THE WOLMER’S TRUST HIGH SCHOOL FOR GIRLS

ECONOMICS UNIT II
TOPIC: THE BASIC KEYNESIAN MODEL
SUB-TOPIC: THE CONSUMPTION FUNCTION

What is the “Consumption Function”?

The consumption function/consumption expenditure refers to the amount of money households

spend on goods and services to satisfy their consumption requirements.

Factors Influencing Consumption

Income: the main factor influencing consumption is the household’s income. However, whether

the appropriate income is current income, life cycle income or permanent income, is the subject

of much theoretical debate.

Availability of credit and the cost of borrowing: In general, it is easy and cheap to borrow then

people will borrow and consume more. If people spend more money than they are earning then

they are dissaving.

Age distribution: Middle-aged consumers tend to save more of their income than young people.

Inflation: The effect of inflation on consumption is uncertain. Some people spend more money

if they expect prices to increase. Other consumers tend to spend less in the presence of higher

prices so that they can maintain the real value of their savings.

Indirect taxes: As indirect taxes increase, the prices of goods and services also increase and

people tend to buy less.

Range of goods and services: People spend more if goods of a high quality are available.
 The Basic Keynesian Consumption Function

Keynes made two assumptions regarding the behaviour of consumption (spending):

1. People’s decisions on their consumption are a function of current income

2. Increments to income are partly spent and partly saved.

Understanding the Consumption Function

The classic consumption function suggests consumer spending is wholly determined by income

and the changes in income. If true, aggregate savings should increase proportionally as gross

domestic product (GDP) grows over time. The idea is to create a mathematical relationship

between disposable income and consumer spending, but only on aggregate levels.

The stability of the consumption function, based in part on Keynes' Psychological Law of

Consumption, especially when contrasted with the volatility of investment, is a cornerstone of

Keynesian macroeconomic theory. Most post-Keynesians admit the consumption function is not

stable in the long run since consumption patterns change as income rises.

The consumption Function: Autonomous and Induced Spending

The consumption function describes the relationship between consumption expenditure and the

variables that influence it. A representative form of the Consumption Function is:

C= f (Y, other variables)

Where, C= aggregate consumption, Y= aggregate income (current)

Other variables include such factors as wealth.

A simplified consumption function proposed by John Maynard Keynes in his book ia:

C = c0 + c1YD,

Where, C= aggregate consumption

Co= autonomous consumption

c1YD,= endogenous spending

c1= marginal propensity to consume

YD= current disposable income

OR

C = A + MD

where:

C=consumer spending

A=autonomous consumption

M=marginal propensity to consume

D=real disposable income

Autonomous consumption Co occurs when a household’s income is zero. Consumption still

occurs when income is zero because such a household can borrow, beg, or use their savings.

Endogenous consumption is consumption that varies as income varies.

Two important concepts associated with the consumption function are the average and the

marginal propensity to consume. The average propensity to consume or the APC is simply the

ratio of aggregate consumption to national income and can be represented as:

apc= C

The marginal propensity consumption or MPC is given as the ratio of the change in consumption

to the change in income.

mpc= 🔺consumption

🔺in national income

 Assumptions and Implications
Much of the Keynesian doctrine centers around the frequency with which a given population

spends or saves new income. The multiplier, the consumption function, and the marginal

propensity to consume are each crucial to Keynes’ focus on spending and aggregate demand.

The consumption function is assumed stable and static; all expenditures are passively determined

by the level of national income. The same is not true of savings, which Keynes called

“investment,” not to be confused with government spending, another concept Keynes often

defined as investment.

For the model to be valid, the consumption function and independent investment must remain

constant long enough for national income to reach equilibrium. At equilibrium, business

expectations and consumer expectations match up. One potential problem is that the

consumption function cannot handle changes in the distribution of income and wealth. When

these change, so too might autonomous consumption and the marginal propensity to consume.