Answer : 2 Consumption Function: Formula, Assumptions, and Implications

The term consumption function

refers to an economic formula that
represents the functional relationship
between total consumption
and gross national income (GNI).
The consumption function was
introduced by British economist John
Maynard Keynes, who argued the
function could be used to track and
predict total aggregate consumption
expenditures. It is a valuable tool that can be used by economists and
other leaders to understand the economic cycle and help them make key
decisions about investments as well as monetary and fiscal policy.

Understanding the Consumption Function

As noted above, the consumption function is an economic formula
introduced by John Maynard Keynes, who tracked the connection
between income and spending. Also called the Keynesian consumption
function, it tracks the proportion of income used to purchase goods and
services. Put simply, it can be used to estimate and predict spending in the
future.

The classic consumption function suggests consumer spending is wholly

determined by income and the changes in income. If true, aggregate
savings should increase proportionally as gross domestic product
(GDP) grows over time. The idea is to create a mathematical relationship
between disposable income and consumer spending, but only on
aggregate levels.

Based in part on Keynes'

Psychological Law of Consumption,
the stability of the consumption
function is a cornerstone of
Keynesian macroeconomic theory.
This is especially true when it is
contrasted with the volatility of an
investment, Most post-Keynesians
admit the consumption function is
not stable in the long run
since consumption patterns change as income rises.
Restating below the relation that income is either consumed or saved:
C+S=Y

Dividing both sides by disposable income Y we have

C/Y + S/Y + Y/Y = 1

Since C/Y is average propensity to consume and S/Y is average propensity to save, we have

APC + APS = 1

or APS = 1 – APC

This means for example, that if a society consumes 75 per cent of its disposable income, that is,
APC = 0.75, then it will save 25 per cent of its disposable income or its average propensity to save
(APS) will be 0.25 (1 – 0.75 = 0.25).

In Fig. 6.6 we have drawn the saving curve SS in the panel at the bottom. The saving curve SS
shows the gap between consumption curve CC and the income curve OZ in the upper panel of Fig.
6.6. It will be seen that up to income level OY1 consumption exceeds income, that is, there is
dissaving.
Beyond income level OY1, there is positive saving. It is worth mentioning that as average propensity
to consume (APC) falls with the increase in income in the upper panel average propensity to save
rises as income increases. Thus in Fig. 6.6 with the increase in income not only the absolute amount
of saving increases, the average propensity to save also increases.
Assumptions and Implications
Much of the Keynesian doctrine centers around the frequency with which a
given population spends or saves new income. The multiplier, the
consumption function, and the marginal propensity to consume are each
crucial to Keynes’ focus on spending and aggregate demand.

The consumption function is assumed stable and static where all

expenditures are passively determined by the level of national income. The
same is not true of savings or government spending, both of which Keynes
referred to as investments.

For the model to be valid, the consumption function and independent

investment must remain constant long enough for gross national income to
reach equilibrium. At equilibrium, the expectations of businesses and
consumers match up. One potential problem is that the consumption
function cannot handle changes in the distribution of income and wealth.
When these change, so too might autonomous consumption and the
marginal propensity to consume.

What Does the Consumption Function Measure?

The consumption function is an economic concept that explains the
relationship between income and spending. It was introduced by British
economist John Maynard Keynes, who suggested that economists could
use the consumption function to track and estimate total consumer
spending in the economy.

How Do You Calculate the Consumption Function?

The consumption function can be calculated using a simple formula:

C = A + MD where C is the consumer spending, A is autonomous

consumption (spending regardless of income levels), M is the marginal
propensity to consume (the amount of additional income needed to spend
on goods and services rather than saving it), and D is the amount of real
disposable income required.

Who Introduced the Consumption Function?

The consumption function was introduced by economist John Maynard
Keynes. He is known as the father of modern macroeconomics and the
founder of Keynesian economics. This branch of economics suggests that
governments should be actively involved in their economies. Rather than
let their economies fall under the free market, Keynes said government
spending can be used as a tool to cut back on weakness in the economy.
What Shifts the Consumption Function Forward?
The consumption function shifts forward (or upward) when disposable
income or accumulated wealth also increases. The inverse is true for a
downward shift in the consumption function. In this case, it drops or shifts
downward when income or wealth drops.