Consumption and Saving

Consumption (C) is the largest component of aggregate demand, typically accounting for around 60% of UK GDP. Understanding what determines consumption — and its mirror image, saving — is therefore critical to analysing macroeconomic performance. This lesson examines the Keynesian consumption function, the key propensities (APC, MPC, APS, MPS), and the factors that influence household spending and saving decisions.

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Defining Consumption and Saving

Term	Definition
Consumption (C)	Household spending on goods and services, including durable goods (cars, appliances), non-durable goods (food, clothing), and services (healthcare, entertainment)
Saving (S)	The portion of disposable income that is not spent on consumption. S = Yd − C, where Yd is disposable income (income after tax)
Disposable income (Yd)	Gross income minus direct taxes plus transfer payments (benefits). Yd = Y − T + Tr

The relationship between consumption and saving is necessarily inverse: every pound of disposable income is either consumed or saved.

Yd = C + S

Therefore: S = Yd − C and C = Yd − S

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The Keynesian Consumption Function

John Maynard Keynes (1936) proposed that consumption is primarily determined by current disposable income. He expressed this as:

C = a + bYd

Where:

• C = total consumption
• a = autonomous consumption (the level of consumption that occurs even when income is zero — financed by borrowing or drawing down savings)
• b = the marginal propensity to consume (MPC) — the proportion of each additional pound of income that is spent
• Yd = disposable income

Key Properties of the Keynesian Consumption Function

Keynes identified several "fundamental psychological laws" governing consumption:

1. Consumption rises as income rises, but by less than the rise in income — people save a portion of additional income
2. The MPC is between 0 and 1 — each additional pound of income leads to some additional spending, but not the full pound
3. The APC falls as income rises — richer households save a larger proportion of their income (Keynes called this the "fundamental psychological law")

Exam Tip: The Keynesian consumption function assumes that consumption depends on current income. Alternative theories (Friedman's Permanent Income Hypothesis and Modigliani's Life-Cycle Hypothesis) challenge this by arguing that consumption depends on expected lifetime income. Be prepared to evaluate the Keynesian view using these alternatives.

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The Propensities to Consume and Save

Average Propensities

Propensity	Formula	Interpretation
APC (Average Propensity to Consume)	APC = C / Yd	The fraction of total income spent on consumption
APS (Average Propensity to Save)	APS = S / Yd	The fraction of total income saved

Since all income is either consumed or saved: APC + APS = 1

Marginal Propensities

Propensity	Formula	Interpretation
MPC (Marginal Propensity to Consume)	MPC = ΔC / ΔYd	The fraction of each additional pound of income that is spent
MPS (Marginal Propensity to Save)	MPS = ΔS / ΔYd	The fraction of each additional pound of income that is saved

Since each additional pound is either consumed or saved: MPC + MPS = 1

Numerical Example

Income (Yd)	Consumption (C)	Saving (S)	APC	APS	MPC	MPS
£20,000	£19,000	£1,000	0.95	0.05	—	—
£30,000	£27,000	£3,000	0.90	0.10	0.80	0.20
£40,000	£34,000	£6,000	0.85	0.15	0.70	0.30
£50,000	£40,000	£10,000	0.80	0.20	0.60	0.40

This table illustrates Keynes's fundamental psychological law: as income rises, APC falls (from 0.95 to 0.80) and APS rises (from 0.05 to 0.20). The MPC also falls at higher income levels.

Exam Tip: You may be asked to calculate APC, APS, MPC, or MPS from data. Practise these calculations — they are straightforward but must be precise. Remember: APC + APS = 1 and MPC + MPS = 1 always.

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Factors Affecting Consumption

Beyond current income, several other factors influence consumption: