Theories of Consumption Function Unit-6

UNIT 6: THEORIES OF CONSUMPTION

FUNCTION
UNIT STRUCTURE
6.1 Learning Objectives
6.2 Introduction
6.3 Absolute Income Hypothesis: Postulates
6.4 Relative Income Hypothesis
6.4.1 Ratchet Effect
6.4.2 Limitations of the Theory
6.5 Permanent Income Hypothesis
6.5.1 Concept of Transitory Income, Expenditure and Transitory
Purchases
6.5.2 Equations of Permanent Income Hypothesis
6.5.3 Criticisms of Permanent Income Hypothesis
6.6 Life Cycle Hypothesis
6.6.1 Postulates of Life Cycle Hypothesis
6.6.2 Numerical Example
6.6.3 Criticisms of Life Cycle Hypothesis
6.7 Let Us Sum Up
6.8 Further Reading
6.9 Answers to Check Your Progress
6.10 Model Questions

6.1 LEARNING OBJECTIVES

After going through this unit, you will be able to-

 describe the concept of Keynesian absolute income hypothesis
 critically evaluate the arguments of absolute income hypothesis
 discuss the concept of relative income hypothesis
 point out the limitations of relative income hypothesis
 explain the equation of permanent income hypothesis
 put forward the shortcomings of permanent income hypothesis.

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6.2 INTRODUCTION

There are several alternative explanations for the theory of consumption

function. But the significant contribution in this regard comes from Keynes
(Absolute Income Hypothesis), Duesenberry (Relative Income Hypothesis),
Milton Friedman (Permanent Income Hypothesis), Modigliani &Brumberg
and Ando & Modigliani (Life Cycle Hypothesis).
In recent years, permanent income hypothesis and life cycle
hypothesishave become popular, and considered to be empirically sound
while explaining consumption behavior. In this unit, we shall discuss some
of the theories of consumption function. Thus, the unit will be helpful in
gaining insights into the major theoretical discussions relating to the
consumption function.

6.3 ABSULUTE INCOME HYPOTESIS: POSTULATES

The Absolute Income Hypothesis was put forward by John Maynard

Keynes. The hypothesis is based on what Keynes called the Fundamental
Psychological Law of Consumption.In the words of Keynes, "The
fundamental psychological law upon which we are entitled to depend with
grate confidence both a priori from our knowledge of human nature and
from the detailed facts of experience, is that men are deposed, as a rule
and on the average, to increase their consumption as their in income
increases, but not by as much as the increase in their income".
Thus, this hypothesis is based on following postulates.
 Consumption is stable function of income.
 The marginal propensity to consume (MPC) is less than 1 but greater
than zero.
 As income increases consumption also increases but less than
proportionately. As a result, the average propensity to consume (APC)
falls over time. This makes marginal propensity to consume (MPC) less
than the average propensity to consume (APC).
Keynes holds the view that household's current consumption
expenditure depends on the current income of the household. On the basis

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of this fundamental argument, absolute income hypothesis builds its

propositions that current consumption expenditure depends upon current
and absolute level of disposable income.

C   Y 
Where, C = current consumption, Y = current disposable income.
Following are the main features of Keynesian consumption function.
 The real consumption expenditure is a positive function of the real current
disposable income.
 The marginal propensity to consume (MPC) ranges between zero and
1, that is 0 < MPC < 1 (0 and 1 excluded).
 The marginal propensity to consume (MPC) is less than the average
C C
propensity to consume (APC) that is, 
Y Y
 The average propensity to consume (APC) declines as income increases.
Diagrammatic Presentation:
Figure 6.1: Absolute Income Hypothesis

Illustration of diagram: In this diagram, the 450 line (C=Y) shows that
consumption is always equal to current income. This is hypothetical example
that shows that if Y = 0 then C = 0. This is not realistic proposition because
even if income is zero, people consume by begging, borrowing and stealing.

