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IS-LM Model

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❶It is useful to make the meaning of investment clear. He was of the opinion that changes in income level will affect investment only in the long ran.

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What Determines the Quantity of Goods That Buyers Demand?

To have more capital goods more investment has to be undertaken. This induced investment is undertaken both in fixed capital assets and in inventories.

The essence of induced investment is that greater income and therefore greater aggregate demand affects the level of investment in the economy. It can be easily shown that investment is determined by expected rate of profit and the rate of interest. A person having an amount of savings has two alternatives before him. Either he should invest his savings in machines, factories, etc. It follows from above, if investment is to be profitable then the expected rate of profit must not be less than the current market rate of interest.

If the expected rate of profit is greater than the market rate of interest, new investment will take place. If an entrepreneur does not invest his own savings but has to borrow from others, then it becomes much clear that the expected rate of profit from investment in any capital asset must not be less than the rate of interest he has to pay.

We thus see that investment depends upon marginal efficiency of capital on the one hand and the rate of interest on the other. Investment will be undertaken in any given form of capital asset so long as expected rate of profit or marginal efficiency of capital falls to the level of the current market rate of interest. The equilibrium of the entrepreneur is established at the level of investment where expected rate of profit or marginal efficiency of capital is equal to the current rate of interest.

Of the two determinants of inducement to invest, marginal efficiency of capital or expected rate of profit is of comparatively greater importance than the rate of interest. This is because rate of interest does not change much in the short run; it is more or less sticky.

But changes in the expectations of profits greatly affect the marginal efficiency of capital and make it very much unstable and volatile. As a result of changes in marginal efficiency of capital, investment demand is greatly affected which causes aggregate demand to fluctuate very much.

The changes in aggregate demand bring about economic fluctuations which are generally known as trade cycles. When profit expectations of businessmen are good, large investment is undertaken which causes aggregate demand to rise and bring about conditions of boom and prosperity in the economy.

Thus, the changes in the marginal efficiency of capital play a crucial role in causing changes in the investment level and economic activity. The theory of interest that, according to Keynes, the rate of interest is determined by liquidity preference and the supply of money. The greater the liquidity preference, the greater the rate of interest.

Given the liquidity preference curve, the greater the supply of money, the lower will be the rate of interest. We have already studied how the rate of interest is determined. We explain below in detail the concept of marginal efficiency of capital and describe the factors on which it depends.

As has been pointed out above, the concept of marginal efficiency of capital refers to the rate of profit expected to be made from investment in certain capital assets.

The rate of profit expected from an extra unit of a capital asset is known as marginal efficiency of capital. Now, the question is how the marginal efficiency of capital is measured. Suppose an entrepreneur invests money in a certain machinery, how will he estimate the expected rate of profit from it.

To estimate the marginal efficiency of capital, the entrepreneur will first take into consideration how much price he has to pay for the particular capital asset. The price which he has to pay for the particular capital asset is called its supply price or cost of capital.

The second thing which he will consider is that how much yield he expects to obtain from investment from that particular capital asset. A capital asset continues to produce goods and yield income over a long period of time. Therefore, an entrepreneur has to estimate the prospective yield from a capital asset over his whole life period.

Thus, the supply price and the prospective yields of a capital asset determine the marginal efficiency of capital. Keynes has defined the marginal efficiency of capital in the following words: Thus, according to Keynes, marginal efficiency of capital is the rate of discount which renders the prospective yields from a capital asset over its whole life period equal to the supply price of that asset.

Thus, r represents the expected rate of profit or marginal efficiency of capital. The measurement of marginal efficiency of capital can be illustrated by an arithmetical example. Suppose it costs rupees to invest in a certain machinery and the life of the machinery is two years, that is, after two years it becomes quite useless, having no value. Suppose further that in the first year the machinery is expected to yield income of Rs. By substituting these values in the above formula, we can calculate the value of r, that is, the marginal efficiency of capital.

On calculating the value of r in the above equation it is found to be equal to In other words, marginal efficiency of capital is here equal to 10 per cent. If we put the value of r, that is, 10 in the above equation, we obtain the following: But we also require to know the marginal efficiency of capital in general. It is the marginal efficiency of capital in general that will indicate the scope for investment opportunities at a particular time in any economy.

