Page 96 - DECO201_MACRO_ECONOMICS_ENGLISH

Unit 5: Consumption Function

Figure 5.3 Notes

As the level of income increases, households generally increase consumption expenditure but
less than proportionally. On the contrary, when the level of income decreases, households are
constrained to reduce consumption, but by a smaller amount. The reason for this 'tendency' or
'propensity' is not far to seek. The satisfaction of the immediate basic needs of households is
usually a stronger motive than the motive toward accumulation. Hence, at lower income levels,
households are constrained to spend almost the entire income and sometimes spend more than
the income on the consumption needs.

!
Caution As a result, saving, which is the difference between income and consumption,
tends to be either "zero" or even "negative". Negative saving is also called dissaving,
which means that at low incomes households may have to use up their past savings or
borrow in order to keep their consumption expenditure in excess of their income. But as
the income level rises, since most of the basic consumption needs are satisfied, the
households do not find it essential to increase the consumption expenditure in the same
proportion. As a result, savings tend to rise more than proportionately when income
rises.

Since saving is the difference between income and consumption and since consumption depends
on income it follows that saving also depends on income. This relationship between saving and
income is called the "propensity to save" or the "saving function".
The nature of relationship between the disposable household income on the one hand and the
household consumption and saving on the other can be explained with the help of a simple
linear equation (as stated earlier):
Y is C + S ...(1)
Where Y is disposable income

C is consumption
S is saving
This equation says that a household, disposable income is partly consumed and partly saved.
The income-consumption relationship can be specified by the equation:
C = a + b.Y (a>0, 0<b<1) ...(2)

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