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Macro Economics

Notes roughly a constant proportion of income on essential consumption items such as rent,
fuel, clothing and lighting.
These generalisations broadly hold from the basis of the law of consumption or propensity to
consume subsequently formulated by J M Keynes. Keynes was the first to stress the importance
of the relationship between income and consumption and to make it one of the central parts of
Macro Economics.

5.1 Concept of Consumption Function

The consumption function – the relationship between consumption and income – is largely a
Keynesian contribution. Keynes postulated that consumption depends mainly on income. In
regard to the relationship, he argued that consumption increases as income increases but by an
amount less than the increase in income. It is, however, assumed that by income Keynes meant
the "disposable income of the consumer". Keynes designated tendency of consumption varying
directly with disposable income as the Fundamental Psychological Law. According to this law,
"men are disposed, as a rule and on the average, to increase their consumption as their income
increases but not by as much as the increase in their income. This law is known as propensity to
consume or consumption function".
This law consists of three propositions:
1. When aggregate income increases, consumption expenditure also increases but by a
somewhat smaller amount. The reason is that as income increases, more and more of our
wants get satisfied and therefore lesser and lesser amounts are spent out of subsequent
increases in income.
2. When income increases, the increment of income will be divided in a certain proportion
between consumption and saving. This follows from the first proposition that what is not
spent is saved.

3. As income increases both consumption spending and saving will go up.
Assumptions of the Law

It is assumed that habits of people regarding spending do not change or propensity to
consume remains the same. Normally, the propensity to consume is more or less stable
and does remain unchanged. This assumption implies that only income changes whereas
other factors like income distribution, price movement, growth of population, etc. remain
more or less constant.

The conditions are normal in the economic system.
The existence of a capitalistic laissez faire economy. The law may not hold good in an
economy where state interferes with consumption or productive enterprise.

Explanation of the Law

The most important determinant of consumption is income. In technical language consumption
is a function of (determined by) income. This relationship between consumption and income is
termed as "consumption function" or " the propensity to consume".
C = f (Y)
Where, C is consumption

f is function
Y is income

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