Consumption Function and Demand Determinants

Chapter Introduction

  • The chapter explores factors determining consumption demand and investment demand, major components of aggregate demand.
  • Emphasis is on consumption as a function of income, with investment discussed in the subsequent chapter.
  • Keynes focused on short-run factors affecting demand rather than aggregate supply.

Concept of Consumption Function

  • Consumption function: Relationship between consumption and income levels.
  • Higher income generally leads to higher consumption, but the rise in consumption is less than the rise in income due to savings.
  • Key Terms:
  • Marginal Propensity to Consume (MPC): Change in consumption resulting from a change in income.
  • Average Propensity to Consume (APC): Consumption divided by total income.
  • Differences between consumption function (schedule) and specific consumption amounts.

Illustrative Data (Table 6.1)

  • Example: At 1200 crores income, consumption is1090 crores. As income increases to 1500 crores, consumption rises to1300 crores.
  • Increments of income lead to smaller increments in consumption:
  • Income 1000-1100 crores: Consumption rises by70 crores
  • Income 1100-1200 crores: Consumption again rises by70 crores
  • Summary of Key Data Points:
  • MPC remains constant at 0.70,
  • APC declines as income increases.

Keynesian Consumption Function

  • Mathematical Form: C = a + bY
  • where C = consumption, Y = income, a = intercept, b = slope (MPC).
  • Graphical representation of the consumption function shows it decreases relative to a 45° line, indicating consumption increases less than income.

Changes and Shifts in Consumption Function

  • Increased propensity to consume shifts consumption function curve upward (more consumption at the same income level).
  • Decreased propensity shifts curve downward (less consumption).

Average and Marginal Propensity to Consume (APC and MPC)

  • APC: Ratio of total consumption to total income (C/Y). Declines as income rises.
  • MPC: Ratio of change in consumption to change in income (ΔC/ΔY). Generally remains constant in this function.

Non-Linear Consumption Function

  • Recognizes MPC may decline with rising income; suggests savings increase as income rises, creating a concave curve.
  • Example showing diminishing MPC: At 1100 crores, MPC = 0.9; at1500 crores, MPC = 0.5.

Saving Function

  • Defined as the income not consumed: S = Y - C.
  • Corresponds with consumption function derived from C = a + bY to yield S = -a + (1-b)Y—indicates the relationship between saving and income.

Average and Marginal Propensity to Save (APS and MPS)

  • APS: Savings to disposable income ratio (S/Y). Generally increases with rising income.
  • MPS: Change in savings induced by change in income (ΔS/ΔY). Sum of MPC and MPS equals 1.

Keynes’s Theory of Consumption

  • Psychological Law of Consumption: Consumption increases with income, but not identically (MPC < 1).
  • Stresses that current levels of income are primary factors affecting consumption.

Determinants of Propensity to Consume

  • Objective Factors include:
  1. General Price Level: Inflation reduces real balance and thereby consumption.
  2. Fiscal Policy: Tax changes can increase or decrease consumption propensity.
  3. Interest Rates: Can induce saving or consumption depending on circumstances.
  4. Wealth: Greater accumulated wealth typically increases consumption.
  • Subjective Factors include psychological influences and individual motivations for saving.

Future-Oriented Theories of Consumption

  • Modigliani's Life Cycle Theory: Consumption is planned over one’s lifetime, based on expected future incomes.
  • Friedman's Permanent Income Hypothesis: Consumption depends on average long-term income rather than current income.

Comparison with Kuznets’s Consumption Function

  • Kuznets suggests that APC is constant over time, while Keynes asserts it decreases as income rises.
  • Discrepancies between empirical findings call for analysis in both short and long-term contexts.

Importance of Consumption Function

  • Establishes foundation for understanding macroeconomic policies, particularly in relation to employment and economic fluctuations.
  • Validates Keynesian economics against classical economic theories (e.g., Say's Law).
  • Central to the theory of the multiplier and investment demand relations.

Key Questions for Review

  1. Explain the consumption function and its determinants.
  2. Distinguish between three forms of the consumption function.
  3. Describe Keynes’ psychological law of consumption and its implications.