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The consumption function C = C₀ + cY_d relates consumption to disposable income, where c is the marginal propensity to consume (0 < c < 1). Empirically, consumption depends on current income, permanent income, wealth, interest rates, and expectations. The marginal propensity to consume determines the fiscal multiplier and is therefore critical for understanding demand dynamics.
From your study of household optimization, you know that consumers solve an intertemporal problem: they allocate spending across time to maximize lifetime utility, subject to a budget constraint that spans multiple periods. The consumption function C = C₀ + cY_d is the macroeconomist's reduced-form summary of this optimization. C₀ is autonomous consumption — the baseline spending that occurs even at zero disposable income, financed by savings or borrowing. The coefficient c is the marginal propensity to consume (MPC) — the fraction of each additional dollar of disposable income that households spend rather than save. If MPC = 0.8, then for every $100 increase in after-tax income, households spend $80 and save $20.
The MPC is not a fixed constant of nature — it varies systematically with household characteristics and the nature of the income change. Permanent income hypothesis, associated with Milton Friedman, argues that households smooth consumption over time: temporary income shocks generate little consumption response because rational agents save windfalls and dissave during temporary income dips. Only changes in permanent income — the expected long-run average — substantially shift consumption. This implies that a one-time tax rebate (perceived as temporary) should produce a small consumption response, while a permanent tax cut should produce a large one. Empirically, the truth lies between extremes: liquidity-constrained households (those who cannot borrow against future income) consume out of current income even when they know it is temporary, raising the aggregate MPC above what pure Friedman optimization would predict.
Wealth effects add another channel. Household wealth — including housing equity and financial assets — enters the consumption function alongside income. A stock market boom that increases household net worth stimulates consumption even without any income change. The housing wealth effect was a major amplifier during the mid-2000s boom and a drag during the 2008–2009 bust. The interest rate also matters: higher rates raise the return to saving and lower the cost of deferring consumption, tending to reduce current consumption (the substitution effect). Whether this dominates or is offset by income effects depends on whether households are net borrowers or net savers.
The MPC is not just a behavioral parameter — it is the key to understanding the fiscal multiplier. When the government increases spending by $1, that dollar becomes income for someone, who spends a fraction c of it, generating c dollars of new income for others, who spend c² of it, and so on. The multiplier converges to 1/(1 − c): if MPC = 0.8, the multiplier is 5. If MPC = 0.5, the multiplier is 2. This is why debates about the MPC are not merely academic — they determine whether fiscal stimulus is a powerful tool for stabilizing recessions or a costly policy with small aggregate effects. The actual multiplier is smaller than the simple formula suggests because of taxes, imports, and crowding out of private investment, but the MPC remains the fundamental parameter controlling its magnitude.