Consumption function

Updated: Aug 20, 2021

The relationship between aggregate consumption expenditure in an economy and aggregate consumers’ disposable income. The relationship was first formulated by J. M. Keynes and played·a central role in his analysis of income determination. He suggested it was a ‘fundamental psychological law’ that as income rises, consumers’ expenditure will also rise, though by less than the increase in income because some of it would be saved.

This relationship. gives rise to the multiplier. Attempts which were made to quantify this relationship produced, however, three results which implied the need to refine the concept of income it is based upon. These results were (a) that when income and consumption were taken as averages over long periods – say ten years – con­sumption was proportional to income, implying that the marginal and average propensities to consume are equal and that the latter does not change as income.changes, (b) that when annua!consumption was related to annua! income the relationship was not proportional (the average propensity to consume exceeds the marginal, and·tends to fall as income increases) ·and (c) that the average propensity to consume tends. to fluctuate quite· widely from year to year.

To explain these results, a distinction is made between. the relationship between consumption and·inc6qie in the short-run on the one hand and the long run on the other. A consumer will try to maintain over time a reasonably smooth flow of consumptibn expenditure, and this will be geared to what he regards as his long-run income leve, which could oe measured as some average of his income over an entire lifetime, Moreoyer, consumption will also be influenced by his holding of wealth: the greater his wealth, the less he may need to save out of a given income. In the short-run there may well be fluctuations in both his income and his wealth, the latter for example because of the movement of prices on the stock market. But if he is maintaining a smooth consumption pattern, this implies ‘short-run variations in the proportion of income which is spent on consumption’. These ideas can then be shown to reconcile findings (a) to (c) and lead to a reformulation of Keynes’ consumption function by the introduction of a wealth variable and the replacement of current disp’osable income by some measure of ‘long-run’ or, to use M. Friedman’s term, ‘permanent’ income.

Reference: The Penguin Dictionary of Economics, 3rd edt.

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James Knight
Editor of Education
James is the Editor of Education for Invezz, where he covers topics from across the financial world, from the stock market, to cryptocurrency, to macroeconomic markets.... read more.