Chapter Six: Consumption Function

6.1. Keynesian Consumption Function

Keynesian Consumption Function (also called Absolute Income Hypothesis) is written as:

C=C 0 +c 1 Y (6.1)

C
where 0 is autonomous consumption; part of consumption which remains constant. c 1 is
marginal propensity to consume; Y is disposable income in this particular case (not income),
and C is consumption.

Three key points:

C
1. The autonomous consumption ( 0 ) is part of consumption, does not change with income
and remains constant. It is an intercept of the consumption function.
dC
=
=c 1
2. Marginal propensities to consume dY or MPC and it has a value between zero and
one;0< c1 <1 . MPC is the slope of the consumption function. MPC >0 ; implies that as
income increases consumption increases. A one unit change in income brings c 1 unit
change in consumption. MPC <1 implies that propensity to save or (1−MPC )<1 . As
income increases, both consumption and saving increase. A one unit increase in income
brings, (1−MPC ) increase in saving.

3. Average propensity to consume

C C 0 +c 1 Y C0
APC= = =c 1 +
Y Y Y …. (6.2)

C
Equation (6.2) says, given 0 constant, APC falls as income increases. It is a slope of
curve that starts from the origin and crosses the consumption function at any given level
of income. According to the equation, as income increases; saving will increase with a
larger fraction of income. Average propensity to save is given by

Y −C 0 −c 1 Y C0
APS= =1−c 1 −
Y Y .... (6.3)

4. Consumption is predominantly determined by disposable income. Thus, there is a strong

positive correlation between consumption and income. Other factors such as interest rate
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do not have a visible role in determining the level of consumption.

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 Figure 6.1: Keynesian Consumption Function
C

C  C0  c1Y

C0
APC  c1 
Y
Y

6.2. Some critics against the Keynesian Consumption Function and the
Consumption Puzzle

Economists such as Simon Kuznets conducted a study based on cross-section data (household
level data for one period) and time series data (country level data for long-period) and found the
following. They found the following outcome. As income grew, the APC did not fall over time.
Consumption grew as fast as income; not less. Thus, APC=C / Y is very stable or constant in
the long-time series data. However, APC declines as income increases in the short-run cross
section data set. Because of this, possibly two different consumption functions curves could be
derived.

Figure 6.2: Short and Long-run Consumption Functions

C
Consumption function from long time series data with constant APC

Consumption function derived from cross-section household data with

6.3. Irving Fisher and Inter-temporal Choice

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This model assumes that consumers are forward-looking. They choose and decide on the present
and the future consumption level that maximize their lifetime satisfaction. In other words, they
assume that the decision that consumers make today on their level of consumption would affect
positively or negatively their future consumption. Assume that there is a typical consumer which
represents the consumption pattern of a country. The consumer’s choices over time are subject to
an inter-temporal budget constraint. The inter-temporal budget constraint is the total resources
available for both present and future consumption.

Assume that the representative household lives only into two periods: present period – Period 1
and future – Period 2.

In Period 1; the consumer earns income level Y1, of which she spends C1 for consumption and
saving, S1. Period 1 saving equals; S1 =Y 1 −C1 . If the consumer decided to forgo his current
consumption or want to save; she will have S1 > 0 . If she wants to borrow in period 1 from the
income she earns in Period 2, then S1 < 0 . Since the consumer lives only for two periods, she
does not have saving in the second period or S2 =0 .

The consumer spends her Period 2 income and Period 1 saving for her consumption in Period 2.

C 2=Y 2 +(1+r )S 1=Y 2 +(1+r )(Y 1−C 1 ) (6.4)

Equation (6.3) indicates that Period 1, saving(S 1 ) earns interest rate income (rS 1 ) and thus the
total saving of Period 1 in terms of Period 2 would become, (1+r )S1 . Thus, summation of value
of consumption in Period 1and value of consumption in Period 2 in terms of period 2 value of
money could be given as follows.

(1+r )C 1 +C 2=Y 1 (1+r )+Y 2 (6.5)

Divide both sides of Equation (6.4) by(1+r ) ;

C2 Y2
C 1+ =Y 1 +
( 1+r ) ( 1+r ) (6.6)

The left-hand side of Equation (6.5) gives the present value of lifetime consumption. The right
hand side of Equation (6.5) gives the present value of lifetime income. The present value of
lifetime consumption equals the present value of lifetime income. Graphically, the inter-temporal
budget constraint given in Equation (6.5) can be depicted by the following graph.
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Figure 6.3: Inter-temporal budget Allocation for Consumption
C2

Saving
Consumption = Income in both periods
(1+r )Y 1 +Y 2

Borrowing
Y2

Y1
C1
Y1  Y2 /(1  r )

The budget constraint (future value of present and future resources =(1+r )Y 1 +Y 2 or present
value of present and future income =Y 1 +Y 2 /(1+r ) shows all combinations of C1 and C2 that
exhausts all present and future resources of consumers. We should notice that if current period
consumption increases future period consumption declines; simply because current consumption
could increase if we borrow from second period income. If C 1 increases by ΔC 1 , then Period 2
dC 2 (−1+r )C1
= =−(1+r )
consumption declines by (1+r )ΔC 1 , then dC 1 C1 . Thus, the slope of the
inter-temporal budget constraint equals −(1+r).

On the other hand, consumers strive to maximize their lifetime utility by selecting a combination
of period 1 and period 2 consumptions.

