1. Consumption Function

2. Consumption
Income is used for consumption and
savings
Yd = C + S

3. If C = a + bYd
Then S = Yd – C
= Yd – a – bYd
= - a + (1-b)Yd
Where Yd = personal disposable income
C = consumption
S = savings
a,b = parameters

4. Components of Consumption
Non-durable goods – foods, drinks,
lighting & heating
Durable goods – furniture, kitchen
appliances, washing machines, cars,
ACs and other white goods.
Services – non durable – transport,
banking, insurance, health, education,
legal etc.

5. Keynes Psychological Law of
consumption
When aggregate income increases, aggregate
consumption also increases, but by a
somewhat smaller amount.
Increase in income is divided in some
proportion between saving and spending.
Increase in income is unlikely to lead to less
savings or less spending than before.

6. Absolute Income Hypothesis
In his 1936 book on ‘The General Theory of
Employment, Interest & Money’, he advanced
the hypothesis that consumption has two
components:
1. Autonomous (C0)
2. Induced => varies directly with current
income through a linear function.

7. C = C0 + bY
Where C0, b > 0
And b<1
or 0<b<1

8. Propensity to Consume
Expresses the relationship between
income and consumption.
Shows how consumption expenditure
changes as income varies.

9. Marginal Propensity to
Consume
change in consumption
mpc = -----------------------------------
change in income

10. DY C S mpc
600 600 0 -
800 760 40 0.8
1000 920 80 0.8
1200 1080 120 0.8
1400 1240 160 0.8
1600 1400 200 0.8

11. C o n s u m p tio n & D I 2000
1500
1000
500
0
1 2 3 4 5 6
DY
C

12. Savings Function
Aggregate Savings is the difference
between disposable income and
consumption expenditure.
Savings function is the schedule relating
total consumer savings to total
disposable income in the economy.

13. Marginal Propensity to Save
change in savings
mps = ------------------------
change in income
mpc + mps = 1

14. Under the AIH, the mpc is a constant
‘b’.
δC
mpc = ---------- = b
δY

15. Average propensity to consume falls as
the income increases.
C C0
APC = --------- = --------- + b
Y Y
APC -> MPC as Y -> infinity

16. Corollary
mps is a constant (=1-b)
aps increases as income increases
S=Y–C
= Y – C0 – bY
= - C0 + (1-b)Y

17. δS
mps = ---------- = 1-b
δY
Co
APS = ---------- + (1-b)
Y
APS -> MPS as Y -> infinity.

18. MPC + MPS = 1
APC + APS = 1
As economy prospers, Y and savings
rate (S/Y=APS) goes up.
Rich people and rich countries have
high savings rates as compared to poor
people and poor countries.
Prosperity leads to stagnation.

19. Permanent Income Hypothesis
Given by Milton Friedman (1957)
Consumption is determined by long
term expected income rather than the
current level of income
long term expected income is called
permanent income
People experience random and
temporary changes in their income from
year to year

20. Current income is the sum of two
components: permanent income YP and
transitory Income YT.
Y = YP + YT
Permanent income is that part of the
income that people expect to persist
into the future.
Transitory income is the random
deviation from it

21. Consumption should depend primarily
on permanent income.
C = α YP
Where α = fraction of permanent income
consumed

22. Keynes Friedman
C YP
APC = --------- = α -------
Y Y

23. Rational Expectations &
Random-Walk Consumption
Forward-looking consumers base their
consumption decisions not only on their
current income but also on the income they
expect to receive in the future.
Rational expectation
People will make optimal forecasts about the
future.

24. Robert Hall was the first to derive the
implications of rational expectations for
consumption.
=> changes in consumption over time
should be unpredictable
– follow a “Random Walk”
=> changes in consumption reflect
“surprises” about lifetime income.

25. Determinants of Consumption
Function
Wealth & Distribution of Wealth
Relative Income =>
1. Current income relative to past peak
income (Y/Ymp).
2. Own income relative to average
income of the neighbourhood.
(Demonstration / Bandwagon Effect)

26. Determinants (cont…)
Interest Rate
Credit availability
Consumer’s expectations

27. Consumption Function
C = f { Y, W, Y/Ymp, i, CA, CE, IWD, µ}
Y = income
W = wealth
Ymp = maximum past income
i = interest rate
CA = ease of credit availability
CE = consumer’s expectations
IWD = inequality of income/ wealth distribution
µ = unknown/other factors

28. The Multiplier

29. Concept
Multiplier expresses the relationship between
an initial increment in investment and the
final increment in aggregate income.
It is the ratio of the change in income to the
change in investment.
Y
K = -----------
I

30. Multiplier & MPC
The size of the multiplier depends upon
the size of the mpc.
The higher the mpc, the higher is the
size of the multiplier; the lower the
mpc, lower is the size of the multiplier.

31. An example
Building a woodshed
Initial/primary investment = Rs. 1,000 =>
income of carpenter & lumber producer (say
tier one consumer ‘A’) = Rs. 1,000
Let mpc = 2/3
Expenditure by A on consumption goods
= 2/3*1000 = 666.67
Producer’s income = Rs. 666.67
Expenditure (B) = 2/3 * 666.67 = 444.44

32. Example (cont…)
Total income generated =
(1 x 1000) + 2/3(1000) + (2/3)2(1000) +
(2/3)3(1000) + ----------
1
= ------------- x 1000 = 3000
1 – 2/3

33. 1 1
K = ---------- = -----------
1-m s
The size of the multiplier depends on
the size of the mpc or the mps

34. Limiting case
if mpc = 0
K=1
If mpc = 1
K = infinity

35. Aggregate Demand
Total amount of goods demanded in the
economy.
AD = C + I + G + (X-M)
Equilibrium is achieved when
Quantity supplied = quantity demanded
Y = AD = C + I + G + (X-M)

36. Diagrammatic representation
AD=Y
E1 AD
Aggregate Demand
ADo
C
E0
Yo Y1 Income

37. Assumptions / Limitations
Availability of consumer goods
Maintenance of investment
No change in mpc
Existence of less than full employment

38. Criticisms
Prof Henry Hazlitt
There is no precise, pre-determinable
relationship between investment and
income
Assumes unemployment
The propensity to consume assumes
that what is not spent on
consumption is not spent at all