EIA2002/EXEE 2111

MACROECONOMICS II

Lecture 8

THEORIES
ON CONSUMPTION
1
Topic outlines;
 Background on Consumption Function
 Theories on Consumption:
i. Absolute Income Hypothesis
ii. Life Cycles Hypothesis
iii. Permanent Income Hypothesis
 Policy implications
Consumption
Background on Consumption Function
 Consumption expenditure is the most important
component of AD in the economy.
 Generally consumption expenditure represents
about 70% of a country's GDP.
 Basically consumption function shows the
relationship between income and consumption
either through a different period of time or at a
particular point of time.
 A simple consumption function were first
introduced by Keynes in his manuscript “General
Theory Employment” in 1928.
 Later Keynes propositions on consumption
function were on the puzzle when the
‘stagnation thesis’ didn’t take place and
followed by empirical work done by Kuznets
(1946) that revealed :
i. the value on APC is constant regardless level
of income.
ii. the value of APC were identical to the value
of MPC.
 This discovery lead to the introduction of the SR
and LR consumption function and then followed
by a number of works trying to reconcile
between the SR and LR consumption function.
 Such related work on this came from
Duesenberry, Friedman and Modigliani.

1. Absolute Income Hypothesis (AIH)

 The AIH is actually refer to the Keynes
consumption function postulated that aggregate
consumption (C) is a function of aggregate
current disposable income (Yd).
 The relation between consumption and income
is based on a fundamental psychological law of
consumption which states that when income
increases consumption expenditure also
increases but by a smaller amount.
 The Keynesian consumption function is written
as:
C = a + bYd ; a > 0, 0 < b < 1
where;
a = the intercept, a constant which measures
consumption at a zero level of disposable income
b = the MPC
Yd = disposable income.
 Since Y is made up between C and S, the value of
MPC will determine the percentage of income to
consume and to save.

Main proposition of Keynes consumption function

1. As income increases, the APC (C/Y) falls.

2. The value of MPC (b) is positive but less than
unity (0 < b < 1) implies higher income leads to
higher consumption.
3. The non-proportional consumption function
implies that in SR the APC and MPC do not
coincide.
4. The consumption function is stable both in the
SR and the LR.
 Keynes Consumption Function

Consumption (C) 450

C = a + bYD

C
YD

0 Y0D Disposable Income (YD)

 To support Keynes propositions, Ackley, using
1929-41 US data on consumption and income,
found the estimate of Keynes consumption
function as:
C = 26.5 + 0.75Yd
 These finding were consistence with Keynes
view on “a” which is positive, support that the
APC > MPC and as income rises, APC declines.
 The comparative study on family budgets
between low and high income group also have
found to be consistence with Keynes
propositions on consumption function.
 Specifically, the study found that:
i. A higher income group increased their
absolute consumption as income increases
but less than the increased in income as a
conformation that (0 < b < 1).
ii. A higher income group consumed a smaller
proportion of income as the evidence that
APC decreases as income increases!
 Keynes assertion that the APC falls as income
rises led to the formulation of the “stagnation
thesis” in 1940.
 According to these thesis, as incomes grew in
the economy, households would save more
and consume less and this eventually may lead
to a stagnation.
 However after World War II, rather than facing
stagnation as predicted, the US economy
experienced inflation when the households
liquidate their government bonds into liquid
assets in order to meet their demand for
consumer goods.
 In 1946, Kuznets studied the consumption and
income data for the United States during the
period 1869-1938 and estimated the
consumption function for this period as 0.9.
 He also arrived at this two additional conclusions
on consumption function:
i. over the LR, on the average, the APC did not
show any downward trend so that the
MPC=APC as income increased along a long-
run trend.
Consumption and National Income,
1869 - 1938
 The LR Consumption Function
Consumption 450
C = 0.9YD

