It is a functional relationship between two aggregates i.e., total consumption and National Income. Consumption is an increasing function of income Symbolically C= f (Y) The Consumption Function

The two determinants of consumption are – Autonomous consumption. – Income-dependent consumption/Induced consumption

The Consumption Function Autonomous consumption: consumer spending not dependent on current income. – people consume even if they have no income… … by borrowing or drawing down savings. They expect future income changes. They perceive greater wealth and increase spending, and vice versa. There is availability of credit. Income-dependent consumption: consumer spending that increases as income increases, and vice versa.

What Determines Consumption Spending? Some consumption spending is simply unavoidable. While individuals may spend less on food, clothing, and shelter when income falls, there are limits to how much one can cut and still survive.

What Determines Consumption Spending? The single most important factor influencing a person’s consumption spending is his or her level of disposable income. The greater the disposable income, the greater the consumption spending.

The Keynesian Theory of Consumption:.The Absolute Income Hypothesis A Consumption Function for a Household A consumption function for an individual household shows the level of consumption at each level of household income.

The Keynesian Theory of Consumption With a straight line consumption curve, we can use the following equation to describe the curve: C = a + bY The aggregate consumption function shows the level of aggregate consumption at each level of aggregate income. The upward slope indicates that higher levels of income lead to higher levels of consumption spending.

The Consumption Equation Together they make up the consumption function: The consumption function allows us to predict how much the consumption component of AD will change when incomes change. C = a + bY D where C = current consumption a = autonomous consumption b = marginal propensity to consume Y D = disposable income

Consumption (C) Consumption (C): expenditure by consumers on final goods and services. – Accounts for over two-thirds of total spending. – Consumers tend to spend most of their disposable income (Y D ) – that is, income remaining after taxes. They save the rest. – Saving (S): Disposable income not spent as consumption (C). Disposable income = Consumption + Saving Y D = C + S

Average Propensity to Consume (APC) APC = Total consumption = C Total disposable income Y D

Marginal propensity to consume (MPC) The slope of the consumption function: The amount by which consumption spending changes when disposable income changes.

Keynes’s conjectures 1. The aggregate consumption function states that real consumption expenditure is a function of real national income 2. 0 < MPC < 1 3. Average propensity to consume (APC = C/Y )) falls as income rises. 4. MPC is less than average propensity to consume (APC). 5. The MPC declines as income increases, that is the proportion of marginal income consumed goes on decreasing.

The Keynesian consumption function C Y slope = APC As income rises, consumers save a bigger fraction of their income, so APC falls.

The Keynesian consumption function C Y Y c c = MPC = slope of the consumption function

45-degree guide line 45 o Aggregate Income (Y) Aggregate Consumption (C) 1000 Consumption = Income 45˚ line: at any point on the 45˚line consumption exactly equals income and the households have zero saving.

The Consumption Function Y C 0 Consumption function C = f(Y) Savings Consumption 45˚ Y 1 Y 2 CACA

Early empirical successes: Results from early studies Households with higher incomes: – consume more,  MPC > 0 – save more,  MPC < 1 – save a larger fraction of their income,  APC  as Y  Very strong correlation between income and consumption:  income seemed to be the main determinant of consumption

Saving Function Like consumption saving is also the function of income: S = f(Y) If autonomous consumption exists then autonomous saving exists as well and saving function is Saving is a source for investment.

Determinants of Planned Consumption and Planned Saving In the classical model, the supply of saving was determined by the rate of interest – The higher the rate, the more people wanted to save, and the less they wanted to consume

Determinants of Planned Consumption and Planned Saving (cont'd) Keynes argued that: – The interest rate is not the most important determinant of individual’s real saving and consumption decisions – Real saving and consumption decisions depend primarily on a household’s real disposable income

What Determines the Level of Saving? People do two things with their income. They either spend it on consumption or they save it.

Savings Saving is that part of income that is not consumed. Saving equals income minus consumption: S = Y – C Income is the sum of consumption and savings: Y = C + S then and

Savings The marginal propensity to save is defined as the fraction of an extra unit of income that goes to extra saving. The marginal propensities to consume and to save add up to 100 percent. MPC + MPS = 1 because the part of each unit of income that is not consumed is necessarily saved.

Consumption and Saving Terminology APC – average propensity to consume – fraction of income that is consumed. Consumption / Income APS+APC=1 MPC – marginal propensity to consume – the fraction of any change in Income that will be consumed. Change in Consumption / Change in Income MPS – marginal propensity to save – the fraction of any change in Income that will be saved. change in Saving / change in Income MPS+MPC=1 APS – average propensity to save – fraction of income that is saved. Saving / Income

Empirical Evidence High income families have a higher marginal propensity to save (MPS = 1 – MPC) High income families have a higher average propensity to save (APS = 1 – APC); APC falls with the level of income In the long-run, autonomous consumption falls to zero

Table 1: Real Consumption and Saving Schedules: A Hypothetical Case

The Consumption and Saving Functions

The Consumption and Saving Function Y C, S 0 C = f(Y) 45˚ Y E CACA -CA-CA S = f(Y) The saving function is the mirror image of the consumption function. It shows the relationship between the level of saving and income.

Saving and Dissaving Planned C Yd Yd (if C = Yd) Dissaving C > Yd Saving Yd > C Yd 1 Yd*Yd 2 C

The Keynesian Theory of Consumption Where the consumption function is above the 45° line, consumption exceeds income, and saving is negative. Where the consumption function crosses the 45° line, consumption is equal to income, and saving is zero. Where the consumption function is below the 45° line, consumption is less than income, and saving is positive.

What Determines the Level of Saving? Saving When C is greater than Y, saving is negative and is called dissaving. People can consume more than their income allows by running down their savings or other forms of accumulated wealth.

