CONSUMPTION

LECTURES 4&5
 OBJECTIVES OF THE LESSON
• By the end of the lesson, students
will be able to:
• explain the absolute income hypothesis
in words
• write an equation to explain the absolute
income hypothesis
• identify the challenges in using absolute
income hypothesis to predict real world
data
 OBJECTIVES OF THE LESSON
• By the end of the lesson, students will be able to:
• explain the permanent income hypothesis
• write a mathematical equation to represent the
permanent income hypothesis
• solve for the MPC and MPS in the life cycle and
permanent income hypotheses both algebraically and
numerically
• use the life cycle hypothesis and permanent income
hypothesis to explain the real world data which the
absolute income hypothesis could not do
• discuss the fiscal and monetary policies implications of
the life cycle and permanent income hypotheses
BACKGROUND: GROWTH, CONSUMPTION AND
INVESTMENT
• Consumption and investment are important to both
growth and fluctuations
• With regard to growth, the division of society’s
resources between current consumption and various
types of investment—in physical capital, human capital,
and research and development—is central to standards
of living in the long run
• That division is determined by the interaction of
households’ allocation of their incomes between
consumption and saving given the rates of return and
other constraints they face, and firms’ investment
demand given the interest rates and other constraints
 BACKGROUND: FLUCTUTATIONS,
CONSUMPTION AND INVESTMENT
• With regard to fluctuations, consumption and
investment make up the vast majority of the
demand for goods
• Thus if we wish to understand how such forces as
government purchases, technology, and monetary
policy affect aggregate output, we must understand
how consumption and investment are determined
 BACKGROUND: CONSUMPTION AND
INVESTMENT AND FINANCIAL MARKETS
• There are two other reasons for studying consumption
and investment
• Firstly, they introduce some important issues ,
involving financial markets
• Financial markets affect the macroeconomy mainly
through their impact on consumption and investment
• In addition, consumption and investment have
important feedback effects on financial markets
• Second, much of the most insightful empirical work in
macroeconomics over the past thirty years has been
KEYNESIAN CONSUMPTION FUNCTION: Absolute Income Hypothesis

• The absolute income hypothesis says that consumption

is assumed to react mechanically to actual current
income
• Keynes advanced this hypothesis about consumption
on the basis of “knowledge of human nature” and
“detailed facts of life”
• The starting point for Keynes’s theory of consumer
behaviour is the following concept:
• “The fundamental psychological law, upon which we
are entitled to depend with great confidence both a
priori from our knowledge of human nature and from
the detailed facts of experience is that men are
disposed, as a rule and on average, to increase their
 Absolute Income Hypothesis
• This psychological law translates into
the Keynesian consumption function:
• , a>0 , 0<b<1 (1)
• where C is real consumption and Yd is
real disposable income which equals
GDP minus taxes. The parameter b is
the marginal propensity to consume
(MPC)
 Absolute Income Hypothesis
• Because of the intercept, the Keynesian consumption
function is not a proportional relationship between
consumption and income; that is, consumption is not a
constant function of disposable income
• The ratio of consumption to income is termed the average
propensity to consume (APC), which is given by
• ( 2)
• The APC is greater than the MPC by the amount . It
follows from this equation 2 that the APC declines as
income increases
 Absolute Income Hypothesis
• The Implication is that as income rises, households
consume
a smaller fraction of income, which is to say that they
save a
• larger fraction of income
• The ratio of saving to income is termed the average
propensity to save (APS) and is equal to (1-APC),
• ( 3)
• This could be seen to increase as disposable income
increases
 Evidence for Absolute Income hypothesis
• Using statistical techniques and annual data for a short period, 1929-
41, Keynesian economists obtained the following type of estimate for
the consumption function:

• Positive value of the intercept supported the Keynesian view that

the APC exceeded the MPC
• The equation also implies that the APC declines as income
increases
• Further support for the Keynesian form of the consumption
came from comparative studies of family budgets
• In the budget of families, at progressively higher income levels,
the absolute amount of consumption increases (b>0) but by less
than the increase ein income (b<1)
• Also families at higher income levels consumed a smaller
proportion of income; the APC declined as income increased
 The downfall of the AIH
• It was observed that despite the continued growth in real GNP in
the US and other industrialized countries, there has been no
tendency for the APC to decline and the APS to rise
• Data used by Simon Kuznets shows that there was no downward
trend in the ratio of consumption to income even though national
income grew from an average of 9.3 billion in the 1869-78 decade
to 72 billion in the 1929-38
• There was also no downward trend in the APC in recent years
(APC was 0.93 in 1950, 0.89 in 1970, 0.93 in 1990, 0.94 in 2000)
• The Kuznets data, as well as later estimates strongly suggest that
the long run relationship between consumption and income is
proportional
• In addition data from the early post War II period showed that
quarter-to-quarter changes in consumption were not well
explained by quarter-to-quarter movements in income.
 Summary of evidence on Absolute Income
hypothesis
• Evidence from short-run annual time series data
and family budgets studies seemed to support the
Keynesian hypothesis about consumption—the
absolute income hypothesis—as represented by
equation 1
• Time series data for a longer time period (e.g.,
1869-1938) suggest that the consumption-income
relationship is proportional, rather than non-
proportional as given by eqn 1
 Summary of evidence on Absolute Income
hypothesis
• Finally, erratic quarter-to-quarter movements of
consumption relative to income cast doubt on the
closeness of the consumption-income relationship in the
short run
• There is therefore a need to reconcile the long –run
evidence with the short-run time series evidence and
cross-sectional evidence from family budget studies
• Resolving these puzzles posed by the early empirical
evidence on consumer behaviour has been the task of the
modern theory of the consumption function
 The Life Cycle Hypothesis of
Consumption
• The life cycle hypothesis was developed by Franco
Modigliani, Albert Ando and Richard Brumberg
• As stated by Modigliani:
• “The point of departure of the life cycle model is the
hypothesis that consumption and saving decisions of
households at each point of time reflect a more or less
conscious attempt at achieving the preferred distribution
of consumption over the life cycle, subject to the
constraint imposed by the resources accruing to the
household over its lifetime”(Modigliani,1966, p.162)
 The Life Cycle Hypothesis of
Consumption
•An individual or household’s
consumption depends not just on
current income but also, and more
importantly, on long-term expected
earnings
•Individuals are assumed to plan their
expenditures based on expected earnings
over their lifetime
 Assumptions
• Consider a worker who has a life expectancy of T
years and plan to remain in the labour force for N
years
• Our representative consumer might, for example be
30 with a life expectancy of 50 (additional years) ,
plan to retire after 40 years, and therefore have
expected years in retirement equal (T-N) or 10
• We assume the individual desires a constant
consumption flow throughout life
• We assume that this person intend to consume
the total amount of lifetime earnings plus
current assets, and that he plans no bequests
• Finally, we assume that interest paid on assets
IMPLICATIONS OF assumptions
• These assumptions imply that
consumption in a given period will be
a constant proportion, 1/T, of expected
lifetime resources
• The individual plans to consume
lifetime earnings in T equal
instalments
• The consumption function implied by
this simple version of the life cycle
hypothesis is
• (1)
 IMPLICATIONS OF assumptions
• Ct is consumption in time period t.
• The term in brackets is expected
resources, which consists of :
• =the individual’s labour income in the
current time period (t)
• = the average annual labour income
expected over the future (N-1) years
during which the individual plans to
work
• A= the value of presently held assets
 The Life Cycle Hypothesis
•Equation 1 indicates that,
according to the life cycle
hypothesis, consumption
depends not only on current
income but also on expected
future income and current
 The Life Cycle Hypothesis

•In fact, the life cycle

hypothesis suggests that
consumption would be quite
unresponsive to changes in
current income that did not
also change average expected
future income
•We could compute
 LCH

