CONSUMPTION AND SAVING FUNCTIONS

 What is ‘Keynesian psychological law of consumption’?

 What is consumption function?
 What is Average Propensity to Consume (APC)?
 What is saving function?
 What is Average Propensity to Save (APS)?
 Prove that MPC + MPS = 1
 Prove that APC + APS = 1
 What are the alternatives to ‘Keynesian psychological law of consumption’?
 Mathematics questions
 Definition or short notes-
Autonomous consumption
Marginal Propensity to Consume (MPC)
Dissaving
Marginal Propensity to Save (MPS)
Disposable income
Tax
 CONSUMPTION AND SAVING FUNCTIONS

What is ‘Keynesian psychological law of consumption’? Disposable income:

The change of other things held constant, when disposable income increases, the Disposable income =
consumption expenditure or consumption increases; but consumption expenditure or Gross income – Tax.
consumption does not increase as much as the increase of disposable income. Tax :Tax is calculated by
Table-1 the following formula-
4 Tax = Tax rate x Gross
1 2 3 5 7
Disposable 6 income
Gross Tax Tax Increase Increase of where tax rate is the
income Consumption
income rate (T) of Yd consumption percentage of gross
(Yd) (C)
(Y) (t) 3 = 2 x 1 (Δ Yd) (ΔC) income which is paid as
4=1-3
tax.
0 5% 0 0 38
95 76
100 5% 5 95 114
95 76
200 5% 10 190 190
95 76
300 5% 15 285 266
95 76
400 5% 20 380 342

Following columns 4 and 6 we see that consumption expenditure or consumption

increases as disposable income increases. From 5 and 7 columns we find that
consumption expenditure or consumption does not increase as much as the increase of
disposable income.

What is consumption function?

Followed by ‘Keynesian psychological law of consumption’ we can construct a
consumption function. Consumption function shows the relationship between
disposable income and consumption expenditure or consumption.
Table-2
1 5
2 4
Disposable 3 MPC
0 Increase of Increase of
income Consumption (ΔC/
Points Yd consumption
(Yd) (C) ΔYd)
(ΔYd) (ΔC)
5 = 4/2
A 0 38
95 76 0.8
B 95 114
95 76 0.8
C 190 190
95 76 0.8
D 285 266
 95 76 0.8
E 380 342

Denoting the horizontal axis as disposable income and vertical axis by consumption we
plot the points A, B, C, D, and E and then we draw a line through these points and thus
we get the consumption function as follows-

National consumption function of an economy is achieved by adding all individuals’

consumptions of that economy.

Autonomous consumption:
We see that at A consumption expenditure (Tk.48) is being undertaken when
disposable income is Tk.0. Autonomous consumption is the consumption expenditure
or consumption at zero level of disposable income.

Marginal Propensity to Consume (MPC):

MPC is the change in consumption expenditure as a result of the change of one extra
unit of disposable income.

c = ΔC/ΔYd ; where c = MPC, ΔC = change of consumption expenditure, and ΔYd =

change of disposable income.

We find from the Table-2 (column 5) that in every case the MPC is 0.8.

MPC always maintain-

0 <MPC<1.

0<MPC→ because consumption expenditure increases as disposable income increases.

MPC<1→ because the increase of consumption expenditure is always less than the
increase of disposable income.

The condition of 0<MPC<1 exactly depicts the Keynesian psychological law of

consumption.

Slope of consumption function and MPC:

As we are concentrating about a function, we have to think about the slope of
consumption function. In mathematics slope is the ratio of ‘rise’ divided by ‘run’. We
see in this case that-
Table-3
Between Run Rise |Slope =
Rise/Run
A&B 95 76 0.8
B&C 95 76 0.8
D&E 95 76 0.8

So we clearly see (from Table-2 and Table-3) that in every case-

Slope of consumption function = MPC

Mathematical view of consumption function:

C = 38 + 0.8 Yd; where C = Consumption
38 = Autonomous consumption
0.8 = MPC
Yd = Disposable income

By this function we can calculate the consumption expenditure at every level of

disposable income.

In generalized form we can write the consumption function as-

C = a + c Yd ; where C = Consumption
a = Autonomous consumption
c = MPC
Yd = Disposable income

What is Average Propensity to Consume (APC)?

APC is the ratio of consumption expenditure to disposable income.

APC = C/Yd; where C = consumption expenditure, and Yd = disposable income.

We see that-
Table-4
1 3
Disposable 2 APC
income Consumption (C/Yd)
(Yd) (C) 3 = 2/1

0 38 Can’t be
determined
95 114 1.20
190 190 1.00
285 266 0.93
380 342 0.90

What is saving function?

Saving is the excess to disposable income after meeting up the consumption
expenditure.

