Consumption Function
The consumption function is a key concept in Keynesian economics that describes the relationship between aggregate consumption and disposable income. It shows how much households are willing to consume at different levels of income, assuming other factors remain constant. The consumption function plays a critical role in determining the overall demand in the economy and is central to understanding how changes in income affect consumption and economic growth.
- Formula: C=C0+C1(Y−T)Where:
- C is consumption,
- C0 is autonomous consumption (consumption when income is zero),
- C1 is the marginal propensity to consume (MPC),
- Y is national income, and
- T is taxes.
Components of the Consumption Function:
- Autonomous Consumption (C0): This is the level of consumption that occurs regardless of income. It represents basic consumption needs funded through savings or credit. Even if disposable income is zero, households will still consume some amount of goods and services.
- Marginal Propensity to Consume (MPC) (C1): This is the change in consumption resulting from a change in disposable income. It reflects the proportion of additional income that consumers are likely to spend. For example, if the MPC is 0.8, then for every additional dollar of disposable income, consumption will increase by 80 cents.
Key Properties of the Consumption Function:
- Positive Relationship: As disposable income increases, consumption also increases, but not by the same amount. The rate at which consumption increases depends on the marginal propensity to consume.
- Saturation Point: In reality, as income rises significantly, the marginal propensity to consume might decrease (people tend to save more as they become wealthier). However, in the basic Keynesian model, we assume a constant MPC across income levels.
- Shifts in the Consumption Function: Factors other than income can shift the consumption function:
- Changes in Consumer Confidence: Higher confidence can increase consumption even at lower income levels.
- Changes in Wealth: An increase in household wealth (e.g., rising home prices or stock market gains) can increase consumption at all income levels.
- Government Transfers or Taxes: A reduction in taxes or an increase in government transfers (e.g., subsidies) increases disposable income, shifting the consumption function upward.
Implications of the Consumption Function:
- Policy Implications: The consumption function is critical for understanding how fiscal policies, such as tax cuts or government spending, impact aggregate demand. If the government reduces taxes, disposable income increases, leading to an increase in consumption, especially if the MPC is high.
- Keynesian Multiplier Effect: The consumption function helps explain the Keynesian multiplier effect. An initial increase in consumption due to an increase in disposable income leads to further increases in economic activity, as higher consumption increases demand for goods and services, thereby stimulating production and income.
Keynes’s Psychological Law of Consumption
Keynes’s Psychological Law of Consumption is a foundational idea in Keynesian economics that helps explain how individuals behave with regard to consumption and savings as their income changes. It describes the relationship between income and consumption and highlights the idea that consumption increases with an increase in income, but not by the full amount. In other words, people tend to consume a smaller proportion of additional income as their income rises.
Key Insights of the Psychological Law of Consumption
- Marginal Propensity to Consume (MPC):
- The MPC is the fraction of an additional dollar of income that is spent on consumption. According to Keynes’s law, the MPC decreases as income increases.
- For example, a person with a low income might spend most or all of an additional dollar, while a wealthy individual may save a larger portion of any increase in income and spend less.
- The MPC is the fraction of an additional dollar of income that is spent on consumption. According to Keynes’s law, the MPC decreases as income increases.
- Diminishing Marginal Propensity to Consume:
- Keynes argued that as income rises, people’s propensity to consume (or their consumption rate) decreases. Initially, when a person’s income is low, they are more likely to consume nearly all of their income because they have greater needs to satisfy. However, as their income grows, their basic needs are met, and they tend to save more of the additional income.
- Keynes argued that as income rises, people’s propensity to consume (or their consumption rate) decreases. Initially, when a person’s income is low, they are more likely to consume nearly all of their income because they have greater needs to satisfy. However, as their income grows, their basic needs are met, and they tend to save more of the additional income.
Explanation of the Law
- Basic Consumption Behavior:
- When people experience an increase in income, they are likely to increase their consumption, but they don’t increase it by the same amount as their income increase.
- For example, if someone gets a raise, they may use part of that extra income to pay for luxury items, but they will save a significant portion of it for the future.
- When people experience an increase in income, they are likely to increase their consumption, but they don’t increase it by the same amount as their income increase.
- The Role of Saving:
- Keynes’s law suggests that as income grows, the share of income that is saved (the marginal propensity to save, or MPS) increases, because people start to prioritize savings over consumption once their basic needs are met.
- The saving function derived from Keynes’s law shows that savings increase with income, but at a higher rate than consumption.
- Keynes’s law suggests that as income grows, the share of income that is saved (the marginal propensity to save, or MPS) increases, because people start to prioritize savings over consumption once their basic needs are met.
- Psychological Factors:
- The psychological part of the law refers to the fact that people’s spending behavior is influenced by a combination of factors, such as expectations about the future, risk aversion, and social status. As incomes rise, people may feel more secure about their financial situation and may choose to save more, given the lower perceived necessity of consuming all of their income.
