θωερτψυιοπασδφγηϕκλζξχϖβνµθωερτψ



υιοπασδφγηϕκλζξχϖβνµθωερτψυιοπασδ
φγηϕκλζξχϖβνµθωερτψυιοπασδφγηϕκλζ


ξχϖβνµθωερτψυιοπασδφγηϕκλζξχϖβνµ
The
Consumption
Function

θωερτψυιοπασδφγηϕκλζξχϖβνµθωερτψ
υιοπασδφγηϕκτψυιοπασδφγηϕκλζξχϖβν
µθωερτψυιοπασδφγηϕκλζξχϖβνµθωερτ
ψυιοπασδφγηϕκλζξχϖβνµθωερτψυιοπα
σδφγηϕκλζξχϖβνµθωερτψυιοπασδφγηϕκ
λζξχϖβνµθωερτψυιοπασδφγηϕκλζξχϖβ
νµθωερτψυιοπασδφγηϕκλζξχϖβνµθωερτ
ψυιοπασδφγηϕκλζξχϖβνµθωερτψυιοπα
σδφγηϕκλζξχϖβνµθωερτψυιοπασδφγηϕκ
λζξχϖβνµρτψυιοπασδφγηϕκλζξχϖβνµθ
ωερτψυιοπασδφγηϕκλζξχϖβνµθωερτψυι
οπασδφγηϕκλζξχϖβνµθωερτψυιοπασδφγ
Brian
A.
Joubran,
Lisa
Hawich,
and
Tina
Dinh

Business
Calculus
(12pm)

ηϕκλζξχϖβνµθωερτψυιοπασδφγηϕκλζξ
Dr.
Lee

October
20th,
2008



χϖβνµθωερτψυιοπασδφγηϕκλζξχϖβνµθ
ωερτψυιοπασδφγηϕκλζξχϖβνµθωερτψυι


 Consumption
Function
‐
1

Table
of
Contents


1.
Introduction........................................................................................................................ 2

2.
Historical
Background ......................................................................................................... 4

3.
The
Consumption
Function
–
The
Model ............................................................................. 6

3.1
Marginal
Propensity
to
Consume
(mpc)...................................................................................................................8

3.2
Marginal
Propensity
to
Save
(mps) .........................................................................................................................10

3.3
The
Multiplier
Model......................................................................................................................................................10

4.
Consumption
Function
and
Its
Applied
Calculations
–
Case
Study ..................................... 14

4.1
Gross
Domestic
Product
and
Personal
Income
Indices...................................................................................15

4.2
GDP
and
PI
from
2000
to
2008..................................................................................................................................16

4.3
Change
in
GDP
and
PI
from
2000
to
2008 ............................................................................................................17

4.4
Marginal
Propensity
to
Consume
(mpc)
from
2000
to
2008 .......................................................................18

4.5
Expressing
the
Consumption
Function
in
Terms
of
GDP
and
PI .................................................................19

5.
Summary .......................................................................................................................... 22

Sources................................................................................................................................. 24

Bibliography ......................................................................................................................... 25

List
of
Figures,
Tables,
Theorems,
Derivations,
and
Images ................................................... 26






 Consumption
Function
‐
2

1.
Introduction

In their Complete 2007 Annual Review report for investors, the Coca-Cola Company boasts 1.5
billion servings of their beverages a day. If this many beverages are served around the globe, we
can2007 Company
logically assume Highlights
that the same amount is consumed. Further, if the current world population
equals approximately 6.7 billion, according to the U.S. Census Bureau, that would mean almost
every human on the planet consumes at least 0.22 beverages owned by the Coca-Cola Company
a day. That is approximately 81 beverages per person a year!

PORTFOLIO

Our unparalleled
portfolio includes
13 brands with sales
of more than

$1B
PROFIT 2007 Stock Performance*
Image 1. From its Complete 2007 Annual Review, Coca-Cola Co. highlights a portfolio boasting more than 1 billion sales a year.
Image taken from Coco-Cola Co. 2007The
22.7 billion
Annual Report.
Coca-Cola Company
Dow Jones Industrial Average
S&P 500
+10%
Why do we consume so much? According to JohnOurMaynard
UNIT CASES WORLDWIDE stock price Keynes, itPERis in our nature
DIVIDEND
outperformed SHARE GROWTH

16.9 billion
+27%

(The General Theory, 1936). We begin consuming when we are born and do not stop until thethe Dow Jones

+20%
Industrial Average
UNIT CASES INTERNATIONAL and the S&P 500
day we die. Throughout our lives we consume material things (goods) like food, computers, cars,
in 2007.

