Aggregate Demand and its components

5 C HAPTER (cid:1) (cid:6)(cid:7) (cid:6) (cid:6) (cid:2)(cid:2)(cid:3)(cid:4)(cid:2)(cid:1)(cid:5)(cid:4) (cid:4)(cid:8)(cid:1)(cid:9)(cid:7) (cid:1)(cid:9)(cid:7) (cid:10)(cid:5)(cid:11) (cid:12) (cid:13)(cid:8)(cid:14)(cid:13)(cid:9)(cid:4)(cid:9)(cid:5)(cid:11) We have defined aggregate demand as and of services that households are able the total demand for goods and services and willing to buy at a particular time. in the economy. In this chapter we will This demand is influenced by many look at the components of aggregate variables such as price of the goods or demand, and what determines the services, income, wealth, expected magnitudes of these components. Our income, tastes and preferences of discussion in this connection will be individuals and so on. Keynes based upon a simple model of formulated his fundamental Keynesian macroeconomics. Psychological Law of Consumption to The components of aggregate lay down a behavioural rule to the demand include goods and services process of consumption activity. demanded for private consumption (C), Keynes proposed that consumption for investment (I), for government demand increases with the level of expenditure (G) and for net exports income. His ‘fundamental psychological (X-M). Aggregate demand (AD) is law’, holds, that “men are disposed, as therefore given by a rule and on the average, to increase AD = C + I + G + (X-M) their consumption as their income We may now focus on the increases, but not by as much as the determinants of the individual increase in their income”.1 This components of aggregate demand. relationship between consumption and Consumption demand and income is called the consumption consumption function function. Consumption demand in microeconomics The consumption function may be is defined as the value of commodities represented by the following equation. 1 This relationship between consumption and income holds good for the individual, the household, as well as for the economy as a whole. In the context of this chapter, consumption and income shall be understood as referring to aggregate consumption and income. AGGREGATE DEMAND AND ITS COMPONENTS 53 C = C + bY C > 0, 0 < b < I. increase in income causes less than a Where, rupee increase (of b) in consumption.4 For example, if b is 0.90, a rupee C = Consumption increase in income causes a 0.90 rupee C = Autonomous Consumption increase in consumption. b = Marginal Propensity to Consume The consumption function may be plotted in a graph, with the help of a Y = Level of income numerical example. Figure 5.1 shows The intercept C represents the graph of the hypothetical autonomous consumption, that is, the consumption function. amount of consumption expenditure Consider a consumption function when income is zero.2 C is assumed to given by be positive, that is, there is C = 100 + 0.8 Y consumption even in the absence of any income. Hence, it is not possible to Since this is an equation of a straight think of a situation where there is no line, the consumption function will have consumption at all. a constant slope. The slope of the consumption Table 5.1 shows the level of function is ‘b’. It measures the rate of consumption for various levels of change in consumption per unit change income. in income and is also known as the Column (1) shows the consumption Marginal Propensity to Consume expenditure at various levels of income. (MPC).3 For example, if b is 0.6, then a The values in column (1) are obtained rupee change in income causes a 0.60 from the consumption function. rupee change in consumption. If b is Column (5) in table 5.1 shows how MPC 0.45, then a rupee change in income is calculated. As income increases from will cause a 0.45 rupee change in Rs.600 to Rs.700 (an increase of 100 consumption. rupees), the consumption increases By assumption, the MPC is positive, from Rs.580 to Rs.660 (an increase of and its value ranges between 0 and 1. 80 rupees). The MPC is therefore 80/ This means that consumption 100 = 0.8. The MPC at all levels of increases with income, but a rupee income is the same because of the 2 The following two points must be kept in mind about the consumption function: (a) consumption is actually a function of disposable income (that is, personal income minus personal taxes) per se. However, since we have ignored the role of government, the disposable income is equal to in- come; (b) consumption is possible when the income is zero, a phenomenon also called as dissaving. 3 ‘Marginal’ in economics means incremental or additional. ‘Propensity’ to consume is the desire or urge to consume. Marginal propensity to consume is thus the additional or extra consumption that results from additional income. 4 The range of ‘b’ may be deduced from the fundamental psychological law. “Men are disposed, as a rule and on the average, to increase their consumption as their income increases…”, this means that b>0. “but not by as much as the increase in their income”; this means that b<1. Taken together, 0<b<1. 54 INTRODUCTORY MACROECONOMICS Table 5.1: Consumption, Income and Marginal Propensity to Consume Consumption Change in Income Change in Income Marginal Propensity C Consumption Y ∆Y to Consume (MPC) ∆C = (2)/(4) = ∆C/∆Y (1) (2) (3) (4) (5) 100 - 0 - - 180 80 100 100 (80/100) = 0.8 260 80 200 100 (80/100) = 0.8 340 80 300 100 (80/100) = 0.8 420 80 400 100 (80/100) = 0.8 500 80 500 100 (80/100) = 0.8 580 80 600 100 (80/100) = 0.8 660 80 700 100 (80/100) = 0.8 740 80 800 100 (80/100) = 0.8 820 80 900 100 (80/100) = 0.8 900 80 1000 100 (80/100) = 0.8 particular consumption function we Thus, at any point on the 45o line, have used in our example. (Constant consumption expenditure exactly slope and therefore constant MPC is a equals income. The 45o line therefore feature of all straight line consumption immediately tells us whether functions). The information given in the consumption spending (as per the Table 5.1 can be plotted in a graph, as consumption function) is equal to, shown in Fig. 5.1. greater than, or less than the level of Fig. 5.1 shows the graph of the income. consumption function C = 100 + 0.8 Y. The consumption function crosses To understand the figure, it is the 45o line at point B. This point is helpful to look at the 45o line drawn known as the breakeven point. Here, from the origin. Since the vertical and households are just breaking even, horizontal axes have the same scale, the because the consumption is exactly 45o line has the property that at any equal to the income. In our example, point on it, the distance up from the the income and consumption at the horizontal axis (which is consumption breakeven point is Rs.500. expenditure) exactly equals the At any point other than B on the distance across from the vertical axis consumption function, consumption is (which is income). not equal to income. At points to the AGGREGATE DEMAND AND ITS COMPONENTS 55 C Consumption Function 1000 S=80 900 800 700 (cid:2) =80 600 500 B (cid:4) y=100 400 C=820 300 S=-60 (cid:4) C 80 MPC(cid:3) (cid:3) (cid:3) 0.8 200 (cid:4) Y 100 100 C=260 45o O Y 100 200 300 400 500 600 700 800 900 1000 Fig 5.1 : The Consumption Function C = 100 + 0.8 Y left of B, the consumption function lies At any point to the right of B, the above the 45o line, therefore consumption function lies below the 45o consumption expenditure is greater line; therefore consumption expenditure than income; for example, at an income is less than the level of income. The part level of Rs 200, the consumption is of income, which is not consumed, is Rs.260. The household must find saved. This must be so, because income funds to meet this consumption is either consumed or saved, there is no expenditure. The shortage in income other use to which it can be put. Savings will make them to sell the assets can be measured in the graph as the acquired in the past, or to resort to vertical distance between the borrowing so that Rs.60 could be consumption function and the 45o line. raised for consumption. This act on the For example, at an income level of Rs.900, part of the household to liquidate their consumption is Rs.820. Therefore, the own assets or to go in for a loan is amount of savings is the difference referred to as the process of dissaving. between the two, that is, Rs.80. Dissaving is in order to help the To sum up: when the consumption households to finance the consumption function lies above the 45o line, over and above the level of income.5 consumption is greater than income at 5 Dissaving literally means the opposite of saving. That is an individual would reduce his prior accumulated savings to compensate for the reduction in his income and thus maintain his consumption level. 56 INTRODUCTORY MACROECONOMICS each level of income. This means that savings made when there is zero level there is dissaving. When the two lines of income. It is already shown that C is intersect, the level of consumption is always positive. Therefore is negative. C exactly equal to the level of income. Thus, there is negative savings C at zero When the consumption function lies level of income. Since negative savings below the 45o line, the level of is nothing but dissaving, this means consumption is less than the level of that at zero level of income, there is a income. This means that there is dissaving of amount C . Note that the positive saving. The amount of amount of autonomous consumption dissaving or saving is always measured is exactly equal to the amount of by the vertical distance between the