- The psychological part of the law refers to the fact that people’s spending behavior is influenced by a combination of factors, such as expectations about the future, risk aversion, and social status. As incomes rise, people may feel more secure about their financial situation and may choose to save more, given the lower perceived necessity of consuming all of their income.
- Economic Implications:
- This behavior of consuming less as income rises has important implications for aggregate demand in an economy. Keynes argued that because consumption does not rise in proportion to income, economic growth might not be fully driven by increases in income alone.
- Moreover, during periods of economic boom, if income increases significantly across society, the economy may not experience a corresponding increase in consumption, which can dampen the multiplier effect (the total increase in economic activity resulting from an initial spending increase).
- This behavior of consuming less as income rises has important implications for aggregate demand in an economy. Keynes argued that because consumption does not rise in proportion to income, economic growth might not be fully driven by increases in income alone.
Short-run vs Long-run Consumption Functions
The consumption function in economics represents the relationship between consumption (C) and income (Y). This relationship can differ in the short-run and the long-run due to various factors such as expectations, changes in income, and the role of savings. Let’s explore the key differences between the short-run and long-run consumption functions.
Short-run Consumption Function
The short-run consumption function describes the behavior of consumption in response to changes in current income, assuming that other factors like wealth, interest rates, and future income expectations remain relatively stable.
Characteristics of Short-run Consumption Function:
- Immediate Response to Income:
- In the short run, consumption is primarily driven by current disposable income. People will adjust their consumption based on immediate changes in income.
- In the short run, consumption is primarily driven by current disposable income. People will adjust their consumption based on immediate changes in income.
- Higher Marginal Propensity to Consume (MPC):
- In the short run, people tend to consume a larger proportion of their income. The MPC is relatively higher because people are more likely to spend their income on immediate needs and wants, especially when they have limited ability to save.
- In the short run, people tend to consume a larger proportion of their income. The MPC is relatively higher because people are more likely to spend their income on immediate needs and wants, especially when they have limited ability to save.
- Limited Adjustment to Changes in Income:
- Although income affects consumption, the relationship between the two is not always linear. The MPC may not remain constant. For example, individuals with higher current incomes may save a larger portion of the increase in income rather than spend it.
- Although income affects consumption, the relationship between the two is not always linear. The MPC may not remain constant. For example, individuals with higher current incomes may save a larger portion of the increase in income rather than spend it.
- Focus on Disposable Income:
- The short-run consumption function typically focuses on disposable income (income after taxes and transfers). People adjust their consumption based on the amount of disposable income they have at any given point in time.
- The short-run consumption function typically focuses on disposable income (income after taxes and transfers). People adjust their consumption based on the amount of disposable income they have at any given point in time.
- Influenced by Immediate Economic Factors:
- Factors such as government transfers, tax cuts, and interest rates have a direct impact on the short-run consumption function. When disposable income changes due to these factors, consumption will adjust accordingly.
- Factors such as government transfers, tax cuts, and interest rates have a direct impact on the short-run consumption function. When disposable income changes due to these factors, consumption will adjust accordingly.
Long-run Consumption Function
The long-run consumption function takes a broader view of consumption over time, accounting for not only current income but also factors like wealth, future income expectations, interest rates, and changes in behavior and habits.
Characteristics of Long-run Consumption Function:
- Adjusted for Future Expectations:
- In the long run, people make consumption decisions based on their expectations about future income and economic stability. If individuals expect sustained higher income or economic growth in the future, they may increase their consumption accordingly, even if their current income does not change.
- In the long run, people make consumption decisions based on their expectations about future income and economic stability. If individuals expect sustained higher income or economic growth in the future, they may increase their consumption accordingly, even if their current income does not change.
- Lower Marginal Propensity to Consume (MPC):
- Over the long run, the MPC tends to be lower compared to the short run. People tend to save a larger portion of their income because their consumption habits adjust over time, reflecting long-term goals like retirement savings and wealth accumulation.
- Over the long run, the MPC tends to be lower compared to the short run. People tend to save a larger portion of their income because their consumption habits adjust over time, reflecting long-term goals like retirement savings and wealth accumulation.
- Wealth Effect:
- The long-run consumption function also accounts for the wealth effect. If people experience a rise in their wealth (through higher asset prices, for example), they may increase their consumption, even if their income remains the same. This is less pronounced in the short run but becomes more significant over time.
- The long-run consumption function also accounts for the wealth effect. If people experience a rise in their wealth (through higher asset prices, for example), they may increase their consumption, even if their income remains the same. This is less pronounced in the short run but becomes more significant over time.
- Saving Behavior:
- In the long run, people plan for the future, including for their retirement or future consumption needs. As a result, their saving rate tends to be higher. They save a larger portion of any increase in income rather than consuming it immediately.
- In the long run, people plan for the future, including for their retirement or future consumption needs. As a result, their saving rate tends to be higher. They save a larger portion of any increase in income rather than consuming it immediately.
- Policy and Economic Environment:
- The long-run consumption function is influenced by long-term factors like demographics, changes in government policy, and economic growth expectations. People’s consumption patterns are more stable over the long term, as their economic situation and future expectations are more certain.