5.8 billion
+6%
+4%
NET CASH PROVIDED
and gasoline. We even consume intangibles like services and experiences.BY For example, we pay
OPERATING
UNIT CASES NORTH AMERICA January December ACTIVITIES GROWTH

an airline to serve us by transporting us from one point of the country to another. We pay a hotel
PARTNERS
service to house us in a safe and comfortable place while we vacation in a foreign city. We pay
watch a film in hopes that$366MM
to No.1 it may tap into our emotions and make us laugh or cry. Regardless
Ranking for the Food & Supplier diversity spend in
of Beverage
what itIndustry
is (goods
categoriesor services) weStates
the United cannot
in 2007,go throughout the day without consuming.
of Best EthicalQuote Progress a 23% increase versus 2006
and Best Reported Performance Updated and relaunched
our Supplier Guiding Principles
Keynes, who studied this inevitability in the 1930’s, defined our inclination as a
in Geneva-based Covalence’s
Ethical Ranking 2007 in 2007, expanding our
criteria for our suppliers’
Marginal Propensity to Consume, and he developed a mathematical relationship between workplace practices

people’s tendency
*For a five-year view to consume
of our stock performance, and
see our 2007 Annual toFormsave
Report on 10-K. based on a person’s income level (The General
10 The Coca-Cola Company

Theory, 1936). Keynes argued that there is a direct relationship between a person’s income level
and the amount he/she consumes. This report evaluates Keynes’ Consumption Function, and
briefly examines its first introduction in his publication, The General Theory of Employment,
Interest, and Money.



 Consumption
Function
‐
3

In addition, this report identifies the function’s main components: Consumption, Savings
and Investment, Income, and the Marginal Propensity to Consume. Once identified, we evaluate
the function’s practicality, and apply it to the current trends of the past eight years (2000-2008).

The report concludes with a brief summary of the facts presented, and offers a simple
analysis on the value of the function to economists and governments that rely on it. To begin, we
evaluate Keynes’ first introduction of the function as well as his motives, or reasoning, behind its
development.



 Consumption
Function
‐
4

2.
Historical
Background

At the time Keynes identified his
postulate on consumption, the United States was
in the midst of a great depression. The
unemployment rate reached a maximum of
twenty-five percent (VanGiezen, Schwenk,
2003), which meant that nearly a quarter of
America’s workforce had no jobs and income was
scarce. It was generally assumed that whatever
money people had at the time they put away for
savings. Although saving money may have
seemed like a smart thing to do at the time,
people saved more than they spent, or consumed,
resulting in slow economic growth. In other Image 2. John Maynard Keynes (1883-1946) developed the
consumption function and several other theories in
words, because no one was spending money, no economics, known as Keynesian Economics. (Photo taken
from the Bretton Woods website.)
one was consuming. This had a strong impact on
the economic situation at the time causing the government to make several policy changes on
how government and businesses run (Case, Fair, 1992).

In The General Theory, Keynes reevaluated several general theories of economics

including what he called the “Postulates of the Classical Economics” (Keynes, 1936), were he
reviewed the classical theory of employment and the demand for employment. He argued that
the classical theory is “misleading and disastrous if we attempt to apply it to the facts of
experience” (Keynes, 1936).

In other words, Keynes believed that traditional thought about employment and the
demand for employment was inaccurate and required reexamination. As a result of his research,
Keynes established a new approach in regards to employment, interest, and money. This new
Keynesian approach had a profound impact on modern economics, as well as political theory,
and governments’ fiscal policies (Case, Fair, 1992).



 Consumption
Function
‐
5

Essentially, the Keynesian economics established new means to explaining spending

behavior, whether it is the spending behavior of the government, an individual, or a group of
individuals (households). Keynes’ Consumption Function contributed to determining the amount
of money the government spends and receives, or inputs and outputs (GDP), as well as how
much households spend on consumer goods, and the amount of money companies invest (Case,
Fair, 1992). To better understand this, we define the function, its variables, and its parameters.



 Consumption
Function
‐
6

3.
The
Consumption
Function
–
The
Model

Simply stated, the Consumption Function is the relationship between consumption and
income. Economists assume that “The higher someone’s income is, the higher her or his
consumption is likely to be. Thus, people with more income tend to consume more than people
with less income” (Case, Fair, 1992).

Looking at Figure 1 below, we observe the properties of a hypothetical consumption

function, where C is the amount of consumption for a given household, and Y is the amount of
income a given household receives. Therefore, C is a function of Y . Also, C is never equal to
zero. In other words, even at an income of zero, consumption is positive. A household must
consume in order to survive regardless if there is no income (Case, Fair, 1992).

One of the key properties of the function is that it yields a positive slope, in other words,
as Y (an individual’s income) increases, C (an individual’s consumption) also increases. Figure
1 illustrates how the change in consumption ( !C ) over the change in income ( !Y ) equals the
slope of the consumption function. Although this may seem obvious, the slope of the
consumption function is a bit more complex, and will be explained later (see section 3.1
“Marginal Propensity to Consume”) (Case, Fair, 1992).

