KEYNESIAN CONSUMPTION FUNCTION &

MULTIPLIER
BYDR.
PAULSON MATHEW CHUNKAPURA
President &
Prof. Of
UAE Campus, Dubai Economics& Business, American City University & London
.

City College,
ODR. PAULSON,
JAN 2003. All rights reserved with
author. No part of this
the
publication may be
reproduced in any form or by any means, by any one.

Consumption function shows the functional

income, i.e., how much of the income will be relationship between consumption and
spent on consumption.
In symbols,
C=f(Y) ORC-f (Yd)
Where, C Consumption
Y Income
Yd Disposable Income
f' is functional
This can also be relationship.
expressed as:
C a+by
Where,
C =Consumption
a =
autonomous consumption
by Income Induced Consumption
b = MPC

The concept of
consumption function was developed by LORD J.M KEYNES.
him, as income
increases, consumption also According to
following table illustrates consumption function: increases,
but less than
proportionately. The
Income (Y)
Disposable Income
Consumption Savings
(in Millionsof S) (in Millions ofS)
(Yd) in Millionsof (S)

0
60
20
70
-20 Negative
0
120 120 0] Zero saving
180 170 +10
240 220 +20 Saving
300 270 +30
360 320 +40
From the above table , it is clear that consumption is a rising function of
Disposable income. Even when income is zero, people are still spending on consumer
goods because they have to eat in order to live. That part of the consumption expenditure
which is independent of the level of income is called autonomous consumption .People finance
autonomous consumption by using their past saving or by borrowing.
 Function:
of Consumption
Diagrammatic Representation

RLaN-Evn
26RoSAVING d C+s

Saving
C f(yd)
=a by

Income Induced Consumotion.

Dissavirng
Autonomous Consumdtion

45

Disposable Income

45° line, consumption is

it is clear that when the 'C' curve ies above the
From the figure,
greater than income. This is called "Dissaving".
"Break-even
This point is called the
the 45° line, C= Yd
0. Point (B) is called zero saving
curve crosses
When consumption
the income level where saving
=

Income". This is
level of
point.

there will be positive saving.

Thus, the consumption
lies below the 45° line, the amount saved.
When the "C' consumption, but also
cuve
the amount spent on
not only
function measures

Income is Zero
When disposable
a u t o n o m o u s consumption.
to point 'B'
the figure, OA and YS represent from their past saving .Up
In OA amount
people still spend rise in consumption
due to an
in the current period, incomne rises, consumption also rises. The there is positive
there is Dissaving.
As
-Induced consumption.
Beyond point B,
Income
increase in income
is called expenditure.
than the consumption
income is greater
because disposable
saving,
Consumption Function
Technical Attributes of of Income spent
on

APC is the amount

(APC):
Average Prosperity
to Consume
1
consumer goods

APC C OR C
Yd saving
used for
of Income
APS is the
percentage

OR S
APS S Yd
 APC + APS = 1, where 1 stands for
original disposable income.
2 Marginal Propensity to Consume (MPC)
MPC is the ratio of change in
consumption to the change in income.
MPC AC OR AC
AY AYd

MPS is the ratio of

change in saving to the change in income.
MPSAS (OR AS
AY AYd

MPC +MPS =
1, where 1 stands for change in disposablelncome (Yd)

INVESTMENT-INCOME MULTIPLIER
The Concept of multiplier (K) is one of the most important contributions of LORD J.M
KEYNES to modern economics.

DEFINITION OF KK
K explains the relationship between an initial increase in Investment and the final
Increase in employment, output and Income.

The K is the ratio of an increase in income and output to an increase in

investment. So it is called the Investment -Income Multiplier.

The K shows what happens when an economy moves from one equilibrium
Level of income to another. It gets its name from the fact that, when investment in an
economy increases, the equilibrium output and income will rise by much more than the
Increase in investment.

