The consumption function
Consumption,
the largest component of aggregate spending, occupies a key place in the
Keynesian macroeconomic analysis. In Keynes view, consumption expenditure of
households is dependent on the level of disposable (after tax) income, i.e.
the largest component of aggregate spending, occupies a key place in the
Keynesian macroeconomic analysis. In Keynes view, consumption expenditure of
households is dependent on the level of disposable (after tax) income, i.e.
C
= F (Yd)
= F (Yd)
Where
C
= Planned Consumption
= Planned Consumption
Yd
= Y – T
= Y – T
Y
= Income, T = Taxes.
= Income, T = Taxes.
If
for simplicity, we assume a two-sector model (without foreign and public
sectors), where firms distribute all profits made to share holders and that
there is no depreciation on capital, so that gross private investment is equal
to net investment, then we can rewrite the consumption functions as
for simplicity, we assume a two-sector model (without foreign and public
sectors), where firms distribute all profits made to share holders and that
there is no depreciation on capital, so that gross private investment is equal
to net investment, then we can rewrite the consumption functions as
C
= F (Y)
= F (Y)
In
general, the consumption function shows the various amount of money households
plan to spend on consumption goods at various levels of income, all other
things, such as prices of goods and services, remaining constant. There are two
basic concepts associated with Keynes analysis of the household’s consumption
function. The first is the concept of autonomous consumption. The second is the
propensity to consume. We look at the two in turn.
general, the consumption function shows the various amount of money households
plan to spend on consumption goods at various levels of income, all other
things, such as prices of goods and services, remaining constant. There are two
basic concepts associated with Keynes analysis of the household’s consumption
function. The first is the concept of autonomous consumption. The second is the
propensity to consume. We look at the two in turn.
The autonomous consumption
This
is the level of consumption that would be made by households irrespective of
the level of income. Put differently, it is the minimum level of consumption expenditure
that must be undertaken by the household even at zero level of income. Every
household must meet some basic consumption needs over a given period, even if
it is not earning any income. This basic level of consumption that must be met
independent of income is the household’s autonomous consumption. When the
household’s income is below the income level required to meet its autonomous
consumption expenditure, there is an income gap that must be filled through one
means or the other.
is the level of consumption that would be made by households irrespective of
the level of income. Put differently, it is the minimum level of consumption expenditure
that must be undertaken by the household even at zero level of income. Every
household must meet some basic consumption needs over a given period, even if
it is not earning any income. This basic level of consumption that must be met
independent of income is the household’s autonomous consumption. When the
household’s income is below the income level required to meet its autonomous
consumption expenditure, there is an income gap that must be filled through one
means or the other.
For
example, if the autonomous consumption requirement of a typical household for a
given period isN500, while its income
for the same period isN300, there is
an income gap ofN200, which the
household must find a way of filling. Generally, there are two ways a household
can fill up any deficit in income needed to finance its autonomous consumption.
The first is by drawing on past savings (wealth) if any. The second is by
borrowing. The first methods are traditionally called dis-saving (the process
of adding a negative saving to the existing savings level).
example, if the autonomous consumption requirement of a typical household for a
given period is
for the same period is
an income gap of
household must find a way of filling. Generally, there are two ways a household
can fill up any deficit in income needed to finance its autonomous consumption.
The first is by drawing on past savings (wealth) if any. The second is by
borrowing. The first methods are traditionally called dis-saving (the process
of adding a negative saving to the existing savings level).
In
general, however, since the household would still have to pay back whatever is
borrowed, even borrowing can be classified as a form of dis-saving (because
what would have been saved out of future income would be used to settle some debts).
The presence of an autonomous element in the consumption function means that
the graph of the function would have an intercept. Specifically, the graph of
the consumption function (relating the house’s consumption expenditure to
income) will intercept the vertical axis at a value equal to the household’s
autonomous consumption expenditure.
general, however, since the household would still have to pay back whatever is
borrowed, even borrowing can be classified as a form of dis-saving (because
what would have been saved out of future income would be used to settle some debts).
The presence of an autonomous element in the consumption function means that
the graph of the function would have an intercept. Specifically, the graph of
the consumption function (relating the house’s consumption expenditure to
income) will intercept the vertical axis at a value equal to the household’s
autonomous consumption expenditure.
The propensity to consume
The
novelty of Keynes analysis of the consumption function lies in his exposition
on the propensity to consume. Simply put the propensity to consume defines a
relationship between income and consumption. It shows the tendency of the
household to spend on consumption goods, given a particular level of income.
Keynes distinguished between the average and the marginal propensity to
consume. The average propensity to consume (APC) shows the fraction of each
unit of income that the household spends on consumption. Algebraically,
novelty of Keynes analysis of the consumption function lies in his exposition
on the propensity to consume. Simply put the propensity to consume defines a
relationship between income and consumption. It shows the tendency of the
household to spend on consumption goods, given a particular level of income.
Keynes distinguished between the average and the marginal propensity to
consume. The average propensity to consume (APC) shows the fraction of each
unit of income that the household spends on consumption. Algebraically,
APC
= C/Y 6.5
= C/Y 6.5
If
for example, Y isN2, 000 and C = N1, 200, then APC = 1200/2000 = 0.6. The
marginal propensity to consume (MPC) shows the proportion of an additional unit
of income that is spent on consumption. It tells us by how much consumption
expenditure will increase if there is a one unit increase in income. Hence,
for example, Y is
marginal propensity to consume (MPC) shows the proportion of an additional unit
of income that is spent on consumption. It tells us by how much consumption
expenditure will increase if there is a one unit increase in income. Hence,
MPC = C/Y
Where
C = Change in consumption expenditure
C = Change in consumption expenditure
Y = Change in income.
If
income changes byN200, from N2000 to N2,200
for example, and planned consumption expenditure increases fromN1200 to N1360,
then Y = 200 and C = 160. Thus, MPC = C/Y = 160/200 = 0.8
income changes by
for example, and planned consumption expenditure increases from
then Y = 200 and C = 160. Thus, MPC = C/Y = 160/200 = 0.8