dissaving at zero level of income. This consumption function and the 45o line. is because of the fact that Y ≡ C + S Consumption and Savings (whether S is positive or negative). The slope of the savings function is We shall now look into the relationship between consumption and saving. We (1 – b). The slope of the savings function may obtain the savings function from gives the increase in savings per unit this relationship. increase in income. This is known as The equation below says that the Marginal Propensity to Save (MPS). income that is not spent on Since b is less than one it follows that consumption is saved, that is (1 – b) and therefore MPS is positive. Therefore, savings is an increasing S ≡ Y – C function of income. Suppose the MPC, This equation tells us that by that is, b is 0.8, then the MPS, that is, definition, saving is equal to income (1 – b) is 0.2. This means that for every minus consumption. one rupee increase in income, savings The consumption function, along increase by 0.2 rupee. with the above equation, implies a Note that MPS = 1 – b = 1 – MPC. savings function. The savings function This means that the part of the increase relates the level of saving to the level of in income, which is not consumed, is income. Substituting the consumption saved. This is because income is either function into the above equation we can consumed or saved. Therefore, it is get the savings function. always the case that MPC + MPS = 1. S ≡ Y – C Using the numerical example of the =Y – (C + bY)(Since C = C + bY) consumption function we had earlier, we can derive the corresponding =Y – C – bY savings function. S =– C + (1 – b)Y S =–C + (1 – b) Y This is the savings function. The =–100 + (1 – 0.8)Y intercept term C is the amount of S =–100 + 0.2Y AGGREGATE DEMAND AND ITS COMPONENTS 57 Table 5.2: Consumption – Saving Relationship Change C Change MPC Saving Change in MPS C+S MPC+MPS Y in Y in C ∆C/∆Y S S ∆S/∆Y ∆Y ∆C ∆S (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) 0 - 100 - 0.8 -100 - - 0 1 100 100 180 80 0.8 -80 20 0.2 100 1 200 100 260 80 0.8 -60 20 0.2 200 1 300 100 340 80 0.8 -40 20 0.2 300 1 400 100 420 80 0.8 -20 20 0.2 400 1 500 100 500 80 0.8 0 20 0.2 500 1 600 100 580 80 0.8 20 20 0.2 600 1 700 100 660 80 0.8 40 20 0.2 700 1 800 100 740 80 0.8 60 20 0.2 800 1 900 100 820 80 0.8 80 20 0.2 900 1 1000 100 900 80 0.8 100 20 0.2 1000 1 Table 5.2 shows the levels of MPS is a feature of all straight line consumption and savings for various savings functions). levels of income. Note that (a) Column (9) of the table shows the consumption plus saving everywhere sum of consumption expenditure and equals income, and (b) MPC + MPS = 1. saving at every level of income. Note that Columns (1) to (5) are repeated from column (9) is identical to column (1). This Table 5.1. Column (6) shows the level of is because income is either consumed savings at different levels of income. The or saved, there is no other use to which values in this column are obtained from it can be put. Thus, the sum of the savings function. Column (8) in table consumption expenditure and saving 5.2 shows how MPS is calculated. As must be identical to income. income increases from Rs.600 to Rs.700 Column (10) of the table shows the (an increase of Rs.100), the savings rises sum of the MPC and MPS. Note that the from Rs.20 to Rs.40 (an increase of Rs.20). sum of MPC and MPS is equal to one. The MPS is therefore (20/100) = 0.2. This means that the part of the increase The MPS is the same at all levels of in income, which is not consumed, is income because of the particular saved. This is because income is either savings function (a linear curve with consumed or saved. constant slope) we used in our example The information given in table 5.2 can (constant slope and therefore constant be plotted in a graph, as shown in Fig. 5.2. 58 INTRODUCTORY MACROECONOMICS C Part-A Consumption 1000 function S=80 900 800 700 600 B 500 400 C=820 300 S=-60 200 100 C=260 45o O Y 100 200 300 400 500 600 700 800 900 1000 S Part-B Savings 100 function S=80 100 300 400 B S=-60 500 600 700 800 900 1000 Y -100 Fig 5.2: The Consumption Function and its associated Savings Function Part A of Fig. 5.2 shows the When income is 500, we see in part consumption function. Part B shows the A that consumption is 500 and saving savings function. This is the counterpart equals 0. This is depicted in part B by of the consumption shown in part A. In the intersection of the savings function part A, the amount of saving at any level with the horizontal axis at point B, which of income is the vertical distance, corresponds to an income level of 500. between the consumption function and When income is 200, consumption is the 45o line. The saving function shown 260 and saving is -60 (dissaving is 60); in part B can therefore be directly derived the savings function lies 60 below the from part A. horizontal axis at an income level of 200. AGGREGATE DEMAND AND ITS COMPONENTS 59 When income is 900, consumption is we have 820 and saving is 80; the saving Y ≡ C + S function lies 80 above the horizontal axis Dividing both sides of the equation at an income level of 900. by Y we have In general, to the left of point B in part A, the consumption function lies above Y/Y ≡ C/Y + S/Y the 45o line (consumption is more than Thus, 1 ≡ APC + APS income). Hence to the left of point B in Using the earlier examples of part B, savings is negative and the savings consumption function and savings function lies below the horizontal axis. function we can calculate the values of To the right of point B in part A, the APC and APS for every level of income. consumption function lies below the 45o This is done in Table 5.3. line (consumption is less than income). Column (3) shows how APC is Hence to the right of point B in part B, calculated. At a particular income level, savings is positive and the savings the APC is the corresponding level of function lies above the horizontal axis. consumption divided by that level of Average Propensities to Consume income. Similarly; APS is calculated in and Save column (5). At a particular income level, From the consumption function, we can the APS is the corresponding level of find out the value of the consumption- saving divided by that level of income. income ratio C/Y, at every level of income. Column (6) shows the sum of APC and At any particular level of income, the ratio APS. As expected, at every level of of consumption to income is called the income, the sum of APC and APS is Average Propensity to Consume (APC). equal to one. This is because income is The APC gives the average consumption either consumed and or saved. – income relationship at different levels Therefore, the proportion of income that of income. is not consumed must be saved. Similarly, from the savings function, As we can see from the above table, we can find out the average savings – APC is continuously declining as income ratio. At any particular level of income increases; and APS is income, the Average Propensity to Save continuously increasing as income (APS) is the ratio of savings to income. increases. This means that as income increases, the proportion of income We have saved increases and the proportion of APC = C/Y and APS = S/Y income consumed decreases. Now, the sum of the APC and APS is always equal to one. This is because Investment income is either consumed and or The second component of aggregate saved. The proof of this statement is as demand is investment which means follows: From the relationship between addition to the stock of capital goods, income, consumption and saving, in the nature of equipment, residential 60 INTRODUCTORY MACROECONOMICS Table 5.3 Average Propensities to Consume and Save Y C APC S APS APC+APS (2)/(1) (4)/(1) (1) (2) (3) (4) (5) (6) ∞ ∞ 0 100 -100 1 100 180 1.8 -80 -0.8 1 200 260 1.3 -60 -0.3 1 300 340 1.13 -40 -0.13 1 400 420 1.05 -20 -0.05 1 500 500 1 0 0 1 600 580 0.97 20 0.03 1 700 660 0.94 40 0.06 1 800 740 0.92 60 0.08 1 900 820 0.91 80 0.09 1 1000 900 0.90 100 0.10 1 Note: (a) ‘∞’ means infinity (b) Figures in table are rounded up to two decimal points structures or inventory. Investment profitable, i.e. it will earn them revenues plays two important roles in greater than the costs of the investment. macroeconomics. Firstly, due to the its So, the three elements important in volatile nature, changes in investment understanding investment are are the main cause of fluctuation in revenues, costs and expectations. aggregate demand. Secondly, since Revenues: An investment will bring a investment leads to capital firm additional revenue only if investing accumulation, it helps the economy to allows a firm to sell more. So investment produce higher levels of output. decision depends upon the demand for Among the three categories of the output produced by the new investment – purchases of residential investment. For example, if the demand structures, additions to inventory, and for glucose biscuits is very high, then a investment in fixed plant and biscuit manufacturing firm can expect machinery, the last is usually the an increase in its revenues by investing largest. In this section, we will consider more in new biscuit making machines. the determinants of investment demand, focusing on the last category Costs: A second important determinant of investment. of the level of investment demand is the In general, firms invest when costs of investing. One type of cost of they expect their investment will be investment is the cost of the equipment AGGREGATE DEMAND