INTRODUCTION

• The previous chapter outlined how the level of national income is determined. This chapter and the next will focus on the factors influencing consumption demand and investment demand, key components of aggregate demand.

• The relationship between aggregate demand and the level of income or employment is direct: higher aggregate demand leads to increased income and employment, while lower aggregate demand results in the opposite.

• Keynes focused primarily on aggregate demand and was less concerned with the factors determining aggregate supply, as his interest lay in the short run and the existing productive capacity.

• Therefore, this chapter will concentrate on the determinants of consumption demand, including the level of income and the propensity to consume, along with how these factors evolve over time.

• The following chapter will address investment demand and its determinants.

The Concept of Consumption Function

• The demand for a good is influenced by its price, just as a community’s consumption depends on its income level. This relationship shows that consumption is a function of income, with the consumption function detailing the amount consumed at various income levels.

• An increase in community income leads to higher consumption. The extent of this increase in consumption in response to income growth is determined by the marginal propensity to consume (MPC).

• It is important to differentiate between the consumption function, which is the complete schedule indicating consumption levels at different incomes, and the amount of consumption, which refers to consumption at a specific income level. For example, at an income of ₹1200 crore, consumption is ₹1090 crore, while at ₹1500 crore, consumption increases to ₹1300 crore.

• The consumption function indicates that when income rises, consumption increases, but at a lower rate. This concept, emphasized by Keynes, states that part of any increase in income is saved. For instance, when income rises from ₹1000 crore to ₹1100 crore, consumption increases from ₹950 crore to ₹1020 crore—an increase of ₹70 crore, with ₹30 crore saved.

• The Keynesian consumption function demonstrates that while the MPC remains constant at 0.70, the average propensity to consume (APC) declines as income increases. The linear nature of the consumption function signifies that the MPC, which indicates the slope of the consumption function curve, remains constant, while the APC falls with rising national income.

• The fall in APC indicates that increases in consumption do not match increases in income. Notably, the MPC is less than the APC at various income levels.

• Consumption demand is determined by income and the propensity to consume, which is influenced by factors such as price level, interest rates, and wealth. Since Keynes focused on the short-run consumption function, he assumed these factors to be constant, making the consumption function primarily dependent on current income, expressed as $)$.

• The specific linear form of the Keynesian consumption function is C=a+bY, where $a$ is the intercept, $b$ is the slope representing MPC, and $Y$ is the current income level.

• This consumption function is illustrated by the CC’ curve in a graph where national income is plotted on the X-axis and consumption on the Y-axis. The line OZ, at a 45° angle, represents points where consumption equals income. In reality, consumption typically increases less than income, so the consumption function deviates below this line.

• At lower income levels, the CC’ curve may lie above the 45° line, indicating that consumption exceeds income, possibly due to borrowing or using accumulated savings. As income rises to level OY0​, consumption equals income, but thereafter, consumption continues to rise at a slower rate than income, causing the CC’ curve to lie below the 45° line, reflecting increased savings.

• Changes in the community’s consumption function can shift the entire curve. An increase in the propensity to consume results in an upward shift of the curve, indicating more consumption at any given income level, while a decrease results in a downward shift, indicating less consumption at the same income level.