CONSUMPTION FUNCTION and hypothesis

In most of the world economies, consumer expenditure covers 50 % to 70 % of spending. Thus, it is not
surprising that consumer expenditure and the consumption function have been some of the most studied
topics in macroeconomics. To understand the nature of the consumption expenditure, we should first
understand the fundamental theories about consumption because modern research about the topic has
mainly been based on these theories .The fundamental theories of consumption are; absolute income
hypothesis (Keynes, 1936), relative income hypothesis (Duesenberry, 1948), permanent income
hypothesis (Friedman, 1957) and life cycle hypothesis (Modigliani, 1986)

Absolute Income Hypothesis: ( J.M.KEYNES )

Keynes’ consumption function has come to be known as the ‘absolute income hypothesis’ or theory.
His statement of the relationship between income and consumption was based on the ‘fundamental
psychological law’.

He said that consumption is a stable function of current income (to be more specific, current dis-
posable income—income after tax payment).

Because of the operation of the ‘psychological law’, his consumption function is such that 0 < MPC <
1 and MPC < APC. Thus, a non- proportional relationship (i.e., APC > MPC) between consumption
and income exists in the Keynesian absolute income hypothesis. His consumption function may be
rewritten here with the form

C = a + bY, where a > 0 and 0 < b < 1.

It may be added that all the characteristics of Keynes’ consumption function are based not on any
empirical observation, but on ‘fundamental psychological law’, i.e., experience and intuition.

Propositions of the Law

Proposition 1

When the aggregate income increases, consumption expenditure increases but by a somewhat
smaller amount
After the fulfillment of intense wants there is less and less pressure to raise consumption in proportion to the
increase in income.

ΔC<ΔY

MPC < 1

MPC is positive but less than unity (0 < MPC<1) in normal situation. This proposition is the core
of Keynes psychological law of consumption.
Proposition 2
An increase in income is divided in some proportion between consumption expenditure and saving. It means
that income increases will be partially consumed and partially saved.
This proposition is corollary to the first proposition, because what is not spent is saved.

Δ Y = ΔC + ΔS

Proposition 3
With the increase in income, both consumption and savings go up.
This means that increase in aggregate income will never lead to fall in consumption or saving than before. It
therefore, emphasizes the short run stability of the consumption function.

Table 1. Psychological Law of Consumption

Income (Y) Consumption (C) Savings (S)

0 40 -40

100 120 -20

200 200 00

300 280 20

400 360 40

500 440 60

600 520 80

Table 1. verifies the three propositions.

Income rises by Rs.100 and consumption rises by Rs.80. Thus it is 0.80.

Increase in income of Rs.100 in each case is divided between consumption and saving (Rs.80 & Rs.20).
With the rise in income both consumption and savings increase. Three propositions illustrated through the Fig.
1.
45º Line is the aggregate supply curve (Y = C+S). At zero level of income consumption is 0C. At 0Y level of
income, consumption is AY which is equal to 0Y savings are zero at point A on consumption curve.
When income rises from 0Y to 0Y1consumption also increases from AY to B1Y1 but this rise in consumption
is less than the increase in income by A1B1.When income increases to 0Y1 and 0Y2 it is divided into some
proportion between B1 Y1 and B2 Y2 (consumption) and saving A1 B1 and A2 B2respectively.
With rise in income to 0Y1 and 0Y2, consumption rises to B1 Y1 and B2 Y2 . B2 Y2>B1 Y1> AY. Savings also
rise. A2 B2>A1 B1> zero.
Savings gap increases as increment in consumption is less than the increment in income.

Assumptions of the Law

Constancy of the existing psychological and institutional complex

1. Keynes presumed a constant psychological and institutional complex.

In other words, consumption depends on income alone and institutional and psychological factors such as
income distribution, tastes, habits, fashion, customs, rate of population growth etc. are assumed to be constant.

2. Existence of normal conditions

This law assumes the existence of normal conditions in the economy. There are no abnormal and extraordinary
circumstances such as war, revolution or hyper inflation etc.

3.Prosperous Capitalist Economy based on Laissez faire

This law assumes a wealthy capitalist economy based on laissez faire that is a free economy in which there is
no government interference. People can consume goods according to their needs & desires.
Implications of the Law
 Relative Income Hypothesis: (J.S. Duesenberry)
Studies in consumption then were directed to resolve the apparent conflict and inconsistencies
between Keynes’ absolute income hypothesis and observations made by Simon Kuznets. Former
hypothesis says that in the short run MPC < APC, while Kuznets’ observations say that MPC = APC
in the long run.

