Question

6.What are the determinants of consumption according the Keynesian view? Write the Keynesian consumption function and explain its meaning in detail (15 points).

Answer 1

Hi

The answer of the following question are as follows :

The Keynesian economics developed during and after the great depression from the ideas presented by Keynes in his 1936 book.

Now let us discuss determinants of the consumption according to the Keynesian view as follows :

The principal determinant of the Keynesian consumption function is income. however there are at least three theories that modify Keynesian absolute income hypothesis. First, James S. Duesenberry says that consumption depends on relative income.

People tend to consume more lo ‘keep up with the Joneses’. This means that consumption spending is largely influenced by incomes earned by neighbouring households. In other words, it is the relative income that determines consumption. This is called ’emulatory con­sumption’. Duesenberry’s hypothesis is known as ‘relative income hypothesis’. He demon-strates that in the long run MPC = APC, as opposed to Keynes’ short run consumption function hypothesis—MPC < APC .

Secondly, the Milton Friedman argues that consumption depends on permanent income. Unexpected, transitory incomes have little effect on permanent consumption. Permanent consumption is always associated with permanent income. Friedman’s hypothesis of permanent income also suggests that in the long run, MPC tends to equal APC, i.e., MPC=APC.

Finally, Modigliani, F.A. Ando and R.E. Brumberg in their life cycle hypothesis, argue that people formulate their expenditure plans in accordance with their expected incomes over lifetime i.e., some perception of lifetime incomes. While making consumption decisions, individuals look at the total income to be earned over their lifetime. Modigliani, Andos’ ‘life cycle hypothesis’ also says that in the long run MPC = APC. All these theories hold the same conclusion: APC tends to decline as the income rises.

However, besides income, Keynes attached importance to other factors under the headings “objective” and “subjective” or “psychological” factors that determine aggregate consumption. Objective factors are also known as “economic factors” which are subject to change in the short run. Objective or economic factors are also quantifiable. On the other hand, subjective factors are psychological and, hence, are not subject to estimation. In addition, structural factors also influence aggregate consumption spending. Finally, Keynes paid attention to fiscal policy variable as another determinant of aggregate consumption.whenwe show consumption-income relationship, we assume all the above- mentioned determinants of consumption spending to remain constant. As income changes, consumption changes. This is called movement along the consumption function.Similarly, one obtains movement along the saving function when saving changes following a change in income, holding all other determinants of saving constant. But, if one of the subjective, objective or other determinants change then consumption function and saving function would shift. Assuming a constant aggregate income, an increase in the volume of wealth would lead to an increase in consumption—thereby shifting the consumption function upwards and the saving function downwards.

There are several Objective or economic factors (which undergo change in the short run) that influences consumption function are considered here as follows :

a) Rate of interest.

b) Sales effort.

c) The volume of wealth.

d) Terms of consumer credits.

e) Deferred payments.

Now let's discuss the Keynesian consumption function ie given as follows :

The Keynesian consumption function expresses the level of consumer spending depending on three factors. Yd = disposable income (income after government intervention – e.g. benefits, and taxes)

Where ,

a = autonomous consumption (consumption when income is zero. e.g. even with no income, you may borrow to be able to buy food)
b = marginal propensity to consume (the % of extra income that is spent). Also known as induced consumption.

Consumption function formula

C = a + b Yd
This suggests consumption is primarily determined by the level of disposable income (Yd). Higher Yd leads to higher consumer spending.

This model suggests that as income rises, consumer spending will rise. However, spending will increase at a lower rate than income.At low incomes, people will spend a high proportion of their income. The average propensity to consume could be one or greater than one. This means people spend everything they have. When you have low income, you don’t have the luxury of being able to save. You need to spend everything you have on essentials.

However, as incomes rise, people can afford the luxury of saving a higher proportion of their income. Therefore, as incomes rise, spending increases at a lower rate than disposable income. People with high incomes have a lower average propensity to spend.

I hope I have served the purpose well.

Thanks .