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Topic: Elementary Theory of Income Determination
Lesson Objectives: At the end of the lesson, learners should be able to;
i. Explain the circular flow of income
ii. State the factors that affects the circular flow of income
iii. Explain the concept of savings
iv. List the types of savings
v. State reasons why people save
vi. Explain the concept of investment
vii. List and explain the types of investment
viii. State the factors that determine investment
ix. Explain the concept of consumption
x. State the types of consumption
xi. State the factors that determine the level of consumption
xii. Explain the relationship between savings, investment and consumption
xiii. Explain concept of propensities to consume, propensities to save, Elementary theory of multiplier and Equilibrium level of income.
The total income of a country is a reflection of real capital investment in that particular country. The volume of investment is determined mainly by certain factors. These factors include expectation of entrepreneurs, rate of interest, savings, marginal efficiency of capital, and consumption.
Circular flow of income: itsmyschoollibrary
Circular flow of income refers to the flow of payments and receipts for factor services and for currently produced out passion between domestic firms and households. In other words, it describes the flow of payments from businesses to households in exchange for labour and other productive services and the return flow of payments from households to businesses in exchange for goods and services.
To make this discussion on circular flow of income simple, a two-sector economy, which involves households and firms, will be used. The households supply factors of production (input) such as labour to firms which need them for production purposes. In return, they are paid wages, interest, rents and profits, which constitute their incomes. The members of the households use their incomes to purchase goods and services produced by the firms. This pattern of consumption expenditure made by households constitutes income for firms. This process leads to the formal of an income flow. The firms again use the income to purchase the productive services of households. Income, therefore, continues to flow in a circular manner to form the circular flow of income. While income flows in one direction, goods and services as shown in the figure above produced by the firms and the productive services of households flow in the other direction.
Factors Affecting Circular Flow of Income
i. Savings: This constitutes part of income which is not consumed immediately. They have the tendency to reduce the expenditure of the households and firms.
ii. Injection: Injection of fund into the circle is an increase in the incomes of households and firms beside their normal processes of selling productive resources and manufactured goods.
iii. Taxes: Taxes tend to reduce the volume of fund in circulation as it reduces the expenditure of firms and households.
iv. Withdrawal: Withdrawal tends to reduce the amount of fund in the circular flow of income.
v. Aids and grants: Aids and grants from government or other sources increase the volume of fund in the circular flow of income.
vi. Import and export: While imports involved expenditure on foreign made goods and services leading to withdrawals from circular flow of income, exports provide funds leading to injection into the circular flow of income.
vii. Investment: Investment creates an additional income leading to injection into the circular flow of income.
Concept of Savings
Savings may simply be defined as that part of income which is not spent. In other words, savings refers to all or part of income which are not spent immediately but reserved for future purposes.
Money which is saved constitutes a withdrawal from the circular flow of income. It can only come back to the circular flow of income through investments.
Types of savings
i. Personal savings: This refers to the type of savings kept by an individual for personal reasons.
ii. Corporate savings: This refers to the type of savings kept by companies and other business organisations. They embark on savings if profits are high, when taxation is low or for other critical reasons.
iii. Government savings: This refers to the type of savings kept by the government of a country. Government can save through budget surplus and many other ways.
Factors that Determine Personal Savings
i. Rate of interest: A higher rate of interest will encourage people to save.
ii. Political stability: People are more likely to save when there is a political stability. But there is little or no savings in times of wars or inter-tribal crises.
iii. Size of income: As the income of a person increases, his ability to save equally increases. In other words, the higher the income, the higher the tendency to save while the lower the income, the lower the tendency to save.
iv. Presence of financial institutions: People are more likely to save if financial institutions like savings banks and other financial institutions are available.
v. Sense of responsibility: People may decide to save for one or more major reason based on their income. A person with a high income who decides to save has a high sense of responsibility while one who refuses to save has a poor sense of responsibility.
vi. Government policy: Government can influence people’s attitude to saving in several ways. Personal savings can be encouraged through the rate of interest and income tax concessions.
Reasons for savings
i. Capital formation: People may decide to save in order to raise capital, which can be used to set up a business outfit.
ii. For unforeseen contingencies: People may also save in order to meet unforeseen and unexpected contingencies such as accommodation problems, retirement, sickness, retrechment, etc.
iii. Acquisition of assets: People also save to enable them acquire certain assets.
iv. Accumulation of wealth: People do embark on savings in order to gather or accumulate wealth.
v. Provision for future purposes: Some people save deliberately for future purposes, e.g old age, education of children, etc.
vi. Acquisition of social status: Some people embark on savings in order to be wealthy, which can lead to or boost their social status in the society.
