14695 Consumption Function

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Consumption Function


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Psychological Law ofConsumption

The relationship betweenconsumption and the level of incomeis 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 isincome.


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According to Keynes, Thepsychology of the community is suchthat when aggregate real income is

increased, aggregate consumption isincreased, but not by so much asincome.

Keynes law of consumption dependsupon the following propositions:

(a) As aggregate income increases,

spending on consumption also


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The rate of increase in consumptionexpenditure is not same beyond thelevel of income of Rs 18 crores.

D i s p o s a b l e i n c o m e ( Y )i n R s

C r o r e s

C o n s u m p t i o n ( C )) i n R s

C r o r e s1 0

1 2

1 4

1 6

1 8

2 0

2 2

2 4

6

7

8

9

1 0

1 0 . 5

1 0. 8

1 0 . 8


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Consumptionexpenditur

e curve inthediagram

risesupward asincomeincreasesand rises

C o n s u m p t i o n

0

2

4

6

8

1 0

1 2

0 1 0 2 0 3 0D i s p o s a b l e

C

o

n

s

um

p

tio

n

C o n s u m p t i o

i n R s C r o r e


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relationship betweenincome and consumption

The two ways of measuringrelationship between income andconsumption are:

(a) The average propensity to consume(APC), and

(b) The marginal propensity toconsume (MPC).


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The Average Propensityto Consume (APC)

The average propensity to consumeis the ratio of consumption toincome. It can be expressed as

under.

For example, if total income is Rs 500crores and total consumption is Rs

200 crores, then:

Y

CAPC =

4.0500

200orAPC =


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The Marginal Propensityto Consume (MPC)

The ratio of change in consumptionto change in income is known asmarginal propensity to consume.

Symbolically, change ( ) in theincome is denoted as Y (read asdelta Y) and change in consumption

as C. Hence,

For example, if income increases by

Rs40 crores and as a result

Y

CMPC

=

5.0

40

20orMPC =


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Table illustrating the concept of APCand MPC.

I n c o m e ( Y )

i n c r o r e s R s

C o n s u m p t i o n

( C ) c r o r e s R s

A P C = C / YM P C =

C / Y0

5

1 01 5

2 02 5

3 0

3 5

5

7

1 01 2

1 51 7

2 0

2 2

-

1 . 4

1 . 00 . 8

0 . 7 50 . 6 8

0 . 6 6

0 . 6 2

-

0 . 4

0 . 60 . 4

0 . 60 . 4

0 . 6

0 . 4


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

C

o

n

su

m

p

tio

n

Y

R

C

O I n c o m e N

ON

NRAPC =

RS

PS

NM

PS

Y

CMPC ==

=


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Propensity toSave/Saving Function

The relationship between the changein income and the change in savingis the propensity to save.

We can also express propensity tosave in two different ways. These arethe following:

a) The average propensity to save(APS), and

b) The marginal propensity to saveMPS .


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The Average Propensity to Save(APS)

The average propensity to save is theratio of total savings to total income.Thus,

where, S = saving and Y = income.

The Marginal Propensity to Save

(MPS) Marginal propensity to save is

Y

SAPS =


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

Y

SMPS

=

Y

CMPS

=1


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e a ons p e weenAPC and MPC

The following relationships arisebetween APC and MPC:

(i) MPC refers to marginal increase inconsumption due to marginal increasein income and APC means the ratio oftotal consumption to total income.

(ii) As income increases, both MPC andAPC decline but decline in MPC is morethan the decline in APC.

iii When MPC is constant the


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Importance ofPsychological Law of

Consumption1. Crucial role of investment: ThePsychological Law of Consumptionestablishes vital and crucial role of

investment when the communityspends less than the increase inincome. This is important for increased

output and employment in theeconomy.

2. Repudiation of Says Law:

Keynes law invalidates Says Law of


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Factors InfluencingConsumption Function

1. Subjective factors: Psychologicalmotives which affect propensity toconsume consist of subjective

factors. These motives affect bothindividual and corporate savings.

