Consumption Function Notes

J.M. Keynes introduced the term 'consumption function' in 1936.
$C = f(Y)$ , where:
- $C$ is consumption.
- $Y$ is income.
- $f$ represents the functional relationship.
The consumption function shows the functional relationship between consumption and income.
- $C$ is the dependent variable.
- $Y$ is the independent variable.
The consumption function is the schedule that describes consumption amounts at various levels of income.
It's important to distinguish the consumption function from the amount of consumption at a specific point in time.

The consumption function can be expressed as: $C = a + bY$ , where:
- $C$ = Consumption
- $a$ = Autonomous consumption (the level of consumption when income is zero).
- $b$ = MPC (Marginal Propensity to Consume), calculated as $(\Delta C / \Delta Y)$ .
- $Y$ = National Income

Average propensity to consume is the ratio of consumption to total income.
$APC = \frac{C}{Y}$
If APC remains constant as income increases, the consumption function is a linear line.
When APC declines with an increase in income, the consumption function is not a straight line passing through the origin.

Marginal propensity to consume (MPC) measures the change in consumption resulting from a change in income.
$MPC = \frac{\Delta C}{\Delta Y}$
MPC is higher for poor communities and lower for rich communities.
When income increases, MPC falls, but more than the APC.
When income falls, MPC rises, and APC also rises, but at a slower rate.

Consumption and income are equal at each point on the 45-degree line.
The break-even point is where $C = Y$ .
When income rises from $0Y<em>1$ to $0Y</em>2$ , consumption increases from $0C<em>1$ to $0C</em>2$ , but the increase in consumption is less than the increase in income, i.e., C1C2 < Y1Y2.

The consumption function measures both consumption and savings.
The propensity to save is the propensity not to consume.
The 45° line is a zero-saving line.
The shape and position of the consumption curve indicate the division of income between consumption and saving.

Keynes emphasized the absolute size of current income as a determinant of consumption; this is known as the absolute income theory of consumption.
The theory was presented in Keynes's book "General Theory," published in 1936.
Keynes acknowledged subjective and objective factors, including interest rates and wealth, influence consumption, but emphasized the current level of income is the main determinant.
Keynes's Psychological Law of Consumption: As income increases, consumption increases, but not by as much as the increase in income.

When the general price level increases, the consumption function shifts downward.
The rise in the general price level reduces the real value (purchasing power) of money balances and financial assets with fixed monetary values.
This is called the real balance effect.
When the general price level falls, people consume relatively more, causing an upward shift in the consumption function.

The government can influence consumption and savings through fiscal policy.
Levying excise duties and sales tax can decrease consumption and increase savings.
Reducing taxes increases consumption.
Rationing and price controls also affect the propensity to consume.
Welfare state policies (progressive taxes on the rich to provide social security to the poor) tend to raise the consumption function.

Higher interest rates may induce people to save more, reducing their propensity to consume, but this isn't true for everyone.

Income distribution affects the consumption function.
Unequal income distribution lowers the propensity to consume because the rich consume a smaller proportion of their income compared to the poor.
Increased income inequality causes a downward shift in the consumption function.

Easy credit increases consumption and shifts the consumption function upward.
Lowering lending interest rates increases consumption.
Tightening credit produces the opposite effect.
Increased availability and acceptance of credit cards shift the consumption function upward.
Higher household indebtedness lowers the consumption function, and vice versa.

Consumption expenditure does not have a proportional relationship with income.
A smaller proportion of income is consumed.
Average propensity to consume (APC) is the proportion of consumption to income.
$C = a + bY_d$ (Short run)
- $Y_d$ is the real disposable income (gross national income minus taxes).
- $a$ and $b$ are constants.
- $b = MPC$ .

Franco Modigliani
Demography impacts your consumption
Consumption function: $C = \alpha W + bY$
- Parameter $\alpha$ is the MPC out of wealth.
- Parameter $b$ is the MPC out of income.

J.S. Duesenberry
An individual's consumption depends on relative income rather than absolute income.
Consumption depends on previously reached peak income level.
Empirical studies show that over a long period, the average propensity to consume remains almost constant.
Saving as a proportion of income does not rise much with increases in income for individuals with relatively low incomes.

When income falls, consumption expenditure does not fall to the same extent.
People try to maintain their consumption at the highest level attained earlier.
People do not want to show that they no longer can afford their previous standard of living.
People become accustomed to their previous higher level of consumption.
This is only possible through a reduction in savings.