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The consumption function

The graph shows an upward-sloping line representative of the consumption function.
In the expenditure-output model, how does consumption increase with the level of national income? Output on the horizontal axis is conceptually the same as national income, since the value of all final output that is produced and sold must be income to someone, somewhere in the economy. At a national income level of zero, $600 is consumed. Then, each time income rises by $1,000, consumption rises by $800, because in this example, the marginal propensity to consume is 0.8.

The pattern of consumption shown in [link] is plotted in [link] . To calculate consumption, multiply the income level by 0.8, for the marginal propensity to consume, and add $600, for the amount that would be consumed even if income was zero. Consumption plus savings must be equal to income.

The consumption function
Income Consumption Savings
$0 $600 –$600
$1,000 $1,400 –$400
$2,000 $2,200 –$200
$3,000 $3,000 $0
$4,000 $3,800 $200
$5,000 $4,600 $400
$6,000 $5,400 $600
$7,000 $6,200 $800
$8,000 $7,000 $1,000
$9,000 $7,800 $1,200

However, a number of factors other than income can also cause the entire consumption function to shift. These factors were summarized in the earlier discussion of consumption, and listed in [link] . When the consumption function moves, it can shift in two ways: either the entire consumption function can move up or down in a parallel manner, or the slope of the consumption function can shift so that it becomes steeper or flatter. For example, if a tax cut leads consumers to spend more, but does not affect their marginal propensity to consume, it would cause an upward shift to a new consumption function that is parallel to the original one. However, a change in household preferences for saving that reduced the marginal propensity to save would cause the slope of the consumption function to become steeper: that is, if the savings rate is lower, then every increase in income leads to a larger rise in consumption.

Investment as a Function of National Income

Investment decisions are forward-looking, based on expected rates of return. Precisely because investment decisions depend primarily on perceptions about future economic conditions, they do not depend primarily on the level of GDP in the current year. Thus, on a Keynesian cross diagram, the investment function can be drawn as a horizontal line, at a fixed level of expenditure. [link] shows an investment function where the level of investment is, for the sake of concreteness, set at the specific level of 500. Just as a consumption function shows the relationship between consumption levels and real GDP (or national income), the investment function shows the relationship between investment levels and real GDP.

The investment function

The graph shows a straight, horizontal line at 500 on the y-axis, representative of the investment function.
The investment function is drawn as a flat line because investment is based on interest rates and expectations about the future, and so it does not change with the level of current national income. In this example, investment expenditures are at a level of 500. However, changes in factors like technological opportunities, expectations about near-term economic growth, and interest rates would all cause the investment function to shift up or down.

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Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
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