital consumption allowance 180
+ Indirect business taxes 163
+ Compensation of employees 1028
+ Rents 24
+ Interest 82
+ Proprietors’ income 97
+Corporate income taxes 65
+ Dividends 35
+Undistributed corporate profits 18
GNP =N=1,692
 The Uses of National Income Estimates
National income estimates are very important and serve many purposes.

1. It permits us to measure the level of production in the economy over a given period
of time, and to explain the immediate causes of that level of performance.

2. It is used in economic planning: National income figure serves as indicator of

economic growth, level of output and employment in the economy. Therefore, national
income estimates enable planners to develop appropriate policies that will promote
economic growth, ensure stable prices and reduce unemployment.

3. It is used for inter-sectoral comparison: With national income statistics, the

performances of various statistic of the economy could be measured and appropriate
policies directed towards revitalizing laggard sectors

4. It is used for inter-country comparison: Apart from measuring the performance or

various sectors of the economy; national income figures, when expressed in terms of
international currency such as dollar, are also useful for measuring the economic
performance of different countries.

5. It is indicator of economic welfare or standard of living: the national income

statistics serve as a useful indicator of economic welfare or standard of living when
expressed in terms of real per capital index.

The real national income, can therefore be expressed as:

Nominal National Income

Real National Income(RNI) =
Price Index

To convert the real national income to per capita income, it has to be divided by the
population of the country at the point in time. This can also be written as:

Real National Income

Real per Capital Income =
Population
6. Contributions to international organizations: National income figures serve as a very
good yardstick for determining the contributions of countries to organizations such as
international Monetary Fund, ECOWAS, and African Union etc.

Limitations of national income estimates

National income estimate, though very useful have several limitations. These include:

1. It tells us nothing about the distribution of income: This means national income
estimates never said anything about whether the national income of a country is
concentrated in the hands of few individuals in the society.

2. It is not a good yardstick for measuring the welfare of citizens: National income
figures are not a good measure of welfare of citizens in a country since negative
externalities in the form of pollution, congestion and unpleasant working conditions
are likely to arise in the process of increasing the national output.

3. Exclusion of non-marketable activities: There are some activities, though highly

productive, which are always excluded from national income because they are difficult
to assign monetary value. These include self-done activities and services of
housewives. It therefore implies and national income estimates lacks accuracy due to
inability to assign monetary value to these activities.

4. National income estimate tells us nothing about the quantity of goods

produced; since national income is the money value of goods and services produced in
an economy at a particular period of time, it does not tell us anything about the
quantity of each good produced. For instance, the welfare of citizens will not be
guaranteed if the quantity of military goods in the national output is more than the
quantity of consumer goods.

5. It does not reflect the amount of leisure available to citizens: one of the
yardsticks for measuring the welfare in a country is the amount of leisure available to
citizens. This information, however, is not reflected in national income estimate.
6. It is not a good measure for inter – country comparison of performance
overtime.
The national income of countries is usually converted into common currency using the
exchange rate. However, since the exchange rates are subject to fluctuation. It can be
inferred that national income estimates are not a good measure of inter-country
comparison

7. The underground economy: National income estimates does not capture the
underground economy. The underground economy reflects those economic activities
that are not reported to the government because those engaged in it are attempting to
avoid taxes. This occurs when a plumber offers to work for less if paid in cash rather
than by cheque or a farmer who sells vegetables of a roadside and undertakes his
revenue to the Inland Revenue serves Factors affecting the level of a country’s national
income

The main factors affecting the level of a country’s national income are:

1. The availability of natural resources: If a country has vast natural resources and
can utilize it to her advantage, the level of national income will rise.

2. The number and quality of the labour force: The greater and more quality a
country’s labour force, the higher the national income. A quality labour force is
characterized with healthy and intelligent workers.

3. The state of technical knowledge in a country: The higher the state of technical
knowledge, the greater the use of natural resources. As natural resources are
efficiently utilized, the level of national income of a country will rise.

4. The amount of capital available: The greater the quantity of capital available to
the working population, the more productive they will be. Therefore, increase in
productivity, will have the effect of increasing the level of national output and income
in a country.

5. Government policy: Government fiscal and monetary policies also affect the level
of a country’s national income. For instance, if the government aims at increasing the
national output, policies will be directed towards giving of subsidies to producers so as
to reduce their cost of production. In a situation whereby government wants to
discourage production, heavy taxes may be imposed on producers. Similarly,
monetary policies that reduces or increases interest rates may be directed at
increasing or reducing production respectively.

6. Political situation in a country: If the political situation in the country is

favourable, businessmen will be motivated to invest in machineries, factories etc.
As the level of investment increases the level of national output, income and
employment will rise.
 THEORY OF INCOME DETERMINATION
The circular flow of income is a diagrammatic representation of the flow of income and
expenditure of the various sectors of the economy. The circular flow of income shows
how the national income is earned and how it is eventually spent in the economy. To
examine a simplified version of the circular flow, it is essential to make following
assumptions:

a) There are only two main sectors which contribute to the flow of goods and
services in the household.

b) There is no government sector in the economy. This assumption implies that

there are no taxes or subsidies in the economy.

c) The economy is closed i.e. there is no international trade.

d) Households spend all their income on goods and services produced by firms.

e) Firms do not invest.

Given these assumptions, the circular flow of income in a two-sector economy

consisting of household and firms is represented in Figure below.
In the flow (1) of the circular flow above, households render factor services to firms for
the purpose of earning wages and salaries. In return, firms as indicated in flow (2)
make payments for hiring the services of households. In addition flow (3) shows the
flow of goods and services from firms to households while the last flow (4) indicates the
payment for goods and services from household to firms.
Since it is assumed that households spend all their money income and that firms do
not invest, it therefore implies that the flow of income in the economy will
automatically equals the flow of expenditure i.e. national income equals national
expenditure or national output.

In reality the household may not spend all their current income and could save some
of it. Saving (S) represents leakage from the circular flow. In addition to the consumer
spending, firms also carry out investment (I) spending. This is an injection to the
circular flow of income, as it does not originate from consumers’ current income.
Under this scenario, the circular flow of income in a simple closed economy is
represented by figure (b) below
The two upper flows in Figure (Ib) indicate the product market. Households sell their
labour services in this market in order to obtain income (salaries and wages).
Moreover, the two lower flows indicate the product market. Here, firms supply their
final goods and services to the household; the latter buy and eventually consume
these goods and services. Household, in this framework save part of their income by
buying financial assets in the money or capital market. On the last note, the financial
mark provides funds which serve as a source of investment to firms. In the circular
flows above, there is the assumption that there is no government sector. Since, in
reality government has vital role to play in the economy, this assumption is relaxed at
this point. In Nigeria, the government sector includes all three layers of government;
local, state and federal; government sector levies a wide variety of taxes and charges
on groups operating in the economy. These charges and taxes represent withdrawals
or leakages from the circular flow and it is given by the flow (c). The government sector
spends on the economy by paying the salaries and wages of public servant, current
expenditure and on capital items such as road construction, hospitals and other social
overhead. Government spending is an injection into the circular flow and is
symbolized by G. The circular flow of income with governments sector is presented in
figure 1(C) below.
By further relaxing the assumption that the economy is closed, we add the
foreign sector to the circular flow model as presented in Figure 1d. The foreign sector
is a vital part of our economy. The components of the foreign sector are import and
export. Exports (X) of goods are injections into the economy while imports (M) are
leakages. When exports (X) are greater than imports (M), a balance of payments
surplus occurs. When the reverse holds, the economy experienced balance of
payments deficit.
 Concepts of savings, investments and consumption Concepts of Savings
Saving can be defined as that proportion of disposable income that is not spent in the
current period.

The disposable income of an individual, assuming there are no any transfer earnings
during the period, is the total income earned during the current period minus taxes i.e
Yd = Y-T where Yd is the disposable income, while Y and T are gross income and taxes
respectively.

Saving(s), therefore, is the difference between the disposable income (Yd) and
consumption (C) i.e S= Yd – C.

It should be observed that whatever is not consumed is saved.

The relationship between savings and the level of income is a direct one. This means
that as the level of income of an individual increases, the higher the level of savings,
all things been equal.

Given that Yd = Y; S=(Y-T)-C or S= (Yd-C).

Factors Affecting Saving

There are several factors affecting the level of savings in the society. These factors are
as follows.
The level of income: the higher the level of income in the society, all things being
equal the higher the level of savings and vice versa.

The level of consumption: Consumption is one of the most important factors

affecting saving; the higher the level of consumption of individuals in the society the
lower the level of savings.

The rate of interest: The rate of interest can be defined as the reward for parting with
money by lenders. It can also be regarded as the cost of holding money. The higher the
rate of interest, the higher the cost of holding money and the greater the level of
savings and vice versa.

Government fiscal policy on taxation: Government fiscal policy on taxation is

another factor affecting saving, for instance, if the government increases the tax, the
disposable income of individual will fall thereby reducing households savings in the
society.
Monetary policy affecting interest rates; deflationary monetary policies would have the
impact of raising interest rates and would increase the level of saving in the society.

The value of money: the value of money affects individuals’ savings habit in the
society. For instance during inflation the value of money falls persistently. As the
value of money falls it serves as a poor store of value and people will prefer buying
physical assets like lands, vehicles, and house rather than saving their money.

Habits and customs: it has been observed that people’s habits also affect savings in
the society. There are some people that will save weather the rate of interest is
attractive or unattractive while there are others that will not save, while spendthrifts
have the natural tendency to consume and dissave. Apart from habit, custom is
another determinant of savings. Where the custom places much importance on
savings, it is expected that the level of savings in such society will be very high.

Family ties: Family ties affect the level of savings. The more the family ties, the lesser
the level of saving. This implies that in West African countries where extended family
system is practiced, there will be much pressure on the level of income of the family,
thereby leading to little or no saving on the part of the family.
 Concept of investment
Investment can be defined as the expenditure by firms on goods and services in the
future period. It is the consumption meant for the production of other goods and
services in the future period. It is a process of increasing real goods in the society.

