consumption theory

Introduction

The Keynesian Theory of consumption is that current real disposable income is the most important determinant of consumption in the short run. Real Income is money income adjusted for inflation. It is a measure of the quantity of goods and services that consumers have buy with their income (or budget).

For example, a 10% rise in money income may be matched by a 10% rise in inflation. This means that real income (the quantity or volume of goods and services that can be bought) has remained constant.

The chart above shows how real disposable incomes and consumer spending have grown in recent years. This increase in real incomes has been a factor behind the yearly growth of consumer demand in each of the last nine years.

The Keynesian Consumption Function

Disposable Income (Yd) = Gross Income - (Deductions from Direct Taxation + Benefits)

The standard Keynesian consumption function is as follows:

C = a + c Yd where,

C= Consumer expenditure

a = autonomous consumption. This is the level of consumption that would take place even if income was zero. If an individual's income fell to zero some of his existing spending could be sustained by using savings. This is known as dis-saving.

c = marginal propensity to consume (mpc). This is the change in consumption divided by the change in income. Simply, it is the percentage of each additional pound earned that will be spent.

There is a positive relationship between disposable income (Yd) and consumer spending (Ct). The gradient of the consumption curve gives the marginal propensity to consume. As income rises, so does total consumer demand.

A change in the marginal propensity to consume causes a pivotal change in the consumption function. In this case the marginal propensity to consume has fallen leading to a fall in consumption at each level of income. This is shown below:

Key Consumption Definitions

Average propensity to consume = Total consumption divided by total income

Average propensity to Save = Total savings divided by total income (also known as the Saving Ratio

A Shift in the Consumption Function

The consumption - income relationship changes when other factors than income change - for example a rise in interest rates or a fall in consumer confidence might lead to a fall in consumption spending at each level of income.

A rise in household wealth or a rise in consumer's expectations might lead to an increased level of consumer demand at each income level (an upward shift in the consumption curve).

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