Consumption Function
Keynesian consumption function
• 1. Consumption is function of current disposable income
• 2.0<mpc<1
• 3.. apc is a falling function of income
• This gave rise to secular stagnation hypothesis.
Kuznets’ Paradox
• Kuznets (1946)
• US consumption and income data
• Period :1836-1938
• Observations :
• Mpc=apc in the long run
• In boom years mpc<apc in slump years mpc>apc
Observation
• 1.Cross sectional budget studies (household consumption-income data) show
that c/y falls as y rises, so that in cross section of the population, MPC < APC
(Consistent with the Keynesian consumption function})
• 2. Business cycle or short run data show that c/y ratio is smaller than average in
boom years and greater than average in slump years . Thus in the short run, as
income fluctuates, MPC < APC (Consistent with the Keynesian consumption
function)
• 3. Long run data show that as income grows along the trend, MPC = APC.
• (Inconsistent with the Keynesian consumption function).
Three theories of consumption
function
• 1. Permanent income hypothesis : Friedman Approach
• 2. Life –cycle hypothesis : Ando-Modigliani approach
• 3.Relative income hypothesis: Dusenberry approach
Intertemporal choice of
consumption
Irving Fisher
Micro foundation: The basis for much subsequent work on consumption.
• Assumes consumer is forward-looking and chooses consumption for the present
and future to maximize lifetime satisfaction(utility)
• Consumer’s choices are subject to an intertemporal budget constraint, a
measure of the total resources available for present and future consumption
Intertemporal Choice :Assumptions
• 1. The representative individual lives for two periods. At the end of
the second period he is dead .
• 2. In each period he receives an income.
• 3.The individual doesn’t have any assets to start with.
Consumption/savings are financed entirely by income.
• 4. Similarly (s)he doesn’t leave any bequest
• 5..There is a loan market where he can borrow and/or lend .The
lending and borrowing rates are the same.
Consumer’s choice alternatives
• 1. the consumer chooses to spend her/his entire income on consumption in each
period
• 2. the consumer deposits all her/his income in the bank which pays a real interest in
the first period .
• 3. the consumer plans not to spend anything in the second (future) time period
• 4. the consumer chooses to save some of her/his income in the first time
period( present period).
• 5. the consumer spends more than her/his income in the first (present) time period
by borrowing.
• 6. the consumer plans to spend less than his/her income in the future
time
Parametric changes
• Change in income
• Change in interest rate
• Income effect
• Substitution effect
Keynes vs Fisher
• Keynes: current consumption depends only on current income
• Fisher: current consumption depends on the present value of lifetime
income; the timing of income is irrelevant because the consumer can
borrow or lend between periods.
Life cycle hypothesis
• Explanation of cross section budget study:
• Income stream is relatively low at the beginning and end of life cycle
and high during middle of life
• Consumption is more stable , may be slightly rising
• C/Y ratio is high for young and old people low for middle aged people
• → apc falls as income increases
Life cycle hypothesis : Assumptions
• 1. Population distribution according to age and income constant
• 2. Tastes between present & future consumption stable
• 3. Capital markets are reasonably efficient
• 4. If current income rises people revise their expected future income
upwards
• 5. In the short run wealth is constant .
Life cycle hypothesis
• Time series explanation:
• =) ; 0<k<1 (1)
• Assumption:
• Population distribution according to age and income constant
• Tastes between present & future consumption stable
• (2)
•+ (3)
Life cycle hypothesis (contd)
• Assumption:
• Capital markets are reasonably efficient
•= (4)
• = (5)
•
• = (T-1) (6)
Life cycle hypothesis (contd)
• Assumption
• If current income rises people revise their expected future income upwards.
• (7)
• +k (8)
• (9)
Permanent income hypothesis:
Friedman
• ) (1)
• (2)
• (3)
• (4)
• (5)
• (6)
• =0 (7)
• =o = (8)
Dusenberry: Relative income
hypothesis
• Explanation of cross section budget study:
• Consumers are more concerned with their consumption relative to
the other consumers
• Maximize: U=U(
