Consumption Function: Formula, Assumptions, and Implications

What Is the Consumption Function?

The consumption function, introduced by John Maynard Keynes, outlines how total consumption relates to gross national income, offering insights into consumer spending behaviors. It serves as a tool for predicting economic trends and shaping policy decisions.

Key Takeaways

The consumption function is an economic formula that shows the relationship between total consumer spending and gross national income, initially proposed by John Maynard Keynes.
Keynes argued that consumer spending is largely determined by income and that understanding this relationship is critical for predicting future spending patterns.
Variations of the consumption function have been developed over time by other economists like Franco Modigliani and Milton Friedman, incorporating additional factors like life expectancy or permanent income.
The stability of the consumption function is essential for Keynesian economics, although its predictions often falter in empirical tests due to changes in income and wealth distribution.
The consumption function informs economic policy decisions by illustrating how changes in income or wealth influence spending and overall economic activity.

Investopedia Answers

Exploring Keynesian Consumption Function Dynamics

As noted above, the consumption function is an economic formula introduced by John Maynard Keynes, who tracked the connection between income and spending. Also called the Keynesian consumption function, it tracks the proportion of income used to purchase goods and services. Put simply, it can be used to estimate and predict spending in the future.

The classic consumption function suggests that consumer spending depends entirely on income and its changes. This implies that as gross domestic product (GDP) grows, aggregate savings should also increase proportionally. The idea is to create a mathematical relationship between disposable income and consumer spending, but only on aggregate levels.

Based in part on Keynes' psychological law of consumption theory, the stability of the consumption function is a cornerstone of Keynesian macroeconomic theory. This is especially true when it is contrasted with the volatility of an investment. Most post-Keynesians admit the consumption function is not stable in the long run since consumption patterns change as income rises.

Important

The consumption function uses gross national income as a component, which is the total amount of income earned by all participants in a nation's economy. This includes individuals and businesses in and outside its borders.

How to Calculate Consumption Function

The formula for the consumption function is:

$\begin{aligned}&C\ =\ A\ +\ MD\\&\textbf{where:}\\&C=\text{consumer spending}\\&A=\text{autonomous consumption}\\&M=\text{marginal propensity to consume}\\&D=\text{real disposable income}\end{aligned}$

Key Assumptions and Implications of the Consumption Function

Much of the Keynesian doctrine centers around the frequency with which a given population spends or saves new income. The multiplier, the consumption function, and the marginal propensity to consume are each crucial to Keynes' focus on spending and aggregate demand.

The consumption function is assumed stable and static where all expenditures are passively determined by the level of national income. The same is not true of savings or government spending, both of which Keynes referred to as investments.

For the model to be valid, both the consumption function and independent investment must stay constant until gross national income reaches equilibrium, when business and consumer expectations align. A problem arises when the consumption function doesn't account for shifts in income and wealth distribution, which can also affect autonomous consumption and marginal propensity to consume.

Fast Fact

Keynes was a proponent of government spending to curb economic downturns. Economists like Milton Friedman challenged these notions, saying government spending and federal debt could lead to inflation.

Modern Variations of the Keynesian Consumption Function

Over time, other economists have made adjustments to the Keynesian consumption function. Variables such as employment uncertainty, borrowing limits, or even life expectancy can be incorporated to modify the older, cruder function.

For example, many standard models stem from the so-called life cycle theory of consumer behavior as pioneered by Franco Modigliani. His model made adjustments based on how income and liquid cash balances affect an individual's marginal propensity to consume. This hypothesis stipulated that poorer individuals likely spend new income at a higher rate than wealthy individuals.

Milton Friedman offered his own simple version of the consumption function, which he called the "permanent income hypothesis." Notably, the Friedman model distinguished between permanent and temporary income. It also extended Modigliani's use of life expectancy to infinity.

More sophisticated functions may even substitute disposable income, which takes into account taxes, transfers, and other sources of income. Still, most empirical tests fail to match up with the consumption function's predictions. Statistics show frequent and sometimes dramatic adjustments in the consumption function.

How Do You Calculate the Consumption Function?

The consumption function can be calculated using a simple formula:

C = A + MD where C is the consumer spending, A is autonomous consumption (spending regardless of income levels), M is the marginal propensity to consume (the amount of additional income needed to spend on goods and services rather than saving it), and D is the amount of real disposable income required.

Who Introduced the Consumption Function?

The consumption function was introduced by economist John Maynard Keynes. He is known as the father of modern macroeconomics and the founder of Keynesian economics. This branch of economics suggests that governments should be actively involved in their economies. Rather than let their economies fall under the free market, Keynes said government spending can be used as a tool to cut back on weakness in the economy.

What Shifts the Consumption Function Forward?

The consumption function shifts forward (or upward) when disposable income or accumulated wealth also increases. The inverse is true for a downward shift in the consumption function. In this case, it drops or shifts downward when income or wealth drops.

Why Is the Consumption Function Important?

There are multiple reasons why the consumption function is important to economics. It is a macroeconomic tool that can help economists understand the economy, including how business cycles work and the function of the money supply among others. Economists and decision-makers can use it (and the formula) to make investment decisions and shape monetary and fiscal policy to direct the economy.

The Bottom Line

John Maynard Keynes' consumption function highlights the link between national income and consumer spending, illustrating how spending tends to increase with income levels. This concept is vital for understanding economic cycles and guides policymakers in shaping fiscal and monetary policy. The consumption function forms a basis for making informed investment decisions and predicting aggregate consumption trends. However, the model's assumptions, such as its static nature and reliance on income distribution stability, require careful consideration to ensure its reliability in economic planning.