Theory of Consumption

Agenda
• Psychological Law of J.M. Keynes
• Consumption Function : Short run and Long run
• Saving Function
 Psychological law of John Maynard Keynes

• When personal disposable income (Y) increases consumption (C) also

increases and vice versa but the change in consumption is less than
the change in income. If personal disposable income rises, households
spend some of the increase and save the rest. This is the psychological
law of Keynes on which Keynes theory of consumption is based.
• The change in consumption due to change in income is called the
marginal propensity to consume (MPC) MPC=dC /dY= C / Y

• Total consumption divided by total income is called average

propensity to consume (APC). APC = C/Y
The consumption function was central to Keynes’ theory of economic
fluctuations presented in The General Theory in 1936.
• Keynes conjectured that the marginal propensity to consume-- the amount consumed out of
an additional dollar of income-- is between
zero and one. He claimed that the fundamental law is that out of
every dollar of earned income, people will consume part of it and save
the rest.
• Keynes also proposed the average propensity to consume-- the ratio of consumption to
income-- falls as income rises.
• Keynes also held that income is the primary determinant of consumption and that the interest
rate does not have an important role.
 Keynes’s Conjectures
1. 0 ≤ MPC ≤ 1
2. Average propensity to consume (APC )
falls as income rises. (APC = C/Y )
3. Very strong correlation between income
and consumption
4. Income is the main determinant of
consumption.

CHAPTER 16 Consumption slide 4

 Keynes’s Conjectures
 MPC = 0, MPS = 1 For an extremely miser person
 MPC = 1, MPS = 0 For an extremely extravagant
person
 0 < MPC < 1 For a rational person who
saves some and consumes some.

CHAPTER 16 Consumption slide 5

 Consumption Function
• There is a definite positive relationship between consumption and
disposable income. This relationship is called consumption function. Like
any other function, consumption function can be expressed in three ways :
by 1) graph 2) schedule and 3) equation.
• Total consumption is the summation of Autonomous consumption plus
Induced consumption
• Total consumption (C) = Autonomous consumption(a) + Induced
consumption(bY)
• “Autonomous consumption” is the amount that consumers spend when income is zero. It
does not vary with the level of income.
• The consumption which depends on income is called induced consumption.
 C
C = a + bY
b Y
a+
=
C
consumption Marginal income
depends
spending by Propensity to C
on
households consume (MPC)
Y
Autonomous
consumption The slope of the consumption function
Chapter Sixteen is the MPC. 7
 The Keynesian Consumption Function
Here’s a consumption function with
C the properties Keynes conjectured:

C  C  cY

c c = MPC
= slope of the
1
consumption
C function

CHAPTER 16 Consumption slide 8

 The Keynesian Consumption Function
As income rises, the APC falls (consumers
C save a bigger fraction of their income).

C  C  cY

C C
APC    c
Y Y

slope = APC
Y

CHAPTER 16 Consumption slide 9

 This consumption function
APC = C/Y = C/Y + b exhibits three properties that
Keynes conjectured. First,
C
the marginal propensity to
consume c is between zero
and one. Second, the average
APC1 propensity to consume falls
C APC2 as income rises. Third,
11 consumption is determined by
Y current income.

As Y rises, C/Y falls, and so the average propensity to consume C/Y

falls. Notice that the interest rate is not included in this function.
Chapter Sixteen 10
 Consumption and Saving
• If personal disposable income rises, households
spend some of the increase and save the rest. This is
measured by the marginal propensity to consume
[MPC] and the marginal propensity to save [MPS],
which are both positive and sum to one.
• Relation between consumption and income might be:
– C = a + bY
– “a” is referred to as “autonomous consumption”. It is the
amount that consumers spend when income is zero.
“bY”is the induced consumption.
– “b” is the marginal propensity to consume.
– This implies a relation for saving:
– S = Y-C = Y-a – bY = -a+Y-bY= -a + Y(1-b) = -a + (1-b)Y
 Consumption and Saving
– “-a” is referred to as “autonomous saving”. It is the amount that consumers
save when income is zero.
– “( 1-b )Y”is the induced saving.
– “1-b” is the marginal propensity to save.
– Autonomous Saving is always equal to ( – Autonomous Consumption ). If
autonomous consumption is 400 (k) then autonomous saving is -400 (-k)
– MPS is always equal to (1-MPC). If MPC is 0.7 (z) then MPS is 0.3 (1-z)
– MPC+MPS =1, APC+APS =1
•
 Consumption and Saving
Relationships: empirical example