Investment is made up of three components, these include; fixed investment, inventory

investment and residential investment. Example of investment goods are factories,
machines, etc. total investment in the society is the total spending by firms on all
forms of capital goods. Although investment is a smaller component of aggregate
demand than consumption and government expenditure, it is more volatile than these
other components.

Factors affecting the level of investment have been identified. These factors
include:
1. The rate of interest: In line with the classical theory, the rate of interest is one of
the factors affecting investment. Accordingly, the relationship between the rate of
interest and investment is an inverse one. This implies that the lower the rate of
interest the higher the level of investment. It can also be inferred from this theory that
the rate of interest is the cost of capital, as such, the higher the rate of interest the
higher the cost of capital and the lower the willingness to invest and vice versa.

2. Businessmen expectation about future economic activities: Investment is

strongly influenced by businessmen’s expectation of future economic activity. If
businessmen are optimistic about future economic activity, the level of investment will
increase. The reverse holds if businessmen are pessimistic about future economic
activity.

3. Political stability. If the political climate in the country is conducive, the level of
investment will rise. However, in an environment characterized by political instability,
businessmen will not be motivated to invest.

4. Rate of changes in aggregate demand: increase in aggregate demand affects the

level of investment. An increase in aggregate demand will have the impact of
increasing investment, while a fall in aggregate demand will have the opposite effect on
investment.

5. Government fiscal policy: Government fiscal policy also affects the level of
investment. For instance, an expansionary fiscal policy which reduces the tax has the
effect of reducing the operating cost of firms, thereby increasing the profit after–tax. As
the profit-after–tax increase, dividend to shareholders as well as retained profit will
rise, the increase in retained profit implies that firms will have more funds for
investment purposes.
 2.0 NATIONAL INCOME ANALYSIS
(Dr. O.T Ojeyinka – Dr. C.O Olaniyi)
NATIONAL INCOME DETERMINATION AND THE CONCEPT OF
MULTIPLIER

Equilibrium level of national income: This is the level of national income at which
aggregate demand equals the monetary value of all the final goods and services
produced in the economy.

The equilibrium national income concept is important in macroeconomic analysis

because of its relevance in the formulation of economic policies such as anti-
inflationary policies, employment policies, and economic growth policies and so on.
For the determination we consider two approaches: income-expenditure approach or
the withdrawal-injection approach. These two approaches are considered in turn.

Income-Expenditure Approach:
Under this approach, the equilibrium national income in an economy is attained at the
point where aggregate expenditure (E) equal the national output (Y).

The aggregate demand or aggregate expenditure in the economy is represented by (E),

while the national income or the monetary value of all the final goods and services
produced in the economy is denoted by (Y). It therefore implies that the equilibrium
national income is determined or established at the point where E=Y, i.e.

𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒(𝐸) = 𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑂𝑢𝑡𝑝𝑢𝑡(𝑌)

In a 2-sector economy composed of households and firms, the aggregate demand is

made up of two basic components—consumption expenditure by the households (C)
and investment expenditure by business firms (I). In this regard, the aggregate
demand/expenditure in this economy can be written in symbols as:

𝐸 =𝐶+𝐼
Moreover, in a three sector economy, consisting of households, firms and the
government; the aggregate demand can be written as:

𝐸 =𝐶+𝐼+𝐺

While in the four sector economy made up of the households, firms, the government
and the foreign sector the aggregate expenditure is:

𝐸 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀)

Where X and M stands for exports and imports respectively. The equilibrium national
income therefore is the point at which aggregate demand equals national output in the
economy. The equilibrium national income therefore can be written symbolically as:

𝑌𝑒 = 𝐸 = 𝐶 + 𝐼 (𝑡𝑤𝑜 𝑠𝑒𝑐𝑡𝑜𝑟 𝑒𝑐𝑜𝑛𝑜𝑚𝑦)

𝑌𝑒 = 𝐸 = 𝐶 + 𝐼 + 𝐺 (𝑡ℎ𝑟𝑒𝑒 𝑠𝑒𝑐𝑡𝑜𝑟 𝑒𝑐𝑜𝑛𝑜𝑚𝑦)
𝑌𝑒 = 𝐸 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀) (𝑓𝑜𝑢𝑟 𝑠𝑒𝑐𝑡𝑜𝑟 𝑒𝑐𝑜𝑛𝑜𝑚𝑦)

The equilibrium national income is presented graphically in the figure below. It could
be observed that in a two-sector economy, equilibrium is established in point 𝑒 0 ,
where the 450 line (which is the locus of points equidistant from both axis) intersects
the aggregate demand function. The level of national income which corresponds with
this point of intersection is 𝑌𝑒0 . This level of national income is called the equilibrium
national income in a two-sector economy.
 National Expenditure Aggregate Supply

450
National Income
𝑌𝑒0 𝑌𝑒1 𝑌𝑒2

Note: the aggregate supply schedule is the 450 line.

The 450 reference line shows the points where aggregate demand or total planned
expenditure (measured on the vertical line/ axis) are equal to aggregate supply or
national income (measured on the horizontal axis).

The figure also indicates that as the aggregate demand increases, the equilibrium
national also increases. For instance, when government expenditure (G) and net
export (X-M) is added to the consumption function, the equilibrium national increased
𝑌𝑒1 to 𝑌𝑒2 and respectively. The main implication of this exposition is that any increase
in policy, raising the aggregate demand has the effect of increasing national income in
the economy.
Injection-Withdrawal Approach
This approach indicates that the equilibrium national income is determined at the
point where injections are equal to withdrawals in the economy.

Injections are those autonomous components of the aggregate demand that infuse
money into the circular flow of income system and they consist of investment,
government expenditure and export.

Withdrawals, on the other hand, are those flows that take away money from the
circular flow of income system. They consist of savings, taxes and imports.

Using the withdrawals-injection approach, the equilibrium national income is attained

in either two, three and four-sector economies when:
𝐼=𝑆 (𝑡𝑤𝑜 𝑠𝑒𝑐𝑡𝑜𝑟 𝑒𝑐𝑜𝑛𝑜𝑚𝑦)
𝑆+𝑇 =𝐼+𝐺 (𝑡ℎ𝑟𝑒𝑒 𝑠𝑒𝑐𝑡𝑜𝑟 𝑒𝑐𝑜𝑛𝑜𝑚𝑦)
𝐼+𝐺+𝑋 =𝑆+𝑇+𝑀 (𝑓𝑜𝑢𝑟 𝑠𝑒𝑐𝑡𝑜𝑟 𝑒𝑐𝑜𝑛𝑜𝑚𝑦)

Two sector economy

𝑌 = 𝐶 + 𝐼............. (𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝑑𝑒𝑚𝑎𝑛𝑑 𝑠𝑖𝑑𝑒)
𝑌 = 𝐶 + 𝑆 ………….. (𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝑠𝑢𝑝𝑝𝑙𝑦 𝑠𝑖𝑑𝑒) (𝐹𝑟𝑢𝑔𝑎𝑙 𝐸𝑐𝑜𝑛𝑜𝑚𝑦)
𝐶+𝐼 =𝐶+𝑆
𝐶+𝐼−𝐶 =𝑆
𝐼=𝑆

Three sector economy

𝑌 = 𝐶 + 𝐼 + 𝐺 ………….. (𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝐷𝑒𝑚𝑎𝑛𝑑 𝑠𝑖𝑑𝑒)

𝑌 = 𝐶 + 𝑆 + 𝑇 …………….. (𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝑆𝑢𝑝𝑝𝑙𝑦 𝑠𝑖𝑑𝑒)

𝐶+𝑆+𝑇 = 𝐶 +𝐼+𝐺
 𝐶+𝑆+𝑇−𝐶 = 𝐼+𝐺
𝑆+𝑇 = 𝐼+𝐺

Four sector economy

𝑌 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀)…………………. (Aggregate 𝐷𝑒𝑚𝑎𝑛𝑑 𝑠𝑖𝑑𝑒)

𝑌 = 𝐶 + 𝑆 + 𝑇……………………………. (Aggregate 𝑆𝑢𝑝𝑝𝑙𝑦 𝑠𝑖𝑑𝑒)

𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀) = 𝐶 + 𝑆 + 𝑇
𝐶+𝐼+𝐺 +𝑋−𝐶 = 𝑆+𝑇+𝑀
𝐼+𝐺 +𝑋 =𝑆+𝑇+𝑀

This can be shown graphically in the figure below. It can be observed that in a two-
sector economy, the equilibrium level of national income is determined at the point e 0
where investment automatically equals savings (𝐼 = 𝑆). In a three and four sector
economy, on the other hand, equilibrium national income is attained at point e 1 and e2
where 𝑆 + 𝑇 = 𝐼 + 𝐺 and 𝐼 + 𝐺 + 𝑋 = 𝑆 + 𝑇 + 𝑀 respectively.

National Expenditure
𝑆 = (−𝑎) + (1 − 𝑏)𝑌
𝑒2
𝐼+𝐺 +𝑋 =𝑆+𝑇+𝑀
𝑒1
𝑆+𝑇 = 𝐼+𝐺
0
𝑒
𝐼=𝑆

0 National Income
𝑌𝑒0 𝑌𝑒1 𝑌𝑒2

-a
Note: Autonomous components of aggregate demand are those variables whose value
are exogenously determined. These include investment, government expenditure,
export and import.

*** Exogenous variables (originating from without )are variables assumed to be

determined by forces external to the model and whose magnitude are accepted
as given in the data.***

Gap Analysis
It should be observed that equilibrium in the level of national income (𝑌𝐸) is only
attained at the point where the sum of withdrawals is equal to the sum of injections in
the economy. However, the equilibrium level may not coincide with the full
employment level of income.

The full employment level is the national income (𝑌𝐹) that be produced when the
country’s productive resources are fully employed. It is also referred to as the potential
national income of a country.

A gap will exist when 𝑌𝐸 is not equal to 𝑌𝐹. That is, a gap will exist when national
income is above or below the full employment level of income.

For instance, if the equilibrium level of income (𝑌𝐸) is less than the full employment
level of income at 𝑌𝐹, withdrawals will be greater than injection (S>I). This implies that
the economy will be demand-deficient and there will be deflationary gap (𝐺𝑑𝑒𝑓).