We review Table-2 and add some information-

Table-5
7
1 4 6
2 MPS
Disposable 3 Saving 5 Increase
0 Increase (ΔS/
income Consumption (S) Identified of
Points of Yd ΔYd)
(Yd) (C) 4=1- as- saving
(ΔY d) 7=
3 (ΔS)
6/2
A 0 38 -38 Dissaving
95 19 0.2
B 95 114 -19 Dissaving
95 19 0.2 -19 - (-38) = 19
C 190 190 0 Break-
even
point
95 19 0.2 S = -38 + 0.2Yd
D 285 266 19 Saving S= -38 + 0.2 () =
95 19 0.2
E 380 342 38 Saving

When consumption expenditure exceeds disposable income, then dissaving occurs.

This excess of consumption is meet up by borrowing. When consumption expenditure
is lower than disposable income, then saving occurs. When consumption expenditure is
equal to disposable income, then there is neither dissaving nor saving. This situation is
called as 'break-even point'. We can show saving, dissaving, and break-even point by
using a 45° line in graph-1.

Along this 45° line every level of disposable income is exactly equal to the
corresponding level of consumption expenditure. Above the 45 line there is dissaving
(A, B); below the 45° line, there is saving (D, E). At C on 45° line there is neither
dissaving nor saving.

Saving function shows the relationship between disposable income and saving. We can
draw the saving function from Table-5 (columns 1 and 4) by plotting A, B, C, and D
and then adding them as follows-
From the above figure we see that A and B represent dissaving. D and E represent
saving. C represents break-even point.
National saving function of an economy is achieved by adding all individuals’ savings
of that economy.

Marginal Propensity to Save (MPS):

MPS is the change in saving as a result of the change of one extra unit of disposable
income.

s = ΔS/ΔYd ; where s = MPS, ΔS = change of saving, and ΔYd = change of disposable

income.

We find from the Table-5 that in every case the MPS is 0.2.
MPS > 0
MPS always maintain-
0 <MPS<1.

Slope of saving function and MPS:

As we are concentrating about a function we have to think about the slope of saving
function. We see in this case that-

Table-6
Between Run Rise Slope = Rise/Run
A&B 95 19 0.2
B&C 95 19 0.2
D&E 95 19 0.2

So we clearly see (from Table-5 and Table-6) that in every case-

Slope of saving function = MPS

Mathematical view of saving function:

S = -38 + 0.2 Yd; where S = Saving
-38 = -Autonomous consumption = Dissaving
0.2 = MPS
Yd = Disposable income

By this function we can calculate the saving at every level of disposable income.

In generalized form we can write the saving function as-

S = -a + s Yd; where S = Saving
- a = -Autonomous consumption = Dissaving
s = MPS
Yd = Disposable income

What is Average Propensity to Save (APS)?

APS is the ratio of saving to disposable income. We see that-

APS = S/Yd, where S= saving, and Yd = disposable income.

Table-7
1
3
Disposable 2
APS
income Saving
(C/ Yd)
(Yd) (S)
3 = 2/1
0 -38 Can’t be
determined
95 -19 -0.20
190 0 0.00
285 19 0.67
380 38 0.10
Prove that ‘MPC + MPS = 1’
Style 1:
We know that-
Y = C + S + T ; Where Y = Economy’s total income,
and C + S + T = Economy’s total expenditure;
where C = Consumption, S = Saving,
and T = Tax.
Now we get-
+2 = (+1) + (+1)
Y–T=C+S 5=3+2
Or, Yd = C + S 7=4+3
The change of Yd = The change of C + The change of S
Or, ΔYd = ΔC + ΔS
Or, ΔYd / ΔYd = (ΔC + ΔS) / Yd ; [dividing by ΔYd in both sides]
Or, 1 = ΔC / ΔYd + ΔS/ ΔYd
Or, 1 = MPC + MPS

So-
MPC + MPS = 1.

Style 2:
We know that-
Consumption function-
C = a + c Yd ; where C = Consumption
a = Autonomous consumption
c = MPC
Yd = Disposable income
And saving function-
S = -a + s Yd ; where S = Saving
- a = -Autonomous consumption = Dissaving
s = MPS
Yd = Disposable income

We know that-
Y = C + S + T ; Where Y = Economy’s total income,
and C + S + T = Economy’s total expenditure;
where C = Consumption, S = Saving,
and T = Tax.
Now we get-
Y–T=C+S
Or, Yd = C + S
Or, Yd = (a + c Yd) + (-a + s Yd) ; [using from consumption and saving functions]
Or, Yd = a – a + c Yd + s Yd
Or, Yd = c Yd + s Yd
Or, Yd / Yd = (c Yd + s Yd ) / Yd ; [dividing by Yd in both sides]
Or, 1 = c Yd / Yd + s Yd / Yd
Or, 1 = c + s
Or, 1 = MPC + MPS

So-
MPC + MPS = 1

Mathematical proof:
Using the information of Table-2 and Table-5 , we get-
Table-8
Between MPC MPS MPC + MPS =
A&B 0.8 0.2 1.0
B&C 0.8 0.2 1.0
D&E 0.8 0.2 1.0

So-
MPC + MPS = 1

Prove that ‘APC + APS = 1’.

Style 1:
We know that-
Y = C + S + T ; Where Y = Economy’s total income,
and C + S + T = Economy’s total expenditure;
where C = Consumption, S = Saving,
and T = Tax.