0 Disposable Income (YD)

 ii.years which APC below the LR average were
boom periods, and years which APC was
above the LR average were of slump periods.
This implies that in the SR as income changes
over the business cycle, MPC<APC!
 Later Goldsmith (1955) found the long-run
consumption function to be stable at 0.87.
 Thus these two studies revealed that for the SR
time series, the consumption function is non-
proportional because APC>MPC and for the LR
time series, the consumption function is
proportional, APC = MPC.
2. Life Cycle Hypothesis (LCH)
 The hypothesis was formulated by Modigliani,
Ando and Brumberg in early 1960’s stated that
the consumption is a function of lifetime
expected income of the consumer.
 The consumption of the individual depends on
the resources available, the rate of return on
capital, the spending plan, and the age at which
the plan is made.
 The present value of his resources includes
income from assets/wealth/property and from
current and expected labor income.
The main assumptions of LCH
1. The consumer plans to have a constant
consumption flow over a life time.
2. The consumer intends to consume all his total
lifetime earnings plus current assets.
3. No change in the price level and no interest is
paid on assets.
4. The consumer does not inherit any assets and
does not plan any bequests and his net assets
are from his own savings.
5. The consumer is certain about his present and
future flow of income.
The Theory
 The model can be explained by referring to the
following diagram.
 The curve Y-Y represents a consumer life time
earnings from its life time resources, namely
from current labor income, expected average
future income and its assets.
 On early and late years, the labor-income and
assets is low lead to the lower Y but in the
middle of the life, Y both from assets and labor,
is high.
 Income and Consumption over the
Life Cycle
Consumption (C)
& Income (Y)
CSR1
Saving

C Dis-saving
Y
Y

Time T
 The C-C curve represents a plan life time
consumption expenditure which is somewhat
constant (or slightly increasing) future by dis-
saving on early and late years and saving during
in the middle years.
The Model
 The general form of the aggregate consumption
function from LCH is given by;
Ct = b1Y1t + b2YeL + b3At
where;
Y1t = current labor income.
YeL = expected average future labor income.
At = the value of presently held assets.
b1,b2,b3 = the value of respective coefficient.
 To study on actual consumer behavior on
consumption, Ando & Modigliani further
assumed that expected future labor income is a
proportion from a current labor income or;
YeL = bYt ; b>0
 Thus the new aggregate consumption and its
statistical estimates are;
Ct = (b1 + b2bYeL)Y1t + b3At
Ct = 0.72Y1t + 0.06At
 The above statistical estimates according to
Ando & Modigliani is refer to the SR
consumption function and “a” is measured by
the wealth effect.
 This wealth effect will shift the SR
consumption function upward from CSR0 to
CSR1 and later to CSR2as the wealth grows over
time.
 The shifting of the non proportional SR
consumption functions will trace out the
proportional LR consumption function (CLR).
 The LR APC is constant because the share of
labor income in total income and the ratio of
wealth (assets) to total income are constant as
the economy grows along the trend.
LCH: The SR and LR Consumption
Functions
Consumption CLR
CSR1
CSR1
CSR0
A2

A1

A0

0 Income
 The LCH also able to explain the evidence from
the cross-section studies that higher income
group have a low APC compared to low
income group.
 A study revealed that more persons in the low-
income groups were at low income level
because they were at the end period of their
lives and thus their APC is higher.
 On the other hand, more than average persons
belonging to the high-income groups were at
high income levels because they were in the
middle years of their lives and thus their APC is
lower.
3. Permanent Income Hypothesis (PIH)
 Introduced by Milton Friedman in 1978
postulates that consumption is proportional to
permanent income :
C = kYp ; k > 1
 k is a constant coefficient and it’s a function of
interest rate (r), the ratio of property and non-
property income to total wealth (w), and the
consumer’s propensity to consume (u).
 Friedman further divides income and into
“permanent (p)” and “transitory (t)”
components, so that;
Y = Yp+Yt
 This transitory component can be either positive
or negative causing the measured income (or
consumption) to exceed or fall short of
permanent income.
 However, only the permanent component of
income (Yp) that will affect consumption.

