Consumption

 Consumption is the portion of

disposable income that is not saved
by an individual or an entity.
 Aggregate consumption is the sum
total of all expenditure on current
consumption of goods and services,
i.e. those which are consumed during
the current period; for example food,
clothing, fuel, rent, etc.
 At low levels of Income Consumption
income, almost the (Y) C = f(Y)
entire income is
0 20
spent on current
consumption. As 60 70
the income level 120 120
increases, some 180 170
income is kept 240 220
aside for saving.
300 270
360 320
 Consumption expenditure may be related to
either national income or disposable
income, that is personal income minus
direct taxes. It is one of the most important
relationships in macro economics.
 Living standards are usually correlated to
per capita consumption of goods and
services. This is obtained by dividing
aggregate consumption by population.
Consumption function
 The consumption function or propensity to consume
refers to income consumption relationship. It is a
“functional relationship between two aggregates, i.e.,
total consumption and gross national income.”
 Symbolically, the relationship is represented as
C=f(Y), where C is consumption, Y is income, and f is
the functional relationship between C and Y.
 This relationship is based on the ceteris paribus
assumption, as such only the income consumption
relationship is considered and all possible influences
on consumption as held constant.
 The consumption function has two technical
attributes or properties:
 The Average Propensity to Consume: The
average propensity to consume may be
defined as the ratio of consumption
expenditure to any particular level of
income.
 It is found by dividing consumption
expenditure by income, or APC=C/Y.
 It is expressed as the percentage or
proportion of income consumed.
 The Marginal Propensity to Consume: The
marginal propensity to consume may be
defined as the ratio of the change in
consumption to the change in income or as
the rate of change in the average
propensity to consume as income changes.
 It can be found by dividing change in
consumption by a change in income, or
MPC=Change in Consumption
Change in Income
Saving
 An expression of the extent to which
people save money instead of
spending it.
 The Saving Function shows desired
saving at each income level.
 The saving function is the counterpart
of the consumption function. It
states that the relationship between
income and saving.
 Saving is also the function of
disposable income. S=f(Y)
 Y=C+S.
 Consumption and saving functions
are counterparts of one another.
Therefore, if one of the functions is
known, the other can be easily
obtained.
 Marginal propensity to save, which is the fraction of
additional income that people save. Since people either
save or consume additional income, the sum of the
marginal propensity to save and the marginal propensity to
consume should equal one.

 The value of the marginal propensity to consume should be

greater than zero and less than one. A value of zero would
indicate that none of additional income would be spent; all
would be saved. A value greater than one would mean that
if income increased by Re 1.00, consumption would go up
by more than a rupee, which would be unusual behavior.
For some people a mpc of 1 is reasonable, meaning that
they spend every additional rupee they get, but this is not
true for all people, so if we want a consumption function
that tells us what people on the average do, a value less
than one is reasonable.
Significance of Consumption
function
 The MPC is the rate of change in the
APC. When income increases, the
MPC falls but more than APC.
 On the contrary, when income falls,
the MPC rises and the APC also rises
but at a slower rate than the former.
 MPC is useful in the short run analysis
and APC is useful in the long run
analysis.
 When income increases the whole of
it is not spent on consumption.
 On the contrary, when the income
falls, consumption expenditure does
not decline in the same proportion
and never becomes zero.
 0<MPC<1, is of great analytical and
practical significance.
 This tells us that consumption is an
increasing function of income and it
increases by less than the increment
of income,
 The theoretical possibility of general
over production or ‘under
employment equilibrium’,
 The relative stability of a highly
developed industrial economy.
 It is implied that the gap between
income and consumption at all high
levels of income is too wide to be
easily filled by investment with the
possible consequence that the
economy may fluctuate around an
under employment equilibrium.
 Thus the economic significance of the
MPC lies in filling the gap between
income and consumption through
planned investment to maintain the
desired level of income.
 Further, its importance lies in the
multiplier theory. The higher the
MPC, the higher the multiplier and
vice versa.
 The MPC is low in the case of the rich
people and low in the case of poor
people.
 This accounts for high MPC in
underdeveloped countries and low in
advanced countries.
Investment
 Investment is the investing of money or
capital in order to gain profitable returns,
as interest, income, or appreciation in
value.
 It is related to saving or deferring
consumption.
 Investment is involved in many areas of the
economy, such as business management
and finance no matter for households,
firms, or governments.
 But this is not real investment because it is
simply a transfer of existing assets.
 Hence this is called financial investment
which does not affect aggregate spending.
 In Keynesian terminology, investment
refers to real investment which adds to
capital investment.
 It leads to increase in level of income and
by increasing the production and purchase
of capital goods.
 Investment thus includes new plant and
equipment, construction of public works
like dams, roads, buildings, etc., net
foreign investment, inventories, and stocks
and shares of new companies.
 Capital, on the other hand, refers to real
assets like factories, plants, equipment,
and inventories of finished and semi
finished goods.
 It is any previously produced input
that can be used in the production
process to produce other goods.
 To be more precise, investment is the
production or acquisition of real
capital assets during any period of
time.
 Gross investment is the total amount
spent on new capital assets in a year.
 Net investment is gross investment
minus depreciation and obsolescence
charges. This is the net addition to
the existing capital stock of the
economy.
 Investment function explains how the
changes in national income induce
changes in investment patterns in the
national economy.
Multiplier
 Multiplier is referred as the manifold
increase in employment, as a result of
initial increase in investment. – F.A.Kahn.
 Keynes propounded the concept of
investment multiplier with reference to the
much larger increase in total income, direct
as well as indirect, as a result of original
increase in investment.
 Kahn’s multiplier is known as
“employment multiplier.”
 Keynes’ multiplier is known as
“investment or income multiplier.”
 The essence of multiplier is the total
increase in income, output or
employment is manifold the original
increase in investment.
 For example, if investment equal to
Rs 100 crores is made, then the
income will not rise by Rs 100 crores
only but a multiple of it. If as a result
of investment of Rs 100 crores,
national income increases by Rs 300
crores, multiplier is equal to 3.
 The investment multiplier is,
therefore, the ratio of increment in
income to the increment in
investment.
 k= delta Y
delta I
Where k is multiplier; Y is income
and I is investment.
Limiting cases of the value of
Multiplier
 One limiting case occurs when the marginal
propensity to consume is equal to one, that
is, when the whole of the increment in
income is consumed and nothing is saved.
In this case, the size of the multiplier will
be equal to infinity, that is, a small increase
in investment will bring about a very large
increase in income and employment so that
full employment is reached and even the
process goes beyond that.
 The other limiting case occurs when
marginal propensity to consume is equal to
zero, that is, when nothing out of the
increment in income is consumed, and the
whole increment in income is saved.
In this case, the value of the multiplier will
be equal to one.
That is, in this case, the increment in
income will be equal to the original increase
in investment and not a multiple of it.
Assumptions to Multiplier Theory
 MPC remains constant throughout as the
income increases in various rounds of
consumption expenditure.
 There is a net increase in investment in a
period and no other further indirect effects
on investment in that period occur or if
they occur they have been taken into
account so that there is a given net
increase in investment.
 There is no time lag between the increase
in investment and the resultant increment
in income. That is, increment in income
takes place instantaneously as a result of
increment in investment.
 Excess capacity exists in the consumer
goods industries. So that when the
demand for them increases, more amounts
of consumer goods can be produced to
meet this demand.
 If there is no excess capacity in consumer
goods industries, the increase in demand as
a result of some original increase in
investment will bring about rise in prices,
rather than increases in real income, output
and employment.
 Imports are important leakage from the
multiplier process and we have ignored
them in our above analysis for the purpose
of simplicity.
Leakages in the Multiplier Process
 Payment of debt.
 People hold a part of their increment in
income as idle cash balances and do not
use it for consumption, they also constitute
leakage in the multiplier process and
reduces the size of the multiplier.
 In an open economy as is usually the case,
a part of increment in income spent on the
imports of consumer goods.
 Taxation is another important leakage in
the multiplier process.
 Increase in prices constitutes another
important leakage in the working of the
multiplier process in real terms. When
output of consumer goods cannot be easily
increased, a part of the increases in the
money income and aggregate demand
raises prices of the goods rather than their
output. Therefore, the multiplier is reduced
to the extent of price inflation.