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Curve C1 shows Keynes's absolute income hypothesis. The curve shows

that consumption expenditure exceeds the current income up to a certain
level of income (say, Y = 10,000). The break-even point in this diagram is
at B. Beyond the point B, consumption expenditure increases with increase
in income but at a slower pace. As a result the slop of the curve C1 goes on
diminishing with increase in income. Similarly, curve C1 is downward
bending positive sloping income-consumption curve depicts the fact that
low income households have higher marginal propensity to consume (MPC)
and higher income households have lower marginal propensity to consume
and result in the downward bending positive sloping income-consumption
curve.
The straight-line consumption function in the above form narrates
absolute income hypothesis of Keynes.
C = a + bY ………………….(1)
Where, 'a' is an intercept showing consumption at zero level of income,
which is called the autonomous consumption, and 'b' stands for
C
MPC 
Y

This consumption function represented by the consumption schedule

labeled C2 in the diagram. The consumption schedule C2has constant slop
that is given by b in the above equation (1).
Criticism of the absolute income hypothesis:
 Absolute income hypothesis is based more on 'introspection' rather than
observed facts.
 Empirical studies have found that consumption expenditure depicts
proportionality with income in time series data for a longer period, while
it shows non proportionality for short period as well as in case of cross
section data. This contradicts the Keynesian hypothesis as it asserts a
non proportional relationship between income and consumption.
In view of the failure of the Absolute Income Hypothesis to explain the
empirical findings, a host of alternative explanations came up that attempt
to reconcile the proportional and non proportional relationship of aggregate

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consumption and aggregate disposable income. It is in this context we

study the following alternative hypothesis, namely, Relative Income
Hypothesis, Permanent Income Hypothesis, and Life Cycle Hypothesis.

6.4 RELATIVE INCOME HYPOTHESIS

The psychologist and sociologists have acknowledged that individuals

care about their status in society. Duesenberry gives careful consideration
to this postulate. He explained his relative income hypothesis in 1949 in a
book title 'Income, Saving and Theory of Consumer Behavior'. In this
bookDuesenberry argued the utility of an individual derived from given
consumption level depends on its relative magnitude in society rather than
its absolute level.
Dusenberry argued that utility index of an individual is depends on the
ratio of his or her consumption to weighted average of the consumption of
the others. It means that utility of an individual depends both on own income
and income relative to others. Relative income hypothesis shows that
people/households make their decisions regarding consumption and saving
based not only on absolute income but on relative income as well. As a
consumer, individual considers his income as it relates to the income of
other before making purchase decisions.
Duesenberry, in his relative income hypothesis argued that if relative
income of an individual remains same, the individual will spend the same
proportion of his income on consumption as he was doing before the
absolute increase in his income. In other worlds, average propensity to
consume (APC) of an individual will remain same despite of the fact that
his absolute income increases. Study conducted by Kuznets based on time-
series has shown that in long run average propensity to consume remains
almost constant. It means in long run the community would continue to
consume the same proportion of income as its income increases.
So the exact difference between absolute and relative income hypothesis
is as follows.

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Keynesian absolute income hypothesis implies that as the absolute

income of community increases, it will offer a smaller proportion of its income
towards consumptions and as a result, APC will decline. On the contrary,
relative income hypothesis implies that if the income of the community
increases, and the relative distribution of income remains the same, then
consumption would increase by the same proportion. Thus, therelative
income hypothesis suggests that as income increases consumption function
curve shifts above so that average propensity to consume remains constant.
Similarly, relative income hypothesis provides slightly different
explanation from absolute income hypothesis on the question of what
happens when household income decreases. On the one hand absolute
income hypothesis holds the view that consumption decreases when there
is decrease in income. On the contrary relative income hypothesis holds
the view that consumption will not decreases in proportion to income
because of 'Ratchet Effect'.

6.4.1 Ratchet Effect

When the income of individual falls, consumption does not fall as

much, this is called Ratchet Effect. How this happens? This is
because people are aware about position in the society they live in
and they do not want to show the neighbors that they can no longer
afford to maintain the previous standard of life.
James Duesenberry (1949) offers slightly different
explanations to conventional argument. Conventionally, if income
falls, then consumption should fall. But Duesnberry rejects this view.
He argues that once the consumption habits are acquired, it
becomes difficult to get rid of these habits. Some of the consumption
habits are formed at high income levels that are not completely
abandoned when income falls.
The ratchet effect arises due to household's resistance
against the fall in consumption following a decrease in household
income. Duesenbeerry argues that when absolute income increase
absolute consumption also increases. But absolute income
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decreases, the household do not allow their consumption to fall in

their income. This is because, in a long run, household gets used to
certain standard of living. Therefore, when income of these
households falls, consumption of these households fall less then
proportionally. When consumption does not falls in proportion to
the fall in income, then average propensity to consume (APC) rises
and marginal propensity to consume (MPC) falls. This is called
ratchet effect in consumption behavior.
Let's understand with suitable example-
If the income of household increases from Rs. 10,000/- per
unit of time to Rs. 11,000/-. The consumption of household would
increases from Rs. 8000/- to Rs. 8800/-.
C 800
In this case, MPC    0.80 and
Y 1000