At a particular time in an economy the marginal efficiency of that particular capital asset which yields the greatest rate of profit, is called the marginal efficiency of capital in general.

In other words, marginal efficiency of capital in general is the greatest of all the marginal efficiencies of various types of capital assets which could be produced but have not yet been produced. Thus, marginal efficiency of capital in general represents the highest expected rate of return to the community from an extra unit of a capital asset which yields the maximum profit which could be produced. Keeping in view the existing stock of a capital asset, we can always calculate the marginal efficiency of any particular capital asset.

The marginal efficiency of capital will vary when more is invested in a given particular capital asset. In any given period of time marginal efficiency of capital from every type of capital asset will decline as more investment is undertaken in it. In other words, marginal efficiency of a particular type of capital asset will be sloping downward as the stock of capital increases.

The main reason for the decline in marginal efficiency of capital with the increase in investment in it is that the prospective yields from capital asset fall as more units are installed and used for production of a good. Prospective yields decline because when more quantity of a good is produced with the greater amount of capital asset prices of goods decline. The second reason for the decline in the marginal efficiency of capital is that the supply price of the capital asset may rise because the increase in demand for it will bring about increase in its cost of production.

We have explained above how the marginal efficiency of capital is estimated. We can represent diminishing marginal efficiency of capital in general by a curve which will slope downward. This has been done in Fig. It will be seen from the figure that when investment in capital asset is equal to 07,, marginal efficiency of capital is i,.

When the investment is increased to OI 2 , marginal efficiency of capital falls to i 2. Likewise, when investment rises to OI 3 , marginal efficiency of capital further diminishes to i 3.

We have seen above that inducement to invest depends upon the marginal efficiency of capital and the rate of interest. With the given particular rate of interest and given the curve of marginal efficiency of capital in general we can show what will be the equilibrium level of investment in the economy.

Thus, if the rate of interest is i 1 then I 1 investment will be undertaken. If the rate of interest falls to i 2 , investment in the capital assets will rise to OI 2 , since at OI 2 level of investment the new rate of interest i 2 is equal to the marginal efficiency of capital. If the entrepreneurs try to provide more employment after this point, the aggregate supply price exceeds the aggregate demand price indicating that the total costs are higher than the total revenue and there are losses.

So the entrepreneurs will not employ workers beyond the point of effective demand till the aggregate demand price rises to meet the aggregate supply price at the new equilibrium point which may be one of full employment.

If the aggregate demand price is raised still further, it will lead to inflation because no increase in employment and output is possible beyond the level of full employment. The following table explains the determination of the point of effective demand. Table III shows that so long as the aggregate demand price is higher than the aggregate supply price, it is profitable for entrepreneurs to employ more workers, when they expect to receive Rs crores, Rs crores and Rs crores than the proceeds necessary amounting to Rs crores, Rs crores and Rs crores, they will provide increasing employment to 20 lakh, 25 lakh and 30 lakh workers respectively.

But when the proceeds necessary and proceeds expected equal Rs crores the level of employment rises to 35 lakhs. If we assume the level of full employment to be 40 lakh workers in the economy, it will necessitate the drawing up of a new aggregate, demand price schedule as shown in Table III last column.

As a result, the new point of effective demand is 40 lakh workers because both the aggregate demand price and the aggregate supply price equal Rs crores. Beyond this point there is no change in the level of employment which is steady at 40 lakh workers. Figure 1 illustrates the determination of effective demand where AD is the aggregate demand function and AS the aggregate supply function.

The horizontal axis measures the level of employment in the economy and the vertical axis the proceeds expected revenue and the proceeds necessary costs. This is effective demand where ON workers are employed. At any point other than this, the entrepreneurs will either incur losses or earn subnormal profits.

At ON 1 level of employment, the proceeds expected revenue are more than the proceeds necessary costs , i. This indicates that it is profitable for the entrepreneurs to provide increasing employment to workers till ON level is reached where the proceeds expected and necessary equal at point E.

It would not be, however, profitable for the entrepreneurs to increase employment beyond this to N F level because the proceeds necessary costs exceed the proceeds expected revenue , i. Thus E, the point of effective demand, determines the actual level of employment in the economy which is of underemployment equilibrium.