Figure 1. Graph of a Hypothetical Consumption Function of an Individual Household (Case,

Fair, 1992)

C

Household Consumption

C(Y ) 


 ΔC 




ΔY 
 ΔC
Slope = 

ΔY

0
 Y

Household Income



 Consumption
Function
‐
7

Now that we have identified the properties of the consumption function in relation to a
given household, we must look at the function in relation to more than one household. To do this
we look at the aggregate consumption, which is defined as “total consumption of all households”
(Case, Fair, 1992). Economists also assume, as with the individual relationship, that the
aggregate yields a positive slope (Case, Fair, 1992).

Knowing all the properties of the function, we can evaluate its expression. The
expression can be easily understood if we express it as a straight line (i.e. y
=
mx
+
b) (Case, Fair,
1992). When we do this the expression looks as follows:

Derivation 1. Consumption Function (Case, Fair, 1992)

y = b + mx
↓ ↓ ↓
C = b + mY

In the above expression, C is the consumption in place of the y-axis, and b is the point at
which the function intersects the C -axis, m is the slope of the line, and Y is in place of the x-
axis. The graph of this function looks like that illustrated in Figure 2 below.

Figure 2. Relationship of Income and Consumption (Case, Fair, 1992)

C


C = b + mY 

Aggregate Consumption


 ΔC 




ΔC
ΔY 
 slope = = m

ΔY

0
 Y

Aggregate Income



 Consumption
Function
‐
8

3.1
Marginal
Propensity
to
Consume
(mpc)

One cannot fully grasp the complexity of the consumption function without taking into
consideration the marginal propensity to consume (mpc). The marginal propensity to consume
(mpc) is “the fraction of a change in income that is consumed, or spent” (Case, Fair, 1992). In
other words, the mpc is equal to the slope of the function.

Derivation 2. Slope of the Consumption Function (Case, Fair, 1992)

ΔC
m = mpc =
ΔY

C = b + mY
↓
C = b + (mpc)Y

To put the equation into perspective let’s take a hypothetical situation:

If, for example, for Gerald to survive every month, he must spend the bare minimum of a
$1,000 to pay his rent, utilities, and food. However, he spends an additional $375 for his own
enjoyment. His monthly salary is $1,500. As a result of his hard work for the past year, Gerald’s
employer has decided to increase his pay an additional $100 a month. As a result of his raise,
Gerald decides to spend some money on a gym membership. It costs him $25 a month on top of
his current monthly expenses (total of $1400). Gerald saves the rest of his money.

Now that he has gotten a raise and increased his spending, what is Gerald’s average rate
of consumption, or Marginal Propensity to Consume (mpc)?

When we substitute the numbers into the equation we find that based on Gerald’s new
increase in pay of $100 and additional cost of $25 for a gym membership, his total consumption
is $1400 (see Example 1 below), and his marginal propensity to consume is 25%. In other words,
for every $4 his income increases, he spends $1, while saving the rest ($3).



 Consumption
Function
‐
9

Example 1. Gerald’s Marginal Propensity to Consume

Given, C = b + mpcY ,

Then, Y = 1600, b = 1000, and

ΔC Change in Consumption 1025 − 1000 25

mpc = = = = = 0.25
ΔY Change in Income (1500 + 100) − 1500 100

Therefore, C = 1000 + (0.25)1600 = 1000 + 400 = 1400

The graph of Gerald’s example looks like that in Figure 3 below. From this illustration
we observe that Gerald’s consumption, even if he had no income, would be $1,000. At an
income of $1,500 he consumes $1,375. When his income increases by $100, he now consumes
$1,400. In other words, Gerald’s behavior of consuming is proportionately related to his mpc.
We can assume if he were to receive another increase in pay that he would spend 25% of the
increase on consuming goods. We can also deduce from this that he will save the remainder,
which would be 75%.

Figure 3. Gerald’s Propensity to Consume

C


C = b + mY 

Gerald’s Consumption

$1400


 $1375 – 1400 = $25

$1375

$1000 

$1600 – $1500 = $100 25
mpc = = .25 

100
0

$1500 $1600 Y

Gerald’s Income


 Consumption
Function
‐
10

3.2
Marginal
Propensity
to
Save
(mps)

In Gerald’s example above we calculated how much Gerald consumed based on the
increase of his income. Although we calculated Gerald’s behavior in spending his money, we can
also calculate Gerald’s behavior in saving his money. In the above example, Gerald spent $25 of
his increased income of $100. He also saved $75 from that increase. This means that Gerald’s
behavior to save his money is proportionately related to his behavior in consuming his money.

Calculating Gerald’s propensity to save is similar to calculating his propensity to

consume. We use the same formula established earlier, C = b + (mpc)Y , but we substitute
Consumption (C) with Savings ( S ). The marginal propensity to save (mps) is equal to the
change in Savings ( !S ) over the change in Income ( !Y ) (see Theorem 1, below) (Case, Fair,
1992). Therefore, in Gerald’s case, he saved $75 of his $100. This means that his marginal
propensity to save (mps) is 75/100, or 75% of his income.