Concept of Investment
Investment may be defined as expenditure on physical assets which are not for immediate consumption but for the production of consumer and capital goods and services. Investment has two related meanings;
a. It could mean the actual production of real capital in economic theory such as building of new factory, purchase of new vehicles, etc.
b. It could also mean, in financial term, the deposit of money in bank, purchase of stock or government securities, etc.
Types of investment
i. Individual investment: This is the type of investment embarked upon by a household or an individual in order to increase his income and raise his standard of living. Examples include investment in houses, motor vehicles, etc.
ii. Corporate investment: This includes investment by companies and other organisations with the sole aim of making profits. Examples include investment on plants and machinery, buildings, etc.
iii. Government investment: Government investment includes the setting up of corporations with the sole aim of providing essential services rather than making of profits, e.g provision of electricity, water, health care services, etc.
Factors that Determine Investment
i. Savings: The amount of money saved determines, to a large extent, the level of investment.
ii. Level of income: The higher the income earned, the higher the level of investment and vice versa.
iii. Rate of taxation: Higher taxation on one’s income reduces investment and vice versa.
iv. Interest rate: High interest rate charged by banks discourages borrowing, which leads to low investment while low interest rate encourages borrowing leading to high investment.
v. Future expectation: When an investor expects a brighter future, this will encourage him to invest.
vi. Business atmosphere: Investors are more interested in investment in a stable economy than those with economic instability.
vii. Changes in technology: The level of investment is greatly influenced by changes or improvements in techniques of production through inventions and innovation.
viii. Changes in level of consumption: A high level of consumption generally leads to low investment and vice versa.
Concept of Consumption
Consumption may be defined as the total quantity of goods and services purchased and used by consumers during a specified period of time. Consumption is also described as expenditure on goods and services at a given period of time. It is the expression of total consumer demand.
Types of Consumption
i. Durable goods: This involves consumption expenditure on certain items which are durable in nature, e.g houses, motor vehicles, furniture, machines, etc.
ii. Non-durable goods: This involves consumption expenditure on goods that are not durable in nature, e.g food, clothing, water, etc.
iii. Services: This involves consumption expenditure on general services, e.g legal fees, medical fees, entertainment fees, educational fees, etc.
Factors that Determine the level of Consumption
i. Savings: The level of savings influence consumption. High savings tend to reduce the level of consumption.
ii. Level of income: The higher the income the higher the level of consumption.
iii. Availability of credit facilities: Availability of credit facilities either to individuals or firms tends to increase the level of consumption.
iv. Income distribution: Equitable distribution of national income will increase the disposable income of individuals thereby increasing the level of consumption.
v. Possession of assets: Revenue generated by assets increases the income of their owners and this tends to raise the level of consumption.
vi. Rate of taxation: High taxation reduces the income of people and this reduces the level of consumption.
vii. Interest rate: If the interest rate received is high, it will generally increase the income leading to a rise in the level of consumption.
viii. Profit earned: High profits earned either by individuals or firms increase income thereby resulting in a rise in the level of consumption.
Relationship Between Savings, Investment And Consumption
Savings, investment and consumption are closely related. We save in order to accumulate capital for investment and for many other personal reasons. There will be no investment without savings. Investment, in turn, creates employment and income for people. Without it and, therefore, without income, we shall have nothing to save and nothing to spend on consumer goods and services.
What we do not spend is what is saved. Consumption, therefore, is affected by decisions to save just ad saving is affected by decisions to spend. If we spend all our income, there will be no capital accumulation for investment. Therefore, the community’s income is made up of savings, investment and consumption.
Savings, investment and consumption are related to income with the use of the following formulae:
Y = C + S
Y = C + I
S = I
Where Y = Income,
C = consumption expenditure
S = savings
I = Investment expenditure
Propensities to Consume
Propensities to consume is discussed under two groupings;
a. Average propensity to consume (APC): The APC is defined as the proportion of the national income that is consumed. In order to calculate APC, the total national consumption is divided by the total national income. The formula is:
The APC decreases with increasing income levels.
