CAPE Economics

Unit 2
Module 1 Topics 3-4
Keynesian Models of the Economy (pt. 1)
The Consumption Function

The consumption function, developed by Keynes, is a mathematical equation used to

express total consumer spending in the economy (C).
In the Keynesian model, the main determinant of consumption is the level of disposable
income for the consumer (Y). Unsurprisingly, when income rises, consumer spending also
rises.
The proportion of income that is spent is called the Average Propensity to Consume
(APC). APC = Consumption/Income = C/Y.
Saving = Income Consumption. Average Propensity to Save is the proportion of
income that is saved. APS = 1 APC.
Poorer people tend to spend a larger proportion of their income than do rich people.
Another way of saying this is that poorer people have lower savings rates (APC). This
makes sense because the poor are forced to spend a larger part of their income on the
basic necessities of life, while richer people can afford such necessities, plus some luxuries,
and still have some income left over for saving. Negative savings (i.e. borrowing) are
known as dissavings.
The Marginal Propensity to Consume (MPC) and the Marginal Propensity to
Save (MPS) are very important concepts, not only in the consumption function, but for
the entire Keynesian model of the economy.
The MPC measures the proportion of extra income that is spent, i.e. if a person gets an
increase in income, how much of that extra income is spent. MPC = C/Y.
The MPS measures the proportion of extra income that is saved. MPC = S/ Y.
MPS = 1 -MPC.
The Consumption function is expressed as - C = a+bY
C = Consumption
a = Autonomous consumption
b = MPC
Y = Income
Autonomous consumption refers to consumption spending that occurs regardless of a
person's income. These usually include the most basic, essential items (food, clothing,
shelter). If a person has no income, they still have to find a way of providing for their
needs. This is the basis of autonomous consumption.
Induced consumption (the 'bY' part of the equation) refers to consumption that is
triggered by increasing levels of income. When your income increases, you are able to
buy nicer shoes, go to fancier restaurants/parties/concerts, buy more expensive wine (or
champagne), etc. All this would be induced by higher income.
The typical Keynesian consumption function has a constant MPC, which leads to a
declining APC as income (Y) . This is due to the fact that autonomous consumption

generally remains constant.

Example:
C = a + bY, a = 40, b = MPC = 0.6
In Year 1, Y = 100, so C = 40 + 60 = 100 APC = C/Y = 100/100 = 1
In Year 2, Y = 200, so C = 40 + 120 = 160 APC = C/Y = 120/200 = 0.6
The APC has declined as Y increased, since autonomous consumption has failed to
keep pace with income (by definition).

The diagram shows a typical graphic representation of the consumption function.

The savings function is essentially the inverse of the consumption function, and is much
less important than the consumption function for our purposes.
S = -a + sY, where s = the MPS, a and Y are the same as for the consumption function.
Since the APC falls as Y increases, the APS must increase as Y increases. This is because
APC + APS = 1, i.e. consumption + savings = income.

Other Ways of Looking at Consumption

The Keynesian model of consumption is somewhat simplistic, since it assumes a linear
path of consumption for individuals, based entirely on income. As we know from
everyday experience, many people base their decisions on other factors than income.
To account for some of these other factors, some other theories of consumption have
been put forward. Two of the most well-known of these are:
Life Cycle Hypothesis - This posits that people change their consumption patterns
as they go through different stages of their lives. Young people, for example, tend
to have low incomes, tend to save very little, and tend to borrow in large quantities
relative to their incomes. As people gain experience and training, their income
tends to peak during middle age. At this point, both consumption and savings are
very high, since their incomes are sufficient to allow for increasing levels of both.
As people get older and retire, however, their income falls, the extent depending
on their pension contributions, and they again are unlikely to save, as in their youth.
Their consumption relative to income rises, though they borrow less than young
people.
Permanent Income Hypothesis - Permanent income refers to a household's usual
monthly income, which is the basis of most consumption decisions. Some

households do not have the luxury of knowing what their permanent income is, as
some incomes vary wildly throughout the year (farmers, people who clean snow off
the streets, some small businesses). Transitory income refers, then, to the sort of
income that fluctuates throughout a period of time for a household. To ensure the
least volatility of living standards, households with transitory income choose to
consume, borrow and save in such a way that living standards remain relatively
stable over time. Another way of saying this is, people with transitory income plan
their consumption as though they have permanent income.
The Multiplier