•An increase in income that was

expected to persist throughout
the work years would mean that
also rose and that the effect on
consumption would be much
greater:
 The Life Cycle Hypothesis
• A one-time or transient change in
income of say, Gh100 will have the
same effect as a change in wealth of the
same amount (note that =
• Lifetime resources will go up by
GH100,and this will be spread out in a
planned consumption flow of
100/T=100/50=2 per period in this
example of an individual who expects to
live for additional 50 years
 The Life Cycle Hypothesis
• A permanent increase in income of GH100 will
lead to an increase of consumption of GH80 in
each of the remaining periods, including the
10 planned periods of retirement
• The increase of GH80 in each of these 10
retirement years, a total of GH800, is financed
by a saving of GH20(100-80) in each of the 40
remaining working years
• Note that this individual will save GH800
(20*40) and spend this money for the rest of
his life (10 years remaining)
 The Life Cycle Hypothesis
• The life cycle hypothesis accounts for the
dependence of consumption and saving behaviour
on the individual’s position in the life cycle
• Young workers entering the labour force have
relatively low incomes and low (perhaps negative)
saving rates
• As income rises in the middle-ages, so does the
saving rate
• Retirement brings a fall in income and might
begin a period of dissaving (negative saving rates).
See figure 1
A diagrammatic representation of
the life cycle hypothesis
The Life Cycle Hypothesis
 The Life Cycle Hypothesis
• The desired pattern of consumption rises mildly with
time instead of maintaining the constant desired
consumption pattern assumed in our individual
example
• The pattern of income rises more sharply, though, and
the typical individual smooths out consumption flow
by a short period of early dissaving, a period of
positive saving, and then a longer period of dissaving
in retirement
 Aggregate Consumption function of
the Life cycle hypothesis
• The general form of the aggregate
consumption function implied by the
life cycle hypothesis is
• (2)
• If the previous simplifying assumptions
of no bequests, zero interest on saving,
and a uniform consumption pattern
over time are relaxed, the parameters
will no longer be simple functions of N
 Aggregate Consumption function of the Life cycle
hypothesis
• In the aggregate consumption function,
consumption depends on current
labour income, average future expected
labour income and wealth
• Similar to the individual consumption
function, in the aggregate consumption
function, a response to a transient or
one-time increase in labour income will
be quite small, much less than the
response to a permanent change (an
 Life Cycle Hypothesis: formation of
expectation
• To study actual consumer behaviour
using equation 4, we mst make some
assumption about the way individuals
from expectations concerning the
lifetime labour income
• In a study for the US, Ando and
Modigliani assume that expected
average future labour income is just a
multiple of current labour income:
• , a>0 (3)
 Life Cycle Hypothesis: formation of
expectation
•According to this specification,
individuals revise their expectation
of future expected labour income by
some proportion a of a change in
current labour income
•By substitution, the aggregate
consumption function becomes
• (4)
 Life Cycle Hypothesis: estimaton
• A representative statistical estimate of
the equation based on the work of Ando
and Modogliani is
• (5)
• An increase in current labour income of
GH100 with the assumed effect on
future labour income will increase
consumption by GH72
• An increase in wealth of GH100 will
 Life Cycle Hypothesis: estimaton
•Recall that an increase in income
that was known to be temporary
and therefore would not affect
future expected labour income
would have the same effect as
increase in wealth
•Thus, according to this
estimate, the MPC out of such a
transient income flow is in the
Resolving the short-run and long-run consumption puzzle
with the LCH
• The Life cycle hypothesis can explain the puzzles
that emerged from from the early empirical work
on consumption functions
• According to the LCH, the relationship between
consumption and current income would be
nonproportional, as seems to be the case in short-
run time series .
• The intercept of the function measures the effect of
wealth(0.06At) But the intercept is not constant
over time; such short-run consumption functions
shift upwards as wealth grows. The shifting short-
run functions trace out a long-run consumption
function (LCF)
 Resolving the short-run and long-run
consumption puzzle with the LCH
• If the ratios of wealth and labour income to
disposable personal income are relatively
constant over time, the life cycle
consumption function is consistent with the
evidence from long-run time series data that
the long run consumption-income
relationship is proportional, with the APC
relatively stable in the neighbourhood of 0.9
(in US)
Resolving the short-run and long-run consumption puzzle with
the LCH
• The life cycle hypothesis also explains evidence from cross-sectional
family budget studies showing higher-income families consume a smaller
proportion of their income than do lower-income families
• A larger proportion of high-income families might be expected to be in
their peak earnings years—that is, in the “humped” proportion of figure 1.
• In this range, according to the LCH, income should exceed consumption by
the greatest amount, and the APC should be the lowest
• Conversely, a sample low-income families would have a high proportion of
new entrants to the labour market and retirees, both group tends to dissave.
These groups with high APCs would push up the APC for the sample of
low-income families
Resolving the short-run and long-run consumption puzzle with the LCH

