Chapter 12, Problem 12.1LO

To determine

Key determinants of consumption & savings in the Keynesian model.

Concept:

Keynesian model: The Keynesian macroeconomic model was presented after the great depression of 1930s. It came into effect when the theories of classical economists failed. It emphasized on the role of government in determining equilibrium level of employment.

Explanation of Solution

According to Keynes, the consumption function takes the following form:

  $C= \alpha + \beta Y$ .

Here, $\alpha$ Autonomous Consumption (It is that level of consumption which is independent of income, it exists even when income is zero. It refers to the consumption expenditure on basic necessities like food, medicine, etc.)

  $\beta$ = Marginal Propensity to Consume (It refers to the ratio of change in consumption due to change in disposable income. It varies from 0 to 1).

Y= Disposable Income (It refers to the income which is left after payment of taxes and receiving transfer payments).

While, the saving function takes the following form:

  $S= -\alpha +\left(1-\beta \right)Y$ .

Here, $\alpha$ - It is negative autonomous savings because the autonomous consumption is financed by this autonomous savings.

  $\left(1-\beta \right)$ = Marginal Propensity to Save (It refers to the ratio of change in savings due to change in disposable income. It varies from 0 to 1).

As per the models stated above, the main determinants of consumption and savings are listed below:

(a) Disposable Income: As we have seen, Keynes consumption and saving functions are major functions of disposable income. It is clear that income can be either consumed or saved. Whenever, disposable income rises, consumption and savings rise, according to the corresponding values of marginal propensity to consume (MPC) and marginal propensity to save (MPS) respectively.

(b) A change in marginal propensity to consume or save: If due to any reasons, marginal propensity to consume (MPC) rises, the consumption level also rises. If marginal propensity to save (MPS) rises, then saving level rises.

(c) Miscellaneous Factors: Other factors include, tax rate, transfer payments and wealth, which in turn affects disposable income and indirectly affects the corresponding consumption and savings level in the economy. If the tax rate is high, the disposable income will be low, and the corresponding consumption and savings will also be low.

On the other hand, if transfer payments rise, the disposable income rise and corresponding consumption and savings will also rise. A rise in wealth will increase consumption and savings level in the economy.

Note: As per Keynesian model, the real interest rate has not been taken into the main determinant of consumption and savings function.