Such motives are family affection, old

age security, foresight, precaution,etc.

According to Keynes individuals

decision to consume or save is a


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2. Objective factors: Consumptionfunction is affected by objectivefactors such as income, distribution of

income, financial policies ofcorporation, changes in expectations,windfall gains, fiscal policy,

demographic factors, wage rates,wealth and stock of money, liquidassets, changes in the rate of interestetc.


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Excess and DeficientDemand


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Meaning of ExcessDemand

Excess demand is a situation whenaggregate demand exceedsaggregate supply at the full

employment level of income. The difference between aggregate

demand and supply at the level of

full employment is called theinflationary gap.

Inflationary gap in the economy

exists when planned expenditure is


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To

ta

le

xp

e

n

d

itu

re

Y

I n f l a t i o n a r y g a p

EA

B

F u l l e m p l o y m

O YN a t i o n a l I n c o m e

AY BY = AB(inflationary gap).

mpac o xcess


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mpac o xcessDemand in the Economy

If the economy has involuntaryunemployment, an increase in demandwill increase employment and output.

Once the economy reaches fullemployment level and demand isfurther increased, it will lead to rise in

prices, i.e., an inflationary situation inthe economy.

Output and employment cannot be

increased. An increase in productivity


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Meaning of DeficientDemand

It is a situation when aggregatedemand is less than aggregatesupply of goods and services at the

full employment level of income. It is also termed as the deflationary

gap.

Deflationary gap in the economycauses large scale unemployment.

It comes to exist in the economywhen demand for oods and services


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To

ta

le

xp

e

n

d

itu

re

Y

D e f l a t i o n a r y g a pC

DE

F u l l

O N a t i o n a l I n c o m e Y

DY CY = CD(deflationarygap).


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Impact of DeficientDemand in the Economy

The impact may be analyzed in threerespects- impact on output,employment and prices. However, its

impact depends upon various factors,important among these are:

1. The structure of the economy-

competitive or oligopolistic;

2. Elasticity of supply of factors ofproduction;

3. Influence of trade unions.


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Causes of Excess andDeficient Demand

(i) An increase in governmentexpenditure (spending), which is notmatched by a corresponding

increase in taxation.

Deficient demand may be caused ifthe government expenditure falls

short of the revenue.

(ii) Increase in autonomous investment(due to past savings) without any

increase in current savings. And no

easures o orrec


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easures o orrecExcess and Deficient

DemandGenerally, we have the following waysto correct excess or deficient demand.

1. Fiscal Policy

2. Monetary Policy

3. Foreign Trade Policy


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Fiscal Policy This is referred to as government

expenditure and taxation policy.Fiscal policy influences aggregatedemand significantly. In a situation of

excess demand, it may help if thereis cut in the governmentexpenditure - to reduce budgetarydeficit - and rise in incomes/revenues

through ways that are notinflationary such as progressivetaxation and borrowing.

Government may reduce expenditure


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Monetary Policy

Monetary policy refers to the policythrough which the monetaryauthority expands or contracts the

money supply in the economy. Inother words, it relates to changes inthe rate of interest and the

availability of credit in the economy. Higher rate of interest means

costlier credit, which discourage

effective demand. Investors get


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To influence availability of credit,bank credit needs to be influenced.Important monetary tools that are

available with the central bank of acountry can be used:

Cash reserve ratio

Bank rate

Open market operations

Changing margin requirements


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Foreign Trade Policy

Foreign trade generally relates toexports and imports of a country.Excess and deficient demand can be

influenced substantially by adopting afavourable foreign trade policy.

Additional exports increase

incomes directly and enlargespending. But additional incomesalso create demand for imports.

Thus, income generated in the


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An inflationary situation can bebrought under control bypreventing wage to increase and

increasing output by fuller use ofexisting idle (inactive)capacities. Wage increase matched

by an increase in productivity oflabour is desirable as it also improvessupply position. But when wageincrease is without corresponding

increase in productivity then it leads

14695 Consumption Function

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