The Interdependence of Markets

Case 8.4
Keynes’ Views on the
Consumption Function
The absolute income hypothesis
Keynes argued that consumption depends on the level of current disposable income (Ydis) (i.e.
income after the payment of taxes).1 If disposable income is very low, consumption will
exceed it. As disposable income rises, so will consumption, but it will account for a
decreasing proportion of income. Saving, by contrast, will account for an increasing
proportion of income.
There are two types of consumption function that are consistent with these assumptions.
The first has the form:
C = a + bYdis
and the second:
C = a + bYdis – cYdis
In both cases, provided the term a is a positive figure, consumption will exceed income at
very low levels of income: the consumption function will cross the 45° line.
1. Using these two equations, what will be the level of consumption when national income
is zero?
Keynes’ argument that people’s consumption depends on the level of their current income,
irrespective of what their previous incomes were or what their future incomes are expected to
be, and irrespective of what other people’s incomes are, has led economists to call this the
‘absolute income theory of consumption’.
2. What will happen to the shape of the consumption function in diagram (b) in each of the
following cases?
(a) When the value of the a term increases.
(b) When the value of the b term decreases.
(c) When the value of the c term decreases.
The theory we develop in Chapter 8 relates consumption to gross income (Y). If we relate consumption to
disposable income (Ydis), as we are doing in this case study, we must remember that the consumption function
we get is not the one we will be using later on in the chapter.