Consumption Function

Consumption, saving, and investment play a central role in a nations economic performance. Nations that save and invest large fractions of their incomes tend to have rapid growth of output, income, and wages; this pattern characterized the United States in the nineteenth century, Japan in the twentieth century, and the miracle economies of East Asia in the last three decades.

 Consumption and investment are central to macroeconomics. Consumption is the largest single component of GDP, constituting around 65 percent of total spending over the last decade. What are the major elements of consumption? Among the most important categories are housing, motor vehicles, food, and medical care.

Consumption function
One of the most important relationships in all macro-economics is the consumption function. The consumption function shows the relationship between the level of consumption expenditures and the level of disposable personal income. This concept, introduced by Keynes, is based on the hypothesis that there is a stable empirical relationship between consumption and income.

 Keynes was not interested in factors determining the aggregate supply. He focused his attention to analyze aggregate demand. Therefore, Consumption function assumes significant role in explaining the composition of aggregate demand and changes there in.

Y 1000 1100 1200 1300 1400 1500 1600

Rs. In Crore C 750 825 900 975 1050 1125 1200

APC= C Y 0.75 0.75 0.75 0.75 0.75 0.75 0.75

MPC=C Y

0.75 0.75 0.75 0.75 0.75 0.75 0.75

Marginal Propensity to Consume

When income rises, consumption also rises but not as much as income. The slope of the consumption function, which measures the change in consumption per rupee change in disposable income, is the marginal propensity to consume.

Determinants of consumption
1. Redistribution of income in favour of poor 2. Easy availability of credit 3. Expectations about price and income changes 4. Money illusion can lead to higher conumption

MPC in different countries

Countries
Argentina Australia Belgium Canada Ethiopia India Japan Pakistan

MPC
0.81 0.76 0.80 0.77 0.90 0.85 0.66 0.89

 1. line tells us whether consumption is equal to, greater than, or less than the level of disposable income. 2. It also tells about how much the household is saving or dissaving
o 45

 The break-even point on the consumption schedule that intersects the 45o line represents the level of disposable income at which households just break even or where the entire disposable income is spent on consumption with nothing left for savings.

Forms of consumption function

C= F(Y)= a+by (a>o, o<b<1) b always lies between O and I a= Autonomous Consumption b or c xy or MPC xy= Induced consumption y

 With the increase in income, saving gap also increases As a result of increase in the propensity to consume of the community, the propensity to consume curves shifts upward. If APC remains constant, the consumption function curve will be linear or a straight line.

Propensity to consume
AP= C Y MPC= C Y APC+APS=Y=1 APC=1-APS APS=1-APC MPC= S Y MPC= 1-MPS MPS= 1-MPC MPC+MPS=1

Non linear consumption function

The continually declining slope implies diminishing marginal propensity to consume.

Such changes (falling MPC and falling APC) are possible during recessionary phase

Saving function and MPS

Along with the marginal propensity to consume goes its mirror image, the marginal propensity to save, or MPS. The marginal propensity to save is defined as the fraction of an extra rupee of disposable income that goes to extra saving.
Personal savings (Disposable income-consumption) Business savings (retained income of business) Govt saving (Net govt receipts govt consumption exp.)

Determinants of Consumption
Current disposable income. Permanent income and the Life-Cycle Model of Consumption. The life-cycle hypothesis assumes that people save in order to smooth their consumption over their life-time.

Determinants of Savings Behaviour

People save to meet unforeseen contingencies (Sickness/ Accident) Future needs For accumulation of wealth to increase future income Social status Psychic satisfaction of acquiring wealth.

Consumption
Demonstration Effect: Natural Instinct to Imitate others General Price Level Inverse Relationship Taxation Policy - Inverse Relation Rate of Interest: Uncertain Relationship Windfall gains & losses Change in Expectations

Keynes CF attributes
Current income determines consumption. MPC is 0.70 but less than 1 When Income increase APC falls. Consumption Function is Stable in Short Run.