The consumption function has very interesting implications for the economy as a whole,
specifically through the MPC and the MPS. These two concepts find their full effect
through the multiplier process.
What is the multiplier process? It is the process by which initial expenditures
("injections") into the economy are spent several times over in many sectors, so that the
final effect on aggregate expenditure is several multiples larger than the initial injection.
The multiplier is the numerical estimate of the relationship between a change in spending
and the final change in aggregate expenditure.
Example:
Assume a tiny, 4-person economy, with MPC = 0.8 (so MPS = 0.2). The 4 people
are a baker, a butcher, a cobbler, and an Apple sales representative (either 'Apple'
the fruit or 'Apple' the computer company, it doesn't matter). If the baker buys a
new pair of shoes from the cobbler for $10, the cobbler doesn't just hide the $10
under his bed, does he? Here's where the multiplier comes in. The MPC is 0.8, so
the cobbler spends $8 of that $10 on something, e.g. pork chops from the butcher.
Similarly, the butcher will have an increase in his income of $8, and will spend
approximately $6.40 of that on something else. And so on. and so on. This
continued process of spending, induced by an original injection of spending by the
baker, is the multiplier process. According to the multiplier process, the original
$10 injection should lead to an increase in total expenditure of $50. As you can see,
when this happens in large economies, the effects can be tremendous, especially in
countries with low savings rates, since the lower the savings rate, the higher the
multiplier effect.
Mathematically, the multiplier is represented as M = 1/MPS so for a country with MPS
= 0.2, like the one in the example, our multiplier is 1/0.2 = 5.
The final effect on spending caused by an initial injection = M x the initial injection.
So, for the initial injection of $10 in the example, the final effect = 5 x 10 = $50.
The multiplier effect will have important implications all over the Keynesian models of the
economy, and will later have major policy implications.

The Labour Market

The main Keynesian argument about the labour market is that unemployment can, and
often does, persist. Why is this? Because wages are sticky downward, i.e. Even when there is
a surplus of labour, wages tend not to fall. When economic times are tough, workers are

still often unwilling to accept wage cuts. As a result, the surplus of labour cannot be
mitigated by falling wages instead, the excess labour is laid off, and as a result,
unemployment persists. In the Keynesian analysis, then, the labour market does not
always clear. The Diagram below makes this clear.

Savings and Investment - Divergence with Classical Theory

Keynes argued that an increase in savings did not always lead to an increase in investment.
The reasoning for this is intuitive. Increasing savings comes from reducing consumption,
ceteris paribus, meaning that aggregate expenditure must fall. Falling aggregate demand
(expenditure) gives negative feedback to firms, i.e. if people are spending less, firms will
be unlikely to show much willingness to invest. As a result, investment is as likely to fall
with increased savings as it is to rise.
The "paradox of thrift" is another implication of the Keynesian view on savings. If all
households in an economy choose to save larger proportions of their incomes, they may
end up saving less money in the end. The reason for this strange result is simple enough.
A rise in saving on an aggregate scale means a fall in consumption, hence aggregate
demand. This can lead to a fall in national income. If the fall in national income is
substantial enough, households will have far less income to save, and even with the higher
savings rates, the absolute value of their savings will fall, relative to the original situation.
There is such a thing as saving too much.
Factors affecting Investment
Consumer demand & Consumer confidence
Rate of interest
State of Technology & Technological change
Cost of Capital Goods
Expectations ("Animal Spirits")
Government Policy

To come in part 2: Much more on Investment, National Income Determination, National

Income Equilibrium/Disequilibrium