Very Short Question Answer

1. What is the main cause of unemployment according to Keynes?

According to Keynes, the main cause of unemployment is deficiency of aggregate demands in the economy. The decrease in aggregate demand results decrease in output, which results unemployment in the economy.

2. What are the causes of declining MEC?

The causes of declining MEC are as follows:

i. Operation of law of diminishing returns in the productivity of capital assets.
ii. Increase in price of capital assets.

3. What are the determinants of effective demand?

The determinants of effective demand are aggregate demand and aggregate supply.

4. What does C = a + by equation refer to?

C = a + bY refers to the linear consumption function, where a = autonomous
consumption and bY = induced consumption.

5. Why saving curve slopes upward?

Saving curve slopes upward because of positive relationship between saving and level of income.

6. What do you mean by dissaving?

Dissaving means excess consumption expenditure over the income. It is also i known as the negative saving.

7. What is responsible for deficiency in aggregate demand according to Keynesian Theory of Employment?

According to Keynesian theory of employment, increase in consumption expenditure less than the increase in income is responsible for deficiency in aggregate demand.

8. Why consumption curve originates from a point of Y axis?

Consumption function curve originates from a point of Y-axis because of autonomous consumption.

9. Define the concept of Paradox of Thrift.

Paradox of thrift is the debate about saving. According to classical economists, saving is good for the economy but according to Keynes, saving is not good, rather consumption is good for the economy. It is also called as the saving is vice, not a virtue.

Short Question Answer

1.  Define APC and MPC. Explain their relationship.

Average propensity to consume is defined as the ratio of aggregate consumption and aggregate income. It is calculated by dividing consumption expenditure by income. It tells us the level of consumption at a given level of income. Symbolically,
APC = C /Y
Where,
APC = Average propensity to consume
C= Consumption
Y= Level of income

Marginal propensity to consume is defined as the ratio of change in consumption to the change in income. It shows that by how much total consumption changes when there is change in income by one unit. It is calculated by dividing change in consumption by change in income. Symbolically,
MPC = ∆A /∆Y
Where,

MPC= Marginal propensity to consume
∆C= Change in consumption
∆Y= Change in income

The relationship between APC and MPC can be explained as follows:

i. APC is the ratio of total consumption to the total income at the particular point of time. MPC is the ratio of change in total consumption to the change in total income. It means that MPC is the rate of change in APC.

ii. When the consumption curve is straight line with positive consumption expenditure at zero level of income or autonomous consumption, APC is always higher than MPC. The slope of consumption curve is MPC which is constant at all level of income but APC is falling. The APC is the slope of the consumption curve from the origin to any point on the consumption curve.

iii. In the long-run, consumption curve passes through the origin. It means that in the long-run, APC equals to MPC. iv. The short-run consumption curve passes from above the origin. It means that as income increases both APC and MPC decline but the decline in MPC is more than decline in APC i.e. MPC < APC.

2. Define APC and MPC. What are properties of MPC?

DEFINITION OF APC AND MPC Please refer to Q. No. 1.

The properties of MPC are as follows:

i. MPC is greater than zero but less than one: This property is the technical expression of Keynesian psychological law of consumption. The value of MPC is always greater than zero because consumption expenditure increases with increase in income and less than one because proportionate increase in consumption is less than proportionate increase in income. Thus Keynesian psychological law of consumption can be technically stated as 0 < MPC < 1

ii. MPC of poor is greater than MPC of the rich: This is because of the fact that the poor people spend a greater percentage of their income on consumption while rich people spend smaller percentage of their income. The needs of rich people are already fulfilled but the needs poor people remain unsatisfied. Therefore, they tend to spend larger amount of their income on consumption.

iii. The short-run MPC is stable: It is because the psychological and institutional factors on which the propensity to consume depends do not change in the short-period.

3. Explain the objective factors determining consumption function.

The objective factors are external to the economic system. They undergo into rapid change and cause shifts in the consumption function or curve. The important objective factors are as follows:

i. Changes in wage level: If the wage rate rises, the consumption function shifts upward. If, however, the rise wage rate is accompanied by more than proportionate rise in prices, the real wage rate will fall and the consumption function will shift downward. A cut in wage rate also shifts consumption curve downward.

ii. Distribution of income: Consumption function not only depends upon income, but also on the way in which the income is distributed. Greater the inequality in income distribution, lower. will be the propensity to consume and vice-versa. The marginal propensity to consume of the poor is higher than that of the rich. Thus, a more equal distribution of income will raise consumption because the poor with their increased income will increase their consumption expenditure.

iii. Fiscal policy: Changes in the fiscal policy also affect the propensity to consume. Heavy indirect taxation, rationing and price control adversely affect the propensity to consume. Progressive taxation shifts the consumption function upward by bringing about more equitable distribution of income.

iv. Changes in expectations: Changes in future expectations also affect the consumption function. For example, the expectation of out-break of war or fear of shortage of goods and rising prices in the near future will induce the people to purchase the goods much in excess of their current needs. This will shift the consumption function upward.

v. Financial policies of corporations: Business policies of the corporations with regard to income retention, dividend payments and re-investment affect the propensity to consume of the equity holders. If the corporations keep more money in reserves and distribute less of their profits as dividends, it will reduce the income of the shareholders and the consumption function will shift downward.

vi. Holding of liquid assets: The consumption function is also influenced by the holding of liquid assets (like cash balances, saving accounts, government bonds, etc.) in hand, they will tend to spend more out of their current income and thus their propensity to consume will increase. An increase in the real value of such assets, as a result of a general fall in the prices, also raises consumption.

vii. Social security: Making contributions to various social security schemes, such as, provident fund, life insurance, etc., reduce the disposable income of the people and to that extent the consumption expenditure falls.

viii. Installment buying: Facilities of installment buying on credit increase propensity to consume because they encourage people to purchase. Even the costly goods are purchased which they otherwise could not purchase. The system of installment buying is very popular in advanced countries and is also becoming popular in developing countries like Nepal.