Of the two determinants of effective demand, Keynes regards the aggregate supply function to be given because it depends on the technical conditions of production, the availability of raw materials, machines etc. It is, therefore, the aggregate demand function which plays a vital role in determining the level of employment in the economy. According to Keynes, the aggregate demand function depends on the consumption function and investment function.

The cause of unemployment may be a fall in either consumption expenditure or investment expenditure, or both. The level of employment can be raised by increasing either consumption expenditure or investment expenditure, or both.

Dillard regards this as the core of the principle of effective demand. It follows that to raise the economy to the level of full employment requires the raising of the point of effective demand by increasing the aggregate demand. This is illustrated in Figure 2, where E is the point of effective demand which determines ON level of employment. If ON F is the level of full employment for the economy, it requires the raising of the point of effective demand. If the aggregate demand function is raised beyond this point the economy will experience inflation because all the existing resources are fully employed and their supply cannot be increased during the short run, as is apparent from the vertical portion of the AS curve in Figure 2.

The principle of effective demand is the most important contribution of Keynes. It is the soul of the Keynesian theory of employment.

Dr Klein attributes the Keynesian revolution solely to the development of a theory of effective demand. Effective demand determines the level of employment in the economy. When effective demand increases, employment also increases, and a decline in effective demand decreases the level of employment.

Thus unemployment is caused by a deficiency of effective demand. Effective demand represents the total expenditure on the total output produced at an equilibrium level of employment. It indicates the value of total output which equals national income.

National income equals national expenditure. National expenditure consists of expenditure on consumption goods and investment goods. Thus the main determinants of effective demand and the level of employment are consumption and investment.

In the Keynesian analysis of effective demand, consumption and investment expenditures relate to the private sector because Keynes considers government expenditure as autonomous. But the post-Keynesian economists include government expenditure as a component of effective demand.

We may conclude that the importance of the principle of effective demand lies in pointing out the cause and remedy of unemployment. Thus the principle of effective demand is the basis of the theory of employment. This principle points out that underemployment equilibrium is a normal situation and full employment equilibrium is accidental. In a capitalist economy, supply fails to create its own demand because the whole of the earned income is not spent on the consumption of goods and services.

Moreover, the decisions to save and invest are made by different people. As a result, the existence of full employment is not a possibility and the point of effective demand at any time represents underemployment equilibrium. The Pigovian view that full employment can be achieved by a reduction in money wage-cut is also repudiated by this principle.

A money wage-cut will bring about a reduction in expenditure on goods and services leading to a fall in effective demand and hence in the level of employment. The principle of effective demand highlights the significant role of investment in determining the level of employment in the economy. The two determinants of effective demand are consumption and investment expenditures. When income increases consumption expenditure also increases but by less than the increase in income. Thus there arises a gap between income and consumption which leads to decline in the volume of employment.

This gap can be bridged by an increase in either consumption expenditure or investment expenditure in order to achieve full employment level of effective demand in the economy. Since the propensity to consume is stable during the short run, it is not possible to raise the consumption expenditure. Therefore, the level of effective demand and hence of employment can be raised by an increase in investment. In this lies the importance of investment.

BREAKING DOWN 'Aggregate Demand'

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The 5 determinants of demand are price, income, prices of related goods, tastes, and expectations. A 6th, for aggregate demand, is number of buyers.

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The sixth determinant that only affects aggregate demand is the number of buyers in the economy. The aggregate demand curve shows the quantity demanded at each price. It's similar to the demand curve used in microeconomics. Term aggregate demand determinants Definition: An assortment of ceteris paribus factors that affect aggregate demand, but which are assumed constant when the aggregate demand curve is gega-f9asygqp.mls in any of the aggregate demand determinants cause the aggregate demand curve to shift. While a wide variety of specific ceteris paribus factors can cause the aggregate demand .

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Determinants of the Components of the Aggregate Demand By using the Aggregate Demand (AD) function, we are able to retrieve different components of aggregate demand. Factors that influence the AD of an economy include, as mentioned above, consumption, investments, government . The determinants of demand are the price of the good or service, income of the buyer, prices of related goods or services, tastes, preferences and future price expectations. The number of buyers may be considered another determinant relating to aggregate demand. The Law of Demand .