AND ITS COMPONENTS 61 and structures, and the costs incurred to happen in the future. Firms invest in their maintenance and operation. when they expect their investment will This is usually netted out from revenue be profitable, that is it will earn them to get net revenue. The other type of cost revenues greater than the costs of the is that associated with the funding of investment. An investment can then be the investment, at the market rate of compared to a bet, that present and interest. future revenues will be greater than Since the capital goods usually last present and future costs. In other words, many years, firms tend to pay for it is a bet that the investment will be investments by borrowing funds. The profitable. However, the future is cost of borrowing is the interest rate on unknown and unpredictable. The firms borrowed funds. The interest rate is the will thus have to make guesses and form price paid for borrowing money for a expectations about the future in order period of time. to invest. Since investment depends on Expectations: The third element in the expectations about unpredictable determination of investment is the future events it is very volatile. entrepreneurial expectations of the The Investment Demand Curve future profit. (This is known as Marginal Efficiency of Capital (MEC) or expected Of all the variables that affect investment rate of return from Capital). This is the demand, the most important one is the Keynerian framework. Expectation is an rate of interest. The relationship between individual’s guess about what is likely investment demand and the rate of Table 5.4: Interest Rates and Investment Project Total size Annual net Cost per Rs.100 Annual net of Project revenue per of project at annual Profit per Rs.100 (Rs. in Lakhs) Rs.100 interest rate of invested, at invested annual interest rate of (10%) (5%) (10%) (5%) (1) (2) (3) (4) (5) (6) (7) A 1 150 10 5 140 145 B 4 22 10 5 12 17 C 10 16 10 5 6 11 D 10 13 10 5 3 8 E 5 11 10 5 1 6 F 15 9 10 5 –1 4 G 10 6 10 5 –4 1 H 20 4 10 5 –6 –1 62 INTRODUCTORY MACROECONOMICS interest is given by the investment depends on the interest rate. The demand function. There is a negative difference between annual revenue and relationship between the rate of interest annual cost is the annual net profit. and investment demand; that is, the When annual net profit is positive, the higher the rate of interest, the lower will investment makes money. When the be the level of investment demand. The annual net profit is negative, the following example will make the investment loses money. Therefore, inverse relationship between the two firms will undertake only those variables clear. investment projects which have positive Consider a simple economy where annual net profits. firms have numerous investment Look at the last column of the Table 5.4. This gives the annual net profit projects: project A, B, C, D, and so on corresponding to a 5% interest rate. At up to H. For simplicity, assume that, this interest rate, projects A to G will be (a) the projects yield a constant annual profitable. So profit-maximizing firms stream of net revenues, (b) all will invest in all seven projects. From investments are financed purely by column (2) we see that this totals up to borrowing at the market interest rate Rs.55 lakhs of investment demand. and (c) the projects are so long lived that Now suppose that the market rate there is no need for replacements. Table of interest increases to 10%. The cost 5.4 shows the financial data for each of of financing the projects would then the investment projects. double. From column (6) we see that The eight investment projects shown investment projects F and G become in the table are ranked in order of unprofitable at an interest rate of 10%. return. Column (2) shows the total size The firms would therefore reject these of the projects. Column (3) calculates two projects. Then the investment the annual net return each year per demand will fall to Rs. 30 lakhs. Rs.100 invested. Columns (4) and (5) We see from this example that a rise show the cost of the investment per Rs. in the interest rate has reduced the 100 of the project. These are assumed investment demand. This is because, at to be two alternative market rates of higher interest rates, the costs of all interest 10% and 5% per year. At 10% projects increase while the revenues of annual interest rate, the cost of all projects remain the same. Thus, borrowing Rs. 100 is Rs.10 per year. fewer projects remain profitable in the At a 5% annual interest rate the cost of face of the higher interest rate. Since borrowing Rs. 100 is Rs. 5 per year. firms invest only in profitable projects, The last two columns show the the investment demand decreases as the annual net profit (revenue – cost) from interest rate increases. the investment. Now, the firms will Government Expenditure compare the annual revenues from an investment with the annual cost of Government expenditure or capital, where the cost of capital government’s demand for goods and AGGREGATE DEMAND AND ITS COMPONENTS 63 services is the third component of and services, it adds to the demand for aggregate demand. The level of domestic goods and services and is government expenditure is determined hence a part of aggregate demand. by government policy. As we will see in Correspondingly, our spending on the next chapter, varying government foreign goods and services has to be expenditure is an important tool for subtracted from the demand for demand management. domestic goods and services in order to get the correct figure for aggregate Net Exports demand. The fourth component of aggregate The determination of income and demand is net exports. Net exports is output in the Keynesian framework the difference between exports and depends mainly on the level of imports. It shows the effect of domestic aggregate demand. Having seen the spending on foreign goods and services various components of aggregate (imports) and foreign spending on demand and their determinants, we are domestic goods services (exports), on now in a position to look at the the level of aggregate demand. When determination of income and output in foreigners purchase domestic goods the Keynesian framework. SUMMARY (cid:1) The components of aggregate demand are consumption, investment, government expenditure and net exports. (cid:1) The relationship between consumption and income is called the consumption function. (cid:1) The slope of the consumption function, which measures the change in consumption per unit change in income, is known as the marginal propensity to consume. (cid:1) That part of income, which is not consumed, is saved. (cid:1) The relationship between savings and income is called the savings function. (cid:1) The slope of the savings function, which measures the change in savings per unit change in income, is known as the marginal propensity to save. (cid:1) Investment means addition to the stock of capital goods in the nature of structures, equipment or inventory. (cid:1) Three elements important in understanding investment are revenues, costs and expectations. (cid:1) The relationship between investment demand and the rate of interest is known as the investment demand function. (cid:1) There is an inverse relationship between investment demand and the rate of interest. (cid:1) The government’s expenditure on goods and services constitutes government expenditure. (cid:1) Net exports is the difference between exports and imports. 64 INTRODUCTORY MACROECONOMICS EXERCISES 1. List the components of aggregate demand. 2. What is the consumption function? 3. What is the savings function? 4. Define the marginal propensity to consume. 5. Define the marginal propensity to save. 6. Which are the elements important in understanding investment? 7. What is the investment demand function? A 5.1: I PPENDIX NVERSE RELATIONSHIP BETWEEN THE INTEREST RATE AND INVESTMENT DEMAND As we know, investment causes an r = marginal efficiency of capital addition to the capital stock, which The MEC is thus the rate of return increases the productive capacity of the that equates the present value of the economy. We assume that the state of returns from the capital good with its technology and employment are cost. We may calculate the MEC of any constant. proposed investment given the An investment will be made only if purchase price of the capital good and it is profitable. In other words, the the expected stream of net income over discounted value of the income which the life of the capital good. the capital good will yield over its life In our example, we get the MEC as must be greater than the purchase price 4329.40 =C of that capital good. 1000 1000 1000 Suppose the proposed investment = + + + (1+r) (1+r)2 (1+r)3 is in a laddoo-making machine. The cost of the machine is Rs.4329.40. The 1000 1000 + machine is expected to produce a net (1+r)4 (1+r)5 income (after deducting the operating Solving either through trial and costs) of Rs.1000 per year over its life error method or with the help of span of five years. We can calculate the discounting tables we get the following Marginal Efficiency of Capital (MEC) as result, follows: r = 0.05 For an income stream over n years the = 5% formula is Thus, the marginal efficiency of R R R R C = 1 + 2 + 3 + 4 + capital in our above example is 5%. (1+r) (1+r)2 (1+r)3 (1+r)4 By comparing the MEC with the market rate of interest, we can R R 5 +.......... n determine whether the investment is (1+r)5 (1+r)n profitable or not. If MEC