What it means
In macroeconomics, consumption is household expenditure on goods and services, and the consumption function sketches how this spending moves as income changes. The simplest version is a straight line whose vertical intercept is spending that the model assumes occurs even at zero current income.
Such spending might be financed by savings, transfers or borrowing in a hypothetical household, and an economy with literally zero income is not the ordinary use case. The slope is the marginal propensity to consume, or MPC, so if MPC is 0.8, an additional $100 of modelled income raises spending by $80.
The remaining $20 is saved in a simplified no-tax setting, and the marginal propensity to save, or MPS, is 0.2 in that example. OpenStax presents a model in which consumption is $600 plus 0.8 times income, so at $4,000 of income calculated consumption is $3,800, though that figure is an illustration from the textbook model, not a measured current national spending amount.
If taxes reduce disposable income, the relationship between gross income and spending changes, and the textbook shows how an assumed tax rate flattens the spending line against gross income. A tax cut can shift the line upward if households spend more at each income level, and if saving preferences change, the slope can also change.
Consumption is one part of aggregate expenditure, alongside investment, government spending and net exports, and in the expenditure-output model the spending schedule meets the 45-degree output line at a modelled equilibrium, although the simple diagram omits many price effects. An income increase does not cause every consumer to spend at once, since some may repay debt or add to savings.
Wealth and access to credit can support spending even when current income is weak, so a model using only current income misses that variation. Expectations about future jobs can shift buying decisions before wages change, which means a confidence shock can move the consumption function.
Inflation complicates measurement, because higher nominal spending can reflect prices rather than more goods purchased, so specify real or nominal quantities. A business should not apply a national MPC to its individual customer as a fixed prediction, since product type, income group and local circumstances matter.
An estimate from one period may also fail during a crisis when households sharply change precautionary savings. The function is useful for scenario analysis: if disposable income rises, how much extra aggregate demand might follow under stated assumptions?
It is not an accounting identity for the entire economy, because estimated parameters come from data and model choices. To evaluate an estimate, ask what income measure, country, period, inflation adjustment and statistical method produced its slope.
In practice
Real-world examples.
Example
At an MPC of 0.8, a modelled $1,000 income increase raises consumption by $800 and saving by $200 in the no-tax example. A different group with an MPC of 0.6 would spend only $600. The economist therefore reports which MPC underlies the estimate.
Example
A household pays down debt after a bonus; its spending increase is smaller than a simple aggregate estimate predicts. A $2,000 bonus goes $1,500 to a credit-card balance and only $500 into purchases, an effective propensity of 0.25. The aggregate model, using 0.8, would have expected $1,600 of spending.
Example
An analyst models a tax change using after-tax income rather than applying a gross-income slope without adjustment. With a 20% tax rate, each $1,000 of gross income leaves $800 of disposable income, and at an MPC of 0.8 spending rises by $640. Applying 0.8 to the gross figure would wrongly give $800.
Formula
Calculation
Basic model: C = a + bY, where C is consumption, a is autonomous consumption, Y is the income measure and b is MPC. With a = $600, b = 0.8 and Y = $4,000, C = $3,800. When using disposable income, write C = a + bYd and define Yd as after-tax income. These illustrative parameters are not universal.
Checking the slope. At Y = $5,000, C = $600 + 0.8 x $5,000 = $4,600. MPC = change in C / change in Y = ($4,600 - $3,800) / ($5,000 - $4,000) = $800 / $1,000 = 0.8, as expected. Saving at $4,000 income is $4,000 - $3,800 = $200 and at $5,000 it is $5,000 - $4,600 = $400.
In the simplest no-tax textbook setting, the spending multiplier = 1 / (1 - MPC) = 1 / 0.2 = 5, so a $1,000 rise in autonomous spending would raise equilibrium output by about $5,000 under those assumptions. The multiplier shrinks if households save more, pay taxes or buy imports.Case study
Seen in the real world.
Fictional case: A retail association asks an economist to estimate demand after local incomes rise. She starts with a consumption function, then checks the data's income definition and adjusts for inflation. She compares essential and discretionary retailers rather than applying the same forecast to all stores. Some households save their raise while others replace delayed purchases.
The forecast presents a range tied to different MPC assumptions, and the association tracks actual receipts before expanding inventory. The model organises the question; it does not replace sales evidence. If total disposable income in the area rises by $10 million, an MPC of 0.6 implies $6 million of extra spending and an MPC of 0.8 implies $8 million. The $2 million gap between the two scenarios is large enough that the association decides to stage its inventory build-up instead of committing to the higher figure at once.
Watch out
Common mistakes.
- Using a textbook MPC as an observed constant for every household or year.
- Mixing gross and after-tax income without changing the model specification.
- Calling a nominal spending increase real growth without adjusting for prices.
Questions
People also ask.
What does MPC measure?
The modelled change in consumption divided by a change in income, with the income definition specified.
Can consumption exceed current income?
Yes in the simple model or in life, through savings drawdown, transfers or borrowing.
Does the line ever shift?
Yes. Wealth, expectations, policy and other factors can change consumption at a given income.
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