Consumption Function Definition - Investopedia

What Is the Consumption Function?

The consumption function is an economic formula that represents the relationship between total consumption and gross national income (GNI). It was first introduced by British economist John Maynard Keynes, who argued that the function could be used to predict total aggregate consumption expenditure.

The consumption function is a valuable tool for understanding the economic cycle and guiding economists and policymakers as they make key decisions about investments, as well as monetary and fiscal policy.

Key Takeaways

• The consumption function is an economic formula that measures the relationship between income and total consumption of goods and services in the economy.
• The consumption function was introduced by John Maynard Keynes.
• Keynes argued that the consumption function could track and predict total aggregate consumption spending.
• Economists and leaders can use the consumption function to make important economic and investment decisions.
• Other economists have come up with variations of the consumption function over time, including those developed by Franco Modigliani and Milton Friedman.

Understanding the Consumption Function

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 consumer spending is wholly determined by income and the changes in income. If true, aggregate savings should increase proportionally as the 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.

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.

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.

Calculating the Consumption Function

The consumption function is represented as:

C = A + M D where: C = consumer spending A = autonomous consumption M = marginal propensity to consume \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} ​C=A+MDwhere:C=consumer spendingA=autonomous consumptionM=marginal propensity to consume​

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 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, the consumption function and independent investment must remain constant long enough for gross national income to reach equilibrium. At equilibrium, the expectations of businesses and consumers match up. One potential problem is that 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.

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.

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.

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 introduced the idea of the consumption function, which explains the relationship between a country's income and spending. According to the theory, spending is sensitive to the level of income. So spending will increase when income does. Economists and leaders can use this theory to help make predictions about future spending and important economic and investment decisions for the future.