The deflationary gap is the amount by which the aggregate demand must be increased
to push the economy to the full employment level. In other words, deflation gap
measures the magnitude of increase in aggregate demand required to push the
equilibrium level to the full employment level of national income.
𝑌𝐹− 𝑌𝐸
𝐺𝑑𝑒𝑓 =
𝑘
Where k is the multiplier.
On the other hand, if the equilibrium level of national income (𝑌𝐸) is greater than the
full employment level of income (𝑌𝐹), injections will be greater than withdrawals in the
economy, aggregate demand will be greater than national output and inflationary gap
(𝐺𝑖𝑛𝑓) will occur.

The inflationary gap, on the other hand, is the amount by which demand must be
reduced to push the equilibrium national income to the full employment level.
𝑌𝐸− 𝑌𝐹
𝐺𝑖𝑛𝑓 =
𝑘
Where k is the multiplier.

Algebraic Approach to Income Determination of Income

Using the 2-sector model
According to Keynes, the national income of a country is determined by the aggregate
effective demand (AD) and the aggregate supply (AS).

The aggregate effective demand refers to the aggregate expenditure of the society.

In a simple economy, aggregate demand consists of two components: Aggregate

effective demand for consumer goods (C), Aggregate demand for investment goods, (I).

Thus, the aggregate demand (AD) is given as:

𝐴𝐷 = 𝐶 + 𝐼

𝐶 = 𝑇𝑜𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑜𝑛 𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑔𝑜𝑜𝑑𝑠 𝑎𝑛𝑑 𝑠𝑒𝑟𝑣𝑖𝑐𝑒𝑠

𝐼 = 𝑇𝑜𝑡𝑎𝑙 𝑝𝑟𝑖𝑣𝑎𝑡𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 (𝑎𝑠𝑠𝑢𝑚𝑒𝑑 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑖𝑛 𝑡ℎ𝑒 𝑠ℎ𝑜𝑟𝑡 𝑟𝑢𝑛)

The aggregate supply (AS) refers to the total supply of goods and services in the
economy.
The aggregate supply of goods and services multiplied by their respective constant
prices equals the total value of goods and services (at constant prices). It denotes the
real income of the society.

Given that in this economic model of without government, taxes are not levied and
hence, the total income (Y) becomes the disposable income. The disposable income is
divided into two parts which is given as: Consumption (C) and Savings (S).

Thus, the aggregate supply function is expressed as:

𝐴𝐷 = 𝐶 + 𝑆

𝐶 = 𝑇𝑜𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑜𝑛 𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑟 𝑔𝑜𝑜𝑑𝑠 𝑎𝑛𝑑 𝑠𝑒𝑟𝑣𝑖𝑐𝑒𝑠

𝐼 = 𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 ℎ𝑜𝑢𝑠𝑒ℎ𝑜𝑙𝑑𝑠 𝑠𝑎𝑣𝑖𝑛𝑔𝑠

National income is determined at a level where aggregate demand (C + I) equals

aggregate supply (C + S), i.e., national income reaches equilibrium where:

𝐸=𝑌
𝐸 =𝐶+𝐼
𝑌 =𝐶+𝑆
𝐶+𝐼−𝐶 =𝑆
𝐼=𝑆
Concepts of Consumption and Savings
In macroeconomic analysis, consumption expenditure refers to expenditures by the
household sector on currently produced final goods and services. This definition
effectively excludes expenditure on goods and services that were produced in a
previous accounting period.

Consumption expenditures constitute a key component of aggregate expenditure used

in national income determination which in its broadest form can be written in for an
open economy as:

𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑋 – 𝑀.
Savings on the other hand is defined as the amount of income per time period that is
not consumed by economic units. For the households, it represent that part of
disposable income not spent on domestically produced or imported consumption of
goods and services. For the firm, it represents undistributed business profits.

***Savings is the supply of investible resources while Investment is the demand of

investible resources. ***

A good understanding of the determination of national income requires an

understanding of the various concepts of consumption and savings which are:
Marginal Propensity to consume (MPC), Average propensity to Consume (APC),
Marginal Propensity to Save (MPS) and Average Propensity to Save (APS).

Marginal Propensity to Consume (MPC)

The MPC refers to the relationship between change in consumption (ΔC) and the
change in income (ΔY). It is expressed as:
𝛥𝐶
𝑀𝑃𝐶 =
𝛥𝑌

***Marginal Propensity to Consume is the ratio of change in consumption that occur as a

result of change in income.
That is the change in consumption resulting from a unit change in the level of income (or
disposable income).***

According to Keynes, the MPC decreases with income. However, we shall assume a
constant marginal propensity to consume.

*** The MPC of the poor is high and tends towards 1, while the MPC of the rich is low
and tends towards zero. This is as a result of the low income of the poor which is
barely enough to allow savings. ***
 For example, suppose that income increases from ₦200 to ₦300, and as a result,
consumption increases from ₦250 to ₦325, thus the change in income ΔY = 300 − 200
= 100, while change in consumption is, ΔC = 325 − 250 = 75. Hence the MPC can be
expressed as:
𝛥𝐶
𝑀𝑃𝐶 =
𝛥𝑌
75
𝑀𝑃𝐶 = = 0.75
100
Similarly, if income increases from ₦300 to ₦400, and consumption expenditure rises
from ₦325 to ₦400, the MPC is thus expressed as:
𝛥𝐶
𝑀𝑃𝐶 =
𝛥𝑌
400 − 325 = 75
𝑀𝑃𝐶 = = 0.75
400 − 300 = 100

Average Propensity to Consume

The APC is defined as the proportion of total income spent on consumer goods and
services, i.e.
𝐶
𝐴𝑃𝐶 =
𝑌
𝐶 = 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
𝑌 = 𝑇𝑜𝑡𝑎𝑙 𝑑𝑖𝑠𝑝𝑜𝑠𝑎𝑏𝑙𝑒 𝑖𝑛𝑐𝑜𝑚𝑒

Given the consumption function, 𝐶 = 𝑎 + 𝑏𝑌,

𝐶
𝐶 = 𝑎 + 𝑏𝑌

𝑎
𝑌
 APC can be obtained as:
𝐶 𝑎 + 𝑏𝑌
𝐴𝑃𝐶 = =
𝑌 𝑌

Note: If consumption function is C = bY, (i.e. without the constant term,

‘a’), then;
𝐴𝑃𝐶 = 𝑏 = 𝑀𝑃𝐶

𝐶
𝐶 = 𝑏𝑌

450
0 𝑌

***APC is the fraction of income that is consumed or the proportion of income that is
consumed. That is, the ratio of C to Y. ***

*** APC is always greater than MPC ***

Proof:

𝐶 = 𝑎 + 𝑏𝑌,
𝑀𝑃𝐶 = 𝑏
𝐶
𝐴𝑃𝐶 =
𝑌
𝑎 + 𝑏𝑌
𝐴𝑃𝐶 =
𝑌
𝑎 𝑏𝑌
𝐴𝑃𝐶 = +
𝑌 𝑌
𝑎
𝐴𝑃𝐶 = + 𝑏
𝑌
𝑇ℎ𝑒𝑟𝑒𝑓𝑜𝑟𝑒 𝐴𝑃𝐶 𝑖𝑠 𝑎𝑙𝑤𝑎𝑦𝑠 𝑔𝑟𝑒𝑎𝑡𝑒𝑟 𝑡ℎ𝑎𝑛 𝑏.
Marginal Propensity to Save (MPS)
Since what is not consumed is by definition saved, the marginal propensity to save
can be defined in a manner analogous to the definition of MPC as the ratio of the
change in savings to the change in income.

*** MPS is the change that occur as a result of change in income. MPS is the slope of
savings function. It is the coefficient/parameter that explains the relationship between
income and saving. ***

Thus, it is the slope of the savings function and symbolically, it can be written as:
𝛥𝑆
𝑀𝑃𝑆 = 𝛥𝑌

Like the MPC, the value of MPS is greater than zero but less than one. Thus:
MPC + MPS = 1

*** MPC + MPS = 1***

Proof:
𝑌 =𝐶+𝑆
𝛥𝑌 𝛥𝐶 𝛥𝑆
= +
𝛥𝑌 𝛥𝑌 𝛥𝑌
1 = 𝑀𝑃𝐶 + 𝑀𝑃𝑆

Average Propensity to Save (APS)

APS refers to that proportion of income that is devoted to saving. Since it is the
fraction of income that is saved, it is expressed as the ratio of total saving to total
income.
Calculation of marginal and average propensity to consume

Yr Y(income) C(consumption) S(Saving) APC APS ∆Y ∆C ∆S MPC MPS

1980 10 5,000 5,000 0.50 0.50 - - - - -
1985 20 12,500 7,500 0.63 0.38 10 7,500 2,500 0.75 0.25
1990 30 20,500 9,500 0.68 0.32 10 8,000 2,000 0.80 0.20
1995 40 29,000 11,000 0.73 0.28 10 8,500 1,500 0.85 0.15
2000 50 38,000 12,000 0.76 0.24 10 9,000 1,000 0.90 0.10
From the table above, it can be inferred that:
𝐴𝑃𝐶 + 𝐴𝑃𝑆 = 1
𝑀𝑃𝐶 + 𝑀𝑃𝑆 = 1
Given the second equation, i.e. MPC + MPS = 1, then,
𝑀𝑃𝐶 = 1 − 𝑀𝑃𝑆
And conversely, 𝑀𝑃𝑆 = 1 − 𝑀𝑃𝐶

Relationship between Income and Consumption

The relationship between income and consumption is generally expressed through
consumption function.