Now we get-
Y–T=C+S
Or, Yd = C + S
Or, Yd / Yd = (C + S) / Yd ; [dividing by Yd in both sides]
Or, 1 = C / Yd + S / Yd
Or, 1 = APC + APS

So-
APC + APS = 1

Mathematical proof:
From Table-4 and Table-7 we find that-
Table-9
At APC APS APC + APS =
A Can’t be Can’t be Can’t be
determined determined determined
B 1.20 -0.20 1.0
C 1.00 0.00 1.0
D 0.93 0.67 1.0
 E 0.90 0.10 1.0

So-
APC + APS = 1

What are the alternatives to ‘Keynesian psychological law of consumption’?

Keynesian psychological law of consumption assumes the disposable income; but it
does not include the effects caused by wealth other that disposable income. It assumes
that consumption expenditure takes place in the period same as the period of
disposable income. But people make decision about the consumption expenditure
considering their income of all periods including their assets- this is ‘permanent
income hypothesis’ provided by Milton Friedman. Over the working life people save
money to finance the consumption expenditure of periods after their working life- this
is ‘life cycle hypothesis’ provided by Franco Modigliani.

References?
1) Economics by Paul A. Samuelson and William D. Nordhaus.
 Mathematics Questions

1) Given that-
consumption function, C = 100 + 0.75 Yd
Gross income, Y = 500
Tax rate, t = 5%
 Find out-
Autonomous consumption
Marginal propensity to consume
Marginal propensity to save
Saving function

 By using the above information prove that-

MPC + MPS = 1
APC + APS = 1

Answer:
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Y t T Yd ∆Yd C= ∆C c= S= ∆S s= APC APS MPC APC
= = 100 + ∆C/∆Yd Yd - ∆S/∆Yd = = + +
Y Y– 0.75 C C/Yd S/∆Yd MPS APS
x T Yd = =
t

0 5% 0 0 100 -100 no no No
475 356.25 0.75 118.75 0.25 1.00
500 5% 25 475 456.25 18.75 0.96 0.04 1.00

 Following from 4 and 6, we find autonomous consumption = Tk.100

 Following from 8, we find MPC = 0.75
 Following from 11, we find MPS = 0.25
 Following from 9 and 11, we find saving function as-
S = -100 + 0.25 Yd
 Following from 14, we find MPC + MPS = 1
 Following from 15, we find APC + APS = 1.
 2) Given that-
saving function, S = -100 + 0.25 Yd
Gross income, Y = 500
Tax rate, t = 5%
 Find out-
Saving
Marginal propensity to save
Marginal propensity to consume
Consumption function

 By using the above information prove that-

MPC + MPS = 1
APC + APS = 1

Answer:
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Y t T Yd ∆Yd S=- ∆S s= C= ∆C c= APS APC MPC APC
= = 100 ∆S/∆Yd Yd - S ∆C/∆Yd = = + +
Y Y– + S/Yd C/∆Yd MPS APS
x T 0.25 = =
t Yd

0 5% 0 0 -100 100 no no no
475 118.75 0.25 356.25 0.75 1.00
500 5% 25 475 18.75 456.25 0.04 0.96 1.00

 Following from 1 and 6, we find at Tk.0 level of income saving is -Tk.100, which
is dissaving and at Tk.500 level of income saving is Tk.18.75.
 Following from 8, we find MPS = 0.25
 Following from 11, we find MPC = 0.75
 Following from 9 and 11, we find saving function as-
C = 100 + 0.75Yd
 Following from 14, we find MPC + MPS = 1
 Following from 15, we find APC + APS = 1.
 3) Given that-
Gross income, Y= 100, 200, 300, 400
Tax rate, t = 5%
Marginal Propensity to Consume is 0.8
Autonomous consumption is Tk.100
 Find out consumption and saving for each level of national income.
 Prove that-
MPC + MPS = 1
APC + APS = 1

Answer:
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Y t T Yd ∆Yd c a C= S= ∆S s= APC APS MPC APC
= = 100 + Yd - ∆S/∆Yd = = + +
Y Y– 0.8 Yd C C/Yd S/∆Yd MPS APS
x T = =
t

100 5% 5 95 100 176 -81 1.85 -0.85 1.00

95 0.8 19 0.2 1.00
200 5% 10 190 100 252 -62 1.33 -0.33 1.00
95 0.8 19 0.2 1.00
300 5% 15 285 100 328 -43 1.15 -0.15 1.00
95 0.8 19 0.2 1.00
400 5% 20 380 100 404 -24 1.06 -0.06 1.00

 Following from 1, 8, and 9, we find-

at Tk.100, Tk.200, Tk.300, and Tk.400, the consumption expenditures are Tk.176,
Tk.252, Tk.328, and Tk.404 respectively and disssavings are -Tk.81, - Tk.62, -
Tk.43, and - Tk.24 respectively.
 Following from 14, we find MPC + MPS = 1
 Following from 15, we find APC + APS = 1.