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Consumption Function

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Psychological Law of Consumption

The relationship between consumption and the level of income is referred to as propensity to consume or consumption function. consumption is a function of income. Thus, C = f(Y) where C stands for consumption expenditure, f = function, and Y is 5/22/12 income.

According to Keynes, The psychology of the community is such that when aggregate real income is increased, aggregate consumption is increased, but not by so much as income. Keynes law of consumption depends upon the following propositions:

(a) As aggregate income increases, 5/22/12 spending on consumption also

D i s p o s a b l e i n c i on m R e s (CY o) n s u m p t i o) ni n ( C )s R C r o r e s C r o r e s 1 0 6 1 2 7 1 4 8 1 6 9 1 8 1 0 2 0 1 0 .5 2 2 1 0. 8 2 4 10 . 8

The rate of increase in consumption expenditure is not same beyond the level of income of Rs 18 crores.

Consumpti on expenditur e curve in the diagram rises upward as income increases 5/22/12 and rises

C o n s u m p t io n

fu n c t io n

1 2 1 0
C o n s u m p t io n

8 6 4 2 0 0 1 0 2 0 3 0
in c o m e D is p o s a b le

C o n s u m p t io n in R s C r o re s

(C )

relationship between income and consumption

The two ways of measuring relationship between income and consumption are:

(a) The average propensity to consume (APC), and (b) The marginal propensity to consume (MPC).


The Average Propensity to Consume (APC)

The average propensity to consume is the ratio of consumption to income. It can be expressed as under.



For example, if total income is Rs 500 crores and APC = 200 or 0.4 total consumption is Rs 500 200 crores, then:

The Marginal Propensity to Consume (MPC)

The ratio of change in consumption to change in income is known as marginal propensity to consume. Symbolically, change () in the income is denoted as Y (read as C MPC = delta Y) and changein consumption Y as C. Hence, For example, ifMPC = 20 or 0.5increases by income 5/22/12 Rs40 crores and as 40 result a

Table illustrating the concept of APC and MPC.

I n c o m e ( C )o n s u m p t i Ao P C = C / YM P C = Y n i n c r o r e s ( RC s ) c r o r e s R s C / Y 0 5 5 7 1 .4 0 .4 1 0 1 0 1 .0 0 .6 1 5 1 2 0 .8 0 .4 2 0 1 5 0 .7 5 0 .6 2 5 1 7 0 .6 8 0 .4 3 0 2 0 0 .6 6 0 .6 3 5 2 2 0 .6 2 0 .4

since Y = OM- ON (= NM) and C = C PS PS Y MPC = = = PM NR (=PS). Therefore, Y NM RS

R C o n s u m p t io n



In c


Propensity to Save/Saving Function

The relationship between the change in income and the change in saving is the propensity to save. We can also express propensity to save in two different ways. These are the following:

a) The average propensity to save (APS), and b) The marginal propensity to save 5/22/12 (MPS).

The Average Propensity to Save (APS)

The average propensity to save is the S ratio of total savings to total income. APS = Y Thus, where, S = saving and Y = income.

The Marginal Propensity to Save (MPS) Marginal propensity to save is 5/22/12


We know that MPC + MPS = 1. Therefore, MPS = C MPC or 1MPS = 1 Y


Relationship between APC and MPC

The following relationships arise between APC and MPC: (i) MPC refers to marginal increase in consumption due to marginal increase in income and APC means the ratio of total consumption to total income. (ii) As income increases, both MPC and APC decline but decline in MPC is more than the decline in APC. (iii) When MPC is constant, the

Implications and Importance of Psychological Law of Consumption 1. Crucial role of investment: The

Psychological Law of Consumption establishes vital and crucial role of investment when the community spends less than the increase in income. This is important for increased output and employment in the economy. 2. Repudiation of Says Law: Keynes law invalidates Says Law of 5/22/12

Factors Influencing Consumption Function


Subjective factors: Psychological motives which affect propensity to consume consist of subjective factors. These motives affect both individual and corporate savings.

Such motives are family affection, old age security, foresight, precaution, etc. According to Keynes individuals 5/22/12 decision to consume or save is a

2. Objective factors: Consumption function is affected by objective factors such as income, distribution of income, financial policies of corporation, changes in expectations, windfall gains, fiscal policy, demographic factors, wage rates, wealth and stock of money, liquid assets, changes in the rate of interest etc.

Excess and Deficient Demand


Meaning of Excess Demand

Excess demand is a situation when aggregate demand exceeds aggregate supply at the full employment level of income. The difference between aggregate demand and supply at the level of full employment is called the inflationary gap. Inflationary gap in the economy 5/22/12 exists when planned expenditure is

AY BY = AB (inflationary gap).

Y In To ta l e x p e n d it u re f la t io n a r y g a p E A B F u O N a Y t io n a l In c o m e ll e m p lo y m


Impact of Excess Demand in the Economy

If the economy has involuntary unemployment, an increase in demand will increase employment and output. Once the economy reaches full employment level and demand is further increased, it will lead to rise in prices, i.e., an inflationary situation in the economy. Output and employment cannot be 5/22/12 increased. An increase in productivity

Meaning of Deficient Demand

It is a situation when aggregate demand is less than aggregate supply of goods and services at the full employment level of income. It is also termed as the deflationary gap. Deflationary gap in the economy causes large scale unemployment. It comes to exist in the economy 5/22/12 when demand for goods and services

To t a l e x p e n d itu re

DY CY = CD (deflationary gap).

Y D e f la t io n a r y g a p C


F u ll e O N a t io n a l In c o m e Y


Impact of Deficient Demand in the Economy

The impact may be analyzed in three respects- impact on output, employment and prices. However, its impact depends upon various factors, important among these are: 1. The structure of the economycompetitive or oligopolistic; 2. Elasticity of supply of factors of production; 3. Influence of trade unions.

Causes of Excess and Deficient Demand


An increase in government expenditure (spending), which is not matched by a corresponding increase in taxation. Deficient demand may be caused if the government expenditure falls short of the revenue.

(ii) Increase in autonomous investment (due to past savings) without any 5/22/12 increase in current savings. And no

Generally, we have the following ways to correct excess or deficient demand. 1. Fiscal Policy 2. Monetary Policy 3. Foreign Trade Policy

Measures to Correct Excess and Deficient Demand


Fiscal Policy

This is referred to as government expenditure and taxation policy. Fiscal policy influences aggregate demand significantly. In a situation of excess demand, it may help if there is cut in the government expenditure - to reduce budgetary deficit - and rise in incomes/revenues through ways that are not inflationary such as progressive taxation and borrowing. Government may reduce expenditure


Monetary Policy

Monetary policy refers to the policy through which the monetary authority expands or contracts the money supply in the economy. In other words, it relates to changes in the rate of interest and the availability of credit in the economy. Higher rate of interest means costlier credit, which discourage effective demand. Investors get 5/22/12

To influence availability of credit, bank credit needs to be influenced. Important monetary tools that are available with the central bank of a country can be used: Cash reserve ratio Bank rate Open market operations

Changing margin requirements

Foreign Trade Policy

Foreign trade generally relates to exports and imports of a country. Excess and deficient demand can be influenced substantially by adopting a favourable foreign trade policy.

Additional exports increase incomes directly and enlarge spending. But additional incomes also create demand for imports. Thus, income generated in the 5/22/12

An inflationary situation can be brought under control by preventing wage to increase and increasing output by fuller use of existing idle (inactive) capacities. Wage increase matched by an increase in productivity of labour is desirable as it also improves supply position. But when wage increase is without corresponding 5/22/12 increase in productivity, then it leads