Consumption expenditure represents the largest component of aggregate expenditure or GDP. Understanding the possibilities cyclical changes in GDP begin with mastery of the characteristics and determinants of this expenditure category. In addition, an understanding of consumption spending decisions over time help us understand the capacity and decisions to defer consumption to some point in the future. Deferring consumption, also known as savings, releases resources for the accumulation of capital in the present allowing for greater potential for future economic growth.
J.M. Keynes, in his General Theory of Employment, Interest and Money, suggested a look at consumption behavior in the aggregate. These models of the consumption function represented initial attempts to aggregate and associate measures of consumption spending and disposable income.
C = f(Yd)
Keynes suggested a linear relationship for these models:
C = a + bYd
whereC = Consumption Expenditure
a = Autonomous consumption
consumption expenditure independent of the level of income.
b = the Marginal Propensity to Consume 'MPC'
which represents the fraction of each additional dollar of income
devoted to consumption expenditure.
Yd = Current Disposable Income.
However, we must note that at the time, very littlle data existed of thes aggregate measures.
Several theoretical implications can be developed by taking the ratio of consumption expenditure to the level of disposable income. This ratio known as the 'APC' the average propensity to consume eliminates the need to convert nominal values into their real counterpart in that changes in the price level cancel out:
APC = Real Consumption / Real Income or APC = Nominal Consumption / Nominal Income
Thus the APC can be computed by dividing both sides the the Keynesian consumption function by disposable income:
APC = C/Yd = a/Yd+ b(Yd/Yd)
APC = a/Yd + MPC.
Given: Savings (S) = Yd - C
APS = S/Yd
we find that:
APS = 1 - APC
Given this final result we can look at the theoretical implications of the Keynesian consumption function over a different income groups (the cross- section) and over time (a time series). For the cross-section we would expect that lower-income groups would consume a greater proportion of their income relative to high-income groups:
APClow income > APChigh income
With time series data we would expect that over time and as disposable income increases the APC should decline:
APCt-1 > APCt> APCt+1
As data became available in the decades following publication of The General Theory..., studies found that in the latter case that this particular consumption function fails to explain real world behavior. In empirical studies, the APC is observed to be smaller for higher income groups relative to low income groups. However, over time the APC is observed to be constant independent of growth in aggregate measures of income. This failure led to the development of alternative theories of the consumption function.