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# Consumption Function

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Consumption Function

Are you thinking of buying a car, tv, going shopping for clothes, or maybe even getting a haircut? Ever wonder how your consumption of goods and services impacts the economy? You would be surprised to know that your consumption actually has a "function" in economics; it's called the aggregate consumption function. It is a tool used in economics to determine various factors and impacts on the economy through consumer expenditure. What's even better is that it allows you as a consumer to get a better understanding of your consumer behavior and direct impact on the economy. So are you ready to learn about the aggregate consumption function? Let's begin!

## Aggregate Consumption Function

To start off, "aggregate" refers to the total or sum of something in economic terms, for example, "aggregate output" refers to total output, "aggregate demand" and "aggregate supply" refer to the total demand and the total supply in the economy. Thus the "aggregate consumption function" shows the relationship between total disposable income and total consumer spending in the entire economy.

The aggregate Consumption Function shows the relationship between total disposable income and total consumer spending in the entire economy.

The aggregate consumption function can be depicted with the following equation:

Where:

C = Consumer spending

A = Autonomous consumption

MPC = Marginal propensity to consume

YD = Consumer disposable income

The equation above essentially summarizes the relationship between the different variables that make up the consumption function. The consumption function depicts consumer spending, "C" as a function of:

• Autonomous consumption, "A", which is the amount that consumers would spend if there was no disposable income
• Marginal propensity to consume, "MPC", which is the extra consumer spending that occurs for every $1 increase in disposable income, and is the slope of the consumption function equation or graph • Consumer disposable income, "YD", which is the income households or individuals have left to either spend or save after taxes and transfers ## Consumption Function Example The consumption function can be depicted through a schedule that shows the relationship between the various amounts of consumption expenditure for different amounts of income. This schedule can be plotted on a graph which then can be used to analyze the resulting outcomes or trends. Figure 1. Aggregate Consumption Function, StudySmarter Originals Figure 1. above shows the consumption function where aggregate current disposable income is found on the X-axis and aggregate consumption expenditure is found on the Y-axis. The slope of the line is MPC, i.e. when consumer income increases by$1, consumer expenditure increases by MPC. The formula for MPC is:

In addition, the consumption function can be linear or non-linear. A linear consumption function would be as seen in Figure 1 above, where. MPC will remain to be a constant value between 0 and 1 through all levels of income. A non-linear consumption function will have a changing MPC through the different levels of income. Economists have theorized that as household income increases and the needs are satisfied, then the MPC will decline and MPS (marginal propensity to save) will be increasing as income increases. The resulting effect is a non-linear consumption function with a diminishing slope.

Figure 2. Aggregate Consumption Function, StudySmarter Originals

Figure 2 above shows a non-linear consumption function with a diminishing MPC.

## Factors Affecting Consumption Function

Now that we have seen a consumption function, we can next examine what causes a consumption function to shift. Since a consumption function depicts the relationship between consumer income and consumer expenditure, ceteris paribus (holding other things constant), the shift in the consumption function results from changes in other factors other than consumer income.

There are two main factors that cause a shift in the consumption function; one being a change in expected future disposable income and the other a change in aggregate wealth.

### Change in expected future disposable income

The permanent income hypothesis, theorized by Milton Friedman, states that the primary factor that consumer expenditure is dependent on is the expected future income rather than the income they currently hold. For example, suppose you are expected to receive a very large bonus from your employer, but the effective date for the bonus is not for another two months. Nonetheless, you start planning a new vacation or buying new things as you are anticipating an increase in your income in the near future. Similarly, if you were to receive the news that you will be receiving a pay cut in the coming months, you would cut back on your expenditure despite your current disposable income not experiencing any change.

## Consumption Function - Key takeaways

• The Aggregate Consumption Function shows the relationship between total disposable income and total consumer spending in the entire economy.
• The permanent income hypothesis states that the primary factor that consumer expenditure is dependent on is the expected future income rather than current income.
• The life cycle hypothesis states that consumer expenditure is a byproduct of accumulated wealth which results in expenditure spread over a lifetime and is not dependent on just current disposable income.
• The absolute income theory of consumption states that an increase in income will result in an increase in consumption, however not by the same proportion.
• The Keynesian multiplier is:

To calculate the MPC from the consumption function, you would calculate the slope of the consumption function.

