The consumption function

Consumption demand depends on income and propensity

to consume.

Consumption function, C= f (Y)

 The demand for consumption goods is not constant but,
rather, increases with income: Families with higher incomes
consume more than families with lower incomes, and
countries where income is higher have higher levels of total
consumption. The relationship between consumption and

income is described by the consumption function.

 The coefficient c is sufficiently important to have a special
name, the marginal propensity to consume (MPC). The
marginal propensity to consume (MPC) is the increase in
consumption per unit increase in income. In our case, the
marginal propensity to consume is less than 1, which implies
that out of a dollar increase in income, only a fraction, c , is
spent on consumption.
[ Why MPS (c) is less than 1 (one) ?
Y = C+S

……………
…………………… ]
 Y   C   S
Divided bothe sides by Y we have
Y C S
  
Y Y Y
 1  MPC  MPS
MPC  MPS  1
MPS  1  MPC or MPC  1  MPS
Consumption and Saving
What happens to the rest of the dollar of income, the
fraction (1 ─ c), that is not spent on consumption? If it
is not spent, it must be saved. Income is either spent or
saved; there are no other uses to which it can be put. It
follows that any theory that explains consumption is
equivalently explaining the behavior of saving.
• Consumption, Aggregate demand and
Autonomous spending
Equilibrium Income and Output
The next step is to use the aggregate demand function,
AD, from Figure 9-2 and equation (9) to determine the
equilibrium levels of output and income. The
equilibrium level of income is such that aggregate
demand equals output (which in turn equals income).
The 45° line, AD = Y, in Figure 9-2 shows points at
which output and aggregate demand are equal. Only at
point E in Figure 9-2, and at the corresponding
equilibrium levels of income and output does
aggregate demand exactly equal output in Figure 9-2.
At that level of output and income, planned spending
precisely matches production.
The arrows on the horizontal axis in Figure 9-2 indicate
how the economy reaches equilibrium. At any income
level below Y0 firms find that demand exceeds output
and inventories are declining, and they therefore
increase production. Conversely, for output levels
above firms find inventories piling up and therefore cut
production. As the arrows show, this process leads to
the output level at which current production exactly
matches planned aggregate spending and unintended
(unplanned) inventory changes ( IU ) are therefore
equal to zero. IU is unplanned
Y  A  cY
 Y  cY  A
 Y (1  c)  A
A 1
Y  or A
I c 1 c
How ( MPC ) is less than 1but greater than 0.
C
1   0; or 1  MPC  0
Y
Problem-1: Suppose in an economy, autonomous investment (I) is $600
crores and the following consumption function is given: C= $200+0.8Y
and find out the equilibrium level of income?
Solution: The equilibrium level of income is Y= C+I……. (i)
Given C= 200+0.8Y and I=600
Putting the value of C and I in the equilibrium equation (i) we have Y=
200+0.8Y+600
=>Y- 0.8Y=200+600
Y(1-0.8) =800
Y (0.20)=800
=> 0.2Y=800
Y=800/0.20
Y= 800*100/20= 4000
Answer: the equilibrium level of income is $4000.
Problem-2: Suppose the consumption and investment function of an
economy are given by C = 20+0.6Y and I = 10+0.20Y then what will be
the equilibrium level of income?
 this will not change our method of determining equilibrium level of income ($).
According to a close economy, given Y = C+ I ………… (i)
The functions of C and I are C = 20+0.6Y and I = 10+0.20Y respectively
Putting the values of C and I in the equilibrium equation (i) we have
Y = 20+0.6Y+10+0.20Y
 Y=30+0.80Y
 Y-0.8Y= 30
 0.20Y= 30/0.20 = (30*100/20)
 Y= 150

The equilibrium level of income is $150.

Problem-3: Suppose in an economy, autonomous investment (I) is $800
crores and the following consumption function is given: C= 400+0.8Y
and find out the equilibrium level of income?
• Problem-4: Suppose the consumption and investment
function of an economy are given by C = 200+0.55Y and I =
100+0.25Y then what will be the equilibrium level of
income?
What are Open economy, closed economy,
Disposable income, Tax, Transfer, MPS and
MPC?