What is the consumption function? Describe the graph of a consumption function and explain its shape.
The consumption function is the relationship between the levels of disposable income that consumers have (horizontal axis of the graph) and the amount that they spend (vertical axis). The curve has two main attributes that determine what you could call its shape. These are its slope and its intercept.
The slope of the consumption function is connected to the marginal propensity to consume (MPC). When people get more disposable income, they will not spend all of it. Instead, they will spend some of it and save the rest. The MPC determines how much they will spend. When the MPC increases, the slope of the consumption function increases as well. When the MPC decreases, the slope flattens. The slope will always, however, be positive.
The intercept of the function is determined by four main factors. These determine how much people will spend regardless of their income level. This type of spending is generally called autonomous consumption because it does not depend on income. The four determinants of autonomous consumption are:
- Interest rates. Higher interest rates reduce consumption and lower the intercept.
- Consumer confidence. Consumers who feel good about the future of the economy will spend more. This raises the intercept.
- Wealth. People who are wealthier will spend more regardless of how much current income they have. This raises the intercept.
- Taxes. Higher taxes will reduce the amount that people have to spend. This will lower the intercept.