In economics, the consumption function describes a relationship between consumption and disposable income. [1] [2] The concept is believed to have been introduced into macroeconomics by John Maynard Keynes in 1936, who used it to develop the notion of a government spending multiplier. [3]
Its simplest form is the linear consumption function used frequently in simple Keynesian models: [4]
where is the autonomous consumption that is independent of disposable income; in other words, consumption when disposable income is zero. The term is the induced consumption that is influenced by the economy's income level . The parameter is known as the marginal propensity to consume, i.e. the increase in consumption due to an incremental increase in disposable income, since . Geometrically, is the slope of the consumption function.
Keynes proposed this model to fit three stylized facts: [5]
By basing his model in how typical households decide how much to save and spend, Keynes was informally using a microfoundation approach to the macroeconomics of saving. [7]
Keynes also took note of the tendency for the marginal propensity to consume to decrease as income increases, i.e. . [8] If this assumption is to be used, it would result in a nonlinear consumption function with a diminishing slope. Further theories on the shape of the consumption function include James Duesenberry's (1949) relative consumption expenditure, [9] Franco Modigliani and Richard Brumberg's (1954) life-cycle hypothesis, and Milton Friedman's (1957) permanent income hypothesis. [10]
Some new theoretical works following Duesenberry's and based in behavioral economics suggest that a number of behavioural principles can be taken as microeconomic foundations for a behaviorally-based aggregate consumption function. [11]
{{cite book}}: CS1 maint: location missing publisher (link)There are not many people who will alter their way of living because the rate of interest has fallen from 5 to 4 per cent, if their aggregate income is the same as before... the short-period influence of the rate of interest on individual spending out of a given income is secondary and relatively unimportant, except, perhaps, where unusually large changes are in question.
... recall Keynes's argument that the marginal propensity to consume should be between zero and one, or his discussion about whether the marginal efficiency of investment should be sensitive to current output or should depend primarily on "the state of long-term expectations." Those are microfoundations.
The marginal propensity to consume is not constant for all levels of employment, and it is probable that there will be, as a rule, a tendency for it to diminish as employment increases; when real income increases, that is to say, the community will wish to consume a gradually diminishing proportion of it.
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Keynesian economics are the various macroeconomic theories and models of how aggregate demand strongly influences economic output and inflation. In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy. It is influenced by a host of factors that sometimes behave erratically and impact production, employment, and inflation.
In economics, the fiscal multiplier is the ratio of change in national income arising from a change in government spending. More generally, the exogenous spending multiplier is the ratio of change in national income arising from any autonomous change in spending. When this multiplier exceeds one, the enhanced effect on national income may be called the multiplier effect. The mechanism that can give rise to a multiplier effect is that an initial incremental amount of spending can lead to increased income and hence increased consumption spending, increasing income further and hence further increasing consumption, etc., resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output that is a multiple of the initial change.
The General Theory of Employment, Interest and Money is a book by English economist John Maynard Keynes published in February 1936. It caused a profound shift in economic thought, giving macroeconomics a central place in economic theory and contributing much of its terminology – the "Keynesian Revolution". It had equally powerful consequences in economic policy, being interpreted as providing theoretical support for government spending in general, and for budgetary deficits, monetary intervention and counter-cyclical policies in particular. It is pervaded with an air of mistrust for the rationality of free-market decision making.
In economics, aggregate demand (AD) or domestic final demand (DFD) is the total demand for final goods and services in an economy at a given time. It is often called effective demand, though at other times this term is distinguished. This is the demand for the gross domestic product of a country. It specifies the amount of goods and services that will be purchased at all possible price levels. Consumer spending, investment, corporate and government expenditure, and net exports make up the aggregate demand.
The marginal propensity to save (MPS) is the fraction of an increase in income that is not spent and instead used for saving. It is the slope of the line plotting saving against income. For example, if a household earns one extra dollar, and the marginal propensity to save is 0.35, then of that dollar, the household will spend 65 cents and save 35 cents. Likewise, it is the fractional decrease in saving that results from a decrease in income.
Consumption is the act of using resources to satisfy current wants and needs. It is seen in contrast to investing, which is spending for acquisition of future income. Consumption is a major concept in economics and is also studied in many other social sciences.
