CHAPTER ONE

THEORIES OF CONSUMPTION
• Most of the economic activities are influenced
directly or indirectly by consumption.
• Consumption spending or consumption
expenditure refers to the total amount of
income used for or spent on either durable or
non-durable consumption goods
• Macroeconomists usually want to know or
explore factors that determine the consumption
of households.
 1.1 Keynesian Consumption Function
• explains the relationship between consumption and income
• It states that when income increases, consumption also
increases linearly.
• This hypothesis is also known as absolute income hypothesis
• stated that the current real consumer spending is a function of
current real disposable income
• The simple linear relationship C = a + cYd, where
c=MPC
• Autonomous real consumption of household ‘a’ indicates that
even if income is zero
• MPC represents the proportion of income that goes to
consumption
 Properties of Consumption Function
• Based on Keynes’ absolute income hypothesis the
consumption function has the following important properties:
A) MPC is between 0 and 1, i.e. 0 < C < 1
• MPC is between zero and one, person with very low income
may consume all his/her income. This is the maximum
possible proportion of income to be consumed where the value
of MPC is one
• a person with very large income for him/her it is
enough to consume only small proportion of his/her
income
• MPC = dC/dYd
B) MPC is less than the APC (Average propensity to
Consume), (MPC<APC).
. APC = C/Yd i.e the fraction of total income which is spent.
Simple Keynesian Consumption schedule

Disposable Consumpti APC MPC Saving

Income on (C) (=C/Yd) (=dC/dYd) (S=Yd – C)
(Yd)
50 87.5 1.75 0.75 -37.5
100 125 1.25 0.75 25
150 162.5 1.08 0.75 -12.5
200 200 1.00 0.75 0
• At low level of income, people spend almost all their income
for consumption purpose. This is because, the small amount of
income is not enough to use for saving and investment. In this
case the value of ‘APC’ = C/Y is close to one.
• as income increases and become excess to consumption
requirement, then only people will think about saving and
hence investing. As a result, a proportion of income goes to
consumption and rest on saving. In this case, the value of
‘APC’ = C/Y will be smaller than one because Y is greater
than C.
• Hence the APC is a declining function of income. In order
words as income increases average propensity to consumes
declines.
C) The APC falls as Income (Yd) rises
• This is because all extra income is not going to be consumed.
• At very low income a household may consume all of its income.
This implies that the ratio of consumption to income is high.
• As income increases the household begins to save part of its
income. This makes the ratio of consumption to income, APC
becomes smaller and smaller
D) At low levels of income dis-saving occurs (saving is negative)
• withdraw some of his/her earlier savings to cover his/her
consumption expenditure.
• Derivation of Saving function
• where there is efficient transfer of savings to investment
through borrowers by bank. At equlibrum level of saving is
equal to the level of investment; i.e. I = S.
• Yd = C + S And S = I
• write the aggregate demand or income as
• Yd = C + S But C = a + cYd where ,c =MPC
• Yd = a + cYd+ S
• S = Yd – a – cYd  S= -a + Yd - cYd
• S = -a + (1-c)Yd  S = -a + (1- MPC)Yd
• When Yd = 0 then S = -a which means that people’s saving is
negative.
• Marginal propensity to save(MPS = dS/dY ) equal to (1 - MPC).
• If MPC = dC/dYd is equal to 0.75, then MPS is equal to
(1 – 0.75 = 0.25).
• This proves an important relationship between MPC and MPS
in the economy.
• This implies that the sum of MPC and MPS equals one
(MPC + MPS = 1)
• This figure clearly put that both the consumption and saving
functions are positively sloped because both increase as income
increases even if the rates may different.
• The figure also shows that the consumption function has positive
intercept. The existence of positive intercept means that for a
person to survive there must be positive consumption even if
his/her income is zero.
• However, the saving function has negative intercept implying
that a person has borrowed or withdrawn his/her earlier savings
for the purpose of consumption during the period of zero income.

