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# Consumption hypotheses

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Details of consumption theories

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### Consumption hypotheses

1. 1. Consumption Hypotheses E ver since macroeconomics began as a field of study, many economists have been trying to establish a relation between consumption and income of consumers. Few famous economists have proposed theories in this context, which are being discussed as follows:I. Keynes Model of current income and current consumption: 1. In his model, Keynes has proposed three conjectures, based on introspection and casual observations, rather than on statistical analysis. 2. His three conjectures are as follows: a) 0<MPC<1 where, MPC is Marginal Propensity to Consume. b) Average Propensity to Consume (APC) falls as current income rises. APC = (C/Y) c) Current Income is the main determinant of current consumption. 3. Based on these conjectures, the current consumption function is given as: C  C  cY Wherein, C = Current Consumption C(bar)=Autonomous Consumption (consumption at zero income) c=Marginal Propensity to consume out on current income Y=Current Income Problem with the hypothesis:1. Keynes had proposed a relation between current income and current consumption. All the anomalies (Failure of Secular stagnation prediction & Simon Kuznets’ findings) that arose were related to the second conjecture of Keynes model.
2. 2. 2. Consumption Puzzle – As Keynes model was based on short term predictions, APC was inversely proportional to income. But in the long run, APC was found to be constant. To solve this consumption puzzle, Irving Fisher proposed his model of Intertemporal choices, II. Irving Fisher’s Model of Inter-temporal Choices:1. In his model, Irving Fisher assumes consumers are forward-looking and chooses consumption pattern for the present & future to maximize his lifetime satisfaction. 2. He also assumes that the consumer’s choices regarding consumption are constrained by their budget, termed as Inter-Temporal Budget Constraint. 3. Irving Fisher’s model is basically a two-period model, i.e., a. Period 1: Present b. Period 2: Future 4. The inter-temporal budget constraint is given by: C1  C2 1r  Y1  Y2 1r Where, C1 & C2 are consumption in period 1, 2 Y1 & Y2 are incomes in period 1, 2 Savings in period 1, S=Y1-C1 (S<0 if the consumer borrows in period 1) Keynes had proposed that current consumption depends only upon current income, whereas, Fisher proposed that current consumption depends only on the present value of lifetime income and that the timing of income is irrelevant because the consumer can lend or borrow between periods. Hence, in Fisher’s model, interest rate was also taken into account. III. Life-Cycle Hypothesis:Proposed by Franco Modigliani, the life cycle hypothesis is derived from the Fisher’s model of inter-temporal choices. a. As per Fisher’s model, current consumption depends on the person’s lifetime income. Modigliani emphasized on the fact that
3. 3. income varies systematically (consumers plan for retirement) over people’s lives and that saving allows consumers to move income from times when income is high to times when it is low. b. As per LCH model, the consumption function is given as, C = (W + R.Y ) /T C = aW + bY Where, c= current consumption W= Initial Wealth R= years left for retirement Y=expected income till retirement T=lifetime in years a= 1/T= Marginal propensity to consume out of wealth b=R/T= Marginal propensity to consume out of income c. As per LCH, over time, aggregate wealth and income grow together, causing APC to remain stable. Thus, LCH model solves the consumption puzzle. IV. Permanent Income Hypothesis:a. Proposed by Milton Friedman in 1957. b. As per PIH, current income (Y) is a function of two incomes, namely, i. Permanent Income: It is the average income that people expect to persist into the future. Denoted by Yp. ii. Transitory Income: It is the random deviation from the average income. It is that part of the income which people don’t expect to persist into the future. Denoted by Yt. c. Thus, the current income is given as, Y = Yp + Yt d. As per PIH, current consumption depends primarily on permanent income, because consumers use saving and borrowing to smoothen out their consumption in response to transitory changes in income. Thus, the consumption function is given as,
4. 4. C = a.Yp Where, a= constant that measures the fraction of permanent income consumed. e. In the long run, as proposed by PIH, the permanent income is constant, hence, APC (C/Y) is constant. Thus, PIH solves the consumption puzzle. NOTE: As per both PIH & LCH, consumers try to smooth their consumption in the face of changing current income and both the models do solve the consumption puzzle as well. However, the two models differ from one another as LCH proposed that the current income varies systematically over their lifetime, whereas, PIH proposed that the current income is subjected to random transitory fluctuations. V. Robert Hall’s Random-Walk Hypothesis:a. Random walk model is based on Fisher’s model and PIH, i.e., forward looking consumers base their current consumption decision on their expected future income. b. RW model adds another assumption to these hypotheses, called as rational expectation, i.e., consumers use all available information to forecast future income. c. Thus, as RW model, if PIH is correct and consumers have rational expectations, then consumption should follow a random walk, i.e., the changes in consumption should be unpredictable. Any change in income that was anticipated has already been factored into expected permanent income, so consumption wouldn’t change. The consumption will change only because of unanticipated changes in wealth or income. VI. David Laibson & the Pull of Instant Gratification:a. All theories from Fisher to Hall assumed consumers to be rational and act to maximize lifetime utility. However, David Laibson brings in psychology of consumers too. It says, that consumers are not always rational and time consistent while making decisions for saving for future. b. Such behaviour of consumers is explained by the his theory of ‘Pull of Instant Gratification’, i.e., the desire to ‘have-it-now’
5. 5. (instant gratification) causes people to save less than they rationally know they should.