ver since macroeconomics began as a field of study, many economists have
been trying to establish a relation between consumption and income of
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
2. His three conjectures are as follows:
where, MPC is Marginal Propensity to
b) Average Propensity to Consume (APC) falls as current
APC = (C/Y)
c) Current Income is the main determinant of current
3. Based on these conjectures, the current consumption function is
C C cY
C = Current Consumption
C(bar)=Autonomous Consumption (consumption at zero income)
c=Marginal Propensity to consume out on 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. 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,
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
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:
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.
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
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.
Permanent Income Hypothesis:a. Proposed by Milton Friedman in 1957.
b. As per PIH, current income (Y) is a function of two incomes,
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,
C = a.Yp
Where, a= constant that measures
the fraction of permanent income
e. In the long run, as proposed by PIH, the permanent income is
constant, hence, APC (C/Y) is constant. Thus, PIH solves the
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.
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.
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’
(instant gratification) causes people to save less than they
rationally know they should.