Theorem 1. Marginal Propensity to Save (Case, Fair, 1992)

Change in Savings ΔS
Marginal Propensity to Save = =
Change in Income ΔY

3.3
The
Multiplier
Model

Essentially, we have applied all the properties of the Consumption Function as explained
in the previous paragraphs to calculate the rate of consumption of a given person such as Gerald;
however, in the real world the function alone does not apply as easily to the complexity of
calculating the rate of consumption for a given nation. To do this, we must consider what
economists call the Multiplier Model. The multiplier model is a more complex model then the
consumption function model. It was originally designed by Alvin Hansen to explain the large
drop in income due to an initial drop in investment during the great depression (Colander, 2006,
p. 616, 621).

The model focuses on Aggregate Expenditures, which is “the total amount of spending on
final goods and services in the economy.” In other words, Aggregate Expenditures (AE) is the



 Consumption
Function
‐
11

sum of Consumption (C) (spending by households), Investment (I) (spending by businesses),

Government Spending (G), and Net Exports (X – M), which is the difference between Exports
(X) and Imports (M) (Colander, 2006, p. 618). Theorem 2 (below) illustrates this model.

Theorem 2. Aggregate Expenditures (Colander, 2006)

AE = C + I + G + (X − M )

Further, the multiplier model distinguishes Autonomous Expenditures from Induced

Expenditures. Autonomous Expenditures are “expenditures that do not systematically vary with
income.” This means that even when the income is zero, there will be some expenditure. Induced
Expenditures are “expenditures that change as income changes.” Usually when someone’s
income rises, his or her expenditures rise due to higher consumption. Figure 4, below, illustrates
the Aggregate Expenditure curve, which shows the relationship between autonomous and
induced expenditures (Colander, 2006, 618-619).

Figure 4. Aggregate Expenditure Curve (Colander, 2006)

Aggregate

Expenditures

Curve




 Consumption
Function
‐
12

In the example above, Autonomous Expenditures is $3,000 at all times, even when
income is zero, and everything above and beyond $3,000 is Induced Expenditures. The graph
shows that at an income of $6,000, aggregate expenditures is at $6,000. But when income rises
by $1,000 (to a total of $7,000), aggregate expenditures increases by $500 (to a total of $6,500).
The same connection can be seen when income falls by $1,000 (to a total of $5,000), aggregate
expenditures drop by $500 to $5,500. Why is the increase/decrease of aggregate expenditures
smaller than the rise/drop of income? The answer is because only the induced expenditures
change as income changes, autonomous expenditures stay the same (Colander, 2006, p. 618-
619).

The slope of the aggregate expenditure curve is “the ratio of the change in aggregate
expenditures to a change in income”, also known as marginal propensity to expend (mpe). From
here we draw the mathematical relationship as seen in Theorem 3 (Colander, 2006, p. 620).

Theorem 3. The Aggregate Expenditures Function (Colander, 2006)

AE = AE0 + (mpe)Y

The formula above describes the aggregate expenditures as the sum of autonomous
expenditures ( AE 0) and induced expenditures ( mpeY ). This formula looks familiar because it is
equivalent to the consumption function, as seen below (Derivation 3).

Derivation 3. Transformation of Aggregate Expenditures Function to Consumption Function

AE = AE0 + (mpe)Y
↓ ↓ ↓
C= b + (mpc)Y



 Consumption
Function
‐
13

As we can see from the transformation above, Aggregate Expenditures (AE) is equal to
Consumption (C) which makes sense, because the total amount of spending on final goods and
services in the economy is basically the same as the amount of consumption for a given
household. Also, because Autonomous Expenditures (AE0) is that which does not systematically
vary with income, it is equivalent to the y-axis intersect (b) of the consumption function. Lastly,
because expenditures is the same as consumption the marginal propensity to expand (mpe) is
identical to the marginal propensity to consume (mpc) (see Derivation 4 below) (Colander, 2006,
p. 546, 618-619).

Derivation 4. Relationship between Marginal Propensity to Expand (mpe) and Marginal

Propensity to Consume (mpc) (Colander, 2006)

Change in Expenditures
= mpe
Change in Income
Change in Consumption
= mpc
Change in Income
↓
mpe = mpc

Now that we’ve established the complexity of the Consumption Function through the
Multiplier Model, we can now apply this information to real world data and identify some
interesting economic trends. The next section applies the consumption function using the Gross
Domestic Product and Personal Income of a nation to calculate the going rate of consumption for
a given period of time.



 Consumption
Function
‐
14

4.
Consumption
Function
and
Its
Applied
Calculations
–
Case
Study


On September 23rd, 2008, Treasury

Secretary Henry Paulson and Federal
Reserve Chairman Ben Bernanke testified
before the House Financial Services
Committee in hopes of persuading congress
to pass a bill that would allocate $700
billion dollars of taxpayer money to
address an aberrant financial crisis.
Financial institutions such as Bear Stearns, Image
3.

Federal
Reserve
Board
Chairman,
Ben
Bernanke
(right),
and

Treasury
Secretary,
Henry
Paulson
(left),
testify
during
a
House

Lehman Brothers, Washington Mutual, Financial
Services
Committee
hearing
on
Capitol
Hill
July
10,
2008
in

Washington
DC.
(Image
taken
from
Zimbio.com.)