• Example Given consumption function of as C = 40 + 0.7Yd and

Find a) Saving function
b) MPC
c) MPS
 Simon Kuznets and the consumption puzzle
• After World War II, several economists cast doubt on the
usefulness and validity of Keynes consumption function. The
reason for this is that the Keynesian consumption function was
unable to predict the post war values.
• The estimations made by Keynes were much less than the actual
amounts. During this time Simon Kuznet published data for the
United states between 1869 and 1938 which appeared to be
linear, but the line started from the origin. This can be put in
equation form as C = cYd . In other words, ‘a’ was
approximately zero. And the value of ‘c’ is more than the
pervious Keynesian estimates.
• During the war national or government expenditures increase
implying increased income through multiplier effect. This in turn
leads to reduced average propensity to consume (APC) implying
depressed Consumption.
• During the war, things become expensive resulting in reduced
aggregate demand (AD). In principle, aggregate demand (AD) stays
in stagnation unless government uses corrective fiscal policy. For
instance, the government reduces tax and increases subsidy to
increase demand. However, the stagnation in aggregate demand is
not observed in reality
• The failure of secular stagnation and Kuznet’s finding proved that
average propensity to consume (APC) is stable over time (from
decade to decade) as opposed to Keynes’ conclusion.
• Initially, these points were supposed to be conflicting or negating
each other. But, later it was found that both findings were correct,
but in different time frames
• Due to this, on the empirical evidence, there appear to be two
consumption functions: short run (cyclical) and long run (secular)
consumption functions. This can be shown in the graph shown
below
• One interesting feature of these findings is that in both cases
marginal propensity to consume (MPC) is constant.
• In the case of the short-run consumption function, the average
propensity to consume decreases as income increases (we have
seen this in the table-6-2) representing Keynesian position
• whereas in the case of the long-run consumption function, the
average propensity to consume (APC) is constant representing
Kuznet’s position.
• What is referred to as Keynesian consumption puzzle is the failure
of Keynesians to identify that the consumption function has
different behaviors in different time frames (in the short run and in
the long run)
• it refers to the lack of clear idea or agreement whether the value of
average propensity to consume (APC) is constant or declining.
The Short-run and Long-run Consumption Function
• There is a final reconciling conclusion of the opposing results of
Kuznet and Keynes.
• In the short run, APC falls as income rises. This is because, in
the short run consumption does not immediately rise with
income. In the long run, the APC is stable or remains constant
because people tend to spend their money on durables as income
increases. Thus, Keynes’ theory is valid in the short run, but not
in the long run.
Shifts in the Short-run and Long-run Consumption function
 Theories of Consumption
I. Relative Income Hypothesis
.Under relative income hypothesis, consumption is a function of
current income relative to the highest level of income previously
attained.
. James. S. Duesenberry explained as he says that there is a strong
tendency in our societies for the people to emulate their neighbors and
to strive towards a higher standard of living.
. Duesenberry explained an interesting concept called demonstration
effect. A family with any given level of income will typically spend
more on consumption if it lives in a community in which that income
is relatively low than if it lives in a community in which that income
is relatively high
According to this theory (as it can be seen from the above
figure), when income of a person declines from Y1 to Y2, the
person will not consume C2 level; rather, he/she will consume a
higher level C1 by moving to on the short run consumption
function. This is because the decline in income makes him/her a
person with a relatively low income in the community and so
spends relatively more on consumption
• Normally, when a family lives in a locality with higher income
groups then the family with lower income spends more by seeing
the spending pattern of other families in the same locality. This
tendency arises in part from pressure on the family to ‘keep up with
the joneses’ and in part from the fact that the family observes the
goods and services used by the neighbors and try to purchase those
goods which are superior goods due to demonstration effect.
• For example, in a locality if somebody buys a colour television then
immediately one can see other families also buying the same
irrespective of their income. This is called demonstration effect
where they try to demonstrate by purchasing superior goods and
services.
 2. Fisher’s Intertemporal Model of Consumption

• the term ‘intertemporal’ that it is concerned with consumption plan

over time
• basic framework for modern optimization analysis of consumer
behavior.
• utility function, given as Ut = lnCt subject to a given income
constraint (Y). This function fulfills the usual properties of marginal
utility function A) MU = δUt /δCt = 1/ Ct > 0
and diminishing marginal utility condition
B) δMUt/δCt = δ2Ut/δCt2 = δ(1/ Ct) /δCt = -1/ Ct 2 < 0
Assumption
1. no bequest transferred from ones’ life time income to the next
generation such as daughter(s) or son(s).
2. expected life of a person is T years
• model is concerned about calculating curren’t consumption
which maximizes expected utility over the current and future
periods given the intertemporal budget constrain given by the
following identity
T T
Ct Yt