Consumption Function
***This is a mathematical relationship between aggregate consumption and aggregate
disposable income.***

The private demand for goods and services account for the largest proportion of the
aggregate demand in an economy and play a crucial role in the determination of
national income. The functional relationship between aggregate consumption demand
and the aggregate disposable income is expressed through a consumption function
expressed as:
𝐶 = 𝑎 + 𝑏𝑌

𝐶 = 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒

𝑌 = 𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑠𝑝𝑜𝑠𝑏𝑎𝑙𝑒 𝐼𝑛𝑐𝑜𝑚𝑒
𝑎 = 𝐶𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑡𝑒𝑟𝑚 𝑜𝑟 𝑎𝑢𝑡𝑜𝑛𝑜𝑚𝑜𝑢𝑠 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛.
𝑌𝑑 = 𝑌 − 𝑇
Note, if there is no government in the economy (no tax). 𝑌 will be the income.

The autonomous consumption is part of the consumption that does not rely on
income. Hence, it is the consumption at zero level of income.
𝑌 = 0, 𝐶 = 𝑎
𝑏𝑌 = induced consumption, it is the part of consumption that depends on income

𝑏 = 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝑐𝑜𝑒𝑓𝑓𝑖𝑐𝑒𝑛𝑡 − 𝑖.𝑒.𝑡ℎ𝑒 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑖𝑛𝑜𝑐𝑚𝑒 𝑠𝑝𝑒𝑛𝑡 𝑜𝑛 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛.

Also, b is the slope of the consumption function

The slope of the consumption function gives the MPC and this can be derived
mathematically as follows:
Given that: 𝐶 = 𝑎 + 𝑏𝑌
𝐶 + 𝛥𝐶 = 𝑎 + 𝑏(𝑌 + 𝛥𝑌)

= 𝑎 + 𝑏𝑌 + 𝑏𝛥𝑌

𝑎𝑛𝑑 𝛥𝐶 = −𝐶 + 𝑎 + 𝑏𝑌 + 𝑏𝛥𝑌

𝑠𝑢𝑏𝑠𝑡𝑖𝑡𝑢𝑡𝑒 𝑎 + 𝑏𝑌 𝑓𝑜𝑟 𝐶, 𝑤𝑒 𝑔𝑒𝑡;

𝛥𝐶 = (𝑎 + 𝑏𝑌) + 𝑎 + 𝑏𝑌 + 𝑏𝛥𝑌

𝛥𝐶 = 𝑏𝛥𝑌

𝛥𝐶
𝐻𝑒𝑛𝑐𝑒, =𝑏
𝛥𝑌
𝛥𝐶
According to Keynesian theory of consumption, = 𝑏 is always less than unity, but
𝛥𝑌

greater than zero, i.e. 0<𝑏<1. This fundamental relationship between income and
consumption plays a crucial role in the Keynesian theory of income determination.
From our consumption function, if the autonomous consumption ‘a’ is N3000.00 and
assuming the marginal propensity to consume ‘b’ is 0.75, then the total consumption
at various level of income can be shown in the table as follows:

Income N (Y) Autonomous Workings: Total Consumption

consumption N (a) C = a + bY

5,000 3,000 C = 3,000 + 0.75(5,000) 6,750

10,000 3,000 C = 3,000 + 0.75(10,000) 10,500

15,000 3,000 C = 3,000 + 0.75(15,000) 14,250

20,000 3,000 C = 3,000 + 0.75(20,000) 18,000

25,000 3,000 C = 3,000 + 0.75(25,000) 21,750

SAVING FUNCTION

Like consumption function, saving (S) is the function of income (Y), i.e., 𝑆 = (𝑌)
Since Y = C + S, consumption and saving functions are counterparts of one another.
Therefore, if one of these functions is known, the other can be easily obtained. For
example, if consumption function is given as 𝐶 = 𝑎 + 𝑏𝑌, then saving function can be
derived as follows, we know that: 𝑆 = 𝑌 − 𝐶

Substitute for 𝑎 + 𝑏𝑌 for 𝐶 in the above equation.

𝑆 = 𝑌 − (𝑎 + 𝑏𝑌) = −𝑎 + (1 − 𝑏)𝑌

This gives the saving function in which ‘1 − 𝑏’ is the marginal propensity to save (MPS).
The saving function is the mirror image of consumption. The slope of the saving
function is negative because, there is no income, that is the level of savings when Y =
0. The MPS can be proved as follows:
Since 𝑌 = 𝐶 + 𝑆

∴ 𝛥𝑌 = 𝛥𝐶 + 𝛥𝑆

Dividing both sides by Δ𝑌, we get;

𝛥𝐶 𝛥𝑆
1= +
𝛥𝑌 𝛥𝑌
Or
𝛥𝑆 𝛥𝐶
=1−
𝛥𝑌 𝛥𝑌

𝛥𝑆
Hence, 𝑀𝑃𝑆 = 𝛥𝑌 = 1 − 𝑏

Numerical Example:
Let consumption function be given as:
𝐶 = 100 + 0.75𝑌

Saving function can be derived as follows:

𝑆 =𝑌−𝐶

∴ 𝑆 = 𝑌 − (100 + 0.75𝑌)
= 𝑌 − 100 − 0.75𝑌

= −100 + (1 − 0.75)𝑌

= −100 + 0.25𝑌

Savings at various level of income

Since the MPC is 0.75 derived from our earlier consumption function, then the MPS
will be 0.25, i.e. 1 – 0.75 = 0.25. With this information and using the same levels of
income in our earlier table, the various levels of income can be calculated as follows:
Income N (Y) Autonomous Workings: Total Savings
consumption N (a) S =- a + bYd

5,000 3,000 S = -3,000 + 0.25(5,000) -1,750

10,000 3,000 S = -3,000 + 0.25(10,000) -500

15,000 3,000 S = -3,000 + 0.25(15,000) 750

20,000 3,000 S = -3,000 + 0.25(20,000) 2000

25,000 3,000 S = -3,000 + 0.25(25,000) 3250

In the analysis of national income determination, it also shows that total expected sale
proceeds, i.e., the value of the total planned output. The schedule 𝐶 = 100 + 0.75𝑌
gives the income-consumption relationship—consumption being a linear function of
income. The schedule 𝑆 = −100 + 0.25𝑌 is the saving schedule derived from the
consumption schedule. The saving schedule shows the income-saving relations.

Investment Function

Unlike consumption and saving, the investment function is assumed to be

autonomous. This means that the investment function is independent of changes in
the disposable income. Although investment is affected by several factors such as
interest rates, businessmen expectation, political stability, etc, these factors are not
determined within the circular flow of income system. The investment function can
therefore be written as:
𝐼 = 𝐼0
Graphical analysis of consumption, savings and investment functions
The consumption, savings and investment functions considered above can be
represented graphically. The slope of the consumption and savings function depend on
the marginal propensity to consume and save out of the level of disposable income
respectively. As the disposable income changes at a given marginal propensity to
consume and save, consumption and savings function also change. Using the
information in consumption and savings table derived above, the functions are
graphically represented as follows:

Consumption Function

Saving function
Change in Aggregate Demand and the Multiplier

A change in aggregate demand is caused by a change in either consumption

expenditure or in investment, or in both. In the Keynesian theory of income
determination, however, consumption expenditure is a function of income: it does not
change unless income changes, whereas investment is exogenously determined.
Therefore, a change in aggregate demand function is assumed to be caused by a
change in investment. A change in investment may be in the form of a decrease or an
increase in it. However, we are assuming an increase in investment and an upward
shift in the investment schedule. The figure below illustrates an upward shift in the
investment schedule from 𝐼 to 𝐼 + ∆𝐼, causing an upward shift in the aggregate
demand function from 𝐶 + 𝐼 to 𝐶 + 𝐼 + ∆𝐼.

As shown in the figure, prior to the increase in investment, the aggregate demand
schedule (C+I) intersected the aggregate supply schedule (𝐶 + 𝑆) at point E1. That is,
the economy was in equilibrium at point E1 where 𝑌 = OY1 = 𝐶 + 𝑆 = 𝐶 + 𝐼 = E1Y1.
When investment increases from 𝐼 to 𝐼 + ∆𝐼, as shown by upward shift in the 𝐼-
schedule, it causes an upward shift in the aggregate demand schedule from 𝐶 = 𝐼 to
𝐶 + 𝐼 + ∆𝐼. Due to upward shift in the aggregate demand schedule, the equilibrium
point shifts from E1 to E2 and, as a result, national income increases from OY1 to OY2.
At this point, the increase in national income implies that E1 represented a less than
full employment situation. It is only under this condition that equilibrium point E 1 can
shift to point E2. The increase in the national income (∆Y) can be obtained as: ∆Y = Y2-
Y 1.
This increase in income (∆Y) is the result of ∆I. it may be seen in the above figure that
∆Y>∆I. It means that when ∆I takes place, the resulting ∆Y is some multiple of ∆I. the
multiple (m) can be obtained as:
𝛥𝑌
𝑚= 𝛥𝐼

𝑚 𝑖𝑠 𝑡ℎ𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟.

The Simple Model of Multiplier

The multiplier model presented below answers the questions: Is there a definite
relationship between ∆Y and ∆I? If yes, what determines this relationship? These
questions can be answered by working out mathematical relationship between ∆Y and
∆I. This is presented as follows:
Given that equilibrium level of income is:

𝑌 = 𝐶 + 𝐼………………………………………….. (1)

Now let there be a ∆I. when ∆I takes place it results in ∆Y and ∆Y induces ∆C. Thus,
the post-∆I equilibrium level of income equals:
𝑌 + 𝛥𝑌 = 𝐶 + 𝛥𝐶 + 𝐼 + 𝛥𝐼………………………………………….. (2)

Subtracting equation 1 from 2 gives:

𝛥𝑌 = 𝛥𝐶 + 𝛥𝐼………………………………………….. (3)

Given the consumption function as 𝐶 = 𝑎 + 𝑏𝑌

𝛥𝐶 = 𝑏𝛥𝑌………………………………………….. (4)

Substituting (4) into (3) gives:

𝛥𝑌 = 𝑏𝛥𝑌 + 𝛥𝐼………………………………………….. (5)

𝛥𝑌(1 − 𝑏) = 𝛥𝐼

1
𝛥𝑌 = 𝛥𝐼
1−𝑏

𝛥𝑌 1
= =𝑚
𝛥𝐼 1 − 𝑏

Given that 𝑏=𝑀𝑃𝐶 and 1−𝑀𝑃𝐶=𝑀𝑃𝑆 therefore, multiplier (m) can also be expressed as:
 𝛥𝑌 1 1 1
𝑚= = = = ………………………………………….. (6)
𝛥𝐼 1−𝑏 1−𝑀𝑃𝐶 𝑀𝑃𝑆

The last term in equation (6) above indicates that m = reciprocal of MPS. Multiplier is
the amount by which income increases when there is a change in the investment level.

