EXACTVIEW TRAINING

COURSE: Intermediate Macroeconomics

COURSE CODE: ECN 321
TOPIC: Theory of Consumption
LECTURE BY: Mr. Muyideen
 4 BASIC THEORIES

• Absolute Income Hypothesis

• Relative Income Hypothesis
• Permanent Income Hypothesis
• Life-cycle Income Hypothesis
 ABSOLUTE INCOME HYPOTHESIS (AIH)
• By John Meynard Keynes in 1936.
Current consumption depends on current and absolute level income
Based on psychological law and cross-sectional short-run studies.
•  
KEYNES’ PROPOSITIONS
1. Income is the main determinant of consumption.
2. Consumption is a positive function of current income.

3. On the average, individuals increase their consumption as their income increases, but not
by as much as the increase in their income.
4. At a very low level of income, consumption is most likely to be greater than income and at
the very high level of income, saving is most likely to be greater than consumption.

5. Low-income households have higher MPC & APC than higher-income households. .
 Simon Kuznet’s Empirical Findings
• 

Time series data of 1868-1929 were gathered in 1940s.

Won a Nobel Prize for this work
FINDINGS:
Keynesian consumption function is unstable in the short run.
Wealth, not only income, is an important determinant of consumption.
APC & MPC are constant and equal. Thus, only propositions 1 to 3 by
Keynes are consistent with long-run time series while 4 to 6 are consistent
with the short run.
Other factors (age, marital status, level of education) are fairly important.
By implication, two types of consumption functions/curves emerge.
THE CONSUMPTION PUZZLE
 RELATIVE INCOME HYPOTHESIS (RIH)

  By James Duesenberry in 1949.
 Household consumption does not so much depend on its absolute income.
 It depends much on the relative income of the households it identifies itself or wishes to keep up
with.

 Demonstration effect Ratchet Effect

Keeping up with the Jones’

 Duesenberry’s Ratchet Effect
 Ratchet Effect: When absolute income increases, absolute consumption
increases but when absolute income decreases, households do not cut their
consumption in proportion to the fall in income. In the long run, they are
used to a certain standard of living, so, when their income falls, their
consumption falls less than proportionately.
 Shortcomings of RIH
• Consumption standards are not irreversible as Duesenberry claims, but are slowly
reversible.
• Unexpectedly large increases in income are, at least initially, associated with less than
proportionate increase in consumption.
• Not all periods of recession are accompanied by a fall in consumption.
• Beyond relative income, several other factors (e.g. wealth, interest rate, age, education,
family size, future income, etc.) can affect consumption.
 PERMANENT INCOME HYPOTHESIS (PIH)
• By Milton Friedman in 1957.

Individuals experience both permanent and transitory fluctuations in their income. Thus,
current income is the sum of permanent income (Yp) and transitory income (Yt).

Permanent income is the average of all the incomes anticipated by the individual in the future.
It is the sum of human wealth (labour incomes) and non-human wealth (financial & capital
incomes).
Transitory incomes are temporary deviations from average income. Thus, they are random.
(e.g. special bonus, gifts & grants, lottery wins, etc.)
There are also transitory income losses (e.g from accident, theft, loss of job, nonpayment of
wages, unpaid sickness leaves, etc.)
• Both transitory incomes and transitory income losses cancel out in the long run.

Because consumers can save and borrow, and because they want to smooth their consumption,
consumption does not respond much to transitory income. Instead, consumption depends
primarily on permanent income. Thus,

Other propositions are that:

•   HOW PIH SOLVES THE CONSUMPTION PUZZLE
The PIH implies

To the extent that high income households have higher

transitory income than low income households, the APC will be
lower in high income households.
Over the long run, income variation is due mainly if not solely
to variation in permanent income, which implies a stable APC.
 Shortcomings of PIH
• APC is not always constant and equals to MPC
• Correlation can be found between transitory income and
consumption.
• Estimation measures of permanent income can prove
difficult.
 LIFE CYCLE HYPOTHESIS (LCH)
•By
  Franco Modigilani in 1959.

Income varies systematically over the phases of the consumer’s “life cycle,” and saving allows
the consumer to achieve smooth consumption.
Consumption depends on both income and wealth as well as age.

• To achieve smooth consumption, consumer divides her resources equally over time:

Where:

= is the marginal propensity to consume out of wealth

b = is the marginal propensity to consume out of income₦
 HOW LCH SOLVES THE CONSUMPTION PUZZLE
•  
The APC implied by the life-cycle consumption function is

 Across households, wealth does not vary as much as income, so high income
households should have a lower APC than low income households.
 Over time, aggregate wealth and income grow together, causing APC to remain
stable.
 Consumption, Income & Wealth over the Lifecycle

 If the consumer smooths

consumption over his lifetime,
(as indicated by the yellow
horizontal consumption line) he
will save and accumulate wealth
during his working years and
then dissaves and run down his
wealth during retirement.
 Shortcomings of LCH
The following assumptions are highly questionable:
 The individual has a perfect vision of his future.
 He has a finely planned life
 His life expectancy is highly certain.
 He has all information and he is rational
 Rate of interest is constant