If a rise in investment by $ 20 million results in an increase in equilibrium

output and income by S 100 million, the multiplier is 5
i.e., $ 100Om
S 20m=5

MULTIPLIER FORMULA

K AY Change in income
AI Change in investment

OR
AY =KxAI |i.e., AY 1 - xAI
1-MPC
 value of K
formulas to find the
LORD KEYNES has given 2

1. K=
1-MPC

2. K 1
MPS

The higher the MPC AC), the greater will be the value of K.

The lower the MPS, the higher will be the value of Multiplier.

MPC AC IfMPC =0.5 K will be 2

AY
=L=2
1-0.5 0.5
MPS= AS
AY

IfMPC=0.8, K will be 5

11-0.8 - =5
0.2

IfMPC0.9, K will be 10. i.e, ( 1 0 )

1-0.9 0.1

In short, the value of K varies inversely with MPS and directly with MPC.

HOW DOESTHE MULTIPLIER EFFECT OCCUR ?

an economy, it încreases output
and income not only in
Whenever a new investment is made in industries whose
but also in some consumer goods
industries where the investment is made, effect
employed in investment industries. The multiplier
products, are demanded by people reaction of spending. As
because the rise in investment spending. sets off a chain
occurs
more output is produced
and more income is earned.
business firms purchase new machines, leads to
with more incomes increase
their consumption expenditure which ,

As a result , those
and income will increase by much
increases in output and income. In the end, output
further Million will.
MPC is 0.8 an investment of $ 10
than the initial increase in investment. If ,

more
income of $ 50 Million. i.e., ,
generate output and 5x10m=$ 50 million
S 50 million AY=_1 = X AI 1=1=
1-MPC 1-0.8 0.2

In a three sector economy, the size of K is measured by the formula= 1 D OR_ MPS+ MPT
1-MPC
formula:
the size of K can be found from the following
In a 4 sector open economy,

4
 K 1 OR K
1-MPC MPS+MPT+MPM
Y
Y
C+TA

E1 C+I

Eo

45 A X

National Income

Suppose MPC =0.66

increase in investment will result in a 300 % increase in
K will be 3, which means an

income.
Y

EP
11
lo
Io

National income
 IfMPS=0.5
K will be 2 (K=1 or 1 -2)
MPS 0.5

It means an investment of$ 5 million will result in an increase in income of $10

Million.

THE OPERATION OF THE MULTIPLIER

The operation ofthe multiplier can be explained by taking a simple example. Assume
that investment and savings are the only injection and withdrawal respectively. Iffa
firm decides to construct a new building costing $ 1000, then the income of builders
and the suppliers ofthe raw materials will rise by $ 1000.

However, the process does not stop there, if we assume that recipients of the $ 1000
have a marginal propensity to consume of 2/3, they will spend S 666.67 and save the
rest. This spending creates extra income for another group of People. If we assume
that they also have MPC of 2/3 , they will spend $ 444.44 of the $ 666.67 and save
the rest. This process will continue, with each new round ofspending being two-thirds
of the previous round. Thus a long chain of extra income, extra consumption and extra
saving is set up ( see the following table)

Increase in Income, Increase in Consumption Increase in saving

Y AC AS

(S) (S) (S)

666.67 333.33
1 recipients 1000
+ +
+
2nd recipients 666.67 444.44 222.23
+ +

444.44 296.30 148.14

3 d recipients + +

296.30 197.53 98.77

4t recipients +
+

197.53 131.69 65.84

sth recipients

Total A Y=S 3000 AC=$2000 AS $ 1000

because the
to a halt when the
addition to savings total S 1000. This is
The process will come
and, therefore
original change in investment (A I) to income is
change in savings (A S)
is now equal to the the additions
because S=I ..At this point
to equilibrium
the economy is returned investment has created a $ 3000 rise in income;
to $ 3000. Thus $ 1000 extra
equal is3.
therefore,in this case, the value of the multiplier