CHAPTER ONE

EQUILIBRIUM INCOME
DETERMINATION
 1.1.The Components of Income
 When judging whether the economy is doing well or poorly, it is
natural to look at the total income that everyone in the economy
is earning(GDP).
 GDP measures two things at once:
-the total income of everyone in the economy and
-the total expenditure on the economy’s output of goods
and services
 We can compute GDP for this economy in one of two ways:
-by adding up the total expenditure by hhds or
-by adding up the total income (wages, rent, and profit)
paid by firms.
 Generally, the GDP or income has four components:
 consumption (C),
 investment (I),
 government purchases (G) and
 net exports (NX).

 For now, to simplify the analysis, we assume a closed economy.

 The three components of GDP are expressed in the national
income accounts
identity: Y=C+I+G.
Consumption:
Households receive income from their labor and their ownership
of capital, pay taxes to the government, and then decide how
much of their after-tax income to consume and how much to
save.
 We define income after the payment of all taxes, Y - T, as
disposable income.
 Households divide their disposable income between
consumption (C) and saving (S).
 consumption is equivalently explaining the behavior of saving.
More formally, which states that income not spent on
consumption is saved:
S=Y-C…………………………………… (1.1)
 The level of consumption depends directly on the level of
disposable income.
 The higher the disposable income, the greater the consumption
would be. Thus,
C = C(Y - T) =a+b(Y-T)………………… (1.2)
The r/nship b/n consumption and disposable income is called the
consumption function.
 The slope of the consumption function is the
marginal propensity to consume (MPC).
 The MPC is the amount by which consumption
changes when disposable income increases by one
dollar.
For example, if the MPC is 0.7, then hhds spend 70
cents of each additional dollar of disposable income on
consumer goods and services and save 30 cents.
Investment:
 Both firms and hhds purchase investment goods.
• The quantity of investment gds demanded depends on the
interest rate, which measures the cost of the funds used to
finance investment.
• For an investment project to be profitable, its return (the
revenue from increased future production of gds and srvcs) must
exceed its cost (the payments for borrowed funds).
• If the interest rate rises, fewer investment projects are
profitable, and the quantity of investment goods demanded falls.
But, to keep things simple, for now we assume that investment is
autonomous.
 Autonomous investment means that investment is independent of
any other variables like interest rate or income.
Government Purchases:
 The government sector basically does two major things or
national economic activities.
-making expenditure on gds and srvcs w/c is denoted by (G) and
-government earns income through tax w/c is denoted by (T).
 Since the gov’t doesn’t have any other separate significant and
sustainable sources of income it basically depends on tax income.
 Transfer payments (TR) to hhds, such as welfare for the poor
and Social Security payments for the elderly.
 Unlike gvt purchases, TR are not made in exchange for some
of the economy’s output of gds and srvics.
Therefore, they are not included in the variable G.
 TR do affect the demand for goods and services indirectly
 It is opposite of taxes
 Disposable income, Y-T, includes both the negative impact of

taxes and the positive impact of transfer payments.

 If government purchases equal taxes minus transfers, G = T-TR,
then the government has a balanced budget.
 If G+TR>T, the government runs a budget deficit, which it funds
by issuing government debt-that is, by borrowing in the financial
markets.
 If G +TR< T, the government runs a budget surplus, which it can
use to repay some of its outstanding debt.
 The budget surplus (BS) can be defined as the excess of
government revenue, consisting of taxes, over its total
expenditure including transfers and is given by the equation as
follows: BS=T-G-TR……………………………. (1.3)
 Here we do not try to explain the political process that leads to
a particular fiscal policy-that is, to the level of government
purchases and taxes.
 Instead, we take government purchases and taxes as
exogenous variables. To denote that these variables are fixed
outside of our model of national income, we write,

and

 The endogenous variable here is consumption.