In economics, the marginal propensity to consume (MPC) is a metric that quantifies induced consumption, the concept that the increase in personal consumer spending (consumption) occurs with an increase in disposable income. The proportion of disposable income which individuals spend on consumption is known as propensity to consume. MPC is the proportion of additional income that an individual consumes. For example, if a household earns one extra dollar of disposable income, and the marginal propensity to consume is 0.65, then of that dollar, the household will spend 65 cents and save 35 cents. Obviously, the household cannot spend more than the extra dollar. If the extra money accessed by the individual gives more economic confidence, then the MPC of the individual may well exceed 1, as they may borrow or utilise savings.
The accelerator effect in economics is a positive effect on private fixed investment of the growth of the market economy. Rising GDP implies that businesses in general see rising profits, increased sales and cash flow, and greater use of existing capacity. This usually implies that profit expectations and business confidence rise, encouraging businesses to build more factories and other buildings and to install more machinery. This may lead to further growth of the economy through the stimulation of consumer incomes and purchases, i.e., via the multiplier effect.
Autonomous consumption is the consumption expenditure that occurs when income levels are zero. Such consumption is considered autonomous of income only when expenditure on these consumables does not vary with changes in income; generally, it may be required to fund necessities and debt obligations. If income levels are actually zero, this consumption counts as dissaving, because it is financed by borrowing or using up savings. Autonomous consumption contrasts with induced consumption, in that it does not systematically fluctuate with income, whereas induced consumption does. The two are related, for all households, through the consumption function:
Induced consumption is the portion of consumption that varies with disposable income. When a change in disposable income “induces” a change in consumption on goods and services, then that changed consumption is called “induced consumption”. In contrast, expenditures for autonomous consumption do not vary with income. For instance, expenditure on a consumable that is considered a normal good would be considered to be induced.
Average propensity to consume (APC) is a concept developed by John Maynard Keynes to analyze the consumption function, which is a formula where total consumption expenditures (C) of a household consist of autonomous consumption (Ca) and income (Y) multiplied by marginal propensity to consume. According to Keynes, the individual's real income determines saving and consumption decisions.
The permanent income hypothesis (PIH) is a model in the field of economics to explain the formation of consumption patterns. It suggests consumption patterns are formed from future expectations and consumption smoothing. The theory was developed by Milton Friedman and published in his A Theory of Consumption Function, published in 1957 and subsequently formalized by Robert Hall in a rational expectations model. Originally applied to consumption and income, the process of future expectations is thought to influence other phenomena. In its simplest form, the hypothesis states changes in permanent income, rather than changes in temporary income, are what drive changes in consumption.
In Keynesian economics, the average propensity to save (APS), also known as the savings ratio, is the proportion of income which is saved, usually expressed for household savings as a fraction of total household disposable income (taxed income).
Microfoundations are an effort to understand macroeconomic phenomena in terms of economic agents' behaviors and their interactions. Research in microfoundations explores the link between macroeconomic and microeconomic principles in order to explore the aggregate relationships in macroeconomic models.
According to Keyne's Psychological Law of Consumption, Consumption is a function of income. In his words; “Human is disposal by nature, as income increases, consumption expenditure also increases but increase in consumption is smaller than the increase in income”. Mathematically C= f(y) ; i.e. C = a + b(y), Where a = Autonomous Consumption, b = MPC and Y = Income
The neoclassical synthesis (NCS), neoclassical–Keynesian synthesis, or just neo-Keynesianism was a neoclassical economics academic movement and paradigm in economics that worked towards reconciling the macroeconomic thought of John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936). It was formulated most notably by John Hicks (1937), Franco Modigliani (1944), and Paul Samuelson (1948), who dominated economics in the post-war period and formed the mainstream of macroeconomic thought in the 1950s, 60s, and 70s.
In macroeconomics, a multiplier is a factor of proportionality that measures how much an endogenous variable changes in response to a change in some exogenous variable.
The Keynesian cross diagram is a formulation of the central ideas in Keynes' General Theory of Employment, Interest and Money. It first appeared as a central component of macroeconomic theory as it was taught by Paul Samuelson in his textbook, Economics: An Introductory Analysis. The Keynesian cross plots aggregate income and planned total spending or aggregate expenditure.
In economics, the absolute income hypothesis concerns how a consumer divides their disposable income between consumption and saving. It is part of the theory of consumption proposed by economist John Maynard Keynes. The hypothesis was subject to further research in the 1960s and 70s, most notably by American economist James Tobin (1918–2002).
The wage unit is a unit of measurement for monetary quantities introduced by Keynes in his 1936 book The General Theory of Employment, Interest and Money. A value expressed in wage units is equal to its price in money units divided by the wage of a man-hour of labour.