C 8800
APC    0.80,
Y 11000
Here, MPC  APC  0.80

But when the income decreases, say to Rs.9000/-,

consumption decreases less then proportionally to say, Rs. 7500.
In this case

C 500
MPC    0.5
Y 1000

C 7500
And, APC    0.83
Y 9000

Note that MPC has decreased from 0.8 to 0.5 and APC has
increased from 0.8 to 0.83.
Diagrammatic Presentation: Duesenberry's consumption
function has been shown with the help of Figure 6.2

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Figure: 6.2: Duesenberry's Consumption Function

Figure 6.2 shows the fundamental framework of relative

income hypothesis by Duesenberry. OX is a horizontal axis showing
income and OC is vertical axis showing level of consumption
corresponding to the level of income. In this diagram, if long run
consumption increases as a result of increase in income is shown
as CLR.
When income is OY0, aggregate consumption is OC0. As
the income increases to OY1 , consumption rises to OC1. This means
a constant APC consequent upon a steady growth of national
income.
Now, let's assume that income levels falls from OY1 to OY0.
In these circumstances, Duesenberry's hypothesis comes in
operation and it's visible. For example, household will maintain the
previous cons8umption level what they enjoyed the past peak of
income levels. It means households are unwilling to reduce their
consumption standards along with CLR. Consumption will not decline
to OC0, but will remain at OC'1 (>OC0 ) at the income level OY0. At
this level of income, APC will be higher than what it was at OY1 and
MPC will be lower.
If income rises, consumption will rises along CSR because
people will maintain their consumption standard at the previous peak
income. Once OY1 level of income is reached consumption will move

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along with CLR. The short run consumption is subject to 'the ratchet
effect'. If ratchets up following an increases in income levels, but it
does not fall back downward in response to fall in income.

6.4.2 Limitations of the Theory

The major criticisms levelled against the relative income hypothesis

are:
 The relative income hypothesis states that income and
consumption would increase upward whether the change in
income is small or large. But empirical data shows that large
increase income has not resulted in large increase in
consumption.
 Relative income hypothesis also states that consumption
standards are irreversible. But this argument is true for short
run. The consumption standards are reversible in the long run.
 The relative income hypothesis states that income and
consumption changes always in the same direction. It means
that recession must always be accompanied by fall in aggregate
consumption expenditure. There is evidence during 1948
recession in the U.S., consumption expenditure was rising while
disposable income was decreasing.
 This hypothesis ignores other factors which influences consumer
expenditure like- asset holding, urbanization, age composition,
appearance of consumer goods etc.

CHECK YOUR PROGRESS

Q 1: State the basic difference between absolute and relative income

hypotheses. Answer in about 60 words.
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Q 2: What is meant by the Ratchet effect? Answer in about 60 words.
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6.5 PERMANENT INCOME HYPOTHESIS

The Permanent Income Hypothesis was formulated by a Nobel Laureate

Milton Friedman in 1957. Earlier, both absolute and relative income
hypothesis related consumption to absolute and relative current income.
But Milton Friedman in his book 'Theory of Consumption Function' rejected
the argument of current income hypothesis and formulated a new theoretical
framework to understand consumption function. This theoretical framework
is known as 'Permanent Income Hypothesis'. Permanent income is the
mean of all the incomes anticipated in the long run. While calculating
permanent income, Friedman says that it is an income anticipated from
human and non-human wealth. Income from human wealth refers to income
from human capital that includes training, education, skill and intelligence.
In short, income from human capital is the income earned by selling the
household labour. On the other hand, income from non-human wealth means
income from assets like- money, stocks, bonds, real estate and consumer
durables etc.
In short, this theory can be stated that it is the permanent income and
not current income that determines the level of consumption expenditure.
Permanent income hypothesis also provided explanations for some of the
issues that rose from the empirical data regarding the relationship between
average and marginal propensity to consume.
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6.5.1 Concepts of Transitory Income, Transitory

