income and consumption function

1. PANDIT JAWAHARLAL NEHRU COLLEGE OF AGRICULTURE AND
RESEARCH INSTITUTE KARAIKAL - 609 603
DEPARTMENT OF AGRICULTURAL ECONOMICS AND EXTENSION
AEC 504 MACROECONOMICS AND POLICY (2+0)
COURSE TEACHER: Dr. L. UMAMAHESWARI
PRESENTED BY
KRISHNANJANA KM
22PGA102

2. INCOME HYPOTHESIS

4. Keynes’s Psychological Law of Consumption
 Keynes put forward a psychological law of consumption, according to which,
as income increases consumption increases but not by as much as the
increase in income.
 In other words, marginal propensity to consume (MPC) is less than one.
1 > ∆C/∆Y > 0
 While Keynes recognized that many subjective and objective factors including
interest rate and wealth influenced the level of consumption expenditure, he
emphasized that it is the current level of income on which the consumption
spending of an individual and the society depends.

5.  As the statement mentioned about consumption behaviour, Keynes makes three
points.
 First, he suggests that consumption expenditure depends mainly on absolute
income of the current period, that is, consumption is a positive function of the
absolute level of current income.
 In other words in any period the rich people tend to consume more than the
poor people do.

6.  Secondly, Keynes points out that consumption expenditure does not have a
proportional relationship with income. According to him, as the income
increases, a smaller proportion of income is consumed.
 The proportion of consumption to income is called average propensity to
consume (APC). Thus, Keynes argues that average propensity to consume
(APC) falls as income increases.

7. Keynes’ consumption function
 The Keynes’ consumption function can be expressed in the following form:
C = a + bYd
 where C is consumption expenditure and Yd is the real disposable income which
equals gross national income minus taxes, a and b are constants, where a is the
intercept term, that is, the amount of consumption expenditure at zero level of
income. Thus, a is autonomous consumption. The parameter b is the marginal
propensity to consume (MPC) which measures the increase in consumption
spending in response to per unit increase in disposable income. Thus
MPC = ∆C/∆Y

8.  It is evident from Fig. 9.1 and 9.3 the
behaviour of consumption expenditure
as perceived by Keynes implies that
marginal propensity to consume (MPC)
which is measured by the slope of
consumption function curve CC at a
point is less than average propensity to
consume (APC) which is measured by
the slope of the line joining a point on
the consumption function curve CC to
the origin (that is, MPC < APC).

9.  This is because as income rises
consumption does not increase
proportionately and as income falls
consumption does not fall proportionately
as people seek to protect their earlier
consumption standards. This can be seen
from Fig. 9.3 the slope of consumption
function curve CC’ measuring MPC and
the slopes of lines OA and OB which
give the APC (i.e C/Y ) at points A and B
respectively are falling whereas slope of
the linear consumption function CC’
remains constant.

10.  This result also follows from the studies of family budgets of various families
at different income levels. The fraction of income spent on consumption by the
rich families is lower than that of the poor families. In other words, the rich
families save a higher proportion of their income as compared to the poor
families.

11.  The assumption of diminishing average propensity to consume is a significant
part of Keynesian theory of income and employment. This implies that as
income increases, a progressively larger proportion of national income would
be saved. Therefore, to achieve and maintain equilibrium at full-employment
level of income, increasing proportion of national income is needed to be
invested.

12.  If sufficient investment opportunities are not available, the economy would
then run into trouble and in that case it would not be possible to maintain full-
employment because aggregate demand will fall short of full-employment
output.
 On the basis of this increasing proportion of saving with the increase in income
and, consequently, the emergence of the problem of demand deficiency, some
Keynesian economists based the theory of secular stagnation on the declining
propensity to consume.

13. Duesenberry’s Relative Income Hypothesis
 The relative income hypothesis refers to a condition where individuals are
more concerned with their income and consumption than those around them
rather than the standard of living.
 American Economist James Duesenberry’s Relative income hypothesis was
first proposed in the Income, Saving, and the Theory of Consumer Behavior in
1949.

15.  According to this theory, people are more concerned with their income and
consumption compared to those around them than with their past income and
consumption patterns.
 Therefore, lower-income people may spend more of their earnings than their
peers of higher socioeconomic status to reduce the disparity in their
consumption levels and quality of living.

16.  The relative income hypothesis states that an individual’s attitude toward
consumption and saving is influenced more by their income than others.
 The level of consumption obtained in a previous time also influences current
consumption, in addition to current absolute and relative income levels.
 Once a family attains a certain level of consumption, they find it challenging to
lower it.