• C = 100 + 0.8Y
– where C is consumer spending in a period, Y is personal disposable
income, Autonomous C = 100;
– Marginal propensity to consume = dC/dY = d(100+0.8Y)/dY = 0.8
Induced consumption = 0.8Y APC=C/Y=(100+0.8Y)/Y=100/Y+0.8
• S = Y-C = Y-(100+0.8Y) =Y -100-0.8Y= -100+Y(1-0.8) = -100 + 0.2Y
– Marginal propensity to save = dS/dY = d(-100+0.2Y)/dY = 0.2
– Autonomous saving = -100, Induced saving = 0.2Y APS=S/Y
 Consumption and Saving Schedules [£ Million]

Disposable Desired Desired

Income Consumption saving

0 100 -100
100 180 -80
400 420 -20
500 500
0
1000 900 +100
1500 1300 +200
1750 1500 +250
2000 1700 +300
3000 2500 +500
4000 3300 +700
 Consumption and Saving Schedules [£
Million]
• Autonomous c Induced C APC MPC
• 100 80 1.8 0.8 at Y= 100
• 100 800 0.9 0.8 at=Y=1000
???????? ??????? ???? ???????????
Autonomous S Induced S APS MPS
-100 20 -0.8 0.2 at Y= 100
-100 200 0.1 0.2 at Y = 1000
????????? ??????? ???? ????????????
 Model solution
• QUESTION : C= 500+0.60Y, Derive the values of total
consumption &saving, autonomous consumption &
saving, induced consumption & saving, APC & APS,
MPC & MPS at Y is equal to 5000. At what income
level saving will be zero? Prove that APC+APS=1 &
• MPC+MPS=1, Y=C+S, Ind. C+Ind.S=Y
• Solution : S =Y-C= Y- 500-0.60Y = -500+Y(1-0.60Y)
• :. S = -500+ 0.40Y
 Model solution

• Total consumption (at Y=5000) = 500+0.60*5000=

3500
• Total saving (at Y=5000) = -500+0.40*5000 = 1500
• Autonomous consumption = consumption(at Y=0) =
500+0.6*0= 500
• Autonomous consumption (at Y=5000) = 500
• Autono saving=saving (atY=0)=-500+0.40*0=-500
• Autonomous saving (at Y=5000) = -500
 Model solution
• Induced C=Total C – Autonomous C= 500+0.60Y-500
= 0.60Y
• Induced C(at Y=5000)= 0.60*5000 = 3000
• Induced S=Total S–Autonomous S=-500+0.40Y-(-500)
= 0.40Y
• Induced S(at Y=5000)= 0.40*5000 = 2000
• Proof : Y=C+S = 500+3000+(-500+2000) = 5000
 Model solution
• APC = C/Y =(500+0.60Y)/Y=500/Y+0.60Y/Y
• =500/Y+0.60
APC (at Y= 5000) = (500/5000) + 0.60 = 0.70
APS = S/Y = (-500+0.40Y)/Y = -500/Y+0.40Y/Y
= -500/Y+0.40
APS (at Y= 5000) = (-500/5000) + 0.40 = 0.30
Proof : APC+APS = .70+.30 = 1
 MODEL SOLUTION
• MPC =dC/dY=d(500+0.60Y)/dY= d500/dY+d(.60Y)/dY
• =0+0.60= 0.60
• MPC (at Y=5000) = 0.60
• MPS =dS/d=d(-500+0.40Y)/dY=- d500/dY+d(.40Y)/dY
• =0+0.40= 0.40
• MPS (at Y=5000) = 0.40
• Proof : MPC+MPS = 0.60+0.40 = 1
 Model solution
• When Saving is zere
• Y = C+0= 500+0.60Y
• Or, Y – 0.60Y= 500
• Or, Y (1-0.60) = 500
• Or, 0.40Y = 500
• :. Y = 500/0.40 = 1250
 The Consumption and Saving Functions

450

Desired Consumption Expenditure 2000

C
1500
500
S
1000
250

Desired saving
500 0
-100

450 -500

500 1000 1500 2000 500 1000 1500 2000

Real Disposable Income Real Disposable Income

(i). Consumption Function[£ million] (ii). Saving Function[£ million]

 Problems for the
Keynesian Consumption Function
Based on the Keynesian consumption function,
economists predicted that C would grow more
slowly than Y over time.
This prediction did not come true:
 As incomes grew, the APC did not fall,
and C grew just as fast.
 Simon Kuznets showed that C/Y was
very stable in long time series data.

