Von Lester L.

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CONSUMPTION FUNCTION change in income. MPC is depicted by a

consumption line- a sloped line created by
What is the 'Consumption Function?'
plotting change in consumption on the
The consumption function, or Keynesian vertical y axis and change in income on the
consumption function, is an economic horizontal x axis.
formula representing the functional
Real disposable income is the total income
relationship between total consumption and
minus taxes
gross national income. It was introduced by
British economist John Maynard Keynes, BREAKING DOWN 'Consumption
who argued the function could be used to Function'
track and predict total aggregate
The classic consumption function suggests
consumption expenditures.
consumer spending is wholly determined by
The consumption function is represented income and the changes in income. If true,
as: aggregate savings should increase
proportionally as gross domestic product
C = A+MD
(GDP) grows over time. The idea is to
Where: create a mathematical relationship
between disposable income and consumer
C = Consumer spending spending, only on aggregate levels.
A = Autonomous consumption
M = Marginal propensity to consume The stability of the consumption function,
D = Real disposable income based in part on Keynes' Psychological Law
of Consumption, especially when contrasted
Autonomous consumption is the minimum with the volatility of investment, is a
level of consumption or spending that must cornerstone of Keynesian macroeconomic
take place even if a consumer has no theory. Most post-Keynesians admit the
disposable income, such as spending for consumption function is not stable in the
basic necessities. long run; consumption patterns change as

The marginal propensity to consume income rises.

(MPC) is the proportion of an aggregate Assumptions and Implications

raise in pay that a consumer spends on the
consumption of goods and services, as Much of the Keynesian doctrine centers
opposed to saving it. Marginal propensity to around the frequency with which a given
consume is a component of Keynesian population spends or saves new income. The
macroeconomic theory and is calculated as multiplier, the consumption function and
the change in consumption divided by the the marginal propensity to consume are
each crucial to Keynes focus on spending propensity to consume. This hypothesis
and aggregate demand. stipulated that poorer individuals likely
spend new income at a higher rate than
The consumption function is assumed
wealthy individuals.
stable and static; all expenditures are
passively determined by the level of Milton Friedman offered his own simple
national income. The same is not true of version of the consumption function, which
savings, which Keynes called investment, he called the permanent income
not to be confused with government hypothesis. Notably, the Friedman model
spending, another concept Keynes often distinguished between permanent and
defined as investment. temporary income. It also extended
Modiglianis use of life expectancy to
For the model to be valid, the consumption
infinity.
function and independent investment must
remain constant long enough for national More sophisticated functions may even
income to reach equilibrium. At equilibrium, substitute disposable income, which takes
business expectations and consumer into account taxes, transfers and other
expectations match up. One potential sources of income. Still, most empirical
problem is the consumption function cannot tests fail to match up with the
handle changes in the distribution of consumption functions predictions.
income and wealth. When these change, so Statistics show frequent and sometimes
too might autonomous consumption and the dramatic adjustments in the consumption
marginal propensity to consume. function.

Other Versions Consumption function, in economics, is the

relationship between consumer spending
Over time, other economists have made
and the various factors determining it. At
adjustments to the Keynesian consumption
the household or family level, these
function. Variables such as employment
factors may include income, wealth,
uncertainty, borrowing limits or even life
expectations about the level and riskiness
expectancy can be incorporated to modify
of future income or wealth, interest rates,
the older, cruder function.
age, education, and family size. The
For example, many standard models stem consumption function is also influenced by
from the so-called life cycle theory of the consumers preferences (e.g., patience,
consumer behavior as pioneered by Franco or the willingness to delay gratification),
Modigliani. His model made adjustments by the consumers attitude toward risk,
based on how income and liquid cash and by whether the consumer wishes to
balances affect an individual's marginal leave a bequest (see legacy). The
characteristics of consumption functions At the microeconomic level the structure
are important for many questions in both of the consumption function is of interest
macroeconomics and microeconomics. in itself, but it also has a powerful
influence on many other kinds of economic
In macroeconomic models the consumption
behaviour. For example, individuals with
function tracks total aggregate
only a small stock of savings who are laid
consumption expenditures; for simplicity it
off from their jobs may be forced to take
is assumed to depend on a basic subset of
new jobs quickly, even if those jobs are a
the factors economists believe are
poor match for their skills. On the other
important at the household level. Analysis
hand, laid-off consumers with substantial
of consumption expenditure is important
savings may be able to wait until they can
for understanding short-term (business
find a better job match. Whether a
cycle) fluctuations and for examining long-
consumer is likely to have much savings
run issues such as the level of interest
when laid off will depend on the degree of
rates and the size of the capital stock (the
patience reflected in the consumption
amount of buildings, machinery, and other
function.
reproducible assets useful in producing
goods and services). In principle, the The standard version of the consumption
consumption function provides answers to function emerges from the life-cycle
both short-run and long-run questions. In theory of consumption behaviour
the long run, since income that is not articulated by economist Franco Modigliani.
consumed is saved, the responsiveness of The life-cycle theory assumes that
households to any tax policy (such as those household members choose their current
meant to spur aggregate saving and expenditures optimally, taking account of
increase the capital stock) will depend on their spending needs and future income
the structure of the consumption function over the remainder of their lifetimes.
and particularly what it says about how Modern versions of this model incorporate
saving responds to interest rates. In the borrowing limits, income or employment
short run, the effectiveness of tax cuts or uncertainty, and uncertainty about other
other income-boosting policies (such as important factors such as life expectancy.
those meant to stimulate a recessionary
Economist Milton Friedman advocated a
economy) will depend on what the
simplified version of this model, known as
consumption function says about how much
the permanent income hypothesis, which
the typical recipient spends or saves out of
abstracts from retirement saving
the extra income.
decisions. The figure shows the
consumption function that emerges from a
standard version of the permanent income Many people confuse the concepts of
hypothesis (assuming uncertain future saving and investment. The differences
income and a standard utility function are important, so we will spend some time
that specifies consumers attitudes toward on the issue.
the level and riskiness of their spending).
Saving takes place when people abstain
The figure relates the consumers current
from consumption, that is, when they
stock of spendable resources (also known
consume less than their income.
as cash on hand, or the sum of current
Investment takes place when we purchase
income and spendable assets) to his or her
new capital equipment or other assets that
level of spending. Perhaps the most
make for future productivity. Investment
important feature of the figure, for both
does not mean buying stocks or bonds.
microeconomic and macroeconomic analysis,
Here are some important facts:
is what it says about the marginal
propensity to consume (MPC)that is, how For Robinson Cruse, the difference
much extra spending will result from a between saving and investment is a
given increase in cash on hand. When levels distinction without a difference.
of cash on hand are low, the MPC is very Since he does all saving and all
high, indicating that poor households are investment, they are automatically
likely to spend any windfall income rather equal. However, for the larger
quickly. However, when levels of cash on economy, this is not true.
hand are high (that is, for wealthy Investment funds come either from
households), the MPC becomes quite low, our own saving or from someone
suggesting that a windfall will prompt only else's saving.
a small increase in current spending.
Several strands of empirical research The motive for saving is one of
confirm the proposition that low-wealth deferring your consumption to a
households exhibit higher MPCs than high- later day. We save when we
wealth households. consume only part of our income now
and save for retirement, a rainy
According to the permanent income
day, putting children through
hypothesis, the marginal propensity to
college, the summer home, etc.
consume decreases as the amount of cash
on hand increases.
The motive for investment is to
SAVINGS-INVESTMENT FUNCTION make money. Investment takes
place when we purchase plants or
Saving and Investment as Different
equipment, which make workers and
Concepts
 businesses more productive in the technical distinctions of how savings is
future. transformed from money balances,
eventually into capital, and emphasize the
Ultimately saving and investment value of those vehicles in selecting which
must be equal, (subject to a couple capital to invest in.
of complications that make for nice
exam questions). As you will see in a In a Keynesian sense, savings is whatever is
moment, you can think of saving as a left over after income is spent on
supply of funds for investment and consumption of goods and services,
investment as a demand for funds. investment is what is spent on goods and
We will later draw supply and services that are not 'consumed', but are
demand curves and show how saving durable. Since Income = Output, Savings =
and investment are equated. Investment for the total world's economy
(or for a hypothetical 'closed' economy
with zero foreign trade).
Role of Savings and Investment

