Keynesian Economics: Consumption Function and Multiplier - Class XII

Aggregate Demand refers to
the desired level of expenditure in the economy during an accounting year. It
is what people wish to spend on the purchase of goods and services during an
accounting year. 

APC refers to Average Propensity to Consume which
defines the amount of consumption in every 1 rupee of income for all level of
income which can be more than one because there are situations in the economy when consumption is more national
income, i.e. before the break-even point, APC > 1. 

Saving function is given in the form of: 
$S = -\bar{C}+sY$
where,

Reduction in government spending will reduce the level of aggregate demand, which will lead to fall in the income and purchasing power of the people. (The extent of fall in the income and purchasing power depends on the size of multiplier).

Propensity to consume refers to the proportion of income used as consumption expenditure. The fall in the propensity to consume is not responsible for creating excess demand in an economy.

False. 

True.

Investment multiplier refers to the number of time by which the increase in output or income exceeds the increase in investment. It is measured as the ratio between change in income and change in investment and it is denoted as 'k'.

Multiplier(k) => Change in income / change in investment = 1/ {1-MPC(c)} where c is the marginal propensity to consume. 

Therefore, the value of multiplier will be maximum when the value of MPC is either infinity or zero. 

Investment multiplier refers to the number of time by which the increase in output or income exceeds the increase in investment. It is measured as the ratio between change in income and change in investment and it is denoted as 'k'.

Multiplier(k) => Change in income / change in investment = 1/ {1-MPC(c)} where c is the marginal propensity to consume.

If MPC = 1, then 

Multiplier(k)= 1/(1-1)= 1/0 = Infinity.

Therefore, the value of the multiplier is infinity. 

The over full employment equilibrium refers to the situation when the aggregate demand in the economy is equal to aggregate supply beyond the full employment level which means that the excess demand in the economy leads to high price and over utilization of resources. 

Investment multiplier refers to the number of time by which the increase in output or income exceeds the increase in investment. It is measured as the ratio between change in income and change in investment and it is denoted as 'k'.

Multiplier(k) => Change in income / change in investment = 1/ MPS(s) where s is the marginal propensity to save. 

So if MPS=MPC then ,

We know that MPC + MPS =1 

=> 2 MPS= 1 

=> MPS= 1/2 

=> MPS= 0.5  

Multiplier (K) = 1/ MPS= 2 times.

Hence, the value of the multiplier is two. 

Investment multiplier refers to the number of time by which the increase in output or income exceeds the increase in investment. It is measured as the ratio between change in income and change in investment and it is denoted as 'k'.

Multiplier(k) => Change in income / change in investment = 1/ {1-MPC(c)} where c is the marginal propensity to consume.

If MPC = 0, then 

Multiplier(k)= 1/(1-0)= 1/1 = 1

Therefore, the value of the multiplier is 1. 

Investment multiplier refers to the number of time by which the increase in output or income exceeds the increase in investment. It is measured as the ratio between change in income and change in investment and it is denoted as 'k'.

Multiplier(k) => Change in income / change in investment = 1/ MPS(s) where s is the marginal propensity to save. 

If MPS= 0.20 and change in investment is by Rs. 400 crores, then 

Multiplier(k) => Change in income / change in investment = 1/ MPS 

                     => change in income/ 400 = 1/0.20

                     => change in income/ 400 = 5

                     => change in income = 5 * 400 = 2000 crores. 

Therefore, Income is increased by Rs. 2000 crores. 

If the value of MPC IS greater than MPS, then the value of the multiplier is always more than two because the change in savings or investment will always be less than half the change in income. 

Disposable income and total income will be the same if tax payment and fines payable are non existing or zero.

Disposable income is that part of total income which is available for consumption and saving. To elaborate it further, note that when a person receives income in return of factor services rendered by him/her, he/she may not spend all the income on consumption only. There are certain compulsory payments he/she has to make out of the income received, such as tax to the government, fines, if any etc. As a result the income available for consumption needs is reduced. Disposable income is defined as the income remained after payment of tax and fines. If tax payment is high, disposable income will be lower and vice versa. Accordingly, the level of consumption will be affected.

MPS = (Change in savings)/(Change in Income),

So, 

MPS = (600-900)/(4500-3000)
 = 300/1500
 = 0.2

The relationship between consumption and the level of income is called consumption function. Consumption function tells that consumption is a function of income, or in other words, consumption depends on the level of income.

Aggregate consumption of all depends on the total income generated in the economy. When the total income of the economy increases total consumption of the economy will also increase. In the same way, it can also be said that economy with higher level of national income consumes more than the economy which has lower level of national income.

APC = $\dfrac{C}{Y}$

Here APC = 60% or 0.6, C = 7,200

Since, APC = $\dfrac{C}{Y}$,
Y = $\dfrac{C}{APC}$ . 
where, Y = Disposable income,
and C = Consumption

Y = $\dfrac{7200}{0.6}$ $= \text{12,000 crore}.$

Consumption is dependent on income and thus, consumption changes with change in income. Marginal Propensity to Consume (MPC) refers to the change in consumption level that takes place due to an additional unit of income earned. 
Symbolically: $MPC=\dfrac{\text{Change in consumption}}{\text{Change in income}}$

Everybody needs income to purchase goods and services. Higher the level of income, higher will be the capacity to buy the goods and services. So for an individual, the total amount of goods and services to be purchased depends on the available disposable income.