The consumption function is calculated using the following formula:

C = A + MPC X YD

Where:

C = Consumer spending

A = Autonomous consumption

MPC = Marginal propensity to consume

YD = Consumer disposable income

The aggregate Consumption Function shows the relationship between total disposable income and total consumer spending in the entire economy.

The marginal propensity to consume, MPC, is the slope of the consumption function.

To find the multiplier you would use the MPC from the consumption function and input it into the following formula: 1/ (1 -MPC)

## Final Consumption Function Quiz

Question

How would you define the consumption function?

The Aggregate Consumption Function shows the relationship between total disposable income and total consumer spending in the entire economy.

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Question

A linear consumption function has an MPC which will be a constant value between 0 and 1 at all levels of income.

True

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Question

A non-linear consumption function will have the same MPC at different levels of income.

False

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Question

The two main factors that cause a shift in the consumption function are:

The expected future disposable income and the change in aggregate wealth.

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Question

The permanent income hypothesis states that:

The primary factor that consumer expenditure is dependent on is the expected future income rather than current income.

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Question

The life cycle hypothesis states that consumer expenditure is a byproduct of accumulated wealth which results in expenditure:

spread over a lifetime and is not just dependent on current disposable income

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Question

The aggregate consumption function will shift ------------------------- resulting from either an increase in the expected future disposable income or from an increase in the accumulation of wealth.

upward

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Question

The aggregate consumption function will shift ------------------------- resulting from either a decrease in the expected future disposable income or from a decrease in the accumulation of wealth.

downward

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Question

John Maynard Keynes was a British economist who theorized that consumer expenditure is a function of -------------------

---------------------.

disposable income

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Question

The absolute income theory of consumption states:

An increase in income will result in an increase in consumption, however not by the same proportion.

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Question

The proportion of expenditure to income is referred to as the:

Average propensity to consume (APC)

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Question

The marginal propensity to consume is the slope of the aggregate consumption function and tells us the change in consumption to the change in income.

True

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Question

The Keynesian Multiplier is an economic concept which states that an increase in government expenditure, private investment expenditure, or private consumption expenditure will result in an increase in GDP greater than the total expenditure.

True

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Question

If the MPC for an aggregate consumption function is 0.6, what will be the multiplier?

2.5

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Question

What is the formula for the consumption function?

C = A + MPC x YD

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Question

_____ refers to the total or sum of something in economic terms.

Aggregate

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Question

The "aggregate consumption function" shows the relationship between total disposable income and total _____ _____ in the entire economy.

consumer spending

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Question

What does "A" stand for in the aggregate consumption function?

Autonomous consumption

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Question

What does Ystand for in the aggregate consumption function?

Disposable income

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Question

What does MPC stand for in the aggregate consumption function?

Marginal Propensity to Consume

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Question

_____ is the slope of the consumption function.

MPC

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Question

To calculate MPC, you divide the change in consumption by the change in _____ _____.

disposable income

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Question

The consumption function can be non-linear.

True

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Question

Economists have theorized that as household income increases and the needs are satisfied, then the MPC will decline and MPS (marginal propensity to save) will be increasing as income increases.

True

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Question

According to the graph below, what happens to MPC as disposable income increases?

MPC decreases

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Question

The permanent income hypothesis, theorized by Milton Friedman, states that the primary factor that consumer expenditure is dependent on is the...

expected future income

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Question

The life cycle hypothesis states that consumer expenditure is a byproduct of...

accumulated wealth

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Question

Through the analysis of the consumption function, we are able to better understand...

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Question

An increase in income will result in an increase in consumption, however not by the same proportion. This is known as the...

absolute income theory of consumption

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Question

Keynes emphasizes that the proportion of the increase in consumption does not equate to the proportion of the increase in income.

True

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Question

With a nonlinear consumption function, MPC is always less than APC at each level of disposable income.

True

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