American International Group (AIG),
Fannie Mae and Freddie Mac have all struggled due to toxic securities linked to falling housing
prices and the institution’s inherent lack of capital to maintain those securities (Economist, 338,
17). As a result to the financial institutions’ instability, and the congressional hearing, the Dow
Jones industrial average dropped a record 777 points the following Monday, September 29th, the
largest single-day decline in its history (Paradis). According to Paulson and Bernanke, the $700
billion will be used to purchase the toxic securities freeing the institutions from their assets and
allowing them to recapitalize (Economist, 338, 17), presumably stabilizing the financial market.

How did this financial crisis come to be? No one is exactly sure, but to help paint a
clearer picture we apply Keynes’ Consumption Function to the past eight years preceding the
financial crisis to make some educated guesses as to what may have triggered the economic
trend.

This section of our report will highlight the nation’s consumption variables from 2000 to
2008 in comparison with the nation’s income variables of the same period. Once we identify
these two variables we then determine the Marginal Propensity to Consume (mpc), to determine
the rate of consumption for each year. With these three variables, we will be able to express
Keynes’ Consumption Function for the economic period. With the function expressed we will
look at its graph and observe the behavior of the nation’s consumption and saving trends.



 Consumption
Function
‐
15

We begin with an analysis of the consumption and income variables: Gross Domestic
Product (GDP) and Personal Income (PI).

4.1
Gross
Domestic
Product
and
Personal
Income
Indices


The method in which economists use to calculate the nation’s income and consumption
comes from the Gross Domestic Product (GDP) index, and the Personal Income (PI) index.
According to the United States Department of Commerce, the Personal Income (PI) is the gross
personal income of the nation. The GDP is “the total market value of all final goods and services
produced in an economy in a one-year period.” It is defined as the sum of consumption,
investment, government spending and net exports (see Theorem 4) (Colander, 2006, p. 540, 546-
547).

Theorem 4. Gross Domestic Product (GDP)

GDP = C + I + G + (X − M )

Looking at the equation above, we observe that the GDP is equivalent to the definition of
Aggregate Expenditures (AE) as was described in Theorem 1 previously. Accordingly, because
Aggregate Expenditure is equivalent to Consumption (C) (see Derivation 3) we can conclude
that Consumption is also equal to the GDP. So if we substitute these variables into our
Consumption Function model we get the following derivation below.

Derivation 5. Consumption Function in Relation to GDP and PI

C = b + (mpc)Y
  
GDP = b + (mpc)PI



 Consumption
Function
‐
16

4.2
GDP
and
PI
from
2000
to
2008


Utilizing the historical database available on the Bureau of Economic Analysis website,
we compiled a list (see Table 1, below) comparing the Gross Domestic Product (GDP) and
Personal Income (PI) of the United States from January 2000 to the end of the third quarter of
2008 (September). The data from 1999 is included only as a reference for later calculations.

Table 1. 2000-2008 Personal Income* (PI) and Gross Domestic Product* (GDP)

 1999
 2000
 2001
 2002
 2003
 2004
 2005
 2006
 2007
 2008

GDP
 9268.4
 9817.0
 10128.0
 10469.6
 10960.8
 11685.9
 12421.9
 13178.4
 13807.5
 14429.2

PI
 7802.4
 8429.7
 8724.1
 8881.9
 9163.6
 9727.2
 10269.8
 10993.9
 11663.2
 12219.9

*In Billions of Dollars (Source: Bureau of Economic Analysis)

The table above shows the GDP and PI for each year. Using the raw data in the table, we
can graph the GDP and PI to make some interesting observations, see Figure 5 below.

Figure 5. 2000-2008 Graph of GDP and PI

16000

14000

Dollar
(in
billions)



12000

10000

8000

GDP
(C)

6000

IP
(Y)

4000

2000

0

2000
 2001
 2002
 2003
 2004
 2005
 2006
 2007
 2008

Year


Looking at the graph above we observe that although both GDP and PI increase each
year, PI is always less than the GDP. In other words, the nation consumes more than it makes.
Also, in 2000 the total GDP equaled $9,817B and at 2008 the GDP equaled $14,150.8B. That is
a difference of $4,333.8B. In other words, the GDP increased 44% in eight years!

To see how the consumption and income is distributed in terms of saving and spending
behavior, we apply the same raw data into the graph below (Figure 6).



 Consumption
Function
‐
17

Figure 6. Consumption and Income Distribution Explanation

Spending
 2008

2007

2006


2005


2004

2003

2002

2001

2000


Saving


From the graph we can see that between 2000 and 2008 the nation consumes more than it
receives in income. We can assume the extra amount of money is borrowed, which may explain
the astronomical debt of the U.S. government, a whopping $10.6 trillion as of November 16th,
2008 (U.S. Dept. of the Treasury, Bureau of the Public Debt).

