Definitions

Consumption function

In economics, the consumption function is a single mathematical function used to express consumer spending. It was developed by John Maynard Keynes and detailed most famously in his book The General Theory of Employment, Interest, and Money. The function is used to calculate the amount of total consumption in an economy. It is made up of autonomous consumption that is not influenced by current income and induced consumption that is influenced by the economy's income level.

The simple consumption function is shown as the linear function:

C = c0 + c1Yd

where C = total consumption, c0 = autonomous consumption (c0 > 0), c1 = the marginal propensity to consume (0 < c1 < 1), and Yd = disposable income (income after taxes and transfer payments, or W – T). The second term (c1Yd) is induced consumption.

Autonomous consumption represents consumption when income is zero. In estimation, this is usually assumed to be positive. The marginal propensity to consume (MPC), on the other hand measures the rate at which consumption is changing when income is changing. In a geometric fashion, the MPC is actually the slope of the consumption function.

The MPC is assumed to be positive. Thus, as income increases, consumption increases. However, Keynes mentioned that the increases (for income and consumption) are not equal. According to him, "as income increases, consumption increases but not by as much as the increase in income".

The Keynesian consumption function is also known as the absolute income hypothesis, as it only bases consumption on current income and ignores potential future income (or lack of). Criticism of this assumption lead to the development of Milton Friedman's permanent income hypothesis and Franco Modigliani's life cycle hypothesis.