is greater than the market rate of interest, then the Where, investment is profitable. If MEC is less C = purchase price or cost of the than the market rate of interest, than capital good the investment is unprofitable. The R = net income from the capital good market rate of interest is used as a 1 in the ith year. yardstick on two accounts: 66 INTRODUCTORY MACROECONOMICS (cid:1) If the firm has to use borrowed MECin% money to finance the investment, then the investment should yield a 10 return greater than the cost of the borrowed funds (which is nothing 8 M SMALLMACHINE but the market rate of interest) in A C order to be profitable. H (cid:1) If the firm is financing the 3 I N investment out of its own funds, E then it would be better off by lending PLANT the amount at the market rate of Investment interest to someone else if the MEC 0 1000 3000 expenditure of the proposed investment is less Fig A5.1:Marginal Efficiency Schedule than the market rate of interest. Here of a Firm the market rate of interest is the investment opportunity is the opportunity cost of the investment. expansion of the firm’s plant at a cost The return from the investment of Rs.1500, with an MEC of 3%. These must be greater than its projects are arranged in order opportunity cost in order for it to of decreasing profitability in be profitable. Figure A5.1. Marginal Efficiency Schedule The bold line in the diagram is the The relationship between investment firm’s marginal efficiency schedule. If demand and the MEC is called the the MEC schedules for all firms are marginal efficiency schedule (MEC added horizontally, we will get the schedule)1. The marginal efficiency aggregate MEC schedule for the schedule for the economy as a whole economy. This will be a continuous may be derived by aggregating the smooth curve because of the marginal efficiency schedules of the aggregation. individual firms. Figure A5.1 shows the The MEC schedule for a single firm marginal efficiency schedule for a is based on the assumption that the hypothetical firm. Suppose the most prices of capital goods are given. profitable investment opportunity for a However, when the individual MEC firm is the purchase of a machine schedules are added, then the capital costing Rs.1000, with an MEC of 10%. costs of the various investment projects The next most profitable investment will not remain constant - it will go up. opportunity is the purchase of a new The aggregate MEC schedule that takes small machine costing Rs.500, with an into account the increased costs of MEC of 8%. The next most profitable capital goods will lie below the curve 1 This section draws on material from ‘‘Principles of Macroeconomics’’ By C. Rangarajan and B.H. Dholakia, Tata McGraw-Hill Publishing Company, 2002. AGGREGATE DEMAND AND ITS COMPONENTS 67 MEIin% Investment Demand Schedule The MEI schedule does not tell us how much investment will be made. The quantum of investment depends on the rate of interest. Investment will be pushed up to a level where the marginal efficiency of investment will be equal to the interest rate. Only this much, and no more investment will be profitable. Thus, by substituting the MEI by the rate of interest we will have the investment demand schedule. Figure A5.3 shows the investment demand Investment schedule. Fig A5.2 : The Marginal Efficiency of Rateof Investment Schedule interest which simply aggregates the individual firms’ MEC schedules. Such an aggregate schedule, that takes into account the increased costs of capital goods, is called the Marginal Efficiency of Investment schedule (MEI schedule). The concept of MEI for investment for the economy as a whole Investmentdemand is analogous to the concept of MEC for Fig A5.3 : The Investment Demand one firm’s investment project. The MEI Schedule schedule will be downward sloping. The X-axis shows the investment This means that the marginal efficiency demand in the economy, and the Y-axis of investment falls as investment shows the rate of interest. If, at Rs.200 increases. This is because with crores of investment, the MEI is 15%, increased investment, the diminishing then at an interest rate of 15%, there marginal productivity of capital will will be Rs.200 crores of investment. The reduce the prospective returns from shape of the investment demand each successive unit of investment. schedule is thus the same as that of the Figure A5.2 shows the marginal MEI schedule. Since the MEI schedule efficiency of investment schedule. is downward sloping, the investment The X-axis measures investment in demand schedule is also downward the economy as a whole and the Y-axis sloping. This shows the inverse measures the marginal efficiency of relationship between the rate of interest investment. and the investment demand.