The Model
 According to PIH, individual form long term
expectation on income through a “backward
looking” adjustment of their estimate on
permanent income.
 Individual adjust their estimate of permanent
income by a fraction of discrepancies between
actual income in the current period and the
estimated of permanent income in the earlier
period :
Ytp= Y pt-1 + j(Yt - Y pt-1 ) ; 0 < j < 1

 For example, suppose j=0.40, and estimated Ypt-1

= $30,000 and the actual income Yt is $40,000,
then the Ytp will be :
Ytp = 30,00 + 0.4(40,000 – 30,000)
= $34,000
 It means 40% of deviation of actual income from
previously estimated permanent income
represent a change in permanent income while
the rest (60%) is regarded as transitory income.
 The next question to seek is whether PIH able
to answer the earlier proposition on
consumption function that there is;
i. a non proportional relationship between
consumption-income in SR.
ii. a proportional relationship between
consumption-income in LR.
 According to PIH, in the LR, the relationship
between income-consumption is proportional
and the value of APC is equivalent to “k”.
 Income growth in the LR is contributed by the
growth in permanent income while the
transitory income component tend to neutralize
each other and thus APC is constant.
 While In SR, during years of high income, the
transitory income is positive and this will lower
the APC.
 And during years of low income, the transitory
income is negative and thus increase the APC.
PIH: The SR and LR Consumption
Functions
Consumption CLR
CSR1
E1
CSR
E2
E

0 Y Y1 Income
 From the diagram, CLR is the LR consumption
function represents proportional relationship
between consumption and income of an
individual where APC = MPC.
 CSR is the non-proportional SR consumption
function where measured income includes both
permanent and transitory components.
 At Y income level, permanent income and
measured income are identical where transitory
factors are non-existent.
 The CSR and CLR curves coincide and
consumption is at E.
 When consumer’s income increases to Y1, he
will increase his consumption consistent with
the rise in his income to E2.
 The movement from E to E2 because in SR the
consumer does not expect the rise in income to
be permanent, so APC falls as income increases.
 However if income level Y1 becomes permanent,
the consumer will increase his consumption
permanently and cause consumption function to
shift upward to CSR1 and intersect the long-run
consumption function CLR at point E1 where APC
= MPC .
 The evidence from studies have found to be
consistent with PIH.
 For example, families with higher income
normally experience positive transitory income
flow and will not affect their consumption and
therefore will have low APC.
 PIH also have found to be consistence in
explaining the changes of income in quarterly
basis which is regarded as transitory and thus
have not affected the consumption.
Policy Implications
Life Cycle Hypothesis
 On fiscal policy, as suggests by LCH that C is very
much influenced by the ∆YeL but not ∆Yt1 and
∆At1.
 However the model assumed that YeL is
proportional to Yt1!
 As a result, any changes in Yt1 will also change
YeL and thus, will have an impact on
consumption as well.
 Therefore, fiscal policy will affect consumption
for example through any changes in tax and
government spending.
 On monetary policy, LCH provides a direct link
between interest rate and consumption
because a change in the interest rate affects the
market value of financial assets.
 Thus any changes in interest rate will directly
affect such the price and return of holding
assets such as bonds & equities and therefore
will affect consumption.
 For example a contractionary MP will increase
the interest rates and this will reduce the
household wealth and consumption.
 While a expansionary MP reduce the interest
rates and this will increase the household
wealth and consumption.

Permanent Income Hypothesis

 Basically the policy implication on PIH is basically
similar to the LCH.
 However they are more uncertain on the
effectiveness of fiscal policy to effect
consumption and aggregate demand.
 For example a tax cuts or increase may be
regarded as a temporary by household and this
will only be translated to the transitory income
and not the permanent income.