Consumption function(Summing Up)

Shows relationship between Y & C consumption exp depends upon (a) Disposable income (b) Past savings ( c ) Rate of interest C= F(Y) Keynesian Analysis Consumption function is stable in the short run.

 Psychological law of consumption As income rises consumption lags behind this can lead to secular stagnation

Determinants of propensity to consume

Distribution of income Nature and pattern of income receipt regular income vs irregular incomes Wealth Consumer credit Stock of consumer durable Availability of goods

Future expectations Capital gains or wind-fall gains Price level Fiscal policy Interest Rate Determinants of savings

Investment function
Real Investment: According to Keynes, it implies creation of new capital goods such as machinery and stores, which directly create additional jobs and new output Types: Induced and Autonomous investment

Induced Investment
Has a direct relationship with income When income increases, C Inc. and to meet this investment also increases. Induced investment is Income elastic I=f(Y)

Autonomous investment
AI is independent of the level of income Income inelastic Influenced by exogenous factors like innovations, inventions,growth of population and labour force, researches, social and legal institutions, weather changes and war But it is not influenced by demand

Determinants of investment
Keynes says that the volume of investment in the economy depends upon: MEC and Rate of interest MEC is dependent upon the prospective yield from the capital asset and supply price of the capital asset,which is the cost of producing the asset Therefore, e = Q/p Further, Keynes defines MEC as equal to the rate of discount which would make the present value of annuities given by the returns expected from the capital asset during its life just equal to the supply price.

 Symbolically: Sp= R1/(1+e)1 + R2/(1+e)2+Rn/(1+e)n

Sp=supply

price of the asset R= prospective yields or the series of expected annual returnsfrom the capital assest in the year 1,2 and n yrs e=rate of discount which makes the capital asset exactly equal to the present value of the expected yield from it.Thus e=MEC

Rate of Interest
Since MEC is expressed as a ratio it can be compared to rate of interest,as the pvt investment directly depends upon a rational comparison between the expected rate of profit and the rate of interest. Such a comparison is in effect b/w the supply price of an asset and its demand price Demand price of the asset is the sum of expected future yield discount at the current rate of interest Thus, DP= Sum of prospective yield discounted at the current rate of interest SP= sum of prospective yields discounted by the MEC

Symbolically: DP= Q1/(1+i)1 +Q2/(1+i)2+Qn/(1+i)n Q1..Qn=prospective yields i= current rate of interest

Keynesian theory of income output and employment

Relates with the level of AD in the economy Always less than full employment in the economy Deals with short term phenomena in economic life Favoured capitalism and suggested reform in pure capitalism,by suggesting fro govt intervention Indicates the mode of fiscal and monetary policies in economic situation of inflation,deflation Principle of effective demand: Employment depends upon ED. If ED Employment ED results in Inc in output, output creates Y(income) and Y provides employment He regards ED,O,Y ,N equal to each other.N=f(Y)

Effective demand: ASF(stable), so more concentration on ADF(cons.)

Money income Propensity to consume: APC,MPC Consumpt APC and MPC dependent upon subjective and objective factors ion

MEC: prospective yield(dependent upon expectations: short run or long run) and supply price of asset Rate of interest : Supply of money and demand for money Demand for money :liquidity preference : transcationary motive ,precautionary motive Investmen and speculative motive t TM and PM are income elastic,never change in short period. M1=L1(Y) Money held for speculative motive if a function of rate of interest,M2=L2(r), Higher the rate of interest, lower the demand for money Autonomous

Govt Exp

Determination of employment
Employment(lak hs) 0 10 AS(Rs crore) 0 60 AD(rs crore) 60 100 Trends in employment rise rise

20
30 40 50 60 70

90
120 150 180 210 210

120
140 160 180 190 200

rise
rise rise equilibrium Fall Fall