17.  According to Duesenberry, “the intensity of any individual’s desire to increase
his consumption expenditure is determined by the ratio of his expenditure to
some weighted average of the expenditures of others with whom he
interacts.”

18.  Duesenberry’s relative income hypothesis has four important components.
They are the following –
1. Individuals are more concerned with their relative well-being than their
absolute well-being.
2. Poor people spend a greater portion of their income than rich people to narrow
the consumption gap.
3. Current absolute and relative income levels and previous consumption levels
determine present consumption.
4.Consumption within a family is influenced by its income compared to other
families.

19. Diagram
 According to Duesenberry’s relative income hypothesis, consumption is not
very responsive to present income at any given time.
 People make decisions about their spending based on their relative income
situation.
 Their spending habits alter if their relative position changes as
their earnings increase or decrease over time.

21.  In the long run, the consumption falls to C1. Now income further falls to the I2
level, and consumption falls to the C2 level because people want to maintain
their previous standard of living. But supposedly, the income increases to I3 in
the long run. Then the consumption level reaches the C3 level only in the long
run and not in the short run.
 Thus the cyclical changes in the business cycles affect the consumption pattern
in the short run. Otherwise, only the long-run effects of consumption levels on
income are apparent.

22. Example
 A person earns $500 a month, and their consumption is $200 per month. Due to the
recession, their income falls to $300 and their consumption to $170. But after the
recession, the income steadily rises to $1000, and the consumption level rises to
$400. But it does not rise at the same rate as their income levels.
 The consumption patterns do not fall at the same rate as the decline in the income
levels because the consumption levels of low-income groups are relative to the
consumption levels of high-income groups. The low-income groups try to reduce
this gap by consuming at the same standard of living, and once the income reaches
a particular level, the consumption increases but not at the same level.

23. Absolute And Relative Income Hypothesis
 Absolute and relative income hypotheses have a few key differences between
them. Economist John Maynard Keynes introduced the former concept under
the theory of consumption. Economist James Duesenberry introduced the latter
concept under “Income, Saving, and the Theory of Consumer Behavior.”
 According to the absolute income hypothesis, an individual
allocates disposable income between spending and saving. In contrast, in the
relative income hypothesis, current income has little impact on consumption.
People spend in line with their relative income situation.

24. Milton Friedman’s Permanent Income Hypothesis:
 The 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.
 Milton Friedman developed this theory in 1957. According to him, individual
expectations influence consumer spending, and the expectations vary
depending on how consumers view the factors that impact future income.
 Hence, any policy decision affecting consumers’ perception of their long-term
income will increase their spending.

26.  Milton Friedman, who developed this theory, consumers view a certain income
level as their permanent income.
 Individuals’liquidity influences their consumption expenditure and income
management, per the permanent income hypothesis of consumption.
 Therefore, people not having an asset may already have the habit of spending
money irrespective of their present or future income.

27.  The theory suggests that if any economic policy manages to increase
consumers’ income level, their spending will not necessarily increase.
 An individual’s future earnings expectations also depend on their liquidity.
One who does not possess any asset may already have a habit of spending
money regardless of their current or future earnings.

28. Graph
 Friedman divided the current measured earnings or the actual income into two
categories — transitory income (YT) and permanent income (YP).
 Hence, Y = YP + YT. The transitory component has an estimated value of 0,
reflecting the assumption that future transitory losses offset the transitory gains
over time.
 As a result, observed income levels (Y) are equal to YP. Finally, according to
PIH, consumption expenditure is proportional to YP, i.e., C = kYP, where ‘k’ is
a constant representing the average propensity to consume or APC
and marginal propensity to consume or MPC.

30.  The theory describes the consumption function (shown with the blue line) as a
long-run consumption function in accord with the long-run behavior of
consumers.
 The transitory income for different earnings groups explains observed short-
run results of consumer behavior. Specifically, the theory assumes the
transitory income for groups of individuals with low income to be negative.
 This reflects the assumption that transitory losses are more than transitory
gains for these groups. This means YT < 0 or YTL < YPL.

31.  In the case of middle-income groups, the transitory income becomes 0 over
time, such that permanent and observed income have the same value. This
means YTM = 0 or YM = YPM.

32.  Lastly, in the case of high-income groups, the transitory gains are more than
the transitory losses such that the value of transitory income is positive on
average over time. This means YTH > 0 or YH >YPH.
 As one can observe in the graph, developing a short-run consumption function
(red line) is possible using this transitory component’s impact.
 The permanent income hypothesis of consumption offers a framework to
understand how households might react to the variations in earnings while
making consumption expenditure decisions in the near term.