 1.2.Keynesian Cross and the Economy in Equilibrium
In the simple Keynesian model, there are three ‘fundamental
assumptions’.
 The flow of output produced by an economy (GDP) in a given
time period is identically equal to income (Y) generated.
 Output is demanded by three types of agents: consumers,
firms, and the government (assume a closed economy).
 The price level is constant, i.e., there is no inflation.
Therefore, the nominal values of Y, C, I, and G are also their
real values.
 Planned expenditure or aggregate demand is the amount of
hhds, firms, and the government plan to spend on goods and
services.
 Actual expenditure is the amount hhds, firms, and the
government spend on goods and services, and it equals the
economy’s GDP.
 Actual expenditure can be either above or below planned
expenditure.
 Assuming that the economy is closed, AD, is the simple sum
of the demands of the three types of buyers (hhds, firms
and government).
AD = C + I + G ---------------------------------------------------- (1.4)
 consumption is determined by disposable income (Yd) which is

total income (Y) minus taxes (T) i.e. Yd=Y-T. Then,

we can write:
C = a + b(Y-T), and 0<b<1 C=a+bYd

Where, ‘a’ autonomous consumption

‘b’ is MPC
• Individual firms’ demands for capital gds can be aggregated
and represented by a planned investment function.
• To keep things simple, for now we assume that planned
investment is determined exogenously; that is, the level of
investment at any point in time is fixed and unaffected by
changes in other variables.
Then, we can write,
• As we have seen above, we assume that fiscal policy-the levels
of government purchases and taxes-is fixed. and
• By substituting the values of consumption functional (C),
autonomous investment (I) and autonomous government
expenditure (G) into equation (1.4), we obtain:
---------------------------------------- (1.5)
 Since both the AD and the consumption are the function of
the same variable, income, they vary in the same manner.
 Under these particular assumptions both AD and
consumption function have the same slope given by MPC:
 it shows how much planned expenditure increases when
income rises by one dollar.
 Graphically, we put the components or the determinants of
the AD on the vertical axis and the income/output level on
the horizontal axis.
 The values of the components of planned expenditure are
the functions of income.
• The higher the income the higher these components and
the higher the values of these component variables the
higher the planned expenditure will be. So, the planned
expenditure curve is upward sloping.
• On the other hand, an increase in any of these components
will shift the aggregate demand curve upward.
 The values of the investment and government spending are
constant values, they affect only the intercept of the
consumption curve and the slope remains the same. So, the
impact of adding autonomous values of investment and
government spending shifts the consumption curve upward
parallel to the consumption curve and the new curve will be
an aggregate demand curve .
Figure 1.1: Aggregate Demand and Consumption Function

AD

MPC C = a + b(Y- 7ࡄ

MPC

a+I+G
a Y
 The two curves slope upward because higher income leads to
higher consumption and thus higher planned expenditure. The
slopes of both lines are the MPC.
This can be proved by taking the first order derivative of both
functions since the first order derivative is the slope of a
function.
 So the slope of AD curve and the slope of the consumption
function is the MPC which is denoted by change in consumption
due to change in income
 We are emphasizing this point since we are going to compute or
estimate the impact of any change in govnt expenditure in terms
of the value of mpc. These types of impacts can easily be
estimated from the graphical presentation of a concept known as
Keynesian cross both of which are again related to the
equilibrium condition.
Equilibrium will be found when the desired amount of output
demanded by all the agents in the economy exactly equals the
amount produced in a given time period. This means the economy
is in equilibrium when actual aggregate demand equals planned
aggregate demand.
Actual aggregate demand = Planned aggregate demandY = AD
The equilibrium will be defined at the point where the planned
aggregate demand curve given by
intersects the curve given by Y = AD.
 The graphical representation of the equilibrium is known as the
"Keynesian cross" because of the crossing of the upward sloping
AD curve and the 450 line. It is important to know that the
intersection of these two lines yields the equilibrium level of
national income.
 In the figure the 45o line serves as a reference line that translates
any horizontal distance into an equal vertical distance. The 450
line allows us to compare a given level of actual GDP and AD on
the vertical axis. Thus, anywhere on the 450 line, the level of AD
is equal to the level of output. If they are not equal, firms will
adjust output.
Figure 1.2: Keynesian Cross and the equilibrium

