CONSUMPTION FUNCTION Shows the relationship between consumption and

CONSUMPTION FUNCTION Shows the relationship between consumption and its determinants Consumption = f (disposable income, wealth, price, expected income, expected price, interest rate)

Disposable income Income that remains after paying taxes Disposable income is the most important variable in determining consumption Psychological Law of Consumption When income increases, people spend more on consumption but not by the same rate as the increase in income Some part of the increased income is saved

Marginal Propensity to Consume (MPC) Ratio of changes in consumption to changes in income MPC = ∆C/ ∆Y MPC = 1—MPS is the Marginal Propensity to Save

SAVING FUNCTION The portion of the income that is left after spending on consumption Saving (S) = Income (Y)—Consumption (C) Saving is a function of income just like consumption i. e. S = f(Y) Positive relation with income When income increases, Saving increases When income decreases, Saving decreases

INVESTMENT FUNCTION Does not include the transfer of ownership of an asset, for example: investing in stocks and bonds Includes new addition to the stock of physical capital for example: land, building, machinery New addition i. e. net investment increases aggregate demand Increase in aggregate demand causes an increase in level of income and creates employment

INVESTMENT MULTIPLIER Investment multiplier = change in income / change in investment Shows the increase in income that results due to increase in investment The multiplier depends on marginal propensity to consume (MPC) MPC shows the change in consumption when income changes MPC = ∆C / ∆Y Multiplier = 1/(1—MPC) 0 < MPC < 1

National Income Accounting Science of measuring aggregate output and income Done by government to observe the changes in economic activities National Income (NI) Macroeconomic variable Money value of flow of output of goods and services Measured over a period of time Estimate of the total economic activity in the country/region 3 ways of measuring National Income Product method Income Method Expenditure Method

Gross Domestic Product (GDP) Value of output produced within the domestic boundaries Measures the flow of output per time period Exchanges and sale of second-hand goods and services are not included GDP = market value of all final goods and services produced domestically Gross National Product (GNP) Value of output produced within domestic boundaries as well as outside as long as factors of production are domestic owned GNP = GDP + Net foreign income

PRODUCT METHOD Measures National Income from output/product side Economy is divided into different sectors Each sector contributes to the GDP = sum of all the production in each sector Total value of output of goods and services produced Advantages Helps trace the origin of national income to different sectors Shows the level of importance of each sector in the overall economy Disadvantage Tendency to double-count

INCOME METHOD (SUM OF FACTOR INCOMES) Measures national income from distribution side National income is computed as the sum of the incomes of all the individuals in the country/region Total income generated through production of goods and services GDP by factor income = income from employed people + profits of private sector + rent from land These are excluded from calculations Income not registered with Inland Revenue Department Private transfers of money from one person to another Transfer payments eg- pension, unemployment insurance etc.

EXPENDITURE METHOD (AGGREGATE DEMAND) Spending on domestic produced goods and services at current market prices GDP = C+I+G+X—M C= Consumer/household spending I= Private Investment spending G= Government spending X=exports of goods and services M= imports of goods and services

DIFFICULTIES IN MEASURING NATIONAL INCOME Lack of statistical data Non-monetized sectors Illiteracy/Ignorance Lack of Occupational Specialization Frequently changing prices Double and multiple counting Shadow/Underground Economy Some goods and services do not have money value