4.3
Change
in
GDP
and
PI
from
2000
to
2008

Now that we know the raw data supplied from Table 1 we can calculate the difference in
change of GDP and PI for each year. To calculate this we subtract the succeeding year’s number
from the preceding year’s number. For example, the difference in GDP (ΔGDP) from 2000 to
2001 is calculated by subtracting the GDP for 2001 by the GDP of 2000. In this case, it is
$10,128.0B minus $9,817.0B, which equals $311.0B. Table 2 below lists the change in GDP and
PI from 2000 to 2008.

Table 2. Change in PI* and GDP* from 2000 to 2008


 2000
 2001
 2002
 2003
 2004
 2005
 2006
 2007
 2008


Δ GDP
 548.6
 311.0
 241.6
 491.2
 725.1
 736.0
 756.5
 629.1
 621.7

Δ PI
 627.3
 294.4
 157.8
 281.7
 563.6
 542.6
 724.1
 669.3
 556.7

*In Billions of Dollars



 Consumption
Function
‐
18

Looking at the data we note that the PI is less than GDP in every year except 2000 and
2007. Figure 7 below depicts the relationship of GDP to PI for each year in the form of a bar
chart.

Figure 7. Graph of Change in PI and GDP from 2000 to 2008

800



700



600



500


Change
in
GDP
(Change
in

400

 Consumption
C)


300

 Change
in
PI
(Change
in

Income
Y)

200



100



0


2000
 2001
 2002
 2003
 2004
 2005
 2006
 2007
 2008


Now that we have identified the change in GDP and PI we can calculate the Marginal
Propensity to Consume (mpc).

4.4
Marginal
Propensity
to
Consume
(mpc)
from
2000
to
2008

Recalling from the previous section (3.1 “Marginal Propensity to Consume”), the
Marginal Propensity to Consume (mpc) is equal to the change of consumption over the change of
income (ΔC/ΔY). We have calculated the mpc for each year and provided the data in Table 3
below.

Table 3. Marginal Propensity to Consume* (mpc) from 2000 to 2008


 2000
 2001
 2002
 2003
 2004
 2005
 2006
 2007
 2008

Δ C/Δ Y
 0.8745
 1.056
 2.165
 1.744
 1.287
 1.356
 1.045
 0.940
 1.117

%
 87.45%
 105.6%
 216.5%
 174.4%
 128.7%
 135.6%
 104.5%
 94%
 111.7%

*In Percentage

We can observe from the table that the rate of consumption exceeds 100% for every year
except in 2000 and 2007, when it was at 87.45% and 94%. This means that the nation consumed
more than 100% of its income, except in 2000 and 2007 where it saved 12.55% and 6% of its



 Consumption
Function
‐
19

income. Also from the table we see that there was a peak of 216.5% consumption in 2002. This
means that the rate of consumption more than doubled from the previous year—it may be
interesting to note that such a drastic change may have been a result of the preceding 9/11
terrorist attacks.

4.5
Expressing
the
Consumption
Function
in
Terms
of
GDP
and
PI

With all the variables defined, we can input them in the consumption function model that
we expressed in the first part of this report (see Derivation 2), but because the mpc fluctuates
from year to year, we can only apply the model one year at a time. Table 4 below shows the
consumption function for each year starting from 2000.

Table 4. Consumption Function Models from 2000 to 2001

Year
 C
 b
 mpc 
 

2000
 9817
 9268.4
 0.8745
 C = 9268.4 + (0.8745)Y 

2001
 10128
 9817
 1.056
 C = 9817 + (1.056)Y 

2002
 10469.6
 10128
 2.165
 C = 10128 + (2.165)Y 

2003
 10960.8
 10469.6
 1.744
 C = 10469.6 + (1.744)Y 

2004
 11685.9
 10960.8
 1.287
 C = 10960.8 + (1.287)Y 

2005
 12421.9
 11685.9
 1.356
 C = 11685.9 + (1.356)Y 

2006
 13178.4
 12421.9
 1.045
 C = 12421.9 + (1.045)Y 

2007
 14429.2
 13178.4
 0.940
 C = 13178.4 + (0.940)Y 

2008
 14429.2
 14429.2
 1.117
 C = 14429.2 + (1.117)Y 


To determine b, we assume that the amount of consumption at the beginning of one year
will equal the amount of consumption at the end of its previous year. For example, the amount of
consumption at the beginning of 2001 is equal to the amount of consumption at the end of 2000.
Thus, regardless of how much income the nation made in 2001 it will still need to consume the
same amount that it did at the end of 2000.

Although we could graph each function as it is shown in Table 4, it would be more

interesting to graph the slope, or the mpc, of the function. To focus only on the slope of the
function we set b equal to zero. We can do this, because as we explained in section 3.3 “The
Multiplier Model,” b is equivalent to 5 Expenditures (AE0). In other words, b is only relevant to



 Consumption
Function
‐
20

identify the y-axis intercept. Table 5 lists the consumption function for each year where b is
equal to zero.