33.  If individuals view the variations in income as transitory, the changes might not
impact consumer spending.
 On the other hand, changes in earnings perceived to be permanent can
significantly impact consumption expenditure immediately.

34. Example
 Suppose a worker expects to get a bonus at the end of the financial year. It
might be reasonable to think that his spending before receiving the bonus
might change in anticipation of the extra income. However, according to this
theory, he may choose not to spend more solely because of the windfall
income. Instead, he might want to increase his savings.

35. Criticism of Permanent Income Hypothesis
 APC is constant
 The MPC from transitory income is 0.
 Economists like Irving B. Kravis criticized Friedman’s theory for its
assumption of a constant APC. They maintain that households with low
permanent income levels are under more pressure than households having
higher permanent income levels.
 Theoretically, the APC of low-income households must exceed that of high-
income households. Hence, Kravis claimed that APC decreases as permanent
income rises.

36.  Various economists have criticized the theory’s assumption that MPC from
transitory income equals 0. This is because there’s a lot of evidence suggesting
that MPC from transitory income is positive. Earlier, the studies involved
analyzing the effect of windfall income. According to such studies, windfall
income increased consumption.
 As per recent studies, the MPC from transitory income is even more than the
previous studies. The new studies also suggest that MPC from transitory
income is less than that from permanent income.

37. Ando- Modigliani’s Life cycle hypothesis:
 Italian-American economist Franco Modigliani propounded the life cycle
hypothesis in 1954. Hence it was named the Modigliani life cycle
hypothesis. However, his student, economist Richard Brumberg, also
contributed to its development, for which both won Nobel Prizes
in economics.
 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.

39.  In other words, people like to maintain the same level of expenditure
throughout their life, either by taking credit or using their income.
 It forms a hump-shaped graph related to consumers’ savings and consumption
patterns.
 People spend money keeping in mind their future increase in income.
However, individuals save less in youth, more in middle age, and very little in
old age.

40.  Most people plan their retirement based on this theory. It is because they are
well versed in economic studies during the three stages of life- youth for loan
and expenditure, middle age for savings, and dissaving in retirement.
 Life-Cycle Hypothesis and Permanent Income Hypothesis differ in the aspect
of saving by people as in the former, and people tend to save and spend as per
their demographics. In contrast, in the latter, it does not.

41.  The life cycle hypothesis of consumption divides the life of a working
employee into three stages: youth, middle-aged and old age.
 Expenditures at all stages depend on their future incomes.
 Each stage has special characteristics associated with earning, saving, and
expenditure. These stages are discussed in the following table –

42. 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 with the
risk of getting
bankrupt.

43. Graph

44.  In the above chart, one observes that to maintain the level of consumption and
spending:
 People take loans in the early earning stage.
 People save from higher income, although they try to maintain the same
spending level.
 All the savings get spent on themselves, or dissaving happens at retirement.

45. Life Cycle Hypothesis & Permanent Income
Hypothesis
 Both theories deal with people’s saving and spending habits and get called
the permanent income hypothesis.
 But they remain different from each other in other aspects, as explained in the
table below:

46. Life-Cycle Hypothesis Theory (LCH) Permanent Income Hypothesis Theory
(PIH)
The life cycle hypothesis focuses more on
savings motives.
This hypothesis does not focus on the
motive for savings.
It tends to include wealth and income
both for consumption functions.
It gets based on the expectations of
individuals related to their savings.
LCH seems to focus on analytical
aspects of wealth
PIH theory is more empirically oriented
on income.
It takes into account the demographic
factor of workers.
It does not take any demographic factors
into account.
LCH theory has a fixed timeline: savings
and consumptions happen only during an
individual’s lifetime.
PIH works on the infinite timeline of
savings and consumptions for themselves
and their heirs after they die.
People tend to save for own self. People tend to save for own self and their
offspring as well.
It got formulated in 1954. It got formulated in 1957.

47. Criticism
 The theory fails to account for celebrities with sporadic income that tend to end
up bankrupt due to financial windfalls.
 It also wrongly assumes that individuals try to maintain all their spending
habits even if they have to take loans.
 It advocates that people only like to save and spend for themselves.
 It also supposes that the saving timeline will remain infinite.

48. Reference:
 www.wallstreetmojo.com
 https://www.richmondfed.org
 www.economicsdiscussion.net