AD Y = AD

Y1
AD1
AD* A

AD2
Y2

450
Y2 Y* Y1 Income, output Y
 Firms produce the exact same level of output next period
and every period after that as long as AD=actual GDP i.e.
AD=Y. For this reason, this level of output is called the
equilibrium level of output (or national income) i.e., the level
of output (or national income) at which there is no tendency
to change. For instance, at point A, both output and
aggregate demand are equal, Y* = AD*. These values are
equilibrium output and equilibrium aggregate demand,
respectively. when there is any deviation from the
equilibrium, the equilibrium output would be achieved
through inventory adjustments.
 The change in inventories is the signal upon which firms base
their decision of whether to increase or decrease production
 The Keynesian cross shows how income Y is determined for
any given levels of planned investment (I) and fiscal policy
variables, G and T. We can use this model to show how income
changes when one of these exogenous variables changes.
Example; Suppose the consumption function and the investment
is given as follows with no government intervention:
C=100+0.75Y; I=150, Where, the investment (I) is autonomous.
a) Find the aggregate demand function
b) Find the equilibrium level of income
c) Find the equilibrium level of aggregate demand
d) Find the equilibrium level of consumption
e) Draw the graph showing the consumption function
and the aggregate demand function with correct
labeling
 1.3.Fiscal policy and Multipliers
There are two major government fiscal policy instruments in the
commodity market.
 government purchase and
 government tax revenue
• Any change in these variables has a multiplied effect on real
factors such as output
• The factors which show the r/p b/n the changes in the
instrument and the effect are known as multipliers
• Thus, the corresponding multipliers are known as government
purchase multiplier and tax multiplier
 1. 3.1.Government Purchase multiplier
 If government purchases rise by ∆G, then the planned aggregate demand schedule
shifts upward by ∆G, as shown in the figure 1.3 below.
 The line ‘Y = AD’ is a 450 line, the triangle ‘ABC’ is an isosceles triangle with side AC and
side BC being equal.
 The change in output (∆Y) is equal to the distance BC, since BC is equal to AC. But the
change in government expenditure (∆G) is equal to distance BD. Thus, the change in
output (∆Y) exceeds the change in government expenditure (∆G) by the distance DC.
Thus, the change in government expenditure (∆G) has a multiplier effect on output.
The ratio is called the government purchase multiplier; and it tells us the factor by
which income rises in response to a unit increase in government purchases.
 An implication of the Keynesian cross is that the government purchases multiplier given
by ( ) is larger than one.
Figure 1.3: Change in Government expenditure & Aggregate Demand

AD Y=AD
AD2
B
∆G
∆Y D
AD1
A
C

0 ∆Y
45 Y
AD1 = Y1 AD2 = Y2
Why does fiscal policy have a multiplier effect on income?
 According to the consumption function, higher income causes higher
consumption.
 increase in government purchases raises income, it also raises
consumption, which further raises income of producers of the
consumption goods, and so on.
i. e. G  Y  C  Y  C Y……………
The process of the multiplier begins when expenditure rises by which
implies that income rises by as well. This increase in income in turn raises
consumption by MPC times .
This increase in consumption raises AD and income once again.
This second increase in income of MPC( ) again raises consumption by MPC
(MPC ), which again raises AD and income, and so on.
We can, thus, write this process compactly as follows:

- - - - - - - - - - - - - - - - - - - - (1.6)

 Note that the expression on the right hand side of the multiplier is an
example of infinite and decreasing geometric series with the common ratio
‘r’ given as follows.

Gn MPC MPC 2 MPC 3

r=     .............................  MPC
Gn 1 1 MPC MPC 2

Note also that the sum of such geometric series is obtained using the following
formula.
Sn = where G1 is the first observation of the series. Since G1 =1 and r = MPC,
the sum of this series can be solved as follows: ------------- (1.7)
Mathematical proof: infinite geometric series
Let Sn = 1+ MPC + MPC2 +… (1)
Multiply both sides of this equation by MPC:
 MPC (Sn ) = MPC + MPC2 + MPC3 +… (2)
Subtract the second equation from the first: Sn - MPC (Sn ) = 1
 Sn(1 -MPC) = 1
Dividing both sides by (1 -MPC) we obtain:  Sn =
 We can also derive the multiplier from our national income
Y  a  b(Y  T )  I  G
identity or from the AD model,
 Assuming that T and I are constant and by taking total
differentiation of the above identity, we would get:
dY = b(dY) + dG
dY -b(dY) = dG (1 – b) dY = dG
Dividing1 both sides by (1 – b)dG
dY/dG = where b = MPC.
1 b
Y 1 1
  Y  G Where, b = dC/ dY = MPC
G 1 b 1 b
The value of MPC lies between zero and one i.e. 0<MPC<1. Hence, the value of
expression (1-MPC) is positive and the value of or
is always positive and greater than one.
Thus, a change in government expenditure ( ) brings about a larger change in
output ( ) given by 1 1
G > G , since > 1.
1  MPC 1  MPC

