THE CONSUMPTION FUNCTION
To make the income-expenditure model more realistic, we will need to introduce other components of demand, including the government and the foreign sector. But first we need to recognize that consumers planned expenditures will depend on their level of income.
Consumer Spending and Income
The consumption function describes the relationship between desired spending by consumers and the level of income. When consumers have more income, they will want to purchase more goods and services. A simple consumption function can be described by the equation
C = Ca + by
In which total consumption spending, C, has two parts. The first part, Ca, is called autonomous consumption, and it does not directly depend on the level of income. The second part, by, represents the part of consumption that does depend on income. It is the product of the fraction b, called the marginal propensity to consume (MPC), and level of income in the economy, y. The MPC, which has a value of b in our formula, tells us how much consumption spending will increase for every dollar that income increases. If b equals 0.7, then for every $1 that income increases, consumption would increase by 0.7 Χ $1, or $0.70. As firms produce output, they pay households income in the form of wages, interest, profits, and rents. We can therefore use y to represent both output and income.
Changes in the Consumption Function
The consumption function is determined by the level of autonomous consumption and by the MPC. The level of autonomous consumption can change, and so can the MPC. Changes in either shift the consumption function to another position on the graph. A higher level of autonomous consumption but no change in MPC will shift the entire consumption function upward and parallel to its original position. More consumption occurs at every level of income. A number of factors can cause...
Please join StudyMode to read the full document