One of the earliest attempts to offer a resolution of the conflict between short run and long run
consumption functions was the ‘relative income hypothesis’ J.S. Duesenberry in 1949. 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 RIH is based on two hypotheseis –

a) First is the relative income hypothesis ,and

b) Second is the past peak income hypothesis.

a) Duesenberry’s first hypothesis says that consumption depends not on the ‘absolute’ level of
income but on the ‘relative’ income— income relative to the income of the society in which an
individual lives. It is the relative position in the income distribution among families influences
consumption decisions of individuals.

A households consumption is determined by the income and expenditure pattern of his neighbours.
There is a tendency on the part of the people to imitate or emulate the consumption standards
maintained by their neighbours. Specifically, people with relatively low incomes attempt to ‘keep up
with the Joneses’—they consume more and save less. This imitative or emulative nature of
consumption has been described by Duesenberry as the “demonstration effect.”

The outcome of this hypothesis is that the individuals’ APC depends on his relative position in
income distribution. Families with relatively high incomes experience lower APCs and families with
relatively low incomes experience high APCs. If, on the other hand, income distribution is relatively
constant (i.e., keeping each families relative position unchanged while incomes of all families rise).
Duesenberry then argues that APC will not change.
Thus, in the aggregate we get a proportional relationship between aggregate income and aggregate
consumption. Note MPC = APC. Hence the R1H says that there is no apparent conflict between the
results of cross-sectional budget studies and the long run aggregate time-series data.

b) In terms of the second hypothesis short run cyclical behaviour of the Duesenberry’s aggregate
consumption function can be explained. Duesenberry hypothesised that the present consumption of
the families is influenced not just by current incomes but also by the levels of past peak incomes, i.e.,
C = f(Yri, Ypi), where Yri is the relative income and Ypi is the peak income.

This hypothesis says that consumption spending of families is largely motivated by the habitual
behavioural pattern. It current incomes rise, households tend to consume more but slowly. This is
because of the relatively low habitual consumption patterns and people adjust their consumption
standards established by the previous peak income slowly to their present rising income levels.

On other hand, if current incomes decline these households do not immediately reduce their
consumption as they find if difficult to reduce their consumption established by the previous peak
income. Thus, during depression consumption rises as a fraction of income and during prosperity
consumption does increase slowly as a fraction of income. This hypothesis thus generates a non-
proportional consumption function.

Duesenberry’s explanation of short run and long run consumption function and then, finally,
reconciliation between these two types of consumption function can now be demonstrated in terms of
Fig. 3.39. Cyclical rise and fall in income levels produce a non-proportional consumption-income
relationship, labelled as CSR. In the long run as such fluctuations of income levels are get
smoothened, one gets a proportional consumption-income relationship, labelled as CLR.

As national income rises consumption grows along the long run consumption, CLR. Note that at
income OY0 aggregate consumption is OC0. As income increases to OY1, consumption rises to OC1.
This means a constant APC consequent upon a steady growth of national income.

Now, let us assume that recession occurs leading to a fall in income level to OY0 from the previously
attained peak income of OY1. Duesenberry’s second hypothesis now comes into operation:
households will maintain the previous consumption level what they enjoyed at the past peak income
level. That means, they hesitate in reducing their consumption standards along the C LR. Consumption
will not decline to OC0, but to OC’1 (> OC0) at income OY0. At this income level, APC will be higher
than what it was at OY1 and the MPC will be lower.

If income rises consequent upon economic recovery, consumption rises along CSR since people try to
maintain their habitual or accustomed consumption standards influenced by previous peak income.
Once OY1 level of income is reached consumption would then move along CLR. Thus, the short run
consumption is subject to what Duesenberry called ‘the ratchet effect’. It ratchets up following an
in- crease in income levels, but it does not fall back downward in response to income declines.

Permanent Income Hypothesis: Milton Friedman

Another attempt to reconcile three sets of apparently contradictory data (cross-sectional data or
budget studies data, cyclical or short run time-series data and Kuznets’ long run time-series data) was
made by Nobel prize winning Economist, Milton Friedman in 1957. Like Duesenberry’s RIH,
Friedman’s hypothesis holds that the basic relationship between consumption and income is
proportional.

But consumption, according to Friedman, depends neither on ‘absolute’ income, nor on ‘relative’
income but on ‘permanent’ income, based on expected future income. Thus, he finds a relationship
between consumption and permanent income. His hypothesis is then described as the ‘permanent
income hypothesis’ (henceforth PIH). In PIH, the relationship between permanent consumption and
permanent income is shown.
Friedman divides the current measured income (i.e., income actually received) into two: permanent
income (Yp) and transitory income (Yt). Thus, Y = Yp + Yt. Permanent income may be regarded as
‘the mean income’, determined by the expected or anticipated income to be received over a long
period of time. On the other hand, transitory income consists of unexpected or unanticipated or
windfall rise or fall in income (e.g., income received from lottery or race). Similarly, he distinguishes
between permanent consumption (Cp) and transistory consumption (Ct). Transistory consumption
may be regarded as the unanticipated spending (e.g., unexpected illness). Thus, measured
consumption is the sum of permanent and transitory components of consumption. That is, C = C p +
Ct.

