A Note on the Consumption Function

The international depression of the early 20th century undermined the existing theory that extended departures from full employment were prevented by the natural stabilization of macroeconomic forces. In response Keynes (1936) developed a theory of equilibrium at less than full employment and in so doing, created the consumption function. As envisaged by Keynes, the function relates aggregate consumption for an economy to variables such as income and wealth. To understand the link between the consumption function and the level of employment at equilibrium, note that the dominant theory prior to Keynes stated that the interest rate would ‡uctuate to ensure that savings equaled the investment required to maintain full employment. By positing that consumption depended on income, Keynes was able to show that if the level of saving was not su ¢ cient to meet investment at full employment, the level of income would fall thereby reducing consumption and increasing saving. The result would be equilibrium at less than full employment, in accord with the reality of the long-lasting depression.