Consumption Function

The Concept of Consumption Function

The consumption function is a mathematical formula laid out by economist John Maynard Keynes.

It shows the relationship between real disposable income and consumer spending.

The consumption function is represented as:

C = A + MD

where:C = Consumer spendingA = Autonomous consumption, or the level of consumption that would still exist even if income was Re.0M = Marginal propensity to consume, which is the ratio of consumption changes to income changesD = Real disposable income

Note: The generic Keynes’ Consumption Function is written as Y = a + bY

The consumption function is shown here to be linear, but that is dependent on the variable "M" (marginal propensity to consume) staying the same.

In fact, consumers tend to spend a smaller percentage of their disposable income as it rises, creating a curved effect at higher income levels.

Marginal Propensity to Consume (MPC)

The proportion of an aggregate raise in pay that a consumer spends on the consumption of goods and services, as opposed to saving it.

It is calculated as the change in consumption divided by the change in income.

MPC is depicted by a consumption line- a sloped line created by plotting change in consumption on the vertical y-axis and change in income on the horizontal x-axis.

Marginal Propensity to Consume (MPC)

The marginal propensity to consume (MPC) is equal to ΔC / ΔY, where ΔC is change in consumption, and ΔY is change in income.

If consumption increases by 80 paise for each additional rupee of income, then MPC is equal to

0.8 / 1 = 0.8.

Initial Assumptions

Two sector model of the goods market in the economy (no government sector, no foreign trade).

A closed economy:

– in which households exercise consumption demand for final goods and services; and

– Firms demand investment goods.

Initial Assumptions

In this economy

AD º C + I

Theories to explain how and why households and firms make consumption and investment decisions.

We will assume investment in the economy is given.

We need to introduce a theory to explain how consumption decisions are made by households.

The Pre-Keynesian Consumption Function

When we construct a macroeconomic consumption function, we take the relative price of goods as given.

We focus on how households divide their expenditure between consumption of all goods and services and saving.

Y º C + S

In the pre-Keynesian era, the predominant view was that the rate of interest was the main variable influencing the division of income between C and S.

The pre-Keynesian savings and consumption functions can be written as:

S = f(r)

C = f(r)

The Keynesian Consumption Function

Keynes accepted that the rate of interest was a variable which influenced consumption decisions, but he believed that the level of income was more important.

C = f(Y)

S = f(Y)

‘The fundamental psychological law, upon which we are entitled to depend with great confidence . . . is that men are disposed, as a rule and on average, to increase their consumption as their income increases, but not by as much as the increase in their income’

The consumption function describes the relationship between consumer spending and income

C = Ca + bY

Consumption spending, C, has two parts:

– Ca = autonomous consumption. This is the part of total consumption which does not vary with the level of income.

– bY = income-induced consumption. The product of a fraction, b, called the marginal propensity to consume (MPC) and the level of income, Y.

The consumption function is a line that intersects the vertical axis at Ca. It has a slope equal to b.

Consumption Function

Although output is on the horizontal axis, output and income in this simple economy are identical.

Output generates income, that is all received by households.

As output rises by Re.1, consumption increases by the marginal propensity to consume b times Re.1.

Marginal Propensity to Consume

The MPC is always less than 1.

Suppose the MPC = 0.75

An increase in income of Rs.100 would increase consumption by

bΔY = 0.75 x 100

= Rs.75

If a consumer receives a dollar of income, consumer will spend some of it and save the rest.

The fraction that the consumer spends is determined by the MPC

The fraction of income that the consumer saves is determined by the marginal propensity to save (MPS)

The sum of the MPC and MPS is always 1

Changes in the Consumption Function

The level of autonomous consumption and the MPC can change, causing movements in the consumption function.

If the level of autonomous consumption is higher, it will shift the entire consumption function.

Changes in the MPC will change the slope of the consumption function.

Autonomous Consumption Changes

Increases in consumer wealth will cause an increase in autonomous consumption.

Consumer wealth consists of the value of stocks, bonds and consumer durables.

Increases in consumer confidence will increase autonomous consumption.

Movements Of The Consumption Function

Marginal Propensity To Consume Changes

Consumers’ perceptions of changes in their income affect their MPC

If consumers believe that an increase in their income is permanent, they will consume a higher fraction of the increased income than if the increase were believed to be temporary

MPC: Example

Suppose you receive a Rs.5,000 bonus on top of your normal annual earnings.

You suddenly have Rs.5,000 more in income than you did before.

If you decide to spend Rs.4,000 of this marginal increase in income on a new business suit and save the remaining Rs.1,000, your marginal propensity to consume will be 0.8 (Rs.4,000 divided by Rs.5,000).

This also means that your marginal propensity to save (MPS) will be 0.2 (Rs.1,000 divided by Rs.5,000).

If you decide to save the entire Rs.5,000, your marginal propensity to consume will be 0 (Re.0 divided by Rs.5,000).