Expenditure and Transitory Purchase

While calculating permanent income, we need to understand and

distinguish between transitory income and transitory expenditure.
Transitory income consists an income earned by people in the form
of bonus to workers, lottery wins etc. Similarly, transitory losses
consists of unpaid sick leave, temporary loss of job, non-payment
of wages due to strikes and lockouts, short term fall in returns on
the income earning assets etc.
Similarly, there is need to understand the concept of
transitory purchases along with transitory income and expenditures.
Sometime households make once in a while purchase of goods
which they do not need for immediate consumption. These types of
purchases are made because of attractive offers, anticipated scarcity
of the commodity etc. But at the same time some routine purchases
are postponed by households due to lack of funds, sudden price
rise or lower prices expected in the future. The purchases that are
deferred by households are treated as negative transitory purchases.
The permanent income hypothesis assumes no relationship between
income and transitory purchases made or postponed.
While estimating permanent income of household, the
transitory income is considered as an addition while transitory
expenditure is considered as a loss from the permanent income.

6.5.2 Equations of Permanent Income Hypothesis

While elaborating permanent income hypothesis, Dornbusch and

Fischer said that Friedman has not provided a standard definition
of permanent income. But certainly he has given a pragmatic
approach to estimate permanent income. Further, they also said
that permanent income was equal to geometrically weighted average
of present and past measured income.

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Friedman's theory of permanent income hypothesis is very

significant and has opened new areas of research on saving and
consumption function. Friedman believes that every household has
some conception of his future expected income that is considered
to be stable. This is called permanent income.
The actual income of the household may or may not coincide
with permanent income. The gap between measured income and
permanent income are called transitory income which may be
negative or positive.
Thus, we have the following identity.
Ym = Yp+Ytr ………………………………… (1)

It means that measured income consists of permanent

income and transitory income. While defining permanent income,
Friedman said that 'the effect of those factors that the unit regards
as determining it's capital value of wealth; the non-human wealth,
personal attributes of earners like his training, ability, personality,
the attributes of the economic activities of the earners and so on.
Besides, transitory component of income, on the other hand,
reflects the effect of 'change' or accidental factors which causes
the measured income to rise or fall temporarily. In fact, income
earned through such windfall gains is temporary and consumer
knows it. As a result, consumer will not base his consumption upon
such transitory income. In fact, consumer would base his
consumption upon what he considers as his permanent income.
Algebraically, permanent income hypothesis can be written
as:
Cp = kYp ………………………(2)

: Permanent consumption ( Cp) equals k proportion of

permanent income (Yp)

Ym = Yp + Ytr ……………………(3)

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: Measured income (Ym) equals permanent income (Yp) plus

transitory income (Ytr)

Cm = Cp + Ctr…………………….(4)

:Measure d consump tion (C m) equals permanent

consumption (Cp) plus transitory consumption (Ctr)

R1 (YtrYp) = 0 ……………………..(5)

: Correlation coefficient (R1) between Ytr andYpe quals zero

R2 (CtrCp) = 0 ………………………….(6)

: Correlation coefficient (R2) between Ctr and Cpe quals zero

R3 (YtrCtr) = 0 ………………………….(7)

: Correlation coefficient (R3)betweenYtr and Ctr equals zero

These equations explain permanent income hypothesis. For
example-equation-1 states that permanent or planned consumption
a certain proportion (k) of the permanent income. The proportionality
factor k need not be a constant for it depends on demographic and
ethnic factors, the interest rate and ratio of non-human wealth to
permanent income.
Friedman estimated permanent income on the basis of
measured income data for 17 years. The formula that he used to
measure the permanent income is given below.


Ypt  Yt  1  Yt 1  1  2
Y
t 2  ..... 1  n Yt  n .......(8)

Where,

Ypt= permanent income in periodt

= rate of declining weightage for the annual measured

income in the past

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In Friedman's own estimate of permanent income, =0.33.

In equation 8, the permanent income of a household in any
year (say, t) can be easily obtained by summing up a declining
percentage of incomes in the past years, t, t-1, t-2 and so on. For
example, assuming =0.33, the permanent income of household
for 1998 can be obtained as follows.
Y1998 = (0.33) Y1998 + 0.33 (1-0.33) Y1997 + 0.33 (1-0.33)2
Y1996 + 0.33 (1-0.33)3 Y1995 and so on ……………….(9)

= (0.33) Y1998 + 0.22 Y1997 + 0.148 Y1996 + 0.10 Y1995 and so

on
In short, the measured permanent income for 1998 equals
33 per cent of 1998 income plus 22 per cent of 1997 income plus
14.8 per cent of 1996 income plus 10 per cent of 1995 income, and
so on.