In a Monetarist sense, savings is the total

There are two views of the topic titled
rate at which units of account exceed
Savings and Investment. One is considered
expenditures, and are accumulated as unit
to apply to real physical macroeconomic
of account (e.g. dollar) balances with
activity, the "Keynesian", or National
financial intermediaries. Or sometimes
Accounts view. The other is considered to
hoarded as currency. Investment is the
apply to money and banking, the
rate at which financial intermediaries and
"Monetarist" view. They primarily differ
others expend on items intended to end up
slightly in definitions of terms, which
as capital that directly creates value, i.e.
consequently lead to different discussions
physical capital, durable goods, human
about very different subject matter. The
capital, etc. In general, savings does not
two views actually are different subject
equal investment, but differs slightly at all
areas, making it the historical debate
times, the differences constituting a
difficult to collate, let alone reconcile.
behavioral relationship, rather than an
accounting one, as in the Keynesian view.
Keynesians start with accounting
definitions, where Savings = Investment,
The two views are just looking at very
by construction, and tend to emphasize the
different things. The most commonly
nonproductive (zero sum) nature of all
referred meaning of the phrase "Savings
vehicles by which savings eventually ends
and Investment" is in first year college
up as capital. Monetarists tend to focus on
economics, where Keynesian and extralegal means, will make saving less
neoclassical macroeconomics are taught, attractive (in contention between
and national accounts, (i.e. the identity Y = Keynesian and Monetarist views here,
C + I + G) is explained. mostly because of differences in
definitions).
Savings
These factors affect the marginal
Saving is what households (i.e. participants propensity to save (MPS) - the greater this
in the consumption account) do. The level MPS, the more saving households will do as
of saving in the economy depends on a a proportion of each additional increment
number of factors (incomplete list): of income.

A higher real interest rate will give a Investment

greater return on saving as banks offer Investment is made into capital (e.g. plant
more favorable rates. and machinery, also 'human capital' -
training and education), with intent to
Poor returns on risky forms of saving, e.g. increase productivity, efficiency and
stocks and bonds, make it more output of goods and services.
advantageous to hold money savings (in
contention between Keynesian and In national accounting terms, stocks,
Monetarist views here, mostly because of bonds, mutual funds, and other items
differences in definitions). whose value is risky, are NOT investments.
They fall into the savings account, not the
Poor expectation for future economic investment account.
growth, increases households' savings as a
precaution for a grim future. In monetary terms, the relationship
between savings and investment is
More disposable income after fixed modeled, rather than being an accounting
expenditures (such as mortgage, heating identity. Stocks and bonds are considered
bill, basic goods purchases) have been to be important intermediary forms of
made (in contention between Keynesian and savings as it gets transformed into a
Monetarist views here, mostly because of capital investment that produces value.
differences in definitions). Mutual funds, CDs, BICs, GICs, pension
obligations, insurance annuities, and other
Perceived likelihood of plunder of the forms of savings marketed by financial
future value of savings, via legal or intermediaries, all consist of stocks, bonds,
and cash balances, which in turn pay for Producers O = C + I
the capital that increases productivity,
efficiency and output of goods and
services.

The 2 Forms of Investment

a) voluntary
normal investment plant
equipment etc.
planned increases in inventory.

b) involuntary
unplanned increases in inventories,
output not consumed.