4. Define the saving function. Explain its determinants.

Saving function states the relationship between income and saving. There is positive relationship between saving and income. It means that the higher the income, the higher will be saving and vice-versa.
Symbolically,
S = f(Y)
There are different factors that affect saving of individuals, households and private business firms. Some of the major determinants of saving are as follows:

i. Level of income: The saving of every individual and household depends upon the level of income. The higher the level of income, the higher will be the amount of saving. Level of income determines the ability to save. In developing countries like Nepal, the income of the majority of people is very low and insufficient for their subsistence. Therefore, saving is extremely low.

ii. Rate of interest: In general, there is direct and positive relationship between rate of interest and saving. When rate of interest is high, saving will be high and vice-versa. If the rate if interest is high, individuals and households are encouraged to save more and more in order to earn more interest. Similarly, if the rate of interest is low, then saving will also be low.

iii. Distribution of wealth and Income: Saving is also determined by the way in which national income and wealth is distributed among different persons in a country. The unequal distribution of income and wealth increases saving and vice-versa.

iv. Demographic factors: The age composition of population also affects the saving. The more the dependent population in the country, the less will be saving. The reason is that the larger number of dependents needs more money to fulfill their requirements. Dependent population means those who cannot earn themselves and have to depend on others.

v. Price level: The price level of the goods and services in the market also affects the saving. The higher the market price less will be the saving of the people. On the contrary, if the market price level is low, people can get goods and services cheaper, and it raises saving in the society.

vi. Fiscal policy: The fiscal policy of the government affects the private saving largely. If the government raises the tax rate, the income of the people remaining constant, propensity to save will decrease. Contrary to this, if the government reduces the tax rate, propensity to save of the people will increase.

vii. Development of banking and financial institutions: The development of banks and financial institutions also play important role to determine savings of people. The development of such institutions provide various facilities and attract people to save their income in these institutions.

viii. Social security: Social security is also one of the important factors that  influence the saving. If the government provides adequate social security to the people, such as pension, old age allowance, handicapped and disabled allowance, unemployment allowance, widow allowance etc., people would feel fully secured for the future and will not be encouraged towards saving and vice-versa.

5. What is investment? Discuss the important determinants of investment.

Investment is defined as the part of income, which is devoted on purchase on those goods, which are used for further production of other goods or earning income. In other words, investment is that part of income and output which is spent to earn more income and output with the use of capital goods.
There are many factors determining investment; both short run as well as long run which are as follows:

a.  Short-run Factors

The short-run factors that influence investment are as follows:  

i. Expected demand: Investment depends largely on the expected demand for the products in the economy. If the demand for the products is expected to increase in the future, investment will increase and vice-versa.

ii. Cost and prices: The future behaviour of costs and prices has a strong influence on investment. If costs are expected to decline and prices are expected to rise in the future, the expectations of the investors about the rate of returns from investment will go up which will cause rise in investment and vice-versa.

iii. Change in Income: If the level of income of people rises in the economy through rise in money wage rates, the inducement to invest will increase. On the other hand, the inducement to invest will fall with lowering of income levels.

iv. Propensity to consume: If the propensity to consume of people is high, then to fulfill the demand the investors will increase investment.

v. Government policy: Government policy also affects investment. If the government follows liberal economic policy in the economy, it will have favourable impact on investment. If the government follows tight economic policy and imposes various unnecessary burdens of taxes entrepreneurs and businesspersons, then the investors will be discouraged.

b. Long-run Factors

The long run factors that influence investment are as follows:

i. Growth of population: A rapidly growing population means growing market for all type of goods in the economy. To fulfill the requirements of an increasing population, investment will increase in all types of consumer goods industries. Similarly, a declining population results in a shrinking market for goods, thereby lowering investment.

ii. Technological progress: If there is a progress and an improvement in the technique of production, it reduces costs and increases profit. This encourages the investors to invest in new capital assets. The absence of new technologies will mean low inducement to invest.

iii. Development of industrial infrastructure: The development of industrial infrastructure plays very important role to encourage investment in the country. The development of transportation, communication, electronics, banking, insurance etc, increases the inducement to invest.

iv. Industrial policy: The policies, which are formulated by the government with regard to industrial development such as licensing, registration, export and import regulations, tax policies etc., are very important factors. If the industrial policy of the government is to encourage private investment, the inducement to investment will increase.

v. Rate of interest: The inducement to invest will be higher if current market rate of interest to be paid at present is lower than the expected rate of profit to be received in future. If the current rate of interest is higher, the inducement to invest will be lower.


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