Similarly, for an economy as a whole, it can be said that the aggregate consumption of all depends on the total income generated in the economy. When the total income of the economy increases total consumption of the economy will also increase. When we refer to income, we normally mean disposable income. Disposable income is that part of total income which is available for consumption and saving.

Disposable income is defined as the income remained after payment of taxes and fines. If tax payment in high, disposable income will be lower and vice versa. 

Here APC = 90% or 0.6, C = 9,000

Since, APC = $\dfrac{C}{Y}$,
Y = $\dfrac{C}{APC}$ . 
where, Y = Disposable income,
and C = Consumption

Y = $\dfrac{900}{0.9}$ $= \text{1,000 crore}.$

Keynesian consumption function is given as: C = a + bY 

where, C= Consumption, 

a = autonomous consumption and 

b = marginal propensity to consume 

C = 700 + (0.8 x 3500) = 2800.

Consumption = Rs. 3500 crore.

The Keynesian saving function is given as: S = -a +(1- b) Y 

where, S= Savings, 

Y = Income

a = autonomous consumption and 

b = marginal propensity to consume 

S = -200 + (1- 0.8) x Y 

S = -200+0.2Y

The Keynesian saving function is given as: S = -a +(1- b) Y 

where, S= Savings, 

Y = Income

a = autonomous consumption and 

b = marginal propensity to consume 

S = -700 + (1- 0.7) x Y  

S = -700 + 0.3 Y

The Keynesian consumption is given as: C = a + bY 

where, C= Consumption, 

a = autonomous consumption and 

b = marginal propensity to consume 

C = 150 + (0.6 x 450) = 420.

Consumption = Rs. 420 crore.

The Keynesian saving function is given as: S = -a +(1- b) Y 

where, S= Savings, 

a = autonomous consumption and 

b = marginal propensity to consume (MPC)

S = -150 + (1- 0.6) x 450 = 30.
Saving = Rs. 30 crore.

Keynesian consumption function is given as: C = a + bY 

where, C= Consumption, 

a = autonomous consumption and 

b = marginal propensity to consume 

C = 500 + (0.5 x 2500) = 1750.

Consumption = Rs. 1750 crore.

The Keynesian consumption function is given as: C = a + b Y 

where, C= Consumption, 

Y = Income

a = autonomous consumption and 

b = marginal propensity to consume 

So C = 600 + 0.8 Y

The factors that influence consumption and savings behaviour in the economy are as follows:

Rate of interest: Commercial bank offer a certain rate of interest on the deposits held by public and charges rate of interest on the loans given to public. When people do not want to purchase goods and services, they keep their money in the bank to earn the rate of interest. But when they want to buy goods and services, they withdraw money from the bank and lose interest in the process. In this way, the rate of interest plays an important role in influencing a persons decision to consume.

Wealth: Propensity to consume is influenced by a persons holding of wealth. People who have wealth in the form of gold, jewellery, ownership of land and building, shares and bonds etc enjoy a higher level of income generated from the wealth. Accordingly, their consumption level will be higher.

Consumer credit: Availability of consumer credit influences consumption behaviour to a large extent in the economy. There are many durable goods which consumers want to buy. But due to lack of credit facility, they are not able to buy them as they are costly items.

The Consumption Function describes the functional relationship between Consumption and Income. 

In dealing with Propensity to consume, Keynes considered two attributes: 

A schedule of propensity to consume refers to a statement that shows the functional relationship between the level of aggregate consumption and aggregate income in the economy at each level of output produced. 

True.

True. 

J.M Keynes explained the relationship between Consumption(C) and Income(Y) through the psychological law of consumption that stated, "as income goes on increasing, the consumption also increases but at a rate less than increase in income because there is always a part of income which is saved for future uncertainties". 

Autonomous consumption refers to that consumption which occurs when there is no income in the economy. It is the minimum level of consumption that takes place in the economy due to the requirement of the basic needs of life. 

The Marginal Propensity to Consume (MPC) is defined as the change in consumption resulting from a change in income.

Marginal Propensity to consume refers to the percentage change in consumption for every one rupee of change in the income. It is the ratio between the change in income and corresponding change in consumption.

Mathematically, 

Consumption function (C) = c+ bY where c=autonomous consumption, b= marginal propensity to consume, and Y= income.

Therefore, marginal propensity to consume is expressed as a product with the income earned by the economy. 

Resources are scarce in nature, so if it will be consumed in large amount then future generation will not be able to meet their needs and it will result in slower economic growth. 

The Keynesian saving function is given as: S = -a +(1- b) Y 

where, S= Savings, 

a = autonomous consumption and 

b = marginal propensity to consume (MPC) 

S = -700 + (1- 0.8) x 3500 = 0.

Level of savings = 0

Consumption is dependent on income and thus, consumption changes with change in income. Marginal Propensity to Consume (MPC) refers to the change in consumption level that takes place due to an additional unit of income earned. 
Symbolically: $MPC=\dfrac{\text{Change in consumption}}{\text{Change in income}}$

The Keynesian saving function is given as: S = -a +(1- b) Y 

where, S= Savings, 

a = autonomous consumption and 

b = marginal propensity to consume 

S = -500 + (1- 0.5) x 2500 = 750.

Level of savings = Rs. 750 crore.