6.5.3 Criticisms of Permanent Income Hypothesis

The major criticisms levelled against the permanent income

hypothesis are:

 Permanent income hypothesis assumes that the coefficient of

correlation between transitory component of consumption and
transitory component of income is zero. This is not real. For
example- an individual who gained a profit is not willing to deposit
his money in bank but would like to spend a whole or part of it in
his current consumption. At the same way an individual who
suffered losses does reduce or postpone his current
consumption.
 This theory also assumes that average propensity to consume
of all households remains same in long run. This does not hold
true because consumption of poor is higher relatively to their
income while the saving of the rich is higher relatively to their
income. Even consumption differs among the person with same
level of permanent income.
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 It seems that the concept of measured income creates confusion

by bringing permanent and transitory component of income.

CHECK YOUR PROGRESS

Q 3: How can one estimate permanent income? Answer in about 60

words.
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Q 4: Mention any two important criticisms levelled against the permanent
income hypothesis. Answer in about 60 words.
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6.6 LIFE CYCLE HYPOTHESIS

The theory of life cycle hypothesis is associated with economist like

Franco Modigliani, Richard Brumberg and Alberto Ando. Given the wealth
constraint, life cycle hypothesis aims to maximize the utility function over
the life span. The maximization of utility function depends upon the
availability of resources. The resource pool of an individual consists of his
current and discounted future earning over his life span and current net

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worth. Modigliani won Nobel prizein Economics in year 1985 for his work
on life cycle hypothesis.
This hypothesis explains the conflict between average propensity to
save (APS) from cross section data and data from time series.
Life cycle hypothesis assumes that an individual earns relatively low
income at the beginning and at the end of his life. But the flow of income
remains high during the middle of his life. The individual maintains increasing
level of consumption in his entire life. But the present value of his total
consumption would not exceed the present value of total income during his
life time.
The life cycle hypothesis also observes that in order to avoid the
fluctuations in income, people save their income especially during the high
income and dissave during the time of low income. If the probability of
future income increases, consumption also increases.
The life cycle hypothesis also suggests that an individual is a net
borrower at the earlier stage of his life. During the middle of his life, individual
save more and also puts aside a sum for his retirement. In the later years,
a person will dissave and consumer more than his income.
In life cycle hypothesis individual smoothen out the consumption pattern in
the lifetime and this process has independent of current level of income.
Life cycle hypothesis states that early stage of life of an individual,
consumption expenditure is likely to exceed income. Because individual
may purchase a new home to start his family life at eh initial stage of his
career. In order to support these consumption need, individual is likely to
borrow from future.
In the mid-career life, individual's income increases. Individual is in a
position to repay and of his past borrowing and also begins to save for her/
his retirement. At the stage of retirement, consumption expenditure may
decline but decline in income is more drastic. At the retirement stage of life,
the individual is dis-saver.
While highlighting the pattern of consumption behavior of an individual,
the life cycle hypothesis emphasise on three factors, viz.:

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1. Availability of resources to the individual.

2. Rate of return on his capital
3. The age of an individual
The availability of resources with an individual consists of individuals
existing net wealth and the present value of all current and future labour
income. Consumer is rational; this is one of the crucial assumptions of life
cycle hypothesis. In order to maximize the total utility over life time, a rational
consumer plans his/her consumption on the basis of resources, allocation
of income and consumption.