Note on so-called "fiscal" policy, i.e.

marginal discretionary government
spending:

A. Planned Injections (J), and Planned

Withdrawals (W)

J > W = economy expansion

J < W = economy contraction
J = W = -economy at equilibrium

B. Savings and investment flows most likely

to change economic activity

Y = Consumption(C) + Savings(S)

Output (O) = C + I Y = O C = C S
= I Therefore:

Consumers Y = C + S
 ALGEBRA OF CONSUMPTION AND Saving (S) = Y - C
SAVINGS FUNCTION
= Y - C0 - MPC*Y = -C0 + (1-MPC)*Y
Assume we are in a world where we either
= -C0 + MPS*Y
spend on consumption goods/services or
save. Note that MPS represents the marginal
propensity to save and that the proportion
Total Income (Y) = Total
we didn't spend of our extra dollar is
Consumption (C) + Savings (S)
saved (ie. MPS+MPC=1).
Consider the consumption component (C).
Consumption:
There is a fixed component and a variable
component which is dependent on our C=Co + cY
income.
Savings:
- The fixed component is called
S= -Co + sY
autonomous consumption (C0) which
represents what we need to consume Consumption:
irrespective of what our income is. This
includes food, rent, bills etc. Effectively it Co= autonomous consumption

is our consumption when our income is 0. (autonomous: independent of

income)
- The variable component depends on our So if C=80+0.8Y
income through our marginal propensity to Co=80=autonomous consumption
consume (MPC). MPC is basically the (survival expenditure when Y=0)
proportion I would spend out of every c=MPC=0.8
extra dollar I earn. For simplicity, we Y=level of income
assume MPC does not change.
Saving:
Thus we have:
so if C=80+0.8Y
Consumption (C)= Fixed component + -Co=autonomous saving=-80
variable component s=MPS=(1-0.8)=0.2
Therefore S=-80+0.2Y
= autonomous consumption (C0) +
MPC * Income (Y)

To derive the savings function, we simply MPS+MPC=1

use the first equation at the top (what we

didn't spend we shall save) to get:
MULTIPLIER CONCEPT much remains for investments. Keynes
rearranged the equations to solve for
What is a 'Multiplier?'
income, or Y = I / (1-b).

In economics, a multiplier is the factor by

Here, Keynes re-defined Y as k, writing k =
which gains in total output are greater
1 / (1-b). This allowed Keynes to assert Y =
than the change in spending that caused it.
k*I. Since investment was multiplied by k,
It is usually used in reference to the
Keynes referred to k as the multiplier. For
relationship between investment and total
any new injection of government spending,
national income. The multiplier theory and
k showed the relationship between change
its equations were created by British
in income (dY) and change in investment
economist John Maynard Keynes.
(dI), or dY = k*dI.

BREAKING DOWN 'Multiplier

Given an MPC = 0.8, for example, then k = 1
/ (1 - 0.8) = 5. This suggested any change in
By investment, Keynes meant government
income will be five times the change in new
spending. He believed that any injection of
investment, or new government
government spending created a
expenditures.
proportional increase in overall income for
the population, since the extra spending
Problems in Multiplier Math
would carry through the economy.
In Keynes' first derivation, income (Y) is
treated as an independent variable, or a
The Mathematics of the Multiplier
cause which drives other changes in the
economy; after introducing the concept of
In his 1936 book "The General Theory of
k, but investment (I) and the multiplier (k)
Employment, Interest, and Money," Keynes
were suddenly independent variables.
wrote following equation to describe the
Income became a dependent variable, or an
relationship between income (Y),
effect.
consumption (C) and investment (I): Y = C +
I. For any level of income, people spend a
Keynes' multiplier reversed cause and
fraction and save/invest the remainder.
effect after k was introduced. While still
mathematically true, this reversal only
Keynes represented the marginal
demonstrated a necessary accounting
propensity to save (MPS) as 1-b, and the
relationship in Keynes equation, not any
marginal propensity to consume (MPC) as b.
meaningful causal relationship.
This creates the equations C = bY, and I =
Y - C. In other words, bY determines how
For an analogy, consider the equation for can find out the total increment in income
converting Celsius into Fahrenheit: F = 32 + that will occur as a result of investment.
1.8C. Here, an increase in 10 degrees
Celsius implies an increase of 18 degrees If the marginal propensity to consume of a
Fahrenheit. This can be expressed community is equal to 2/3, we can find out
mathematically as dF/dC = k, where k is a the size of multiplier as under:
Celsius multiplier. (Mathematically, this is
identical to the Keynesian multiplier.) Multiplier, k = 1/1-MPC
It would not make much sense to claim a
10-degree rise in Celsius causes an 18- 1/1-2/3 = 1/1/2 = 3
degree rise in Fahrenheit. The two may be
mathematically related in a fixed equation, Likewise, if the marginal propensity to
but there is no sensible causal link involved. consume is equal to or 0.5, then the
The same goes for Keynesian multipliers. multiplier:

