Consumption Function

• The theory given by Keynes on consumption expenditures is

known as psychological law of consumption.

• According to this law: when income (Y) increases, consumption

expenditure also increases but some what at a lower fraction than
increase in income.

• This suggests that people dont want to consume their entire

incremental income, a part of the income is saved.

• There could be several factors which induces people to save a part

of their income.

1. One of such factor could be uncertainty about future event.

2. people save to smoothen their consumption over different period
of time.
Distinction between consumption and
consumption function
consumption consumption function
• Means the amount • Means the whole of the
spent on consumption schedule showing consumption
at a given level of expenditures at various levels
income. of income
• Tells us how C increases as Y
increases.
• Keynes Psychological • Indicates a functional
Law: when Y increases C relationship between C and Y.
also increases but by • It is a schedule that expresses
less than the increase in relationship between C&Y
income.
 Factors influencing consumption demand

• The real income of the Individuals

• His past savings
• Rate of interest

• In The General Theory, Keynes argued that

household consumption is directly related to its
income.
Keynes fundamental law of consumption or psychological law
of consumption:
• Propositions of the Law- three related propositions:
1. when Y increases, C will also increase but by a somewhat smaller
amount. The reason is that as Y increases more and more of our wants
gets satisfied , hence not as much is again spent on consumption as the
increase in income.
2. When Y increases the increment of income will be divided in same
proportion between savings and consumption. It follows from the first
proposition.
3. As Y increases both consumption spending and saving will go up.

• Assumptions:

• Habbits of the people regarding spending do not change.

• conditions remain normal: no hyperinflation or no war or other
abnormal condition.
• Free economy.
 The Consumption Function
• The consumption function shows the relationship
between the level of consumption expenditure
and the level of income.
C = f (Y)

If autonomous and induced consumption is identified

then: C = CA + CI
C = CA + MPC . Y
 Autonomous consumption

• Autonomous consumption expenditure CA

occurs when income levels are zero. Such
consumption does not vary with changes
in income.
• If income levels are actually zero, this
consumption is financed by borrowing or
using up savings.
 Induced consumption

• Induced consumption CI describes

consumption expenditure by households on
goods and services which varies with income.
• Consumption is considered induced by
income.
 Keynsian consumption concepts:

• APC=C/Y
• MPC= ∆C/∆Y=
• APS=S/Y
• MPS= ∆S/∆Y
• C= Total consumption
• Y=Total Income
• S=Savings
• The marginal propensity to consume (MPC) is the
extra amount that people consume when they
receive an extra unit of income.
MPC = ΔC / ΔY
Household Consumption and Saving

C = a  bY
• The slope of the
consumption function (b) is
called the marginal
propensity to consume
(MPC), or the fraction of a
change in income that is
consumed, or spent.

0  b<1
Household Consumption and Saving

• The fraction of a change in income that is saved is

called the marginal propensity to save (MPS).

MPC+MPS  1
• Once we know how much consumption will
result from a given level of income, we
know how much saving there will be.
Therefore,

S YC
 An Aggregate Consumption Function
Derived from the Equation C = 100 + .75Y

C  100 .75Y
• At a national income of
zero, consumption is
$100 billion (a).
• For every $100 billion
increase in income (DY),
consumption rises by
$75 billion (DC).
 Savings

• Saving is that part of income that is not

consumed. Saving equals income minus
consumption: S = Y – C
• Income is the sum of consumption and
savings: Y = C + S
C S DC DS
 1  1
Y Y DY DY
• then and
 Savings

• The marginal propensity to save

DS
MPS 
DY

is defined as the fraction of an extra unit

of income that goes to extra saving.
• MPC + MPS = 1 because the part of each
unit of income that is not consumed is
 Saving Function

• Like consumption saving is also the

function of income: S = f(Y)
• If autonomous consumption exists then
autonomous saving exists as well and
saving function is: S = -CA + MPS.Y

• Saving is a source for investment.

 The Consumption and Saving
Function
C, S

The saving function is

the mirror image of the
C = f(Y) consumption function. It
shows the relationship
between the level of
saving and income.

CA S = f(Y)

45˚
0
YE Y
-CA
 APC and MPC: the relationship between Y
and C is measured by APC and MPC
APC MPC
• Measures the incremental change in
• Is a relationship consumption C as a result of a given
between total C increment in come (Y)
and Y in a given • But MPC = the ratio of change in
time period. consumption to the change in income.
• In otherwords APC
= C/Y. DC
MPC 
DY
• ∆C: Incremental change in consumption.
• ∆Y: Incremental change in income
• The normal relationship between Y and C is
such that when y increases C also increases
but by less than the increase in income. In
normal times MPC is less than 1.
• It is drawn as a straight line
with a slope of less than one.
• This slope indicates the
percentage of additional
income that will be spent.
• If it is less than one bcz it is
assumed that the whole
additional income is not spent.
Certain percentage is spent
and remainder is saved
Y C S
100 75 25
120 90 30
140 105 35
180 135 45
220 165 55
Y C S APC=C/Y APS=S/Y MPC MPS
1000 950 50 0.95 .05 - -
1100 1040 60 0.94 0.06 90/100=0.9 10/100=0.1
1200 1125 75 0.93 0.062 85/100=0.85 15/100=0.15
1300 1205 95 0.92 0.073 80/100=0.80 20/100=0.2
1400 1280 120 0.91 0.093 75/100=0.75 25/100=0.25
 The Consumption Function

C
Savings

Consumption
function C = f(Y)

CA Consumption

45˚
0 Y1 Y2 Y
 The Consumption Function

• 45˚ line: at any point on the 45˚line

consumption exactly equals income and
the households have zero saving.
• MPC is the slope of the consumption
function, which measures the change in
consumption per unit change in income.
 Factors of consumption function
• Distribution of income
• Fiscal policy
• Substantial changes in rate of interest
• Changes in business expectation
• Windfall gain and losses
• Liquidity preferences