• Finally, the LCH explains why quarter-to-quarter

movements n consumption do not closely mirror quarter-to
quarter movements in income
• The change in income from any given quarter to the next
will be partly the result of one-time factors that will not
affect individuals’ perceptions of lifetime average income
and since transient income changes have little impact on
consumer behaviour in the life cycle hypothesis, we do not
expect to see any meaningful relationship
 POLICY IMPLICATIONS OF THE
LCH:FISCAL POLICY
• According to the LCH, consumption is determined
by primarily by expected lifetime income and
wealth. A change in current income, of itself, has
little influence on consumer behaviour
• In the work of Ando and Modigliani, expected
future income is assumed to be proportional to
current income
• If this assumption is correct, we would expect a
strong response of consumption to current
income, because changes in current income cause
proportional changes in expected lifetime income
as well
• Ando and Modigliani’s estimate of the
consumption function implies that the MPC out of
POLICY IMPLICATIONS OF THE LCH:FISCAL POLICY
•In other empirical work by
Modigliani, expected lifetime income
is assumed instead to depend on a
weighted average of the past 12
quarters’ income level
•With this assumption as well, the
response of consumption to income
was strong enough to produce
results consistent with earlier
Keynesian analysis
•The LCH does not, therefore, imply
an essential modification of the
 MONETARY POLICY AND
CONSUMPTION
• In our analysis of monetary policy effects,
the main focus was on investment. The
LCH implies that monetary policy has
important direct effects on consumption as
well
• According to the LCH, household wealth is
one of the main determinants of
consumption. MP affects wealth and
therefore consumption
• MP affect wealth primarily by
affecting interest rates and
consequently the market value of
 MONETARY POLICY AND
CONSUMPTION
• An increase in interest resulting from a tight
monetary policy causes bond price to fall
and capital losses for bondholders (note that
there is an inverse relationship between the
price of a bond and the interest rate)
• Tight monetary policies reduce wealth and
consumption whereas expansionary policies
have the opposite effects
• Also tight monetary policy result in larger
down-payment requirements and stricter
credit standards for consumer credit, thus
increasing the severity of the liquidity
constraint facing many households
• Expansionary monetary policy makes credit
 The Permanent Income Hypothesis
• An(PIH)
alternative explanation of consumer behaviour is the
permanent income hypothesis suggested by Milton
Friedman (1957).
• This hypothesis shares with the life cycle
hypothesis the assumption that long-term income
is the primary determinant of consumption
• Friedman postulates that consumption is proportional to
permanent income:
• (1)
• where is permanent income and is the factor of
proportionality (>0).
• Permanent income is expected average long-term
income from both human and nonhuman wealth—that is,
both expected labour income (the return to human
wealth or huma capital) and expected earnings from
asset holdings (nonhuman wealth)
 The Permanent Income Hypothesis (PIH)
• Friedman does not expect this equation to predict consumption
perfectly because, in addition to the part of consumption
determined on the basis of permanent income, in any period
there is a random element to consumption that Friedman terms
‘transitory’ consumption
• Similarly, in any given period, there is transitory component of
income; measured income generally does not equal permanent
income for the individual or in the aggregate
• We can write measured income (Y) as:
• (2)
• where is transitory income which may be either positive or
negative, causing measured income to exceed or fall short of
permanent income
• According to the PIH, only the permanent component of income
influences consumption. Consumption, even the transitory
component of consumption, is independent of transitory income
 The Permanent Income Hypothesis (PIH)
• In order to implement the PIH, we must make an
assumption about how individuals form long-
term expectations about income
• Friedman assumed that individuals revise their
initial estimate of permanent income from period to
period in the following manner:
• , 0< <1 (3)
• The equation (3) states that in each period
individuals adjust their estimate of permanent
income by a fraction of the discrepancy between
actual income in the current period and the prior
period’s estimate of permanent income
The Permanent Income Hypothesis (PIH): Illustration
• Assume that =0.40. Then coming into 2022,
assume that an individual estimated her
permanent income to be GH30,000 but actual
income in 2022 turned out to be GH40,000
• From the equation (3), we compute

• The individual assumes that 40% (4,000) of the

deviation of actual income from the previous
estimate of permanent income represents a
change in permanent income, whereas the other
6000 is transitory income
 Resolving Consumption Puzzles with PIH
• The PIH is consistent with the
proportional long-run consumption
function (APC is constant) and the
nonproportional short-run consumption
function (APC declines as Y increases)
found in time series data
• In the long run, income growth is
dominated by changes in permanent
income, with positive and negative
transitory changes in income cancelling
out
 Resolving Consumption Puzzles
with PIH
•In the short run, years of high income
will generally be years when the
transitory component of income is
positive
•Because consumption rises only with
increases with permanent income, in
these high-income years the ratio of
consumption to measured income
(APC=C/Y=C/(Yp+Yt) will be low. The
opposite is true for low income years
 Policy Implications of PIH
• The policy implications that follow from the
PIH are similar to those of the life cycle
hypothesis.
• With respect to fiscal policy, and in
particular to the Keynesian multiplier
process, the crucial question again is
whether consumption responds strongly to
changes in current income
• The short-run MPC, will be , that is the
long run MPC out of permanent income u
multiplied by a fraction by which the
individual’s estimate of permanent income
is adjusted to a change in actual income, j.
 Policy Implications of PIH
• If an individual adjust their estimates of
permanent income to changes in current income
only slowly over time, j and therefore the MPC
of the current income will be small
• For example, if =0.9 but j is 0.3, the MPC out of
current income will be 0.27
• With a low MPC, a change in tax policy, for
example, will not cause a large consumption
response
• In the Keynesian system, tax policy works by
affecting current disposable income and
therefore consumption by means of the MPC
• If the response of consumption to income is