In fact, a derivation of the Keynesian 1/1-1/2 = 1/1/2 = 2

multiplier can be written dY / dC = 1/b.
With an MPC = 0.8, a change in income is Two Limiting Cases of the Value of
only 1.25 times the change in new Multiplier:
expenditures, not five times.
One limiting case occurs when the marginal
THE SIZE AND PROCESS OF THE propensity to consume is equal to one, that
MULTIPLIER is, when the whole of the increment in
income is consumed and nothing is saved. In
Calculating the Size or Value of this case, the size of multiplier will be
Multiplier: equal to infinity, that is, a small increase in
investment will bring about a very large
It follows from above that the size or increase in income and employment so that
value of multiplier is the reciprocal of full employment is reached and even the
marginal propensity to save. Therefore, we process goes beyond that. In such
can obtain the value of multiplier if we circumstances, the Government would need
know the marginal propensity to consume to employ only one road builder to raise
or the marginal propensity to save of the income indefinitely, causing first full
community. Given the size of multiplier employment and then a limitless spiral of
form the net increase in investment, we inflation.
However, this is unlikely to occur since investment in a period and no further
marginal propensity to consume in the real indirect effects on investment in that
world is less than one. The other limiting period occur or if they occur they have
case occurs when marginal propensity to been taken into account so that there is a
consume is equal to zero, that is, when given net increase in investment.
nothing out of the increment in income is
consumed, and the whole incre-ment in 2. We have assumed that there is no any
income is saved. time-lag between the increase in
investment and the resultant increment in
In this case, the value of the multiplier will income. That is, increment in income takes
be equal to one. That is, in this case, the place instantaneously as a result of
increment in income will be equal to the increment in investment. J.M. Keynes
original increase in investment and not a ignored the time-lag in the process of
multiple of it. But in actual practice the income generation and therefore his
marginal propensity to consume is less than multiplier is also called instantaneous
one but more than zero (1 > C/Y > 0). multiplier. In recent years, the importance
of time lag has been recognized and
Therefore, the value of the multiplier is concept of dynamic multiplier has been
greater than one but less than infinity. developed on that basis. But in an
ele-mentary study as the present one the
Assumptions of Multiplier Theory: time lags will be ignored as was done by
Keynes.
1. We have assumed that the marginal
propensity to consume remains constant 3. Excess capacity exists in the consumer
throughout as the income increases in goods industries so that when the demand
various rounds of consumption expenditure. for them increases, more amounts of
However, the marginal propen-sity to consumer goods can be produced to meet
consume may differ in various rounds of this demand. If there is no excess capacity
consumption expenditure. in consumer goods industries, the increase
in demand as a result of some original
But this constancy of marginal propensity increase in investment will bring about rise
to consume is a realistic assumption, since in prices rather than increases in real
all available empirical evi-dence shows that income, output and employment.
marginal propensity to consume is very
stable in the short run. Secondly, we have
assumed that there is a net increase in