If the total national income is #20 million and the total national consumption is #5 million, calculate the APC.
b. Marginal propesnity to consume (MPC): The MPC is defined as the relationship between changes in income and changes in consumption. It shows the extent to which the level of consumption changes as a result of a change in income. It, therefore, shows the proportion of any addition to income, which is used for consumption. The Formula is:
If the monthly income of an individual increases from #10,000.00 to #15,000.00 and increases his level of consumption from #4,000.00 to #6,000.00, calculate the marginal propensity to consume.
Propensities to Save
Propensities to save is discussed under two groupings:
a. Average propensity to save (APS): The average propensity to save is defined as a measure of the proportion of income which is saved (not spent on consumption). It shows the expected amount of savings at different levels of income. The formula is:
If a firm earns an annual income of #80 million and spent #50 million on procurement of working materials, calculate the APS of the firm.
b. Marginal propensity to save (MPS): The marginal propensity to save is defined as a measure of the relationship between changes in the level of savings and changes in income. It shows the change in savings brought about by a change in income level.
The formula is:
If the daily income of a factory worker increases from #500.00 to #700.00 and he increases his level of consumption by #80.00, calculate the marginal propensity to save and to consume.
Elementary Theory of the Multiplier
The theory of the multiplier states that an increase in consumer or business investment spending in a country would produce a multiplier effect by raising the level of national income. In other words, the multiplier is the figure by which an increase in total expenditure in the country may be multiplied to get the resulting increase in the national income. The multiplier is also referred to as the ratio of changes in national income to changes in the autonomous expenditure which led to it.
The multiplier effect can be as a result of changes in consumption expenditure, which is known as consumption multiplier, or investment changes, which is known as investment multiplier.
Using the investment multiplier as an example, if a #3 million increase in total investment in a country leads to a #9 million increase in national income, the multiplier is therefore equal to three.
The multiplier is a system used in all types of spending in a country by individuals, firms and the government.
The multiplier, denoted by K, is usually calculated with the aid of a formula:
A knowledge of the marginal propesnity to consume or the marginal propesnity to save helps us to know the multiplier. And a knowledge of the multiplier helps us to know the extent to which consumption expenditure or investment should be increased or decreased to achieve a desired level of income.
The higher the MPC, the higher the multiplier effect and the higher the MPS, the lower the multiplier effect. Therefore, a higher MPC increases national income while a higher MPS will reduce it.
Suppose the MPC is 0.75. This means that 0.75 of every additional income will be consumed. The amount saved will be 1 – 0.75 = 0.25, since MPC + MPS = 1.
The multiplier, the MPC and the MPS are related by the formula;
C(a) If the marginal propensity to consume is 0.8, calculate the multiplier.
(b) By how much must consumption expenditure be increased to increase income by #10,000.00
Equilibrium Level of Income
Equilibrium level of income may be defined as a situation where the total amount people wish to save equals total investment of business units. It refers to a point at which aggregate savings equals aggregate investment.
At equilibrium level of income, there is a balance between demand and supply and there will be no tendency to increase or decrease output. The business sector is satisfied that the right volume of output has been achieved and there will be no tendency to alter it.
For equilibrium national income to be obtained, the volume of total withdrawals from the circular flow of income must be equal to the total injections. For instance, total amount of savings must be equal to total value of investment goods, and aggregate expenditure must be equal to total output.
Income earners (or households) can spend their income on consumption goods or save it. Hence, Y = C + S. On the other hand, the firms can produce either consumption goods or investment goods. Hence, Y = C + I. Therefore, for Y to be constant, the level of savings (S) must be equal to investment (I). By implication, the amount of consumption goods and services produced by firms will be equal to the aggregate demand by the households.
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Take a quick test for this lesson
i. With the aid of a diagram, explain circular flow of income.
ii. Discuss the factors affecting the circular flow of income
iii. Define savings
iv. Explain five factors that determine personal savings
v. Give five reasons why people say
vii. Define investment
viii. Explain six factors that determine the level of investment in your country
ix. Define consumption
x. Discuss five factors that determine the level of consumption in your country
xi. Explain the relationship that exist between savings, investment and consumption
xii. If the marginal propensity to save is 0.45, calculate
(a) the multiplier
(b) the level of investment which is required to raise income by #12,000.00.
Questions answered correctly? Kudos!!
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