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Keynesian Theory Aggregate Demand : Consumption Function

Keynesian Theory Aggregate Demand : Consumption Function
People spend most of their income on commodities. Some spend their income fully and some others spend a portion and keep the rest for saving.

Consumption Function

 

People spend most of their income on commodities. Some spend their income fully and some others spend a portion and keep the rest for saving. How much the community as a whole spends and saves? It is about the relationship between income and consumption.

 

The term 'consumption function' explains the relationship between income and consumption. A function is the link between two or more variables. The proportion of income spent on actual consumption at different levels of income is called propensity to consume.

 

Keynes made it clear that there is a direct relation between income and consumption. Consumption function or propensity to consume is the ratio that measures the functional relationship between income and consumption. In mathematical form the relation can be expressed as,

 

C = a + b y     .. .. .    ( 2 )

C = 4 + .8Y   

Thus a consumption function is generally described in terms of the linear equation Y = a + bY where the constant 'a' is the amount of autonomous consumption and slope (b) is MPC. The rate of change in consumption due to change in income depends on the MPC.

 

Equation (2) simply says that consumption (C) depends on income

 

(Y). The + sign indicates that as income increases, obviously consumption will also increase. But the rate of increase in consumption will be little less than that of the rate of increase in income. It is because some unspent portion of the income will be saved. This aspect is made clear in the Keynes law of consumption. He points out, 'the psychology of the community is such that when real income is increased, aggregate consumption is increased, but not so much as income' . Keynes also made it clear that in the short run, the consumption function is stable because consumption habits of the people are more or less stable in short period.

 

All these points or the income-consumption relationship can also be expressed in Figure . The vertical axis shows the spending on consumption indicated by C and the horizontal axis shows income or output indicated by Y. The straight line consumption function CC is defined in terms of equation C = 4 + .8Y.

 

The consumption curve CC is a short run curve. In this case consumption takes place even when income is zero. In equation (2) 4 is the level of initial consumption when income is zero and it is not affected by income. Even when income is zero, people spend some minimum level either by gift or borrowing. This consumption which is not related to income is called as autonomous consumption. That is the reason why curve C starts from 4 on the vertical axis.

In equation (2)  indicates that 80 per cent of additional income is spent on consumption and it is called as marginal propensity to consume (MPC). Thus MPC is the ratio of change in consumption to change in income. In other words, MPC is the rate of change in propensity to consume.

MPC   =                   Change in consumption /         Change in income

            

Or MPC =      ∆       ∆ C    /        ∆ ∆ Y

   

Where ∆ ∆ C - Change in consumption and∆ ∆ Y - Change in income The slope of the consumption function or any other straight line is

 

measured by dividing the vertical change by horizontal change. The symbol � represents a change. Or slope can also be calculated as

 

Slope = Vertical change / Horizontal change

The propensity to consume is assumed to be stable in the short run. Therefore out of the given income how much will be spent depends on the slope of the curve.

In our case, .8 indicates that out of every additional income earned eighty per cent will be spent for consumption keeping the rest for saving. In short, consumption function relates the amount of consumption to level of income. Thus consumption of an economy depends upon the level of income. When the income of an economy rises, consumption also rises and vice versa. Suppose people spend more in an economy in relation to their income, their MPC will be more.

 

Keynesian Law of Consumption implies the following three aspects. Thus the concept of consumption function plays a vital role in Keynesian income determination.

 

1.        Increase in income and increase in consumption are not at the same proportion. Consumption function is positive but less than one.

2.        An increase in income is shared between consumption and saving.

 

3.        Increase in income will not cause rise in consumption and saving at the same time. If the rate of increase in savings rises, the rate of increase in consumption will fall.

 

Saving Function

 

The portion of the income not spent on consumption is saving. Saving is consumption forgone. If saving rises, consumption will fall. According to Keynes, the level of saving in the economy, like consumption, depends basically on income. The relationship between saving and income can mathematically be expressed as in equation ( 3) and that is called as saving function.

S = -a + by    

S = - 4 + .2Y  �.    ( 3 )

 

Where S - Saving ; Y - Income; -a - dis-savings.

 

Marginal Propensity to Save (MPS) is the ratio of change in saving to a change in income. Thus it is the rate of change in the propensity to save.

 

Or MPC =      ∆ ∆ S / ∆ ∆ Y

   

Where∆ ∆ S - Change in saving and∆ ∆ Y - Change in income

 

With an increase income, if MPC tends to fall, MPS will tend to rise. If MPC remains constant, MPS also will remain constant. Thus income consists of consumption and saving.

 

Hence    Y = C + S

 

Or         MPC + MPS = 1

 

MPS = 1 - MPC or

 

MPC = 1 - MPS

 

In an economy where people spend less of their additional income, MPC will be less and the CC curve will be less steep. Note that the constant (-a) is dis-saving because it is autonomous consumption which is unrelated to income. The autonomous consumption will became zero in the long run. That is, households cannot consume without income in the long run. Hence in the long run, the consumption purely depends upon income and the curve C starts from origin.

 

Other Determinants of Consumption

 

Though income is the most important factor that has greater influence on consumption, there are other factors which influence the propensity to consume. They are:

 

1.        Income distribution

 

2.        Size and nature of wealth distribution

 

3.        Age distribution of population

 

4.        Inflation or price level

 

5.        Government policies

 

6.        Rate of interest

 

7.        Expectations about price, income, etc.

 

8.        Advertisements

 

9.        Improvement in the living standard

 

10.   Changes in cultural values

 

As discussed earlier, aggregate demand consists of two parts (if you ignore government and external trade) namely consumption function and investment function. However, consumption function or MPC remains constant in the short run. Hence, Keynes placed greater emphasis on investment function.

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