Investment Investment pays two roles in macroeconomics: – It can have a major impact on AD (real output and employment) – It leads to capital accumulation (it increases the nation's potential output and promotes economic growth in the long run)

Actual versus Planned Investment Desired or planned investment refers to the additions to capital stock and inventory that are planned by firms. Actual investment is the actual amount of investment that takes place; it includes items such as unplanned changes in inventories.

Planned Investment (I) Investment refers to purchases by firms of new buildings and equipment and additions to inventories, all of which add to firms’ capital stock. One component of investment—inventory change— is partly determined by how much households decide to buy, which is not under the complete control of firms. change in inventory = production – sales

Determinants of Investment Revenues: an investment should bring the firm additional revenue. Costs: interest rate influences the costs of the investment. Consumer demand: the bigger the increase in consumer demand, the more investment will be needed. Expectation: business expectation about future state of economy.

36 Autonomous investment The autonomous investment is not affected by the level of income or the rate of interest Most of the investment made by the government in the public utilities (social and economic overheads such as railways, roads, electricity, posts and telegraph, etc.) belongs to this category, since the investment decisions of the government are not simply motivated by gains or losses. Induced Investment Induced Investment is that investment which depends on level of income and rate of interest.

The Simple Theory of Investment In the simple Keynesian model, investment is independent of national income (autonomous investment). The investment function will be a horizontal straight line.

EXHIBIT 6THE AUTONOMOUS INVESTMENT CURVE

Exhibit 6: The Investment Curve How does the investment curve (I) in Exhibit 6 change as the level of national income changes? The investment curve does not change. It remains at $75 billion at every level of national income.

EXHIBIT 7THE EFFECT OF CHANGES IN THE RATE OF INTEREST ON THE LEVEL OF INVESTMENT

Exhibit 7: The Effect of Changes in the Rate of Interest on the Level of Investment Why is the demand curve for investment in panel a of Exhibit 7 downward sloping? The demand curve for investment is downward sloping because as the rate of interest decreases, the level of investment in the economy increases.

Figure 12-4 Combining Consumption and Investment

Saving and Investment Determine Output Equilibrium occurs when desired saving of households equals the desired investment of businesses. When desired saving and desired investment are not equal, output will tent to adjust up or down.

Saving and Investment Determine Output Y S, I 0 S = f (Y) E Y 1 Y E Y 2 I - Aggregate output will be equal to planned aggregate expenditure only when saving equals planned investment (S = I). The S = I Approach to Equilibrium

Saving and Investment Determine Equilibrium Output At output level Y 2 families are saving more than businesses are willing to go on investing. Firms will have too few customers and large inventories of unsold goods than they want. Then, businesses will cut back production and lay off workers. This move output gradually downward and economy returns to equilibrium Y E.

What Determines Consumption Spending? A change in national income induces a change in consumption. The change in consumption is considered movement along the consumption curve.

What Determines Consumption Spending? The consumption curve can also shift. Shifts in the consumption curve are unrelated to national income. There are several factors that can shift the consumption curve.

Consumption Saving o o 45 o C S Consumption schedule Saving schedule C S Disposable Income SAVING DISSAVING MPC = Slope of C MPS = Slope of S MPC + MPS = 1 CONSUMPTION AND SAVING

Consumption Saving o o 45 o C0C0 S0S0 Disposable Income C2C2 S2S2 TERMINOLOGY, SHIFTS, & STABILITY Decreases in Consumption Means… An Increase In Saving

Consumption Saving o o 45 o C0C0 S0S0 Disposable Income C1C1 S1S1 TERMINOLOGY, SHIFTS, & STABILITY Increases in Consumption Means… A Decrease In Saving

What Determines Consumption Spending? 1. Real asset and money holdings. An increase or decrease in real assets or money holdings causes the consumption curve to shift. For example, a substantial inheritance of money or property would cause the curve to shift upward.

What Determines Consumption Spending? 2. Expectations of price changes. An expectation of inflation could cause an increase in the current level of consumption, even though incomes are not expected to change. The increase in consumption would shift the curve upward.

What Determines Consumption Spending? 3. Credit and interest rates. If credit is more easily available or if the credit terms are made more attractive, people are likely to increase their spending on durable goods, even if their incomes haven’t changed. The consumption curve would shift upward.

What Determines Consumption Spending? 4. Taxation. If government decided to increase the income tax, people would end up with a smaller pay check, even though their salaries remained unchanged. This would cause a decrease in consumption and a downward shift in the consumption curve. 5. Household Debt – more debt enables more consumption

Objective Factors 1.Changes in wage level. 2.Windfall Gains or losses. 3.Changes in the Fiscal Policy. 4.Change in Expectations. 5.Change in Rate of interest 6.Volume of wealth 7.Consumer credit 8.Financial policies of Corporations. 9.Distribution of Income 10.Attitude towards Saving 11.Demographics 12.distribution of income.

Subjective factors Expectations and attitudes have been referred to as psychological factors in influencing consumption. Rational behavior suggests that a consumer who expects an increase either in his income or in the price level would consume more than one who expects no such change. Foresightedness is another motive which includes people to plan for the old age, family needs in future (marriage, children’s education) Pride motive- People feel proud in showing of wealth and prosperity. That is why they consume less to hoard more. Some people are basically miser. They are compelled by the habits to consume less.

Measures to raise the Propensity to Consume Income Redistribution Increased Wages Social Security Measures Credit Facilities Advertisement Development of the Means of Transport Urbanisation

Equilibrium Aggregate Output (Income) (1) (2) (3) By substituting (2) and (3) into (1) we get: There is only one value of Y for which this statement is true. We can find it by rearranging terms: