What Is the Consumption Function?

The term consumption function refers to an economic formula that represents the functional relationship between total consumption and gross national income (GNI). The consumption function was introduced by British economist John Maynard Keynes, who argued the function could be used to track and predict total aggregate consumption expenditures. It is a valuable tool that can be used by economists and other leaders to understand the economic cycle and help them make key decisions about investments as well as monetary and fiscal policy.

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, 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.

Calculating the Consumption Function

The consumption function is represented as:

 $\begin{aligned}&C\ =\ A\ +\ MD\\&\textbf{where:}\\&C=\text{consumer spending}\\&A=\text{autonomous consumption}\\&M=\text{marginal propensity to consume}\\&D=\text{real disposable income}\end{aligned}$​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.

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.

The Bottom Line

John Maynard Keynes is often credited as being the father of modern macroeconomics. His branch of economics, called Keynesian economics, suggested that demand was the driving force of any economy. He also 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.