Loading the player...

What is the 'Consumption Function'

The consumption function, or Keynesian consumption function, is an economic formula that represents the functional relationship between total consumption and gross national income. It was introduced by British economist John Maynard Keynes, who argued the function could be used to track and predict total aggregate consumption expenditures.

BREAKING DOWN 'Consumption Function'

The classic consumption function suggests consumer spending is wholly determined by income and the changes in income. If true, aggregate savings should increase proportionally as gross domestic product (GDP) grows over time. The idea is to create a mathematical relationship between disposable income and consumer spending, but only on aggregate levels.

The stability of the consumption function, based in part on Keynes' Psychological Law of Consumption, especially when contrasted with the volatility of investment, is a cornerstone of Keynesian macroeconomic theory. Most post-Keynesians admit the consumption function is not stable in the long run since consumption patterns change as income rises.

Calculating the Consumption Function

The consumption function is represented as:

Consumption Function

Where: C = Consumer spending; A = Autonomous consumption; M = Marginal propensity to consume; D = Real disposable income.

Assumptions and Implications

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; all expenditures are passively determined by the level of national income. The same is not true of savings, which Keynes called “investment,” not to be confused with government spending, another concept Keynes often defined as investment.

For the model to be valid, the consumption function and independent investment must remain constant long enough for national income to reach equilibrium. At equilibrium, business expectations and consumer expectations match up. One potential problem is the consumption function cannot handle changes in the distribution of income and wealth. When these change, so too might autonomous consumption and the marginal propensity to consume.

Other Versions

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.

RELATED TERMS
  1. Marginal Propensity To Consume ...

    Marginal propensity to consume represents the proportion of a ...
  2. Aggregate Function

    An aggregate function includes values grouped together to form ...
  3. Conspicuous Consumption

    Conspicuous consumption is the acquisition of particular goods ...
  4. Acceleration Principle

    The acceleration principle is an economic concept that draws ...
  5. Keynesian Economics

    Keynesian Economics is an economic theory of total spending in ...
  6. Average Propensity To Consume

    The average propensity to consume refers to the percentage of ...
Related Articles
  1. Insights

    Can Keynesian Economics Reduce Boom-Bust Cycles?

    Learn about this famous British economist's proposed solution to a widespread economic problem.
  2. Investing

    Consumer Confidence: A Killer Statistic

    The consumer confidence is key to any market economy, so investors need to learn how to analyze them.
  3. Insights

    What's the Economy?

    The economy is the production and consumption activities that determine how scarce resources are allocated in an area.
  4. Investing

    Global Energy: Exploring Revenue Trends & Fundamentals

    Examine global energy sector revenue data by country and region, and identify geographical trends and analyze forecasts related to energy consumption.
  5. Investing

    India as Fastest-Growing Big Country: Don't Buy It

    In January 2015, India changed the method it uses to calculate GDP, shifting the base from the year that ended March 2005 (fiscal 2005) to fiscal 2012 and using a benchmark based on gross value ...
  6. Insights

    Free Market Maven: Milton Friedman

    As proponent of free market capitalism, this economist changed the way the world's economies operate.
  7. Investing

    A Study On The Wealth Effect And The Economy

    The notion that the wealth effect spurs personal consumption makes sense intuitively. After all, wouldn’t you be more inclined to buy that big-screen TV or SUV if your house or stock portfolio ...
  8. Insights

    Seven Decades Later: John Maynard Keynes' Most Influential Quotes

    It's been 72 years since the influential economist died; here are some of his most influential quotes.
RELATED FAQS
  1. What is the utility function and how is it calculated?

    Economists measure utility in revealed preferences by observing consumer choices and ordering consumption baskets from least ... Read Answer >>
  2. What impact does disposable income have on the stock market?

    Learn what disposable income is and what it means for average consumers. Understand the impact that disposable income has ... Read Answer >>
  3. How do investment banks help the economy?

    Learn more about the functions of investment banks in a modern economy and how investment banks have been treated differently ... Read Answer >>
  4. How is marginal propensity to save calculated?

    Learn about the marginal propensity to save, what it indicates about a household, and how to calculate a household's marginal ... Read Answer >>
  5. How can a change in fiscal policy have a multiplier effect on the economy?

    A change in fiscal policy has a multiplier effect on the economy because fiscal policy affects spending, consumption, and ... Read Answer >>
Trading Center