6.6.1 Postulates of Life Cycle Hypothesis

Total consumption of an individual is determined by current physical

and financial wealth and life timelabour of an individual.
The consumption expenditure of an individual depends upon
life time income and stock of wealth.
Life-time consumption pattern of an individual remains more
or less stable.
There is no relationship between current income and current
consumption.
The postulate No. 1 & 2 will pave the way for life-time
consumption.
C = aW R + cYL.............................................(1)
Where, W R= real wealth, YL= labour income, a = mpc wealth
income, and c= mpclabour income.
Now let's assume that an individual starts working at the
age of B, and this individual wants to live for N years with his
retirement age at R. Therefore, his working life equals R-B years.
Let's also assume that: 1. Individual has no uncertainty about
his longevity, employment and health condition. 2. He earns no
interest on his accumulated savings. 3. He does not consume his
total labour income 4. Prices remain constant.
Taking in to considerations of the following assumptions,
the lifetime income is estimated as follows:
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Lifetime income = YL (R - B)
Where, YL = annual labour income, and R-B = number of
working years.
Assuming R-B = EL to the earning life, we may redefine
lifetime labour income as lifetime income = YL X EL.
Life-cycle hypothesis states that an individual plans his
lifetime consumption in such as way that his lifetime consumption
equals his lifetime income. Here the term 'lifetime' means working
life = N -B. Given the individual's expected life of N years and his
planned constant (annual) consumption (C), the consumption
hypothesis can be written as-
C X N = YL X EL………………………………(2)
Let's divide both the sides by N, we get the lifetime
consumption (C) as
EL
C XYL .............................................(3)
N
Equation (3) reveals that not only a fraction of labour income
is consumed annually and the rest is saved and accumulated. We
will return to the savings aspects shorts. Let us first explain the life-
cycle hypothesis through a numerical example in Indian context.

6.6.2 Numerical Example

Let's assume and calculate consumption-saving pattern according

to life cycle hypothesis:
Life expectancy (N) = 70 years.
Retirement age of an individual (R) = 60 years.
Age at the beginning of working life: 18 years.
Working life (R-B) = EL = 40 years.
Annual income of an individual: Rs. 5,00,000/-
On the basis of these assumptions:
Lifetime income = YL X EL = Rs. 5, 00,000 X 42 = Rs. 2, 10,
00000/-

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EL 42
C XYL  X5,00,000
N 60
 0.7X5,00,000
 3,50,000/ 

In other words, an individual spends 70 per cent of his income

on consumption and remaining 30 per cent income is saved and
will be consumed after the retirement. Once we know the annual
income and annual consumption, it becomes easy for us to calculate
the annual saving of an individual.
S = Lifetime income - Working life consumption
= (YL X EL) - (C X EL)
= (5, 00,000 X 42) - (3, 50,000 X 42)
= 2, 10, 00000 - 1, 47, 00000
= 63, 00000/-

6.6.3 Criticisms of Life Cycle Hypothesis

The major criticisms levelled against the life cycle hypothesis are:
 This theory is strongly criticized on the basis of the very
assumptions of this theory. For example- this theory assumes
that individual has definite vision and idea about his future
income, life time income, future credits, future emergencies,
opportunities and social pressures, etc. These assumptions are
rather strong and unrealistic.
 This theory assumes that individual is rational, he knows the
entire market information he needs; individual can make fine
and complex calculations about the future etc. It is difficult to
assume that all individuals in the community really have this set
of information while making decisions.

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CHECK YOUR PROGRESS

Q 5: State the basic argument of the life cycle hypothesis. Answer in

about 60 words.
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6.7 LET US SUM UP

 Absolute Income Hypothesis was put forward by John Maynard Keynes

 According to Keynes, consumption increases as income increases, but
not at the way income increases. Keynes also holds the view that
household's current consumption expenditure is depends on the basis
of current income of the household.
 In short, Keynes has highlighted a fundamental psychological rule of
any modern society that when its real income increased, it will not
increase its consumption by an equal absolute amount, so that a greater
absolute amount must be saved. Keynes also identified the subjective
factors in decision making on saving.
 The psychologist and sociologists have acknowledged that individuals
care about their status in society.
 Duesenberry argued the utility of an individual derived from given
consumption level depends on its relative magnitude in society rather
than its absolute level.
 Dusenberry argued that utility index of an individual is depends on the
ratio of his or her consumption to weighted average of the consumption
of the others.