CHAPTER 16 Consumption slide 23

 During World War II, on the basis of Keynes’ consumption function,
economists predicted that the economy would experience what they
called secular stagnation-- a long depression of infinite duration--
unless fiscal policy was used to stimulate aggregate demand. It turned out
that the end of the war did not throw the U.S. into another depression, but
it did suggest that Keynes’ conjecture that the average propensity to
consume would fall as income rose appeared not to hold.

Simon Kuznets constructed new aggregate data on consumption and

investment dating back to 1869 and whose work would later earn a
Nobel Prize. He discovered that the ratio of consumption to income was
stable over time, despite large increases in income; again, Keynes’
conjecture was called into question.
Chapter Sixteen 24
This brings us to the puzzle…
 The failure of the secular-stagnation hypothesis and the findings of
Kuznets both indicated that the average propensity to consume is fairly
constant over time. This presented a puzzle: why did Keynes’
conjectures hold up well in the studies of household data and in the
studies of short time-series, but fail when long time series were
examined?

Long-run Studies of household data and short

C consumption time-series found a relationship
function between consumption and income
(constant APC) similar to the one Keynes conjectured--
Short-run this is called the short-run consumption
consumption function. But, studies using long time-
function series found that the APC did not vary
(falling APC) systematically with income--this
Y relationship is called the long-run
Chapter Sixteen 25
consumption function.
Short-run and long-run consumption function.
1. Keynesian consumption theory
 Keynes’ conjectures
 MPC is between 0 and 1
 APC falls as income rises
 current income is the main determinant of
current consumption
 Empirical studies
 in household data & short time series:
confirmation of Keynes’ conjectures
 in long time series data:
APC does not fall as income rises

CHAPTER 16 Consumption slide 26

Short-run and long-run consumption function.
 Keynes suggested that consumption depends
primarily on current income.
 Recent work suggests instead that consumption
depends on
– current income
– expected future income
– wealth
– interest rates
 Economists disagree over the relative
importance of these factors and of borrowing
constraints and psychological factors.

CHAPTER 16 Consumption slide 27

 long-run consumption function.
2. Fisher’s theory of intertemporal choice
 Consumer chooses current & future
consumption to maximize lifetime satisfaction
subject to an intertemporal budget constraint.
 Current consumption depends on lifetime
income, not current income, provided consumer
can borrow & save.
3. Modigliani’s Life-Cycle Hypothesis
 Income varies systematically over a lifetime.
 Consumers use saving & borrowing to smooth
consumption.
 Consumption depends on income & wealth.
CHAPTER 16 Consumption slide 28
 long-run consumption function.
4. Friedman’s Permanent-Income Hypothesis
 Consumption depends mainly on permanent
income.
 Consumers use saving & borrowing to smooth
consumption in the face of transitory
fluctuations in income.
5. Hall’s Random-Walk Hypothesis
 Combines PIH with rational expectations.
 Main result: changes in consumption are
unpredictable, occur only in response to
unanticipated changes in expected permanent
income.
CHAPTER 16 Consumption slide 29
 long-run consumption function.
6. Laibson and the pull of instant gratification
 Uses psychology to understand consumer
behavior.
 The desire for instant gratification causes people
to save less than they rationally know they
should.

CHAPTER 16 Consumption slide 30

 assignment
 QUESTION : C= 900+0.75Y, Derive the values of total
consumption &saving, autonomous consumption & saving,
induced consumption & saving, APC & APS, MPC & MPS at Y
is equal to 7000. At what income level saving will be zero?
Prove that APC+APS=1 &
 MPS+MPS=1, Y=C+S, Ind. C+Ind.S=Y
 QUESTION : C= A+zY, Derive the values of total
consumption &saving, autonomous consumption & saving,
induced consumption & saving, APC & APS, MPC & MPS. At
what income level saving will be zero? Prove that
APC+APS=1 & MPS+MPS=1, Y=C+S, Ind. C+Ind.S=1
CHAPTER 16 Consumption slide 31
 c
 C =a+bY
 S=Y-C=Y-a-bY=-a+(1-b)Y
 id.c+id.s=bY+(1-b)Y=Y

CHAPTER 16 Consumption slide 32