1. 3.2.Tax multiplier

 Decrease in tax by T immediately raises disposable income (Y-T) by T and,

therefore, consumption by MPCxT. For any level of income Y, aggregate
demand is now higher. As shown in the figure below, the aggregate demand
schedule shifts upward by MPCxT. The equilibrium of the economy moves
from point A to point B.
 As in government purchases has a multiplied effect on income; taxes do
also have multiplier impact. Starting with the national income identity, we
can also prove this multiplier effect as follows.
Y= a+b(Y-T) + I + G
Assuming I and G to be constant, and differentiating the above
expression we obtain
dY = b(dY – dT)+dI+dG,
Since I and G are assumed to be constant, dI=0 and dG=0, thus,
the above relation is simplified as:
 dY = bdY – bdT,  dY-bdY= – bdT, dY(1-b) = -bdT
Dividing both sides by (1-b)dT, we obtain the following tax
multiplier.
Since b=MPC and its value is between zero and one, i.e. 0<b<1, the sign of the tax
multiplier ( ) is negative.
That means ( ) but, in absolute terms the value of the tax multiplier is
greater than one since the value of (MPC) is normally greater than 0.5 (b>0.5).
 This is because the majority of individuals or households, the larger proportion
of an increase in their income goes to consumption. Thus, in general, the
multiplier implies that taxes and income are inversely related and a unit
decrease in tax leads to a more than proportionate increase in income or
output.
 A decrease in tax by T leads to upward shift in AD by MPCxT amount.
Consequently, income increases from Y1 to Y2 which is measured by the
distance AC in the figure below.
Figure 1.4: Impact of taxes on Aggregate Demand

AD Y=AD
AD2
B MPC*∆T
∆Y
D AD1
A
C

0 ∆Y
45 Y
AD1 = Y1 AD2 = Y2

The distance AC which is the measure of the change in income is also

measured by:
 1.3.3. The Balanced Budget Multiplier
• To find out the total impact of a simultaneous change in government spending
and tax
• An increase in government expenditure is exactly equal to the change in tax.
This may be the case when the government collects more tax to increase its
spending as part of its macroeconomic policy
• We know that government spending increases the AD and taxes reduces it.
and the change in income due to a change in taxes

Thus, the total change can be written as follows: +

 Since ( we can substitute

 From this identity, we can conclude that when government expenditure and
taxes increase by the same amount, income changes by an amount equal to
the change in government purchase or the tax revenue. Since the change in
income is exactly equal to the government purchase, the multiplier is equal to
one. This multiplier is called the balanced budget multiplier.
Example: Given consumption function (C), investment (I) and government
expenditure (G) as follows (the values are in millions birr): C=50+0.8Yd, I=100,
G=130 and if Yd =Y-T
a. Calculate the equilibrium level of output and consumption if the tax is equal to T=80
b. Calculate government purchase multiplier and interpret the result
c. Calculate government tax multiplier and interpret the result
d. Calculate the change in output and the new equilibrium output if
government expenditure increases by 50 units
e. Calculate the change in output and the new equilibrium output if
government increases tax by 10 units
f. Graphically demonstrate the changes owing to the two policy changes
g. Calculate the change in output and the new equilibrium output if both
government purchase and government tax increases by 20 units
simultaneously.
 CHAPTER 2
CONSUMPTION SPENDING
2.1. Definition and Concepts of Consumption
 The economy can be taken as the combination of several sectors. These
sectors can be hhd sector, business sector, gvrnt sector and foreign sector.

 All of these sectors demand gds and srvcs from the economy.

 The AD for all of them includes consumption of hhd sector (C), investment
spending of business sector (I), gvt spending (G) and net of exports (NX)
which is the difference between export and import (X – M).

Aggregate demand (AD)  C  I  G  NX ………………………………2.1

2.2. Theories of Consumption

 Consumption theories explain about consumption and income relationship..

 Some of theories or hypotheses are:
 Keynesian absolute income hypothesis,
 Relative Income hypothesis,
 Fisher’s Intertemporal Model of Consumption,
 Modigliani’s Life-Cycle Hypothesis and
 Friedman’s Permanent Income hypothesis

2.2.1. Keynesian Consumption Function

 The Keynesian Consumption function states that when income increases,
consumption also increases linearly. This hypothesis is also known as
absolute income hypothesis. It can also be stated that the current real
consumer spending is a function of current real disposable income.

C  a  cYd ; a  0, 0  c  1………………………………………2.2
For example, a linear consumption function with MPC of 0.75 indicates that 75
percent of the income of the household will be devoted to consumption and
autonomous consumption of 500 birr indicates that even if income is zero, the
households will consume 500 birr.
This condition can be specified as: C = 500 + 0.75Yd.
I) Properties of Keynesian Consumption Function

a) The marginal propensity to consume (MPC) is between 0 and 1, i.e. 0 < c 1

b) The APC falls as Income (Yd) rises
The ratio of consumer expenditure to income (C/Y) = APC (average propensity
to consume) varies inversely with the level of income. This is because all extra
income is not going to be consumed. At very low income a household may
consume all of its income. This implies that the ratio of consumption to income
is high.
c) MPC is less than Average propensity to Consume, (MPC<APC)
d) At low levels of income dis-saving occurs (saving is negative)
and S = I, So we can write the AD or income as

When income is zero i.e. Y = 0 then S = -a, which means that

people’s saving is negative. This indicates that in order to consume
people should use their past savings. Marginal propensity to save is
equal to (1 – c) or (1 – MPC).
Example: Given consumption function of a two sector economy
as find
a) Saving function c) MPS
b) MPC d) Compare the values of MPC and MPS
II) Keynesian Consumption Puzzle
 After World War II, several economists cast doubt on the usefulness and
validity of Keynes consumption function. The reason for this is that the
Keynesian consumption function was unable to predict the post war values.
 The estimations made by Keynes were much less than the actual amounts.
 During this time Simon Kuznet published data and this can be put in
equation form as
 In other words, ‘a’ was approximately zero. And the value of ‘c’ is more than
the previous Keynesian estimates.
 During the war national or govt expenditures increase implying increased
income through multiplier effect.
 This in turn leads to reduced APC implying depressed Consumption
 During the war, things become expensive resulting in reduced AD.
 In principle, AD stays in stagnation unless government uses corrective fiscal
policy.
 The failure of secular stagnation and Kuznet’s finding proved that APC is stable
over time (from decade to decade) as opposed to Keynes’ conclusion.
 On the empirical evidence, there appear to be two consumption functions:
-short run (cyclical) and
-long run (secular) consumption functions.
 In both cases MPC is constant.
 In the case of the short-run consumption function, the APC decreases as income
increases representing Keynesian position whereas in the case of the long-run
consumption function, the APC is constant representing Kuznet’s position.
 Keynesian consumption puzzle is the failure of Keynesians to identify that the
consumption function has different b/rs in d/t time frames (in the short run and
in the long run) or it refers to the lack of clear idea or agreement whether the
value of APC is constant or declining.
There is a final reconciling conclusion of the opposing results of Kuznet and
Keynes.
1. In the short run, the APC falls as income rises. This is because; in the
short run consumption does not immediately rise with income.
2. In the long run, the APC is stable or remains constant because people
tend to spend their money on durables as income increases. Thus,
Keynes’ theory is valid in the short run, but not in the long run.
 CHAPTER 3
INVESTMENT EXPENDITURE AND SAVING
 Investment is a crucial component of any economy as the growth of the
economy depends on the level of investment
 It can be defined as the process of putting ones resource (money) in a given
system with expectation of some benefits (more income, some products for
sale or for consumption and satisfaction).
 Some examples of investment process are:
-establishing a production plant or factory;
-opening a new business;
-expanding an existing business or factory;
-depositing money in saving accounts
-constructing public infrastructures such as road, schools and
- hospitals and building business centers or residential houses and so on.
Some of the major factors that affect investment decision are:
i) Market demand (required for investment in production); the larger the
market demand the larger the investment would be.
ii) Financial resource; the availability of enough financial resource also has
positive implication for the level of investment.
iii) Political factors (political stability); peace and stable political situation
encourages investment.
iv) Level of uncertainty (level of risk); the higher the level of uncertainty the
lower the incentive for investment will be. Unstable political situation and
investing in agricultural production are some of sources of uncertainty and
areas with higher level of risk.
v) Availability and efficiency of banking system (credit or lending
institutions); existence of efficient banking system or lending institutions
facilitates investment process and so affect its size positively.
vi) Government economic or investment policy; conducive investment and related
economic policies encourage investment and increases its level.
vii) Interest rate (cost of borrowing); higher interest rate means high cost of
borrowing and so affects investment negatively.
 This also implies that lower interest rates encourage investment for two
reasons: low cost of borrowing and unattractive interest income to save money
instead of saving.
viii) The size of liquid assets at dispose of the investor, level of development in
research and development, population growth which represents the potential
demand for public infrastructure and future consumers demand are also some of
the factors that determine investment level.
 Such larger population growth implies that there will be larger consumer
demands. These all have positive impact on investment.
Why do people and government make investment?
 The purpose of investment is either a profit motive or non-profit motives.
Most of the private investors have profit motive where as government and
non-governmental organizations may involve in investment projects because
of non-profit motives such as welfare and national growth issues.
 Investment decision depends on the wellbeing of the money market and
related macroeconomic variables such as the size of money supply and
interest rates.
i) Profit Motives
 profits received today are worth more than the profits received in the near future or
sometimes in future.
 The decision to investment is very complicated and to know if the investment is
profitable or not and to rank investment projects in the order of overall profitability,
individual investors and governments use different investment decision criteria such
as present value criterion and marginal efficiency criterion.
 a. Present Value (PV) Criterion
we can have a general formula which can be written as:

Pn  P0 (1  i ) n
Where Pn is the amount one gets at the end of ‘n’ years at market rate of interest

(i) if one invests P0 amount today or this year.

 The present value given by ‘Po’ is obtained by solving for ‘Po’ from equation
above. The general formula for the present value of future income is given as
Pn
follows: P0 
(1  i ) n

 The above equation shows that the present value and market rate of interest
are inversely related. This means that higher interest rates leads to lower

investment and so lower national output or GDP.

This is because of two major facts:
1) Higher interest rate makes people interested more in saving than to invest
as they receive larger interest income.
2) As interest rate gets larger and larger, the cost of borrowing will be higher
and makes investment through borrowing expensive.

 In investment projects, the streams of future incomes in

different times can be taken as sum of these discounted values
at the end of every year we pass through for the life of the
investment project.
 After discounting every year we can obtain the general formula
of present value (PV) which is:
P1 P2 P3 Pn
PV     ...... 
(1  i ) 1
(1  i ) 2
(1  i ) 3
(1  i ) n
Investment Criteria: The Decision to Invest
If the cost of project is less than the present value of the future income then
it is profitable for the investor to invest.
 The decision to invest depends on three related elements:
1)The expected income flow from the capital good in question;
2)The purchase price of that good (cost of the investment project); and
3)The market rate of the return from the project or sale of the products
which in turn depends on the market demand for the product.
Example: Given the present value of stream of returns and the required
amount of money for the investment by different parties (A, B and C) as
follows, decide whether each party has to make the investment or not if we
consider the profit motive of investment.
 Investing Present value of the estimated The amount of money required
parties returns from the investment (in Birr) for the investment (in Birr)
A 8,000 10,000
B 80,000 70,000
C 6,000 6,000

Solution:
For party ‘A’, since the PV of the return from the investment is less than the amount of
money required, which is the cost of the investment (8,000 < 10,000), it is proper not to
invest.
For party ‘B’, since the PV of the benefit or the return is larger than the cost (80,000 >
70,000) it is preferable to invest the resource or the money.
For party ‘C’, since both the PV of the return and the cost are equal (6,000 = 6,000), it is the
same for the party to invest or not. From the point of view of producers it may be advisable
to invest with the argument that the party will accumulate experience; however, from the
point of view of national economy it is better not to invest and rather to save the money to
provide the fund for some other alternative investments.
 b. Marginal Efficiency Criterion

 Marginal efficiency of capital (r) is the rate of interest, which equates the cost
of the project and the discounted value of the future income stream
associated with the project.
 Then, the discount rate (r) will be compared with the market or banks Interest
rate (i), which is the cost of or the return on saving.
 If the discount rate (r) is greater than the market or banks interest rate (i), it
means that the money put into the investment is increasing itself by larger rate
through returns from the investment products than it brings if we save in
banks or than the rate we should pay if we borrow the money for the
investment.
ii) Non–Profit Motives
• The most important non – profit motive is the welfare reason or humanitarian issues.
Individuals and NGOs spend their resources on investment to benefit a community
from the return from the investments.
• There is national or political obligation on the government of a country to spend on
some investment activities in providing the society with some basic infrastructure
such as road, schools and health infrastructures. The later usually accounts for a
considerable proportion of government expenditure (G) in national income identity or
GDP.
3.2. Investment Demand and Saving Curve
3.2.1.Investment Demand

 Investments demand (I) has negative r/p with market or banks

interest rate (r).
Figure 3.2: Investment demand curve
Being the important determinant of investment, interest rate by itself is affected by
several factors. Some of these factors are:
a) Level of saving known as supply of loanable fund. High saving increases the supply for
loan and make loan cheaper by reducing interest rate.
b) Level of income of the people which determine the ability to save.
c) The demand for investment itself has effect on interest rate. Higher investment
demand pushes the interest rate up and make loan expensive.
d) The level of money supply is another factor which affects interest rate and so
investment level. Higher money supply makes loan cheaper and pushes the interest
rate down.
e) Government may borrow from banks for the use of public sector investment
spending. Higher government expenditure also pushes the interest rate upward and
reduces investment in the private sector known as crowding out effect.
 Crowding effect represents the case where the government action such as fiscal policy or government
investment activity itself reduces the investment in the private sector. For instance an increase in
government expenditure on investment or some other activities reduces the government saving. This
increases interest rate and as a result investment declines as borrowing become expensive.
Figure 3.3: Crowding Out Effect increase in government spending

 When the government investment increases, the government either cut its saving
(shifting saving curve from S1 to S1) as money moves to the investment or the
government increases borrowing. Both borrowing and reduction in saving pushes
the interest upward (from r1 to r2) making the borrowing expensive for private

investors. So, private investors cut their investment spending from I 1 to I2. This is
also contributed to by increased private saving attracted by higher interest income.
 3.2.2. Investment demand and Saving Relationships

 Investment spending is on the demand side where as saving is on the supply side of
investment and finance sectors.
 Investment is determined by the level of supply of the investment resources which is
saving.
 Level of saving determines the level of interest rate, which is the cost of borrowing or
the opportunity cost of investment.
 The higher the saving, the lower the interest rate will be and the more the investment
expenditure will be since the cost of borrowing or opportunity cost of investing their
money (foregone interest income) will be lower.
 Saving is known as supply of loanable fund whereas the interest rate is known as the
price of the loan. Thus, the larger the supply of the fund, the lower its price will be
and so the higher the demand (investment) will be.
 Higher interest rate discourages investment since cost of borrowing or opportunity
cost of investment is high.
Figure 3.4: Investment demand and saving curves

 The Figure depicts that the equilibrium level of investment and saving is equal
to I*; (I = S) defined at the point of intersection between the saving and the
investment curves.
 The larger the saving the smaller the consumption will be.
 Lower consumption level again implies lower demand for the products of different
investment activities and other national products. This discourages further investment
and reduces aggregate demand and national output or national income. This can
easily be seen in the following national income identity:
Y GDP = C + I + G + X – M
 Excessive saving reduces the value of ‘C’ and this discourages investment leading to
smaller value of ‘I’. Both of these impacts of excessive saving by households finally
lead to lower level national income.
Y = GDP = C + I + G + X – M.
 This is what is known as the paradox of thrift or the paradox of saving where it
affects the national income negatively even if it is expected to improve national
income by encouraging investment.