K. Murugan

1. Theories of Consumption
Function
by
Dr. K. Murugan
Assistant Professor
Department of Economics
Guru Nanak College
Chennai-42.

2. Theories of Consumption Function
1. Absolute income hypothesis
2. Relative income hypothesis
3. Permanent income hypothesis
4. Life cycle hypothesis

3. 1. Absolute Income Hypothesis:
Keynes’ consumption function based on
Psychological Law.
Not based on empirical data.
Short run analysis.
Y Rise C Rise, but < Y Increase.
 C = a + bY, where a is autonomous C, and b is
MPC.
According to Keynes, MPC is constant.
But APC falls as Y increases.

4. Empirical Consumption Function
Keynes assumed that:
 Current absolute C is related to current Y.
C-Y relationship is reversible consumers will
increase C when Y increases, and decrease C
when Y decreases.
Consumer’s C- patterns are determined
autonomously. That is, consumers’ C is
independent of other’s C.
APC Decline as Y Increases and
MPC remains constant as Y Raise

5.  Kuznets Paradox
 Empirical data does not entirely support Keynes’ C-
function. Simon Kuznets: showed that behaviour of
APC and MPC were not the same for the short run,
and long run consumption functions, and for cross
section and time series data.
 Kuznets’ empirical analysis: Time series data showed
APC is constant for the long run (1889-1938 USA
data), around 0.8.
 Therefore MPC = APC. But for Cross section data, or
short run, APC falls and APS increases, as Y
increases, This is called Kuznet’s Paradox. Different
economists tried to explain this empirical puzzle.

6.  2. Relative Income Hypothesis
 James Stemble Duesenberry was an American
economist.
 He made a significant contribution to the Keynesian
analysis of income and employment, Saving and the
Theory of Consumer Behavior.
 Consumption is relative to other’s C, as well as to
relative Y. Depends on a person’s position in society,
compared to others.
 C is irreversible over time, as Y increase C will not
fall at the same rate.
 Consumers want to maintain their old standard of
living

7.  C = a + bYt + bYt-1
 According to Duesenberry (cross section data):
 If one person’s Y increase, and Ys of all others also
increase at the same rate, then C function shifts
upwards.
 Relative position will not change and there will be no
change in consumers’ C/Y.
 This means APC and APS remain constant.
 Supports Kuznet’s findings of empirical analysis.
 Keynes hypothesis states that in short run MPC < APC and
 Simon Kuznets's hypothesis states that in the long run MPC =
APC.

8. Duesenberry believed that the basic
consumption function was long run and
proportional. This means that average fraction
of income consumed does not change in the
long run, but there may be variation between
consumption and income within short run
cycles.
Duesenberry’s Relative Income Hypothesis is
based on two hypothesis conducted by him:
1. Demonstration effect
2. Ratchet effect

9.  Demonstration Effect
 Consumption depends on relative income of society
in which an individual lives
 Income distribution of families influences
consumption decisions of individual
 There is a tendency to emulate the consumption
standards maintained by neighbors or society
 People with relatively low income experience high
APC and relatively high income experience low APC
in the long run
 Income distribution is constant when each family’s
relative position is unchanged and income of all
families rise
 RIH says there is no cross sectional budget series and
long run aggregate time series data.

10. Rachet Effect
Present consumption of families is not influenced
not just by current incomes but also by levels of
past peak income
Consumption spending of families is largely
motivated by habitual behavioral pattern
If current income rises, households tend to
consume more but slowly.
If current income declines, households do not
immediately reduce their consumption as they
find it difficult to reduce their consumption
established by past peak income.
Ratchet effect is more often observed in short run
cyclicalconsumption pattern

12.  3. Permanent Income Hypothesis Milton Friedman
 Proposed by Milton Friedman in 1957.
 PIH, current income (Y) is a function of two incomes,
namely,
 Permanent Income: It is the average income that people
expect to persist into the future. Denoted by Yp.
 Transitory Income: It is the random deviation from the
average income. It is that part of the income which people
don’t expect to persist into the future. Denoted by Yt.
 Thus, the current income is given as, Y = Yp + Yt
 As per PIH, current consumption depends primarily on
permanent income, because consumers use saving and
borrowing to smoothen out their consumption in response
to transitory changes in income.