Table 5. Consumption Function Models from 2000 to 2001 – Simplified

Year
 C = b + (mpc)Y , where b = 0 


2000
 C = (0.8745)Y 

2001
 C = (1.056)Y 

2002
 C = (2.165)Y 

2003
 C = (1.744)Y 

2004
 C = (1.287)Y 

2005
 C = (1.356)Y 

2006
 C = (1.045)Y 

2007
 C = (0.940)Y 

2008
 C = (1.117)Y 


With a simpler version of the consumption function, we can now graph the rate of
consumption for each year. Again, for simplicity, we will calculate total consumption where
income (Y) is equal to $1.00. Table 6 lists the values for each year.

Table 6. GDP from 2001 to 2008 for every $1 of Income (Y)

GDP
 GDP
 GDP
 GDP
 GDP
 GDP
 GDP
 GDP
 GDP

PI
(Y)

(2000)
 (2001)
 (2002)
 (2003)
 (2004)
 (2005)
 (2006)
 (2007)
 (2008)

$1.00
 $0.87
 $1.06
 $2.17
 $1.74
 $1.29
 $1.36
 $1.05
 $0.94
 $1.12


The table above lists the value of consumption (GDP) for every $1.00 increase of
personal income. We observe from the table that in 2000 for every $1.00 increase of personal
income, the nation spends $0.87 of that dollar and saves $0.13. In 2001, for each $1.00 increase
in income, the nation spends $1.06 and borrows $0.06, and so on and so forth for the remaining
years. Figure 8 below shows each rate of consumption (mpc) from 2000 to 2008.



 Consumption
Function
‐
21

Figure 8. Rate of Consumption (mpc) from 2000 to 2008

Change
in
Consumption
($)
 2.5


2
 2000

2001

1.5
 2002

2003

1

2004

2005

0.5

2006

0
 2007

0
 1
 2008

Change
in
Income
($)


To exemplify the savings and consumption behavior of the nation from 2000 to 2008, we
can graph the rate of consumption in respect to savings and spending for each year (see Figure 9,
below). When we observe this graph we notice that in the year 2000 and 2007 that for every
increase of $1.00 to the nations income, the nation saved $.013 and $0.06 respectively. Also,
from 2001 to 2006, and 2008, the nation spent so much that it needed to borrow money.

Figure 9. Consumption in Respect to Savings and Spending

2.5

2.25

2

1.75

Consumption/Savings


1.5

1.25

1

0.75

0.5
 Savings

0.25

Consumption

0

‐0.25
 2000
 2001
 2002
 2003
 2004
 2005
 2006
 2007
 2008

‐0.5

‐0.75

‐1

‐1.25

‐1.5

Year




 Consumption
Function
‐
22

5.
Summary


In the first part of our report (section 1 “Introduction) we introduced the concept of
consumption by giving a real world example, such as the number of servings of Coca-Cola
products sold throughout the world in 2007. We have also shown the significance of this concept
by reviewing the history of its development by its creator, John Maynard Keynes (section 2
“History”). We provided the mathematical content as established by economists today,
identifying the functional model, its variables, parameters, and terms (section 3 “The
Consumption Function – The Model”. We showed the derivation of the function from the
equation y = mx + b. We identified the expression and provided a hypothetical scenario (the mpc
of Gerald) as a means to identify the proper application of the function.

In the final part of this report (section 4 “Consumption Function and Its Applied
Calculations – Case Study”), we identified the Gross Domestic Product (GDP) and the Personal
Income (PI) of the nation from 2000 to 2008. We also calculated the change of GDP and PI from
each year. From this information we were able to yield the Marginal Propensity to Consume
(mpc) by dividing the change of consumption by the change of income (ΔC/ΔY). Finally, we
applied the variables to the consumption function for each individual year. To illustrate the rate
of consumption for each year, we simplified the equation to show the value of consumption for
every dollar of personal income and graphed the results.

To conclude, it may not be clearly evident how the consumption function applies to the
real world; however, economists rely on it continuously to help determine the behavior of a
nation. It was the intension of this report to clearly show the application of the function by
breaking down its larger parts and applying it to economic data from 2000 to 2008. The product
from this period yielded some valuable and interesting characteristics of the behavior of a nation.
Surprisingly, the behavior of the United State from this period was one of overspending, so much
to point of borrowing more than it could afford. Likewise, it is at no surprise why the United
States is in the current financial crisis that it is in today. We obviously spend more than we
should, nor do we posses the ability, as a nation, to afford the purchases that we make.

The Consumption Function has proven to be a valuable tool for economists and
governments to make important decisions. It has played a major role in economic decisions and



 Consumption
Function
‐
23

government fiscal policy. Since its development in 1936, it has helped economists to identify the
rate of consumption of an entire nation, allowing authorities to predict and anticipate economic
trends, such as growth and recessions, ameliorating economic uncertainty. It use will most likely
be applied for many years to come.