t  0 1  r 
t = 
t  0 1  r 
t

From this right hand, we can generalize that consumption

level of any two adjacent periods are related by the
following relation.
• Ct’ is consumption level at time t,
Ct-1’ is consumption level at time t-1,
Ct = Ct-1 ‘r’ is discount rate values of return from saving
‘σ’ is discount rate for consumption
• we can draw the following three major consumption patterns;
• increasing consumption time path,
• declining consumption time path and
• Constant consumption time path
• These consumption time paths depends on the values of return
from saving given by ‘r’ and the consumption discount return
from
1. If rate of interest is greater than discount rate (r > σ), then
current consumption will be greater than previous period’s
consumption (Ct > Ct-1,). In other words, current consumption
level is larger than the level of consumption in previous period.
Due to this, it is better for consumers to save now and consume
more in the future. This situation implies upward sloping
consumption curve.
2.If rate of interest is less than discount rate (r < σ), then current
consumption will be less than previous period’s consumption (Ct
< Ct-1). This implies that current consumption level is less than
the level of consumption in the previous period. Due to this, it is
better for consumers to consume more presently than saving
implying a downward sloping consumption curve.
3. If rate of interest is equal to discount rate (r = σ) , then current
consumption will also be equal to previous period’s consumption
(Ct = Ct-1) This condition implies that consumption level over
time (from one period to another) remains the same or equal.
Thus, consumer(s) will be indifferent between consuming and
saving, implying horizontal consumption curve.
 Consumption Time Path
•
 3 Modigliani Life Cycle Hypothesis
. F. Modigliani, Ando Albert and Richards Brumberg explained
the declining APC function based on Fisher’s consumption model
. They classified the society into different age groups. The main
argument is that income varies systematically over these age
groups.
. Consumers use saving and borrowing; and these situations
enable consumers to move income from those times in life when
income is high to those times when income is low.
. According to this assumption, a typical individual has an income
stream that is relatively low at the beginning (very young age)
and at the end of her/his life (during old age). The individual
might be expected to maintain more or less constant or perhaps
slightly increasing level of consumption. (See the figure below).
• This consumption path corresponds to the case where market
interest rate is greater than subjective discount rate (r > ) in
Fisher’s model. Modigliani considered time preference in
consumption by mentioning current preference is better than
delayed preference. Thus, the consumption curve is upward
sloping.
• : Life Cycle Consumption Hypothesis
• The model classified ages of individuals into three paths of age
(young, middle, and old age) and so called life cycle hypothesis.
According to the model, an individual is a net borrower in earlier
years of his/her life and saves during the middle age to repay young
age loans and to provide for old age consumption.
• In the model, consumption is linear while income is non linear
over time
• This is because individuals have no income or have very low
income during their young age,
• for instance, when they are in schools for training. However,
once they complete their education or training and get
employed they will get relatively larger income.
• During old age again people usually need recreation which
means the person has to work lower hours and as a result
receive lower income; or they may eventually retire from their
job.
 4. Permanent Income Hypothesis (Friedman Approach)
• income does not have a predictive trend
• theory people rather experience random and temporary
changes in their income from time to time.
• for Friedman consumption is not a function of current income
whereas function of permanent income
• . Income has two components
A. permanent income (Yp) :income that a person receives in
constant collection base
B. transitory or temporary income (YT); unanticipated income; it
may be positive or negative -earn less due to illness or natural
disasters - medical bill.
.
• There fore, permanent consumption and transitory
consumption
• These categories of income and consumption can be expressed
mathematically in the following way:
• Y = Yp + YT and C = Cp + C T
• major assumptions used by the economists who developed
the theory
1. The two income are uncorrelated meaning there is no
systematic or functional relationship between.
2. the transitory component of consumption is not correlated
with the transitory component of income. a negative
transitory component, it does not reduce its consumption in
response, nor, under the opposite circumstances, does it
raise its consumption
• under depressed consumption level (very low
permanent income), there is no much saving
and any rise in income goes to consumption.
In this case, consumption is a function of
current income rather than permanent
income.

• Figure 4-9:
Permanent income and transitory income
• The extra transitory income (YT) above the
trend of permanent income (YP) goes to
savings or purchase of durables for future
consumption. i.e. people usually save the
transitory income rather than to consume.
Thus, transitory income does not explain
consumption
• .