Friedman’s basic argument is that permanent consumption depends on permanent income. The basic
relationship of PIH is that permanent consumption is proportional to permanent income that exhibits
a fairly constant APC. That is, C = kYp where k is constant and equal to APC and MPC.

While reaching the above conclusion, Friedman assumes that there is no correlation between Y p and
Yt, between Yt and Ct and between Cp and Ct. That is

RYt. Yp = RYt . Ct = RCt. Cp = 0.

Since Yt is uncorrected with Yp, it then follows that a high (or low) permanent income is not
correlated with a high (or low) transitory income. For the entire group of households from all income
groups transitory incomes (both positive and negative) would cancel each over out so that average
transitory income would be equal to zero. This is also true for transitory components of consumption.
Thus, for all the families taken together the average transitory income and average transitory
consumption are zero, that is,
Yt = Ct = 0 where Y and C are the average values. Now it follows that

Y = Yp and C = Cp

Let us consider some families, rather than the average of all families, with above-average measured
incomes. This happens because these families had enjoyed unexpected incomes thereby making
transitory incomes positive and Yp < Y. Similarly, for a sample of families with below-average
measured in come, transitory incomes become negative and Yp > Y.

Now, we are in a position to resolve the apparent conflict between the cross-section and the long run
time-series data to show a stable permanent relationship between permanent consumption and
permanent income.

The line Cp = kYp in Fig 3.40 shows the proportional relationship between permanent consumption
and permanent income. This line cuts the CSR line at point L that corresponds to the average
measured income of the population at which Yt = 0. This average measured income produces average
measured and permanent consumption, Cp.

Let us first consider a sample group of population having an average income above the population
average. For this population group, transistory income is positive. The horizontal difference between
the short run and long run consumption functions (points N and B and points M and A) describes the
transitory income. Measured income equals permanent income at that point at which these two
consumption functions intersect, i.e., point L in the figure where transitory income in zero.

For a sample group with average income above the national average measured income (Y 1) exceeds
permanent income (YP1). At (CP1) level of consumption (i.e., point B) average measured income for
this sample group exceeds permanent income, YP1. This group thus now has a positive average
transitory income.

Next, we consider another sample group of population whose average measured income is less than
the national average. For this sample group, transitory income component is negative. At C p2 level of
consumption (i.e., point A lying on the CSR) average measured income falls short of permanent
income, Yp2. Now joining points A and B we obtain a cross- section consumption function, labelled
 as CSR. This consumption function gives an MPC that has a value less than long run proportional
consumption function, Cp = kYp. Thus, in the short run, Friedman’s hypothesis yields a consumption
function similar to the Keynesian one, that is, MPC < APC.

However, over time as the economy grows transitory components reduce to zero for the society as a
whole. So the measured consumption and measured income values are permanent consumption and
permanent income. By joining points M, L and N we obtain a long run proportional consumption
function that relates permanent consumption with the permanent income. On this line, APC is fairly
constant, that is, APC = MPC.

LIFE CYCLE HYPOTHESIS: Modigliani

Definition: The Life-cycle hypothesis was developed by Franco Modigliani in 1957. The theory states
that individuals seek to smooth consumption over the course of a lifetime – borrowing in times of low-
income and saving during periods of high income.

The graph
shows individuals save from the age of 20 to 65.

 As a student, it is rational to borrow to fund education.

 Then during your working life, you pay off student loans and begin saving for your retirement.
 This saving during working life enables you to maintain similar levels of income during your retirement.

It suggests wealth will build up in working age, but then fall in retirement.

Wealth in the Life-Cycle Hypothesis

The theory states consumption will be a function of wealth, expected lifetime earnings and the number
of years until retirement.

Consumption will depend on

 C= consumption
 W = Wealth
 R = Years until retirement. Remaining years of work
 Y = Income
 T= Remaining years of life

It suggests for the whole economy consumption will be a function of both wealth and income.

The implication is that if we have an ageing population, with more people in retirement, then
wealth/savings in the economy will be run down.

Prior to life-cycle theories, it was assumed that consumption was a function of income. For example,
the Keynesian consumption function saw a more direct link between income and spending.

However, this failed to account for how consumption may vary depending on the position in life-cycle.