 Consumption
Function
‐
24

Sources

(2008, September 27th). “Leaders: I want your money.” Economist, 338, p17. Paradis, Tim.
(2008, September 29th). “Dow plummets record 777 as financial rescue fails.” Associated Press
(2008, September 27th). “Leaders: I want your money.” Economist, 338, p17.

Case, Karl E., Fair, Ray C. (1992). Principles of Economics. 2nd Ed. Prentice-Hall, Inc.
Englewood Cliffs, New Jersey.

Coca-Cola Co. (2007). Complete 2007 Annual Review. Retrieved October 14th, 2008, from Coca-
Cola website: http://www.thecoca-colacompany.com/investors/annual_review_2007.html

Colander, D. C. (2006). Economics. Boston, Mass: Irwin/McGraw-Hill.

Keynes, John Maynard. (1936). The General Theory of Employment, Interest, and Money.
Harcourt, Brace & World, Inc. 1962.

Robert VanGiezen and Albert E. Schwenk. (2003). Compensation from before World War I
through the Great Depression. Bureau of Labor Statistics. Retrieved October 14, 2008, from
http://www.bls.gov/opub/cwc/cm20030124ar03p1.htm

United States Census Bureau. U.S. and World Population Clocks – POPClocks. Retrieved
October 16, 2008, from http://www.census.gov/main/www/popclock.html

United States Department of the Treasury, Bureau of the Public Debt, Debt to the Penny and
Who Holds It. Retrieved November 16, 2008, from
http://www.treasurydirect.gov/np/bpdlogin?application=np



 Consumption
Function
‐
25

Bibliography


Bowers, David A., Baird, Robert N. (1971). Elementary Mathematical Macroeconomics.

Prentice-Hall, Inc., Englewood Cliffs, NJ

Ferber, R. (1966). A study of aggregate consumption functions. Ann Arbor: University

Microfilms.
Friedman, M. (1957). A theory of the consumption function. Princeton: Princeton University
Press.
Hadjimatheou, G. (1987). Consumer economics after Keynes: theory and evidence of the
consumption function. New York: St. Martin's Press.
Harcourt, G. C. (2006). The structure of post-Keynesian economics: the core contributions of the
pioneers. Cambridge, UK: Cambridge University Press.
Keynes, J. M. (1936). The general theory of employment, interest and money. New York:
Harcourt, Brace.
Lavoie, M. (2006). Introduction to post-Keynesian economics. Houndmills, Basingstoke,
Hampshire: Palgrave Macmillan.
McKenna, J. P. (1969). Aggregate economic analysis. New York: Holt, Rinehart and Winston.
Speight, A. E. H. (1989). Consumption, Rational Expectations and Liquidity: Theory and
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Wright, D. M. (1983). The Keynesian system. Westport, Conn: Greenwood Press.



 Consumption
Function
‐
26

List
of
Figures,
Tables,
Theorems,
Derivations,
and
Images

Figure 1. Graph of a Hypothetical Consumption Function of an Individual Household (Case,
Fair, 1992)
Figure 2. Relationship of Income and Consumption (Case, Fair, 1992)
Figure 3. Gerald’s Propensity to Consume
Figure 4. Aggregate Expenditure Curve (Colander, 2006)
Figure 5. 2000-2008 Graph of GDP and PI
Figure 6. Consumption and Income Distribution Explanation
Figure 7. Graph of Change in PI and GDP from 2000 to 2008
Figure 8. Rate of Consumption (mpc) from 2000 to 2008
Figure 9. Consumption in Respect to Savings and Spending
Theorem 1. Marginal Propensity to Save (Case, Fair, 1992)
Theorem 2. Aggregate Expenditures (Colander, 2006)
Theorem 3. The Aggregate Expenditures Function (Colander, 2006)
Theorem 4. Gross Domestic Product (GDP)
Derivation 1. Consumption Function (Case, Fair, 1992)
Derivation 2. Slope of the Consumption Function (Case, Fair, 1992)
Derivation 3. Transformation of Aggregate Expenditures Function to Consumption Function
Derivation 4. Relationship between Marginal Propensity to Expand (mpe) and Marginal
Propensity to Consume (mpc) (Colander, 2006)
Derivation 5. Consumption Function in Relation to GDP and PI
Table 1. 2000-2008 Personal Income* (PI) and Gross Domestic Product* (GDP)
Table 2. Change in PI* and GDP* from 2000 to 2008
Table 3. Marginal Propensity to Consume* (mpc) from 2000 to 2008
Table 4. Consumption Function Models from 2000 to 2001
Table 5. Consumption Function Models from 2000 to 2001 – Simplified
Table 6. GDP from 2001 to 2008 for every $1 of Income (Y)
Example 1. Gerald’s Marginal Propensity to Consume
Image 1. Coca-Cola Product Portfolio
Image 2. John Maynard Keynes



 Consumption
Function
‐
27

Image 3. Ben Bernanke and Henry Paulson before the House Financial Committee.