Keynesian_Consumption_Puzzle_Lecture.pptx

Keynesian_Consumption_Puzzle_Lecture.pptx

1. The Keynesian Consumption Puzzle Lecture Notes for Economics Students

2. 1. Introduction John Maynard Keynes proposed that consumption depends primarily on current income. His consumption function is expressed as C = a + cY, where C is total consumption, a is autonomous consumption, and c is the marginal propensity to consume (MPC).

3. 2. Key Terms in Keynesian Function • Autonomous Consumption (a): Consumption when income is zero. • Marginal Propensity to Consume (c): The fraction of additional income spent. • Average Propensity to Consume (APC): The ratio of consumption to income (C/Y).

4. 3. Keynes’ Prediction Keynes argued that as income rises, consumption increases but at a decreasing rate. Thus, APC declines as income grows, meaning higher-income groups save more.

5. 4. Post-War -II Evidence and Kuznets’ Findings Post-War-II, Simon Kuznets analyzed U.S. data (1869–1938) and found that consumption and income moved proportionally over time. The relationship appeared linear, represented as C = cY, implying APC remained constant.

6. 5. The Keynesian Consumption Puzzle The contradiction between Keynes’ theory (declining APC) and Kuznets’ findings (constant APC) created what became known as the Keynesian Consumption Puzzle.

7. 6. Wartime Consumption Patterns During war, government expenditure and income rose due to the multiplier effect, but consumption lagged behind. Inflation and uncertainty caused households to save more.

8. 7. Aggregate Demand and Fiscal Policy Despite high income, aggregate demand stagnated. Governments used fiscal tools—reducing taxes and increasing subsidies—to stimulate demand.

9. 8. Multiplier Effect The multiplier shows how an initial increase in spending raises national income. However, the full impact on consumption takes time to manifest.

10. 9. Reconciling Keynes and Kuznets Economists concluded that both were correct, but in different time horizons—Keynes for short run, Kuznets for long run.

11. 10. Short Run Consumption Function In the short run (Keynesian view): • APC falls as income rises. • Consumption responds slowly. • Households may save more temporarily.

12. 11. Long Run Consumption Function In the long run (Kuznets’ view): • APC remains stable. • People adjust their spending habits. • Rising income leads to durable goods purchases.

13. 12. Graphical Representation The short-run consumption curve (C = a + cY) starts above the origin. The long-run curve (C = cY) passes through the origin. This shows the difference in APC behavior over time.

14. 13. Diagram Explanation Short Run: Positive intercept, decreasing APC. Long Run: Passes through origin, constant APC. Both share a constant MPC.

15. 14. Relation Between Consumption and Saving As income rises, the proportion saved increases in the short run, but stabilizes over time. This helps explain stable long-term growth patterns.

16. 15. Policy Implications Understanding time horizons is vital for fiscal policy. Short-term policies target immediate demand, while long-term strategies address sustainable growth.

17. 16. Modern Theories Later models such as the Life-Cycle Hypothesis and Permanent Income Hypothesis explain how consumers base spending on expected lifetime income, not just current income.

18. 17. Life-Cycle Hypothesis Proposed by Modigliani, it suggests individuals plan consumption and saving behavior over their lifetime, smoothing consumption between working and retirement years.

19. 18. Permanent Income Hypothesis Proposed by Milton Friedman, it argues that people base consumption on long-term expected income rather than short-term fluctuations.

20. 19. Summary of Findings • Keynes: APC falls with income (short run). • Kuznets: APC constant over decades (long run). • Both correct in different time frames.

21. 20. Final Conclusion The Keynesian Consumption Puzzle showed that economic behavior differs across time horizons. It paved the way for modern understanding of consumption dynamics and long-term fiscal analysis.