Alternate way of deriving the multiplier

This can be derived by subtracting a pre-∆I position from a post-∆I position (Y2-Y1).
Thus, given:
𝑌1 = 𝐶 + 𝐼

While 𝐶 = 𝑎 + 𝑏𝑌1 , the pre-∆I equilibrium level of income (Y1) may be rewritten as:

𝐶 = 𝑎 + 𝑏𝑌1 + 𝐼………………………………………….. (7)

1
= 1−𝑏 (𝑎 + 𝐼) ……………………………………………. (8)

Similarly, at post-Δ𝐼 equilibrium, Y2.

𝑌2 = 𝐶 + 𝐼 + ∆𝐼
= 𝑎 + 𝑏𝑌2 + 𝐼+∆𝐼

1
= 1−𝑏 (𝑎 + 𝐼 + ∆𝐼)…………………………………………. (9)

By subtracting equation 8 from 9, we have;

1 1
= 1−𝑏 (𝑎 + 𝐼 + ∆𝐼) − 1−𝑏 (𝑎 + 𝐼)

1
∆𝑌 = 1−𝑏 ∆𝐼…………………………………………. (10)

1
Equation 10 yields the relationship between ∆Y and ∆I, that is ∆Y equals (1−𝑏)
times ∆I.
1
therefore, (1−𝑏)
is the multiplier (m). Thus,
 1
𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 (𝑚) =
(1 − 𝑏)

Numerical Example:
Given that 𝑌 = 𝐶 + 𝐼, where 𝐶 = 𝑎 + 𝑏𝑌; = 100 + 0.75𝑌; and 𝐼 = 200. Find the
equilibrium level of national income and compare it to a new level of income if the
investment spending increases to 300 thereby obtaining the investment multiplier.

Solution

𝑌1 = 100 + 0.75𝑌 + 200

𝑌1 − 0.75𝑌 = 300
300
𝑌1 = = 1200
0.25

When Investment increased to a new level of 300, then new equilibrium Y2 is derived
as:
𝑌2 = 100 + 0.75𝑌 + 300
𝑌2 − 0.75𝑌 = 400
400
𝑌2 = = 1600
0.25

From here:
𝛥𝑌 = 𝑌2 − 𝑌1 = 1600 − 1200 = 400

𝛥𝐼 = 𝐼2 − 𝐼1 = 300 − 200 = 100

𝛥𝑌 400
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 (𝑚) = = =4
𝛥𝐼 100

It may be concluded that if MPC = 0.75, the multiplier (m) equals 4.

This implies that if m = 4, then any additional investment will generate an additional
income equal to four times of Δ𝐼. The value of the multiplier is determined by the size
1
of the MPC, i.e. 𝑚 = 1−𝑀𝑃𝐶

Mathematical Derivation of the Equilibrium level of National Income

Two-sector economy
Example: Given that in a two-sector economy,

𝑌 =𝐶+𝐼
𝐶 = 𝑎 + 𝑏𝑌
𝐼 = 𝐼0

Equilibrium is derived by substituting 𝐶 and 𝐼 into 𝑌 as follows:

𝑌 = 𝑎 + 𝑏𝑌 + 𝐼0

𝑌 − 𝑏𝑌 = 𝑎 + 𝐼0

𝑎 + 𝐼0 1
𝑌= = (𝑎 + 𝐼0 )
1−𝑏 1−𝑏

The example above illustrates the derivation of equilibrium level of national income in
a two-sector economy.
Three-sector economy
In an attempt to extend the model to three-sector economy, we assume that apart
from households and the business firms, the economy is also composed of the
government. Since households and business firms can save and invest, the
government also imposes taxes on the households and the business firms.
Government imposes taxes so as to provide some basic functions such as
infrastructural facilities, education etc., in the economy.
In view of the above, assuming the government adopts proportion tax system and the
tax rate is denoted by t, the equilibrium national income in a three-sector economy
can therefore be derived as follows:

Given that:
𝑌 =𝐶+𝐼+𝐺
𝐶 = 𝑎 + 𝑏𝑌𝑑
𝐼 = 𝐼0
𝐺 = 𝐺0
𝑌𝑑 = 𝑌 − 𝑇
𝑇 = 𝑡𝑌

Hence, substituting, 𝑇, 𝐺 , 𝐼, 𝑌𝑑 and 𝐶 into 𝑌, we have:

𝑌 = 𝑎 + 𝑏(𝑌 − 𝑡𝑌) + 𝐼0 + 𝐺0

𝑌 = 𝑎 + 𝑏𝑌 + 𝑏𝑡𝑌 + 𝐼0 + 𝐺0

Re-arranging by putting all the coefficients of Y on one side:

𝑌[1 − 𝑏(1 − 𝑡)] = 𝑎 + 𝑏𝑌 + 𝑏𝑡𝑌 + 𝐼0 + 𝐺0

𝑎 + 𝑏𝑌 + 𝑏𝑡𝑌 + 𝐼0 + 𝐺0
𝑌 =
1 – 𝑏 (1– 𝑡)
 1
𝑌 = . 𝑎 + 𝑏𝑌 + 𝑏𝑡𝑌 + 𝐼0 + 𝐺0
1 – 𝑏 (1 – 𝑡)

1
The term 1 – 𝑏 ( 1– 𝑡)
is the multiplier in this economy. It could be observed that as

government imposed taxes in this economy, the multiplier is smaller relative to that in
a two sector economy.

Four sector economy

Following similar procedures as in the two and three sector economy, the equilibrium
in a four sector economy can also be derived mathematically.
Given that:
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑋 – 𝑀,

𝑋 = 𝑋0 ,

𝑀 = 𝑀0

while 𝐶, 𝐼, 𝑎𝑛𝑑 𝐺 are as previously defined in the three sector economy.

𝐶 = 𝑎 + 𝑏𝑌𝑑; 𝐼 = 𝐼0 ; 𝐺 = 𝐺0

Show that equilibrium level of income is:

𝑎 + 𝐼0 + 𝐺0 + 𝑋0 – 𝑀0
𝑌 =
1 – 𝑏( 1 − 𝑡)

solution
Given, 𝐶 = 𝑎 + 𝑏𝑌𝑑; 𝐼 = 𝐼0 ; 𝐺 = 𝐺0 ; 𝑋 = 𝑋0 ; 𝑀 = 𝑀0 ; 𝑌𝑑 = 𝑌 − 𝑇 ; 𝑇 = 𝑡𝑌

substituting, 𝐶, 𝐼, 𝐺, 𝑋, 𝑀, 𝑌𝑑 , and 𝑇 into 𝑌, we have:

𝑌 = 𝑎 + 𝑏(𝑌 − 𝑡𝑌) + 𝐼0 + 𝐺0 + 𝑋0 − 𝑀0

𝑌 = 𝑎 + 𝑏𝑌 + 𝑏𝑡𝑌 + 𝐼0 + 𝐺0 + 𝑋0 − 𝑀0

Re-arranging by putting all the coefficients of Y on one side:

 𝑌[1 − 𝑏(1 − 𝑡)] = 𝑎 + 𝑏𝑌 + 𝑏𝑡𝑌 + 𝐼0 + 𝐺0 + 𝑋0 − 𝑀0

𝑎 + 𝑏𝑌 + 𝑏𝑡𝑌 + 𝐼0 + 𝐺0 + 𝑋0 − 𝑀0
𝑌 =
1 – 𝑏(1 – 𝑡)

1
𝑌 = . 𝑎 + 𝑏𝑌 + 𝑏𝑡𝑌 + 𝐼0 + 𝐺0 + 𝑋0 − 𝑀0
1 – 𝑏(1 – 𝑡)

1
The term 1 – 𝑏(1 – 𝑡)
is the multiplier in this economy.

Note: Multiplier is inverse/reciprocal of MPS.

*Multiplier is the ability of a given change in planned expenditure to cause a bigger

total change in equilibrium national income.

It is the multiple of the change in planned expenditure by the equilibrium national

income increase, in other words multiplier is the ratio of ∆Y to ∆I.

Disposable income can be expressed as follows:

𝑌𝑑 = 𝑌 − 𝑇

where 𝑇 can be given as:

𝑇 = 𝑇0 ………… (lump sum tax) or;

𝑇 = 𝑡𝑌…………. (proportional tax).

Example

Given 𝐶 = 100 + 0.75𝑌

𝐼0 = 200

Find the equilibrium level of income and compare it to a new level of income if
investment increases to 300.
𝑌 = 𝐶 + 𝐼0

𝑌 = 100 + 0.75𝑌 + 200

𝑌 − 0.75𝑌 = 300

𝑌(1 − 0.75) = 300

300
𝑌= = 1200
0.25

the equilibrium level of income = 1200

𝐼𝑖 = 200 ; 𝐼𝑓 = 300

∆𝐼 = 300 − 200 = 100

∆𝑌 1
𝑘= =
∆𝐼 1 − 𝑏

400
𝑘= =4
100

or

1 1 1
𝑘= = = =4
1 − 𝑏 1 − 0.75 0.25
Practice questions
1. Suppose consumption is ₦ 40 + 0.75𝑌, and investment is ₦60.
(a) find equilibrium output, and consumption and saving at equilibrium.
(b) show that at equilibrium spending equals output and saving leakages equal
investment injections.

2. Suppose consumption is ₦ 50 + 0.85𝑌;𝐼 = ₦ 80;𝑎𝑛𝑑 𝑌𝑑=𝑌 and 𝐺 = 0, since there is no

government sector.
(a) derive an equation for the saving function
(b) find the equilibrium output by equating saving leakages and investment injections.

3. Given that

𝐶 = ₦20 + 0.80𝑌,

𝐼 = ₦90,

𝐺 = ₦20,

𝑌𝑑 = 𝑌 − 𝑇𝑁 ,

𝑇𝑁 = 𝑇𝑥 − 𝑇𝑟 ,

𝑇𝑟 = 0 𝑎𝑛𝑑 𝑇0 = ₦10.

(a) Find the equilibrium output,

(b) Find consumption and saving at equilibrium output.

(c) Show the equality of leakages and injections from the spending flow at equilibrium

(d) How is the ₦20 government expenditure financed? 𝑇𝑁 = Net tax revenues, 𝑇𝑥 = Gross
Tax revenue, 𝑇𝑟 = Transfers
Assignment

Given that:
𝑌 =𝐶+𝐼+𝐺
𝐶 = 100 + 0.85𝑌𝑑
𝐼 = ₦30
𝐺 = ₦50
𝑇 = ₦5
𝑌𝑑 = 𝑌 − 𝑇
Find the equilibrium output, consumption and saving using

i) Income expenditure approach

ii) Injection withdrawal approach
iii) If investment changes to ₦100𝑚 by how much would national income
increase?
iv) What is the new level of national income?
 3.0 Theory of consumption, savings and investment.
Dr. T.T Osinubi.

Consumption and investment are very important aggregates in macroeconomics.

Indeed, they both play crucial roles in the determination of equilibrium level of income
and employment. A change in any one of them will cause the level of national income
to change through the multiplier effect. Therefore, there is the need to examine and
analyze the determinants of these aggregate variables in order to design adequate
macroeconomic policies that will bring about full employment and accelerated
economic growth.

Theories of Consumption
Both consumption theory and knowledge of consumption function have come a long
way since Keynes introduced the notion of consumption function in his General
Theory. Consumption can simply be defined as the spending by household on goods
and services that yield utility in the current period. When all individual consumption
is summed together we then have aggregate consumption. In other word, consumption
is defined as that part of disposable income that is not saved, since income is either
saved or spent (C= Yd –S). The question then is what determines the amount expended
on goods and services in the whole economy? This question leads us to our discussion
of consumption theory. Consumption Theory or function simply indicates these factors
that determine aggregate consumption or demand and the relationship that exist
between them. There are four types of consumption theory and each indicates those
factors that are assumed to impact on aggregate consumption spending.

These theories of consumption are:

1. Absolute Income Hypothesis (AIH) by J.M Keynes
2. Permanent Income Hypothesis (PIH) by Milton Friedman
3. Relatives Income Hypothesis (RIH) by J.S Deusenberry
4. Life Cycle Hypothesis (LCH) by A. Ando, F. Modigliani.
1. The Absolute Income Hypothesis
The absolute-income theory of consumption is linked to the basic principle of
Keynes’ theory of consumption. This theory is based on a fundamental psychological
law which states that “men are disposed, as a rule and on average, to increase their
consumption as their income increases, but not by as much as the increase in their
income”. That is, 𝛥𝐶 ⁄ 𝛥𝑌 is positive and less than unity. Based on this law, the
absolute-income theory of consumption hypothesizes that current consumption
expenditure depends on the current and absolute level of income. Formally, the
absolute income theory of consumption can be stated as current consumption is the
function of the current income i.e.
𝐶 = 𝑓 (𝑌 )
Where: C = current consumption, and Y = current income.

Properties of the Keynesian consumption function

The main properties of the Keynesian consumption function can be summarized as
follows:

i. The real consumption expenditure is a positive function of the real current

disposable income. This property makes the absolute income hypothesis a short-run
theory.

ii. The marginal propensity to consume (MPC) ranges between zero and 1,
i.e. 0 <MPC < 1 (0 and 1 included).

iii. The MPC is less than the average propensity to consume (APC), that is,
𝛥𝐶 𝐶
𝛥𝑌
< 𝑌

iv. The MPC declines as income increases, that is, less and less of an equivalent
marginal income is consumed.

An additional factor that Keynes adduced to increase in consumption is the increase

in wealth of the households. However, the first two properties are essential for the
Keynesian theory of consumption, but not the latter two. In fact, property (iii) has been
abandoned by the Keynesians on the ground that it does not stand the empirical test.
𝛥𝐶 𝐶
The Keynesians hold that APC = MPC, i.e. 𝛥𝑌
=𝑌.

The absolute-income theory of consumption is illustrated in the figure below.

The 450 line (C=Y) shows a hypothetical relationship between income and
consumption, i.e., current consumption expenditure always equals the current
income. It implies that if Y = 0, then C = 0. This is not a realistic proposition. For,
people do consume even when their income equals zero.

Another feature of consumer behavior is that when income increases, people do not
spend their entire incremental income on consumption. They save a part of it for their
financial security during the period of unemployment, illness, death of the bread
winner, or for investment to enhance their future income. The overall consumer
behavior is shown by the curve C1. The curve C1 delineates Keynes’s absolute-income
theory of consumption. As the curve C1 shows, consumption expenditure exceeds the
current income up to a certain level of income (say Y =₦10,000). At point B, income
and consumption break-even. Beyond point B, consumption expenditure increases
with the increase in income but at a slower pace.
Note that the slope of the curve C1 goes on diminishing with increase in income.

The empirical analysis in subsequent years of Keynes theory revealed that MPC was of
stable nature. In other words, the studies carried out later by the Keynesians found a
straight-line relationship between consumption and income.
The straight consumption function of the following form gives the absolute-income
hypothesis.

𝐶 = 𝑎0 + 𝑏𝑌

Where a = intercept showing consumption at the zero level of income, and b stands for
MPC. This consumption function is represented by C2 in our diagram above. The slope
of C2 is a constant one given as b.

2. The Relative Income Hypothesis

Given the apparent contradictions observed between theory and empirical evidence,
many economists embarked on several studies to reconcile the contradiction. The first
attempt in this direction was Duesenberry in the late 1940s and, in the process, he
propounded the relative income theory of consumption, also known as the Relative
Income Hypothesis.

Assumptions of Duesenberry’s Relative Income Hypothesis

This theory is based on the assumptions that:

(i) the consumption behavior of individuals is interdependent and not

independent; and

(ii) consumption relations are irreversible over time.

Duesenberry believes that a good understanding of the consumer behavior must
incorporate the social character of consumption patterns. By social character, he
means the tendency in human beings not only to keep up with the Joneses, but also
to surpass the Joneses. In other words, the tendency is to strive constantly toward a
higher consumption level and to emulate the consumption patterns of one’s rich
neighbors and associates. Thus consumers’ preferences are interdependent. It is,
however, differences in relative incomes that determine the consumption expenditures
in a community. A rich person will have a lower APC because he will need a smaller
portion of his income to maintain his consumption pattern. On the other hand, a
relatively poor man will have a higher APC because he tries to keep up with the
consumption standards of his neighbor or associates. This provides the explanation of
the constancy of the long-run APC because lower and higher APCs would balance in
the aggregate. Thus even if the absolute size of incomes in a country increases, the
APC for the economy as a whole at the higher absolute level of income would be
constant.

The second part of the theory is the past peak income hypothesis which explains the
short-run fluctuations in the consumption function and refutes the Keynesian
assumption that consumption relations are reversible. The hypothesis states that
during a period of prosperity, consumption will increase and gradually adjust itself to
a higher level. Once people reach a particular peak income level and become
accustomed to this standard of living, they are not prepared to reduce their
consumption pattern during a recession (what Duesenberry calls, the Ratchet
Effect.).

Thus, as income falls, consumption declines but proportionately less than the
decrease in income because the consumer di-saves to sustain consumption. On the
other hand, when income increases during the recovery period, consumption rises
gradually with a rapid increase in saving.

Duesenberry combines his two related hypothesis in the following form:

𝐶𝑡 𝑌𝑡
= 𝑎+𝑏
𝑌𝑡 𝑌0
Where C and Y are consumption and income respectively, t refers to the current
period and the subscript (0) refers to the previous peak, a is a constant relating to the
positive autonomous consumption and b is the consumption function. In this
equation, the consumption-income ratio in the current period (Ct/Yt) is regarded as
function of Yt/Y0, that is, the ratio of current income to the previous peak income. If
this ratio is constant, as in periods of steadily rising income, the current consumption
income ratio is constant. During recession when current income (Yt) falls below the
previous peak income (Y0), the current consumption income ratio (Ct/Yt) will increase.
3. The Permanent Income Hypothesis (Milton Friedman)
This hypothesis was developed by Milton Friedman. It rests on the fact that
consumption does not depend on the current disposable income (as in AIH) rather, it
depends on some measure of expected or permanent income i.e.

𝐶𝑡 = 𝑓 (𝑌𝑝 )

Where Yp is a measure of permanent income

According to this theory, consumption will not fall drastically even if for some reasons,
peoples’ income fall below what they think their permanent income should be.
Conversely, consumption will not rise very significantly if peoples’ income suddenly
exceeds the level considered permanent. Thus, the permanent income hypothesis
states that the level of consumption will remain fairly stable every time. It is only when
permanent income increases that consumption will increase and vice versa.
Consumption level therefore depends on permanent income and that people do not
change their consumption patterns in response to: every change up or down in their
income receipts.

Permanent income is defined as the present value of the expected flow of income from
the existing stock of both human and non-human wealth over long period of time.
Friedman pointed out that current measure of Income for a household or for the whole
economy could be greater or lesser than the permanent income.
The difference between these two is referred to transitory income which is regarded as
temporary unexpected rise or fall in income. Consequently,
𝑌 = 𝑌𝑝 + 𝑌𝑡 => 𝑌𝑡 = 𝑌 − 𝑌𝑝
𝑌𝑝 = 𝑝𝑒𝑟𝑚𝑎𝑛𝑒𝑛𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑌𝑡 = 𝑡𝑟𝑎𝑛𝑠𝑖𝑠𝑡𝑜𝑟𝑦 𝑖𝑛𝑐𝑜𝑚𝑒
𝑌 = 𝑀𝑒𝑎𝑠𝑢𝑟𝑒 𝑜𝑟 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑖𝑛𝑐𝑜𝑚𝑒

Friedman also divided consumption into permanent and transitory consumption.

Permanent consumption is defined as the planned level of spending out of
permanent income while transitory consumption is any unplanned or temporary
increase or decrease in consumption spending. Combining the two concepts
together, we then have;
𝐶 = 𝐶𝑝 + 𝐶𝑡
𝐶𝑝 = 𝑝𝑒𝑟𝑚𝑎𝑛𝑒𝑛𝑡 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
𝐶𝑡 = 𝑡𝑟𝑎𝑛𝑠𝑖𝑠𝑡𝑜𝑟𝑦 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
𝐶 = 𝑀𝑒𝑎𝑠𝑢𝑟𝑒 𝑜𝑟 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛

Friedman also makes an important assumption about transitory consumption:

Transitory consumption is neither correlated with permanent income nor transitory
income. Thus, transitory income is completely random. With this assumption, the
basic consumption function in a permanent income hypothesis is expressed as:

𝐶 = 𝐾𝑌𝑝

That is, Permanent Consumption is a multiple (K) of permanent income. The

relationship between consumption and permanent income can also be illustrated
graphically as shown below.
From the diagram, CL is the long-run consumption function which represents the
long-run proportional relationship between consumption and income of an individual.
Over the long-run, transitory components of both variables cancel out and there is
proportional relation between the permanent components. Cs is the non-proportional
short-run consumption function where measured (current) income includes both
permanent and transitory components. At OY0 income level where Cs and CL lines
coincide at E0, changes in permanent income and measured income are identical, and
so are permanent and measured consumption as shown by OC0. Here transitory
factors are non-existent.

If we move to the left of point E0 on the CS curve at E3, the measured income declines
to OY3 due in part to the negative transitory income component. Since permanent
income at OY4 is higher measured income at OY3, permanent consumption will remain
at OC3 and equal measured consumption.

On the other hand, a movement to the right of point E0 on the Cs curve at E1 shows
measured income to be OY1 and measured consumption as OC2. But OC2 level of
consumption can be maintained permanently at the permanent income level of OY2.
Thus Y1Y2 is the positive transitory income component in measured income OY1 which
is higher than the permanent income OY2.
4. The Life Cycle Hypothesis
Ando and Modgliani have formulated a consumption function which is known as the
Life Cycle Hypothesis. According to this theory, consumption is a function of lifetime
expected income of the consumer. The consumption of the individual consumer
depends on the resources available to him, the rate of return on capital, the spending
plan, and the age at which the plan is made. The present value of his income (or
resources) includes income from assets or property and from current and expected
labour income.

The aim of the consumer is to maximize his utility over his lifetime which will, in turn,
depend on the total resources available to him during his lifetime. Given the life-span
of an individual, his consumption is proportional to the resources.
But the proportion of resources that the consumer plans to spend will depend on
whether the spending plan is formulated during the early or later years of his life.
As a rule, an individual’s average income is relatively low at the beginning of his life
and also at the end of his life. This is because in the years of his life he has little
assets, and during the late years his labour income is low. It is, however, in the middle
of his life that his income, both from assets and labour, is high. As a result, the
consumption level of the individual throughout his life is somewhat constant or
slightly increasing, shown as the CC1 curve in the figure below.
Y0YY1 curve shows the individual consumer’s income stream during his lifetime
T. during the early period of his life represented by T1 in the figure, he borrows
CY0B amount of money to keep his consumption level CB which is almost constant. In
the middle years of his life represented by T1T2, he saves BSY amount to repay his debt
and for the future. In the last years of his life represented by T2T, he di-saves SC1Y1
amount.

The main difference between the lifecycle hypothesis (LCH) and permanent income
hypothesis (PIH) is that the former explicitly considered the role of asset accumulation
and the effect of age on household consumption.

THEORIES OF INVESTMENT/INVESTMENT DEMAND FUNCTIONS

1. Introduction
Investment is an important component of aggregate demand. It can also be argued
that fluctuations in economic activities or business cycles can partly be fluctuations in
investment. Under national income determination in previous chapter, investment was
treated as autonomous (i.e. its value is not determined within the model and therefore
it is independent of any macroeconomic variable or factor including current income
level. In this section, investment is no longer taken as given from outside the model
but we need to adequately analyze investment model by identifying those factors that
determine or influence its level in an economy as well as the role attributable to each
one of them.

2. Investment Demand
Investment decisions are made by firms or private investors with the motive of making
profits. Firms add to their existing plants and equipment because they foresee
profitable opportunities to expand their output or because they can reduce costs by
moving to more capital-intensive production methods. For instance, when an
organization needed new-equipment, it developed new products for the company
through investments spending. In this case, the firm has to weigh the benefits
(returns) from new plant or equipment (i.e. increase in profits) against the cost of
investment.
Aggregate /total investment includes spending or the flow of expenditure devoted to
projects to produce goods which are not intended for immediate consumption. It
includes investment in factory building, machinery, houses, etc.
Expenditure of firms on these items and many like them are regarded as investment.
Investment project may also take the form of addition to both physical and human
capital as well as inventory. Inventory refers to the stock of goods or resources held by
firms to enable them meet temporary and unexpected fluctuations in their production
or sales.
Total investment in an economy during a specific period is referred to as gross
investment. However, in national income accounting, it is net investment (i.e. gross
investment less depreciation) that actually account for the level of investment in an
economy. Net investment measures the actual increase in the productive capacity in
an economy.

𝑁𝑒𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (𝑁𝐼) = 𝐺𝐼 − 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛

Investment decisions pertain to whether or not to undertake an investment project;

how to make choice between competing investment projects; and how to find optimum
level of investment.

There are several methods of investment decision making. We shall however explain
the role of
(i) the Net Present Value(NPV) and
(ii) the Marginal Efficiency of Capital (MEC) in this course.

i. The Net Present Value (NPV) Method

The NPV method is one of the popular methods of taking decision on investment
projects. The net present value (NPV) is defined as the difference between the present
value (PV) of a future income stream and the costs of investment (C).
That is:
𝑁𝑃𝑉 = 𝑃𝑉 – 𝐶
The PV of a future income is the discounted value of the income expected at a future
date. The future income is discounted at the market rate of interest. The need for
discounting future income arises because money has a time value. The time value of
money means preference for an amount of money today to the same amount at some
future date. For example, ₦1000 today is always preferable today to ₦1000 after one
year or some future time period. The PV of an income receivable after one year is
obtained by a discounting formula given below.
𝑅 1
𝑃𝑉 = =𝑅
1+𝑖 1+𝑖
The amount of income receivable in the nth year can thus be given as:
𝑅𝑛 1
𝑃𝑉 = 𝑛
= 𝑅𝑛
(1 + 𝑖) (1 + 𝑖)𝑛
R = amount expected after one year, i = rate of interest.

The market rate of interest is regarded as the opportunity cost or the time value of
money. To compute the Total Present Value of a stream of income, the formula below
is used.
𝑅1 𝑅2 𝑅3 𝑅𝑛
𝑇𝑃𝑉 = 1
+ 2
+ 3
+ ⋯+
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖) (1 + 𝑖)𝑛

𝑛
𝑅𝑛
𝑇𝑃𝑉 = ∑
(1 + 𝑖)𝑛
𝑗=1

Given the formula for the TPV, the Net Present Value is thus given as follows:

𝑛
𝑅𝑛
𝑁𝑃𝑉 = ∑ −𝐶
(1 + 𝑖)𝑛
𝑗=1

Where C is the total investment cost.

Hence, if:
𝑁𝑃𝑉 ≥ 0 , 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑖𝑠 𝑎𝑐𝑐𝑒𝑝𝑡𝑒𝑑 𝑎𝑠 𝑝𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑙𝑒.
𝑁𝑃𝑉 < 0 , 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑖𝑠 𝑟𝑒𝑗𝑒𝑐𝑡𝑒𝑑.
Example: suppose that an investment project costs 𝐶 = ₦1000 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 and it is
expected to yield an annual stream of income as shown below.

Period Returns (R) (₦)’M

1 500
2 400
3 300
4 200
5 100

𝑖 = 20% = 0.20

500 400 300 200 100

= 1
+ 2
+ 3
+ 4
+
(1 + 0.20) (1 + 0.20) (1 + 0.20) (1 + 0.20) (1 + 0.20)5

500 400 300 200 100

= 1
+ 2
+ 3
+ 4
+
(1.20) (1.20) (1.20) (1.20) (1.20)5

= 416.67 + 277.78 + 173.61 + 96.45 + 40.19

= 1004.69 > 1000

Hence, the project is accepted since the discounted value is higher than the cost.

ii. The Marginal Efficiency of Capital (MEC)

Keynes suggested an alternative method of investment based on what he called
Marginal Efficiency of Capital (MEC). This is also known as Internal Rate of Return
(IRR).

MEC is defined as the rate of discount which makes the discounted present value of
expected income stream equal to the cost of the capital.
If for example the cost of an investment project is C and it is expected to yield a return
R for one year, then MEC can be found as follows:
 𝑅
𝑀𝐸𝐶 = =𝐶
1+𝑟

Where, r is the rate of discount that makes the discounted value of R equal to C.

Therefore the value of r is the marginal efficiency of capital or the internal rate of
return. If a capital project costing C is expected to generate an income stream over a
number of years as R1, R2, R3, …Rn, then MEC of the project can be computed by using
the formula:
𝑅1 𝑅2 𝑅3 𝑅𝑛
𝐶= + + + ⋯ +
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑖)𝑛

Using our earlier example, we’ll try 20.27 per cent rate = 0.2027 of discount.
500 400 300 200 100
1000 = 1
+ 2
+ 3
+ 4
+
(1 + 0.2027) (1 + 0.2027) (1 + 0.2027) (1 + 0.2027) (1 + 0.2027)5

500 400 300 200 100

1000 = 1
+ 2
+ 3
+ 4
+
(1.2027) (1.2027) (1.2027) (1.2027) (1.2027)5

1000 = 415.73 + 276.53 + 172.44 + 95.59 + 39.74 = 1000.03

Hence, 20.27% is the discount rate for this project.

