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Determinants of Consumption Function- 6 Major Points Explained | Macroeconomics

Consumption Function

In economics, the consumption function is the relationship between total consumption and gross national income, also called the Keynesian consumption function. Keynes proposed the concept, arguing it could be used to track and predict aggregate consumption expenditures.

Using the classical consumption function, we find that consumer spending is completely determined by income and changes in income. If this were true, aggregate savings would increase proportionally with GDP growth. In this model, disposable income is modeled as a function of consumer spending, but only on an aggregate level.

A cornerstone of Keynesian macroeconomic theory is the stability of the consumption function, derived in part from Keynes’ Psychological Law of Consumption and contrasted with the volatility of investment. Most post-Keynesians admit that consumption patterns change as income rises, making consumption functions unstable in the long run.

The factors that affect the demand for consumption are called determinants of consumption function. .M Keynes has divided factors influencing the into two parts: Subjective factors (They are the internal factors ) and Objective factors ( They are the external factors)

A) Subjective Factors

Subjective factors are the internal factors or we can say factors related to psychological feelings influencing the consumption function. Major subjective factors influencing consumption function are:

1) Security Motive

Securitive motive plays an important role in determining the consumption function. As we know there are many providers of social security programs like old-age allowances, unemployment allowances, and disable allowances which help to increase the consumption expenditure or simply consumption function.

If there is insecurity, people may hold a certain amount of money which reduces consumption expenditure.

2) Demonstration Effects

Demonstration Effects play an important role in determining the consumption function. Many people are influenced by the consumption of other people and try to adopt similar consumption practices which is called a demonstration effect. This effect increases the consumption expenditure.

3) Increasing Social Status

Social Status plays an important role in determining consumption. People are more motivated to save more and accumulate large wealth with a belief that it will increase their social status. This helps to increase saving and decrease the consumption of the people.

4) Financial Prudence

Business firms desire to save more to increase undistributed corporate profit for the expansion and modernization of business. If the business firm keeps a relatively larger amount of its profit for financial prudence development and pays a smaller amount of profit as dividends to the shareholder, which will automatically reduce the propensity to consume of the society.

B) Objective Factors

Objective factors are the external factors or we can say factors that are real and are measurably influencing the consumption function. These factors can be easily changed in the long run. Major subjective factors influencing consumption function are:

1) The income of the people

Income plays an important role in determining consumption. The income of the people is the most influencing factor for consumption and there is a positive relationship between income and consumption. When income increases, consumption also increases, and vice-versa.

2) Income Distribution

Income Distribution plays an important role in determining the consumption function. If there is large disparity between rich and poor, the consumption is low because rich people have a low propensity to consume than poor people. Similarly, a community with a very equal distribution of income tends to have a high propensity to consume and a low propensity to save.

Consumption functions are also shaped by the distribution of income in a community. There is a low consumption function if the rich and poor have large income differences because the rich do not consume much and the poor with a very low income can’t spend more on consumption.

In the event that income and wealth inequalities are reduced through progressive taxation and other fiscal measures, then consumption will shift upward since as income for the poor increases, their consumption expenditure increases more than the reduction in expenditures for the rich.

A change in the distribution of income may also affect consumer habits in such a way that the shape or position of the whole consumption function can be perceptibly altered for political or humanitarian reasons.

3) Price level

Price level plays an important role in determining consumption. When the price falls, people will consume more, and the propensity to consume of society increases.

4) Wages level

Wages level plays an important role in determining consumption. When wages increase, people will consume more and vice-versa. The consumption function shifts upward when the wage rate rises. Consumption is high among workers with high incomes, which tends to shift the C curve upward.

But if the rise in wage rate is accompanied by an increase in price level that is greater than proportionate, the real wage rate will fall, and this will tend to shift the C curve downward. In addition to cutting wages, a fall in income, employment, and output will also reduce the consumption function of the community. As a result, the curve will shift downward.

5) Interest rate

The rate of interest plays an important role in determining the consumption function. A higher rate of interest will lead people to save money more and reduce consumption. According to the classical view, consumption and saving are dependent on interest rates.

An increase in interest rate discourages consumption because it encourages saving. Consumption/saving and interest rates can also be explained in another way. An increase in interest rates results in a decline in the money value of bonds.

Bondholders are thereby discouraged from spending. When interest rates rise, fixed interest-bearing assets lose money value. Consumers will be discouraged from spending on these assets when rates rise. The preference for bonds tends to rise when interest rates are high. As a result, people will consume less.

Anyhow, despite the weak correlation between interest rates and consumption, we may not consider rates of interest as a major factor influencing our consumption decisions.

6) Fiscal Policy

Fiscal policy plays an important role in determining consumption. When the government reduces the tax, the propensity to consume the community increases. The progressive tax system increases the propensity to consume of the people by altering the income distribution.

A change in fiscal policy in the form of taxation and public spending affects the consumption function. Consumption is adversely affected by heavy commodity taxes because disposable income is reduced.

Due to heavy indirect taxation, rationing, and price controls, the consumption function shifted downward during the Second World War.

Alternatively, progressive taxation in conjunction with public expenditures for welfare programs tend to alter the distribution of income so as to shift the consumption function upward.

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