13.  Thus, the consumption function is given as, C = a. Yp
 Where, a= constant that measures the fraction of permanent
income consumed.
 In the long run, as proposed by PIH, the permanent income
is constant, hence, APC (C/Y) is constant. Thus, PIH solves
the consumption puzzle.
 According to Friedman:
 Actual Y is made up of: (a) Permanent Y and (b)
 Transitory Y Y = YP + YT
 YT includes unexpected Y, interest, prizes, lotteries, etc.
 People base their consumption on ‘Permanent Y’ which is
constant and sure.
 C from YP is constant, even if YT changes in different time
periods.
 YT may change in the short run, but YP remains constant in
the long run.

14.  Short term fluctuations in Y are temporary, and will not
affect C.
 Actual Y = YP + YT (expected future Y)
 C = a + bYP + cYT
 Short run: temporary income may not lead to increase C.
APC Decline, but APS Increase
 Long run: C is based on permanent Y, so as YP increase,
APC is constant.
 Consumers base their permanent C on permanent Y, so APC
= MPC = constant.
 This C-function starts from the origin (0).
 PIH & LCH, consumers try to smooth their consumption in
the face of changing current income and models do solve
the consumption puzzle
 LCH proposed that the current income varies systematically
over their lifetime, whereas, PIH proposed that the current
income is subjected to random transitory fluctuations.

15.  4. Life Cycle Hypothesis
 It is Proposed by Modigliani, the life cycle hypothesis is
derived from the Fisher’s model of inter-temporal choices.
 As per Fisher’s model, current consumption depends on the
person’s lifetime income.
 In 1950s, Modigliani of MIT and his student Richard
Brumberg developed a new theory for saving.
 LCH argued that people seek to maintain roughly the same
level of consumption throughout their lifetimes by taking on
debt or liquidating assets early and late in life (when their
income is low) and saving during their prime earning years
when their income is high.
 This hypothesis predicts that wealth accumulation will
follow a “hump-shaped” pattern that is, low near the
beginning of adulthood and in old age, and peaking in the
middle.

16.  Keynesian view that a country’s aggregate saving rate
is driven by its total level of income, the life cycle
hypothesis implies that the savings ratio depends on the
growth rate of income. When income is growing, each
new generation has higher consumption expectations
than the previous one.
 To maintain their higher consumption when they get
older, prime-age workers will save more than past
cohorts
 The study suggest that retirees do not draw down their
wealth as quickly as the model would predict.
Moreover, studies in the United States and the United
Kingdom find that consumption, too, is not smooth
over people’s lifetimes; instead, it tends to rise through
middle age and fall after retirement.

17. Consumption may be lower for young people than
the model predicts if they are credit constrained.
Uncertainty plays a role at the end of life as well.
Since individuals do not know exactly how long
they will live, their wealth throughout retirement.
Retirees may also save more than predicted
because they wish to leave some of their wealth to
their descendants.
Finally, the drop in consumption at the end of the
life cycle could be due to “hyperbolic
discounting.”

18. As per Fisher’s model, current consumption
depends on the person’s lifetime income.
Modigliani emphasized on the fact that income
varies systematically (consumers plan for
retirement) over people’s lives and that saving
allows consumers to move income from times
when income is high to times when it is low.
As per LCH model, is given as,
C = (W + R.Y ) /T
C = aW + bY
Where, c= current consumption
W= Initial Wealth
R= years left for retirement

19.  Y=expected income till retirement
 T=lifetime in years
 a= 1/T= Marginal propensity to consume out of wealth
 b=R/T= Marginal propensity to consume out of income
 As per LCH, over time, aggregate wealth and income
grow together, causing APC to remain stable. Thus,
LCH model solves the consumption puzzle.
 Long period C is related to life time average Y.
 It does not respond to changes in current Y.
 Consumption depends on:
 Wealth:
 Present value of all current and future earnings,
 Rate of return to capital,
 Age of the consumer

20. • Life cycle – Age of the Population influences
• C and S
Y
C
c
18 Yrs 60 yrs T