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Attachment Video 1 - Consumption Function Lyst9751
Attachment Video 1 - Consumption Function Lyst9751
Economics
Phase
1&2
Consumption Function
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Code: NABARD50
Introduction
The level of Income and employment are dependent on Aggregate demand.
Greater the Aggregate Demand = Greater the level of Income and Employment
Note: If there is a change in any other variable affecting consumption spending there will
be a shift of the consumption function.
Suppose, C0 = 500
Propensity to consume = 0.6
Disposable Income = 2000
Consumption
2500
500 0.6 0 500
2000
500 0.6 1000 1100
C = a+ bY
500 0.6 2000 1700 1500 b
500 0.6 3000 2300 1000
500 0.6 4000 2900 500
a
Graph of Consumption function is Upward sloping, 1000 2000 3000 4000
implying that as income increases consumption Income
spending also increases.
This makes it clear that consumption changes are • Keynesian linear consumption
induced by income changes. can be written as C = a + bY
Where,
a is intercept term = C0
If consumption function curve coincides with the 45 b stands for slope = marginal
line, it would imply that the amount of consumption propensity to consume
is equal to the income at every level of income. Y = Level of current income
Shift in Consumption Function
• When the consumption of a
community changes, the whole
consumption curve changes or
shifts.
• When propensity to consume
increases, it means that at any
given level of income, more is
consumed than before.
• Therefore, as a result of increase
in propensity to consume, the
whole consumption function
curve shifts upwards.
• On the contrary, when the
propensity to consume of the
community decreases, the whole
consumption function curve
shifts downwards.
Propensity to Consume
There are two important concepts of
propensity to consume-
• Average Propensity to consume
• Marginal propensity to consume
Keynes divided the factors determining the propensity to consume into two groups:
1. Objective Factors
2. Subjective Factors
Objective Factors
✓ Changes in General Price Level: Real Balance Effect
✓ Fiscal Policy
✓ Rate of Interest
✓ Stock of Wealth
✓ Monetary Policy and Credit conditions
✓ Income Distribution
✓ Windfall gains and losses
✓ Change in Expectations
Determinants of Propensity to Consume
Subjective Factors
• Subjective factors include those factors which induce and prompt people to save some part of
their income.
Like
✓ Unforeseen Contingencies
✓ Expected Future Needs
✓ To increase their Future income
✓ Wealth Creation
✓ Speculative Purposes & Other business Projects
✓ Leaving a good fortune for their heir
• The above factors increases the propensity to save and therefore reduce the propensity to
consume.
• However, Keynes pointed out that some subjective factors also increase the propensity to
consume.
• Like – Demonstration effect – People have a natural instinct to imitate others consumption
habits. People in lower and middle income ranges imitate the consumption standards of higher
income groups which increases their propensity to consume.
Non-Linear Consumption Function
• Previously, we saw that marginal propensity to consume remains constant, that’s
why consumption function curve was a straight line.
• But according to some economists, it is not necessary that marginal
propensity to consume should be the same at all levels of income.
Thus, Y = C + S
Or, S=Y–C
• Like consumption, saving is also a function of income. Thus it can be written as-
S = f (Y)
• By substituting the Keynesian consumption function for C in the equation, we get
S = Y – (a +bY)
= Y – a – bY
= -a + Y – bY
= -a + (1 - b) Y
• Note that, (1-b) is the marginal propensity to save, where b is the value of marginal
propensity to save.
Like MPC,
APS + APC = 1
Or APS = 1 - APC
Absolute level of current Income is the important factor that determines consumption
• Classical economists thought that it was rate of interest that primarily determines saving and
consumption in the economy. While, Keynes said that Increase in National Income causes an
increase in consumption.
Marginal Propensity to Consume is less than one but greater than zero ( 0 < MPC < 1)
• This is also known as Keynes’s psychological law of consumption.
• According to this, as income increases → consumption increases, but not as much as the increase
in income.