Theory of consumption

K. Murugan

1. Theories of Consumption Function by Dr. K. Murugan Assistant Professor Department of Economics Guru Nanak College Chennai-42.

2. Theories of Consumption Function 1 . Absolute income hypothesis 2. Relative income hypothesis 3. Permanent income hypothesis 4. Life cycle hypothesis

3. 1. Absolute Income Hypothesis: Keynes’ consumption function based on Psychological Law. Not based on empirical data. Short run analysis. Y Rise C Rise, but < Y Increase. C = a + bY , where a is autonomous C, and b is MPC. According to Keynes, MPC is constant. But APC falls as Y increases.

4. Empirical Consumption Function Keynes assumed that: Current absolute C is related to current Y. C-Y relationship is reversible consumers will increase C when Y increases, and decrease C when Y decreases. Consumer’s C- patterns are determined autonomously. That is, consumers’ C is independent of other’s C. APC Decline as Y Increases and MPC remains constant as Y Raise

5. Kuznets Paradox Empirical data does not entirely support Keynes’ C-function. Simon Kuznets: showed that behaviour of APC and MPC were not the same for the short run, and long run consumption functions, and for cross section and time series data. Kuznets’ empirical analysis: Time series data showed APC is constant for the long run (1889-1938 USA data), around 0.8. Therefore MPC = APC. But for Cross section data, or short run, APC falls and APS increases, as Y increases, This is called Kuznet’s Paradox. Different economists tried to explain this empirical puzzle.

6. 2. Relative Income Hypothesis James Stemble Duesenberry was an American economist. He made a significant contribution to the Keynesian analysis of income and employment, Saving and the Theory of Consumer Behavior. Consumption is relative to other’s C, as well as to relative Y. Depends on a person’s position in society, compared to others. C is irreversible over time, as Y increase C will not fall at the same rate. Consumers want to maintain their old standard of living

7. C = a + bYt + bYt-1 According to Duesenberry (cross section data): If one person’s Y increase, and Ys of all others also increase at the same rate, then C function shifts upwards. Relative position will not change and there will be no change in consumers’ C/Y. This means APC and APS remain constant. Supports Kuznet’s findings of empirical analysis. Keynes hypothesis states that in short run MPC < APC and Simon Kuznets's hypothesis states that in the long run MPC = APC.

8. Duesenberry believed that the basic consumption function was long run and proportional. This means that average fraction of income consumed does not change in the long run, but there may be variation between consumption and income within short run cycles. Duesenberry’s Relative Income Hypothesis is based on two hypothesis conducted by him: 1. Demonstration effect 2. Ratchet effect

9. Demonstration Effect Consumption depends on relative income of society in which an individual lives Income distribution of families influences consumption decisions of individual There is a tendency to emulate the consumption standards maintained by neighbors or society People with relatively low income experience high APC and relatively high income experience low APC in the long run Income distribution is constant when each family’s relative position is unchanged and income of all families rise RIH says there is no cross sectional budget series and long run aggregate time series data.

10. Rachet Effect Present consumption of families is not influenced not just by current incomes but also by levels of past peak income Consumption spending of families is largely motivated by habitual behavioral pattern If current income rises, households tend to consume more but slowly. If current income declines, households do not immediately reduce their consumption as they find it difficult to reduce their consumption established by past peak income. Ratchet effect is more often observed in short run cyclicalconsumption pattern

11. 3. Permanent Income Hypothesis Milton Friedman Proposed by Milton Friedman in 1957. PIH, current income (Y) is a function of two incomes, namely, Permanent Income: It is the average income that people expect to persist into the future. Denoted by Yp . Transitory Income: It is the random deviation from the average income. It is that part of the income which people don’t expect to persist into the future. Denoted by Yt . Thus, the current income is given as, Y = Yp + Yt As per PIH, current consumption depends primarily on permanent income, because consumers use saving and borrowing to smoothen out their consumption in response to transitory changes in income.

12. Thus, the consumption function is given as, C = a. Yp Where, a= constant that measures the fraction of permanent income consumed. In the long run, as proposed by PIH, the permanent income is constant, hence, APC (C/Y) is constant. Thus, PIH solves the consumption puzzle. According to Friedman: Actual Y is made up of: (a) Permanent Y and (b) Transitory Y Y = YP + YT YT includes unexpected Y, interest, prizes, lotteries, etc. People base their consumption on ‘Permanent Y’ which is constant and sure. C from YP is constant, even if YT changes in different time periods. YT may change in the short run, but YP remains constant in the long run.

13. Short term fluctuations in Y are temporary, and will not affect C. Actual Y = YP + YT ( expected future Y) C = a + bYP + cYT Short run: temporary income may not lead to increase C. APC Decline, but APS Increase Long run: C is based on permanent Y, so as YP increase, APC is constant. Consumers base their permanent C on permanent Y, so APC = MPC = constant. This C-function starts from the origin (0). PIH & LCH, consumers try to smooth their consumption in the face of changing current income and models do solve the consumption puzzle LCH proposed that the current income varies systematically over their lifetime, whereas, PIH proposed that the current income is subjected to random transitory fluctuations.

14. 4. Life Cycle Hypothesis It is Proposed by Modigliani, the life cycle hypothesis is derived from the Fisher’s model of inter-temporal choices. As per Fisher’s model, current consumption depends on the person’s lifetime income. In 1950s, Modigliani of MIT and his student Richard Brumberg developed a new theory for saving. LCH argued that people seek to maintain roughly the same level of consumption throughout their lifetimes by taking on debt or liquidating assets early and late in life (when their income is low) and saving during their prime earning years when their income is high. This hypothesis predicts that wealth accumulation will follow a “hump-shaped” pattern that is, low near the beginning of adulthood and in old age, and peaking in the middle.

15. Keynesian view that a country’s aggregate saving rate is driven by its total level of income, the life cycle hypothesis implies that the savings ratio depends on the growth rate of income. When income is growing, each new generation has higher consumption expectations than the previous one. To maintain their higher consumption when they get older, prime-age workers will save more than past cohorts The study suggest that retirees do not draw down their wealth as quickly as the model would predict. Moreover, studies in the United States and the United Kingdom find that consumption, too, is not smooth over people’s lifetimes; instead, it tends to rise through middle age and fall after retirement.

16. Consumption may be lower for young people than the model predicts if they are credit constrained. Uncertainty plays a role at the end of life as well. Since individuals do not know exactly how long they will live, their wealth throughout retirement. Retirees may also save more than predicted because they wish to leave some of their wealth to their descendants. Finally, the drop in consumption at the end of the life cycle could be due to “hyperbolic discounting.”

17. As per Fisher’s model, current consumption depends on the person’s lifetime income. Modigliani emphasized on the fact that income varies systematically (consumers plan for retirement) over people’s lives and that saving allows consumers to move income from times when income is high to times when it is low. As per LCH model, is given as, C = (W + R.Y ) /T C = aW + bY Where, c= current consumption W= Initial Wealth R= years left for retirement

18. Y=expected income till retirement T=lifetime in years a= 1/T= Marginal propensity to consume out of wealth b=R/T= Marginal propensity to consume out of income As per LCH, over time, aggregate wealth and income grow together, causing APC to remain stable. Thus, LCH model solves the consumption puzzle. Long period C is related to life time average Y. It does not respond to changes in current Y. Consumption depends on: Wealth: Present value of all current and future earnings, Rate of return to capital, Age of the consumer

19. Life cycle – Age of the Population influences C and S Y C c 18 Yrs 60 yrs T