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 Duesenberry, in his relative income hypothesis argued that if relative

income of an individual remains same, the individual will spend the same
proportion of his income on consumption as he was doing before the
absolute increase in his income.
 When the income of individual falls, consumption does not fall as much,
this is called Ratchet Effect. The ratchet effect arises due to household's
resistance against the fall in consumption following a decrease in
household income.
 The Permanent Income Hypothesis was formulated by a Nobel Laureate
Milton Friedman in 1957.
 Friedman says that it is an income anticipated from human and non-
human. Income from human refers to income from human capital that
includes training, education, skill and intelligence. In short, income from
human capital is the income earned by selling the household labour. On
the contrary, income from non-human means income from assets like-
money, stocks, bonds real estate and consumer durables etc.
 The theory of life cycle hypothesis is associated with economist like
Franco Modigliani, Richard Brumberg and Alberto Ando.
 Life cycle hypothesis assumes that an individual earns relatively low
income at the beginning and at the end of his life. But the flow of income
remains high during the middle of his life. The individual maintains
increasing level of consumption in his entire life. But the present value
of his total consumption would not exceed the present value of total
income during his life time.
 The life cycle hypothesis also observes that in order to avoid the
fluctuations in income, people save their income especially during the
high income and dissave during the time of low income. If the probability
of future income increases, consumption also increases.

6.8 FURTHER READING

1) Ahuja, H. L. (2007). Macroeconomics: Theory and Policy. New Delhi: S.

Chand & Co.

Macro Economics - I 99
Unit-6 Theories of Consumption Function

2) Dwivedi, D. N. (2008). Macroeconomics: Theory and Policy. New Delhi:

Tata McGraw-Hill Publishing Co. Ltd.
3) Gupta, R. D. & Rana, A. S. (2009). Keynes and Post-Keynesian
Economics. Ludhiana: Kalyani Publisher.
4) Jha, R. (2008). Contemporary Macroeconomic Theory and Policy. New
Delhi: New Age International (P) Ltd.
5) Kurihara, K. K. (1986). Monetary Theory and Public Policy. New Delhi:
Kalyani Publishers
6) Rana, K. C. &Verma, K. N. (2014).Macro Economic Analysis. New Delhi:
Vishal Publishing Co.
7) Shapiro, E. (1988). Macroeconomic Analysis. New Delhi: Galgotia
Publications Pvt. Ltd.

6.9 ANSWERS TO CHECK YOUR PROGRESS

Ans to Q No 1: The basic difference between absolute and relative income

hypotheses is: the absolute income hypothesis holds that as the
absolute income of community increases, it will offer a smaller
proportion of its income towards consumptions and as a result, APC
will decline. On the other hand, relative income hypothesis implies
that if the income of the community increases, and the relative
distribution of income remains the same, then consumption would
increase by the same proportion.
Ans to Q No 2: According to the relative income hypothesis, when the
income of individual falls, consumption does not fall as much. This
is because people are aware about position in the society they live
in and they do not want to show the neighbors that they can no
longer afford to maintain the previous standard of life. This is called
as the Ratchet effect.
Ans to Q No 3: While calculating permanent income, one has to consider
both transitory income and transitory expenditure. Transitory income
consists of: income earned by people in the form of bonus to workers,
lottery wins etc. Similarly, transitory losses consists of unpaid sick

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Theories of Consumption Function Unit-6

leave, temporary loss of job, non-payment of wages due to strikes

and lockouts, short term fall in returns on the income earning assets
etc.
It is to be noted that transitory income is the gap between measured
income and permanent income and it can be either negative or
positive.
Ans to Q No 4: Two major criticisms levelled against the permanent income
hypothesis are:
 It assumes that the coefficient of correlation between transitory
component of consumption and transitory component of income is
zero. This is not real.
 The assumption that average propensity to consume of all households
remains same in long run, does not hold good; because consumption
of poor is higher relatively to their income while the saving of the
rich is higher relatively to their income. Even consumption differs
among the person with same level of permanent income.
Ans to Q No 5: Life cycle hypothesis assumes that an individual earns
relatively low income at the beginning and at the end of his life. But
the flow of income remains high during the middle of his life. The
individual maintains increasing level of consumption in his entire
life. But the present value of his total consumption would not exceed
the present value of total income during his life time.

6.10 MODEL QUESTIONS

A) Short Questions (Answer the following questions in about 150 words)

Q 1: Discuss the concept of absolute income hypothesis.
Q 2: Draw the major distinctions between the absolute and relative income
hypotheses.
Q 3: Discuss the concept of ratchet effect.
Q 4: Why hasthe theory of permanent income hypothesis been criticized?

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Unit-6 Theories of Consumption Function

B) Essay-type Questions (Answer the following questions in about 300-

500 words)
Q 1: Critically evaluate the theory of life cycle hypothesis.
Q 2: Make a comparative assessment of the relative income hypothesis
and the permanent income hypothesis.

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102 Macro Economics - I