it describes about theories of consumption function

1. CONSUMPTION
FUNCTION

2. AGENDA
1. Absolute Income Hypothesis
2. Duesenberry’s Relative Income Hypothesis
3. Ando-Modigliani’s Life Cycle Hypothesis
4. Milton Friedman’s Permanent Income
Hypothesis.

3. ABSOLUTE INCOME HYPOTHESIS

4. Consumption function gives the relationship between Aggregate
income and Aggregate consumption.
Keynes laid stress on Absolute size of current income as a
determinant of consumption.
Keynes theory of consumption also known as Absolute income
theory of consumption.

5. Keynes framed the Fundamental Psychological Law of
Consumption

6.  The entire increase in income is not spent on consumption.
 Part of the increase in income is not consumed is saved.
 Consumption function (C) = a + bY
Where,
C = Consumption expenditure
a = Intercept
b = Slope (MPC) --- (Change in C / Change in Y)
Y = Income

7. APC = C / Y, (C = a + bY)
APC = a/Y + b
dAPC / dy = -a / y2
APC is decreasing function of income.
Savings is that part of income which is not spent on consumption.
Y = C + S
S = Y – C (C = a + bY)
S = Y – (a + bY)
S = -a + (1 – b)Y

9. S = -a + (1 – b)Y
MPS = dS / dY = 1 – b = 1 – MPC
MPC + MPS = 1
APS = S / Y = -a / Y (1 – b)
dAPS / dY = a / y2
APS is increasing function of income.

10. POLICY IMPLICATIONS
1. APS (S/Y) increases as income increases and MPC < APC. i.e., In
the short run when income increases, MPC and APC decreases but
MPC < APC.
2. During boom period in a business cycle C/Y ratio is smaller than the
average and greater than the average during slumps. So that in the
short run income fluctuates, MPC < APC.
3. In long run MPC = APC, C/Y Ratio is Constant.

11. DUESENBERRY’S RELATIVE INCOME
HYPOTHESIS

12.  James Duesenberry was an American economist born in 1918.
 He proposed the Relative Income Hypothesis in his book "Income,
Saving and the Theory of Consumer Behavior" published in 1949.
Basic Concepts or Assumptions
1. Individuals consumption patterns are influenced not only by their
absolute income but also by their income relative to others.
2. Consumption of a person does not depend on his current income but
on certain previously reached income level.

13. According to Duesenberry’s Utility function U=U(C0/R0,…CK/RK,…CT/RT)
Utility increases only if the individuals consumption raises relative to that of
the average.
It leads to the result that the individuals C/Y will depend on his position in
the income distribution.
When income (Y) of an individual is below the population average,
Consumption(C) remaining constant, income(Y) is less, C/Y ratio is high.
When income (Y) is more, C/Y ratio is low.
When income (Y) is equal to average population income, C/Y ratio is
constant.

14.  Present consumption of individual is not influenced merely by his current, absolute
and relative income but also by the levels of consumption during previous peak
period income Yp.
 Based on savings function,
 APS = S/Y = a0 + a1 Y/Yp
 When income(Y) increases relative to that of Yp APS will be more and vice-versa.
 When Y = Yp, APS = (a0+a1)
 When Y<Yp, APS will be less.
 APC = C/Y = (Y-S)/Y = 1-(S/Y)
 C = (1-a0) Y-a1 Y2/Yp ------------ Duesenberry’s Consumption function

15. RATCHET EFFECT
 Ratchet effect is an economic phenomenon when a process continues indefinitely
and has difficulty reversing its direction.
 process happens in a particular way continuously that it would be extremely
difficult to reverse the direction.

16. RATCHET EFFECT

17.  As income(Y) grows along LR, C/Y ratio is constant.

18. ANDO-MODIGLIANI’S LIFE CYCLE
HYPOTHESIS

19.  Italian-American economist Franco Modigliani propounded the life cycle
hypothesis in 1954.
 The life cycle hypothesis refers to an economic theory focusing on how
individuals spend and save money over their lifetimes.
 It motivates people to save for retirement during their earnings period instead of
spending all their incomes.
 In other words, people like to maintain the same level of expenditure throughout
their life, either by taking credit or using their income.
 However, individuals save less in youth, more in middle age, and very little in
old age.
 It forms a hump-shaped graph related to consumers’ savings and consumption
patterns.

21. Characteristic stages Youth Age Middle Age Old Age
Earning In this stage, individuals
tend to consume and
spend a lot. Hence, they
earn more and like to
take loans to maintain
their lifestyle.
In this stage, people like
to have stable finance for
their families.
The income becomes
zero, and dependency on
pension and savings
increases.
Expenditure Their expenditure
exceeds their income.
Here the expenditure
remains the same, but
their income gets
increases.
They still try to maintain
the level of expenditure
as before.
Savings Their savings become
negative.
They manage to save
some amount of money
from their income after
clearing all their debts.
All the savings get drawn,
or dissaving occurs to
maintain the expenditure.

22. MILTONFRIEDMAN’S PERMANENT INCOME
HYPOTHESIS.

24. Developed by Milton Friedman in 1957.
permanent income hypothesis definition refers to the theory that states
that consumers spend their earnings at a level in accord with their
estimated future income over the long term.
The theory suggests that if any economic policy manages to increase
consumers’ income level, their spending will not necessarily increase.

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26.  Friedman divided the current measured earnings or the actual income into two
categories — transitory income (YT) and permanent income (YP).