Decision Rule:
𝑀𝐸𝐶 > 𝑟 𝑡ℎ𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑖𝑠 𝑎𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒
𝑀𝐸𝐶 = 𝑟, 𝑡ℎ𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑖𝑠 𝑎𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒 𝑜𝑛 𝑛𝑜𝑛 − 𝑝𝑟𝑜𝑓𝑖𝑡 𝑏𝑎𝑠𝑖𝑠.
𝑀𝐸𝐶 < 𝑟 , 𝑡ℎ𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑖𝑠 𝑟𝑒𝑗𝑒𝑐𝑡𝑒𝑑
Derivation of the MEC Schedule
We have just described investment decision rule when a single project is involved. We
now describe how total investment decision is taken when a firm has a number of
possible investment projects to select from.

Suppose a profit maximizing firm having a large amount of investable funds is

considering four investment projects—

Project 1: setting up of a new production unit;

Project 2: expansion of the existing production plant;

Project 3: modernization of the production plant; and

Project 4: construction of a new building.

In this case, the firm will have to work out the MEC of the different projects and list
them in order of their MEC. Suppose the cost of each of these projects is given in the
table below:

Projects Cost of Projects (₦ million) MEC (%)

Project 1 100 25
Project 2 100 18
Project 3 100 15
Project 4 100 10

This information can be presented in the form of a diagram as shown in the figure
below. In this figure, the vertical axis measures the MEC and the horizontal axis
shows investment cost cumulatively. The MEC of each project is shown in the form of
a bar-diagram in its decreasing order.
When the top of the bars are joined by a solid line, it gives a stair-like MEC schedule.
The stairs-like MEC schedule is the result of a small number of projects presented in
the above figure. If a firm is considering a large number of investment projects of
varying MEC and cost of capital and if they are all plotted together, the stairs like
formation of the MEC schedule will get evened out and it will produce a smooth MEC
schedule as shown in the figure below. The MEC schedule gives the investment
demand schedule of an individual firm.

This figure shows the relationship between the market rate of interest and the
investment demand under the investment rule that i = MEC. Given the MEC schedule,
when the market rate of interest is Oi3, the profit maximizing investment demand is
limited to OK1. And, when market rate of interest decreases from Oi3 to Oi2, the
demand for capital increases to OK2 and when the interest rate falls to Oi1, investment
demand increases to OK3. Thus, given the MEC schedule and the market rate of
interest, firm’s demand for capital can be easily known. It may thus be concluded that
the MEC schedule represents the investment demand schedule for an individual firm.

The Accelerator Theory Investment

The accelerator theory of investment describes the technological relationship between
the change in capital stock and the change in the level of output. The technological
relationship between capital and output is defined as capital-output ratio, that is,
𝛥𝐾
𝛥𝑌

Suppose that the demand for firm’s output in period t is given as 𝑌𝑡 and firms use
𝐾
capital stock 𝐾𝑡 to produce 𝑌𝑡 . Denoting capital-output ratio ( 𝑌 ) by 𝑘, the relationship

between capital stock (𝐾𝑡 ) and the output (𝑌𝑡 ) can be expressed as:

𝐾𝑡 = 𝑘𝑌𝑡 -------------------------------------------------------------------(1)

If the demand for output increase in period 𝑌𝑡 to 𝑌𝑡 + 1 . The increase in the

demand for output may be expressed as:

𝛥𝑌𝑡 + 1 = 𝑌𝑡 + 1 − 𝑌𝑡 ----------------------------------------------------------(2)

The firm will hence be required to increase their desired capital stock of capital in
period t+1 to produce an additional output of ΔYt + 1.

Given the capital-output ratio (k) and the additional demand for output (ΔYt + 1), the
desired capital stock Kt + 1 in period t+1 is given as:

𝐾𝑡 + 1 = 𝑘 𝑌𝑡+1 -------------------------------------------------------------------------(3)

The change in capital stock (ΔK) in response to the change in output (ΔY) can
be obtained as given below:
𝐾𝑡 + 1 − 𝐾𝑡 = 𝑘( 𝑌𝑡+1 − 𝑌𝑡 )
∆ 𝐾𝑡 + 1 − 𝐾𝑡 = 𝑘( 𝑌𝑡+1 − 𝑌𝑡 )----------------------------------------------------------------(4)

We know that ∆𝐾 = 𝐼. (𝑁𝑒𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡).

Therefore,
∆ 𝐾𝑡 + 1 = 𝐼𝑡+1

Hence, equation (4) can be re-written as;

𝐼𝑡 + 1 = 𝑘(∆ 𝑌𝑡+1 )

Equation (4) states the accelerator theory of investment. It reveals that the investment
is a function of the change in the level of income (or output). The conclusions that
follow from equation 4 can be stated as follows:
𝑖𝑓 𝑌𝑡+1 − 𝑌𝑡 > 0, 𝑡ℎ𝑒𝑛 𝑌𝑡+1 > 0
𝑖𝑓 𝑌𝑡+1 − 𝑌𝑡 = 0, 𝑡ℎ𝑒𝑛 𝑌𝑡+1 = 0
𝑖𝑓 𝑌𝑡+1 − 𝑌𝑡 < 0, 𝑡ℎ𝑒𝑛 𝑌𝑡+1 < 0

The implication of the accelerator theory expressed in equations (4) can be

summarized as follows:

1. When income is constant, investment is not necessary and firms will only
concern themselves with the maintenance of the existing capital stock rather
than expanding their stock of capital.

2. If income is rising, it is necessary to invest in new plant and machinery in

order to expand the existing capacity produce.

3. In order to maintain the level of net investment, demand for firms’

products must be rising at a steady rate.

4. Net investment is desirable if and only if aggregate demand is increasing at

an increasing rate.
 5. New investment is a multiple of a change in output i.e. 𝐼𝑡 = 𝑘ΔY , i.e.
𝐾
accelerator coefficient multiplies by change in 𝑘 = 𝑌

(𝑖. 𝑒. 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 − 𝑂𝑢𝑡𝑝𝑢𝑡 𝑟𝑎𝑡𝑖𝑜).

6. If aggregate demand remains unchanged, net investment will be zero.

Criticisms against Accelerator Principle

The accelerator theory has been criticized on certain grounds. The working of the
accelerator principle rests on some assumptions and these assumptions provide the
basis upon which the theory is criticized or attached.

(i) The first assumption is that the existing stock of capital is fully utilized.
This assumption may not be true for all firms in an economy. If excess capacity exists
in an economy the principle breaks down because additional output can be supplied
from the existing capacity without necessarily incurring new investment spending.

(ii) The next assumption is that firms always alter their capacity to meet every change
in demand. While firms may want to increase the capital stock when demand rises,
they may be unwilling to divest as quickly when demand declines especially when the
fall in aggregate demand is expected to be temporary.

(iii) The theory assumes that there is no time lag between the time investment decision
is made and the time when acquisition of capital goods is done. Since capital
investment is of long-term in nature, firms will examine their experience over a long
period of time and in some cases will act on the basis of future expectation of demand
profits.

(iv) The accelerator principle gives no consideration to the cost of capital (real interest
rate) as a factor influencing investment spending. The theory simply assumes that
firms have unlimited fund to carry out its investment or expansion projects but this is
not so.
Investment Model:
In economic theory, several factors affecting the level of investment have been
identified. Empirical investigations have also shown that most of these factors, indeed,
can be used to explain the aggregate investment spending in an economy.
These factors include:

(i) The rate of interest (r): The relationship between investment and rate of interest is a
negative one. The rate of interest is the cost of capital and so the higher the cost of
capital the lower the willingness to invest and vice versa.

(ii) The income level changes in Aggregate demand (ΔY): The relationship between
investment and the change income in an economy is a positive one. The higher the
income, the higher the level of aggregate investment and vice versa

(iii) Investors expectation about future economic activities (e): Investment is strongly
influenced by businessmen’s expectation of future economic activities in the following
ways: if investors are optimistic about future economic activities, the level of
investment will increase but if they are pessimistic or skeptical about future economic
activities, the level of investment would fall.

(iv) Political situation (P): If the political climate of a country is conducive or stable, the
investment will rise while in a country characterized by political instability, investors
will not be encouraged to invest. They may even withdraw their capital (divest).

(v) Government fiscal action/policy: An expansionary fiscal policy which reduces the
tax rate has the effect of reducing the operating cost of firms, thereby increasing the
profit-after-tax. As the profit-after-tax increases, dividends to shareholders as well as
retained profit will rise.
The increase in retained profit implies that firm will have more funds for investment
purpose. Apart from its effect on the operating costs of firms, expansionary fiscal
policy which increases the level of government expenditure will increase the future
demand for output. As businessmen expect future increase in output, they will
increase their spending in investment goods. For contractionary FP (Fiscal Policy), the
opposite is the case.

(vi) Government Monetary Policy: An expansionary monetary policy by the central

bank or monetary authority will affect the level of investment via the interest rate.
Increase in money supply relative to money demand brings about a fall in interest
rate. As interest rate falls, the cost of capital reduces thereby stimulating investment.
For a contractionary monetary policy (MP) the opposite is the case.

(vii) Rate of Inflation: As the general price level is increasing, investors’ profit increase.
As profit increases, businessmen would invest more. The opposite is the case if the
general price level is falling.

Taking all these factors together the aggregate investment function becomes:

𝐼 = 𝑓(𝛥𝑌 , 𝑟 , 𝑃∗ , 𝐺𝑃 , 𝜋 , 𝑒)

𝐼 = 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝛥𝑌 = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒
𝑟 = 𝑅𝑒𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒
𝐺𝑃 = 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑃𝑜𝑙𝑖𝑐𝑦
𝜋 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
𝑒 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑎𝑡𝑖𝑜𝑛 𝑎𝑏𝑜𝑢𝑡 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠
𝑃∗ = 𝑃𝑜𝑙𝑖𝑡𝑖𝑐𝑎𝑙 𝐸𝑛𝑣𝑖𝑟𝑜𝑛𝑚𝑒𝑛𝑡