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C A+Byd: What Is The 'Consumption Function'

The consumption function represents the relationship between total consumption and gross national income. It was introduced by John Maynard Keynes and shows that consumption (C) equals autonomous consumption (A) plus the marginal propensity to consume (MPC) multiplied by real disposable income (Yd). The MPC represents the proportion of additional income that is spent on consumption goods and services rather than saved. Autonomous consumption is the minimum level of spending required even without income. The consumption function can be used to predict aggregate consumption expenditures.

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Pulasthi Prabashana Kuruppuarachchi
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84 views3 pages

C A+Byd: What Is The 'Consumption Function'

The consumption function represents the relationship between total consumption and gross national income. It was introduced by John Maynard Keynes and shows that consumption (C) equals autonomous consumption (A) plus the marginal propensity to consume (MPC) multiplied by real disposable income (Yd). The MPC represents the proportion of additional income that is spent on consumption goods and services rather than saved. Autonomous consumption is the minimum level of spending required even without income. The consumption function can be used to predict aggregate consumption expenditures.

Uploaded by

Pulasthi Prabashana Kuruppuarachchi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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What is the 'Consumption Function'

The consumption function, or Keynesian consumption function, is an economic formula representing the
functional relationship between total consumption and gross national income. It was introduced by British
economist John Maynard Keynes, who argued the function could be used to track and predict total
aggregate consumption expenditures.
The consumption function is represented as:

C=a+bYd
Where:
C = Consumer spending
A = Autonomous consumption
b= Marginal propensity to consume
Yd = Real disposable income
The marginal propensity to consume (MPC) is the proportion of an aggregate raise in pay that a consumer
spends on the consumption of goods and services, as opposed to saving it. Marginal propensity to
consume is a component of Keynesian macroeconomic theory and is calculated as the change in
consumption divided by the change in income.
Autonomous consumption is the minimum level of consumption or spending that must take place even if
a consumer has no disposable income, such as spending for basic necessities.

Savings Function
saving is that part of income which is not spent on current consumption. The relationship between saving
and income is called saving function.
Simply put, saving function (or propensity to save) relates the level of saving to the level of income. It is
the desire or tendency of the households to save at a given level of income. Thus, saving (S) is a function
(f) of income (Y).
Symbolically,
S = f (Y)
(i) Saving can be negative (-) at zero or low level of income and (ii) As Income increases, savings also
increase but more than the increase in income
Remember, saving is residual income of households that is left after consumption.

Algebraically:
S = Y-C
Now, substituting the above Keynesian function for C in (i) we have:
S = Y (a + bY)
= Y a bY = a + Y bY
= a + (1 b) Y (ii)
Note that (1 b) in the above saving function in (ii) is the value of marginal propensity to save where b is
the value of marginal propensity to consume. Let us give a numerical example. Suppose the following
consumption function is given.
C = 150 + 0.80 Y
S= 150 + 0.20 Y

2. Marginal Propensity to Save (MPS):


Whereas average propensity to save indicates the proportion of income that is saved, marginal propensity
to save represents how much of the additional disposable income is devoted to saving. The marginal
propensity to save is therefore change in savings induced by a change in the disposable income.
Thus,
MPS = S/ Y

Meaning of Equilibrium:
By equilibrium we mean the state of balance or state of no change. By equilibrium national income we
refer to that level of national income which remains unchanged at a particular level.
At the equilibrium level of national income there is no tendency for income/output to rise or fall.
In the Keynesian two-sector economy there are only household and business sectors.
Government is absent and the economy is a closed one. In this simple economy, there are two elements of
national incomeconsumption and investment, i.e., C + I. An economy is said to be in equilibrium when
aggregate expenditure equals aggregate income or aggregate money value of all goods and services.
Aggregate demand is, thus, sum of consumption demand and investment demand. Since, in a two-sector
economy, there are only two goodsconsumption goods and investment goodsaggregate expenditure

is, the sum of consumption and investment expenditures. Thus, aggregate demand (C + I) equals
aggregate expenditure (C + I).
Alternatively, whenever aggregate income equals aggregate expenditure, leakages from and injections
into the circular flow of income become equal to each other. In a two-sector economy, saving is the only
source of withdrawal and investment is the only source of injection. Thus, an economy is said to be in
equilibrium when saving (i.e., withdrawal) equals investment (i.e., injection).
The above argument, thus, suggests that there are two alternative approaches of national income
determination. First approach slates that the equilibrium level of national income is determined by the
equality of aggregate demand (or aggregate expenditure) and aggregate supply of output. In terms of a
diagram, one can say that in a two-sector economy, the equilibrium level of national income is determined
at that point where C + I line cuts the 45 line. This approach is, thus, known as income-expenditure
approach or aggregate demand-supply approach.
Aggregate demand = money value of output (income)
or Y = C + I
Alternative approach states that, when injection (I) equals leakage (S) in a two-sector economy,
equilibrium level of national income is determined. In terms of a diagram, when saving line and
investment line intersect each other, equilibrium level of income is determined.
Leakage (saving) = injection (investment)
or S = I
Remember that these two approaches are alternative to each other.

Demand for money


The demand for money is the desired holding of financial assets in the form of money: that is, cash or
bank deposits. It can refer to the demand for money narrowly defined as M1 (non-interest-bearing
holdings), or for money in the broader sense of M2 or M3.

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