The other side of marginal propensity to consume is marginal propensity to save, which shows how much a change in income affects levels of saving.

Marginal propensity to consume + marginal propensity to save = 1. (MPC + MPS = 1)

Given the data on household income and household spending, economists can calculate households’ MPC by income level.

This calculation is important because MPC is not constant; it varies by income level.

Typically, the higher the income, the lower the MPC, because as wealth increases, so does the ability to satisfy needs and wants, so each additional rupee is less likely to go toward additional spending.

According to Keynesian theory, an increase in production increases consumers’ income, and they will then spend more.

If we know what their marginal propensity to consume is, then we can calculate how much an increase in production will affect spending.

This additional spending will generate additional production, creating a continuous cycle.

The higher the MPC, the higher the multiplier—the more the increase in consumption from the increase in investment.

Average Propensity to Consume (APC)

The average propensity to consume (APC) refers to the percentage of income that is spent on goods and services rather than on savings.

One can determine the percentage of income spent by dividing the average household consumption (what is spent) by the average household income (what is earned).

The inverse of the average propensity to consume is the average propensity to save (APS).

Economic periods where consumers are spending can boost the economy: more goods are purchased (high demand for goods and services); keeping more people employed and more businesses open.

Periods where the tendency to save is increased can have a negative effect on the economy as people purchase fewer goods and services (low demand for goods and services), resulting in fewer jobs and increased business closures.

Average Propensity to Save (APS)

The average propensity to save (APS) is an economic term that refers to the proportion of income that is saved rather than spent on goods and services.

Also known as the savings ratio, it is usually expressed as a percentage of total household disposable income (income minus taxes).

The inverse of average propensity to save is the average propensity to consumer (APC).

The average propensity to save can be affected by factors such as the proportion of older people in an economic region who have less motivation and ability to save, and the rate of inflation, as people spend now and save later when prices are expected to rise.

Important Features of Keynes’ Consumption Function

Absolute level of current income is the most important factor that determines consumption of the community.

This factor is over and above the role of interest rate that influenced consumption level.

0 < MPC < 1 : As income increases, consumption increases, but as much as the increase in income.

C = a + by : As income increases, APC falls.

Rich people relatively save a higher proportion of their income so that at higher income levels APC i.e., proportion of total consumption to national income falls as national income rises.

Consumption function remains stable in the short run.

According to Keynes, consumption function depends upon institutional factors such as distribution of income and wealth, and psychological factors such as willingness to save.

These factors don’t change quickly in the short run.

That is, it does not shift upward or downward.

Determinants of Propensity to Consume

There are two types of factors that influence or determine the propensity to consume:

1. Objective factors, and

2. Subjective factors

1. Objective factors

(i) Changes in the general price level : real balance effect

- an increase in general price level (inflation) results in a fall in consumption function because rise in prices results in fall in purchasing power (real value) of money balances and financial assets.

- this results in downward shift in consumption function.

- this is called real balance effect.

- Again, when prices fall, real value of money and financial assets increase.

- this induces people to consume more from their income, resulting in upward shift in the consumption function.

(ii) Fiscal Policy:

- fiscal policy affects the propensity to consume.

- tax hikes reduce consumption, and thereby increase savings.

- tax cuts increase consumption, and reduce savings.

(iii) Rate of Interest:

- higher interest rates induce people to save more and consume less, and vice versa.

(iv) Stock of Wealth:

- wealth includes real assets, such as land, houses, automobiles, etc., and financial assets, such as cash balances, saving and fixed deposits in banks, shares, bonds, etc.

- greater the wealth, higher the propensity to consume.

- increase in wealth shifts the consumption function upward, and decrease in wealth shifts the consumption function downward.

(v) Credit Conditions and Consumer Indebtedness:

- easy credit increases consumption, shifting the consumption function upward.

- tightening of credit shifts the consumption function downward.

- highly indebted households are committed to save more or consume less.

(vi) Income Distribution:

- greater the unequal distribution of national income, lower the propensity to consume by the nation.

- this is because the propensity to consume of the rich is relatively less as compared to that of the poor.

(vi) Windfall Gains and Losses:

- when the prices of shares go up, the shareholders think that they are better off and raise their consumption, and vice versa.

- these affect the propensity to consume

(vii) Change In Expectations:

- a gloomy future (with expected price rise) will make people consume more during the current period, and vice versa.

2. Subjective Factors

Some factors that induce people to save are:

People save for unforeseen circumstances such as illness, unemployment, accidents, etc.

Providing for expected future needs such as education, marriage, etc.

Use the accumulated savings for generating future income, profits and interest.

Accumulate wealth for social status.

Consumption Function

The factors that induce business firms to save are:

Investing in new enterprises or growth of the current one(s).

Maintaining liquidity to meet future contingencies.

Maintaining a good depreciation practice (to replace worn out plants and machinery) with financial prudence in order to ensure smooth flow of uninterrupted production in the future.

To repay old debts.