2
U =∑ u( C t )
t =1 ; (6.7)

d (U t )
4

u '(. )= >0,
dC t . u ''(.)<0 ,
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Equation (6.6) says utility increases with increase in consumption (or u '(. )>0 ). The rate of
change in the marginal utility of consumption declines as consumption increases; implying the
existence of what is called diminishing marginal utility. Consumer’s preferences can be depicted
using indifference curves. An indifference curve represents consumer’s preferences over the
first-period and second period consumptions.

Figure 6.3: Consumer’s Preference

C2

A
C
B IC2

IC1
C1
As you have learnt in your microeconomics, an indifference curve gives the combinations of
consumptions in the two periods that make the consumer equally happy. Thus, all points such as
A and B on the first indifference curve (IC1) gives you a different combination of period 1
consumption and period 2 consumption levels that provides similar utility level or satisfaction.
However, utility tends to increase as the consumer moves towards an indifference curve to the
right (IC2). Thus, point C at IC2 gives a higher utility level and these points A and B; which are
found at a lower indifference curve, (IC1).

The consumer should not only consider the indifference curve that gives her the highest
satisfaction but also the amount of resources that it has or mobilize both at present and in the
future. Thus, the consumer achieves the highest possible (or optimal) level of satisfaction by
choosing the point on the inter-temporal budget constraint that is on the highest indifference
curve. At the optimum, the indifference curve will be tangent to the budget constraint.

Figure 6.4: Consumer’s Optimal Consumption Composition

C2
At this point, IC1 provides sub-optimal combination of period 1an

At this point, IC2 is tangent to the budget constraint line and thu
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IC2

IC1
C1
The effect of change in income on Consumption: We have indicated that first and second
period consumptions are determined by the lifetime (two periods’) income or resources. If either
first period or second period income increases, the budget constraint or line shifts outwards.
Response of consumption goods to changes in income differs from one good to another. There
are three broad categories of goods, inferior goods, normal goods and luxury goods. An inferior
good or service is any good or service for which demand falls with an increase in income and
rises with a decrease in income. A normal good or service is any good or service for which
demand rises with an increase in income and falls with a decrease in income. A luxury good or
service is any good or service for which demand rises proportionally faster than income. Given
these types of goods, let us assume that the consumer uses normal goods; type of goods or
services for which demand rises with an increase in income and falls with a decrease in income.
If this is the situation, the consumer will have a new optimal combination of consumption items
with a new indifference curve (IC3).

Figure 6.5: Consumer’s Optimal Consumption Composition

New Budget Constraint

New Optimal combinations

C
IC3
IC2
IC1

Real Interest Rate Effect on Consumption: Interest rate affects the inter-temporal budget
allocation or inter-temporal consumption. The impact of an increase in the real interest rate on
consumption can be decomposed into income and substitution effects. The income effect is the
change in consumption that results from the movement to a higher indifference curve. The
substitution effect is the change in consumption that results from the change in the relative price
of consumption in the two periods.

An increase or decrease in interest rate rotates the budget constraint and changes the intercepts.
For instance, if we assume that interest rate increases; this makes current consumption more
expensive in terms of interest income foregone. Thus, first period consumption declines and
second period consumption increases. The increase in interest rate makes the consumer a saver,
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not a borrower; he would become better-off and expected to move into a higher indifference
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curve. Let us assume that consumptions in both periods are normal goods. The income effect: If
 the consumer is a saver, the rise in real interest rate makes her better-off and this tends to
increase his consumption in both periods.

Figure 6.6: The Effect of Increased in Interest Rate on Consumer’s Optimal Consumption
Composition

Second-Period Consumption, C2
New Budget Constraint

Point B Income effect: Pont C –Point B

Substitution Effect
Point C
B
Point A
C 2
IC2
A

IC1
Y2

Initial Budget Constraint

C1
First Period
Consumption
Y1

Because the real interest earned on saving is higher, the consumer must give up less first period
consumption to obtain an extra unit of second period consumption. The substitution effect tends
to make the consumer choose more consumption in period two and less consumption in period
one. Thus, an increase in interest rate reduces C 1 and increasesC 2 . The consumer’s choice
depends on both the income and substitution effects. The two effects have opposite effects on
consumption. Thus, the increase in interest rate raises or reduces consumption. The same way,
depending on the relative sizes of income and substitution effects, interest rate either stimulates
or depresses saving.

Constraints on Borrowing

In the case of Keynes, consumption depends on current income. According to Fisher, the timing
of income does not matter because the consumer can either save or borrow. If she knows that her
income will increase, she can spread the extra consumption over both periods by borrowing in
the current period. If the consumer faces borrowing or liquidity constraint, she may not be able to
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increase current consumption and her consumption may behave as in the case of the Keynesian
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theory.
 Figure 6.7: Budget line with and without Budget Constraint
C2

C2

Y2
Budget line with no Budget line with borrowing constraint
borrowing constraint

Y2

C1
C1
Y1
Y1

Figure 6.8: Optimal Consumption Choice in Borrowing Constraint

Fig 6.8b: Borrowing is binding

Fig 6.8a: Borrowing is not binding

If the consumer thinks that optimal choice
C2 that maximizes his utility is at point D, he
C2

C1  Y1
could not achieve it. The consumer
cannot borrow; thus the best she can do it
to choose point E. , where C1 exhausts all
Y2 his current income.
A

C2 IC1 E
D

IC2

IC1
C1
C1 Y1
C1 Y1

6.4. The Life Cycle Hypothesis

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This theory is primarily contributed by Franco Modigliani (1950). According to the inter-
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temporal consumption theory that we just discussed, consumption is assumed to depend on

 lifetime income and consumers try to smooth consumption over their lifetime The Life Cycle
Hypothesis says that income varies systematically over the phases of consumer’s “life cycle”.
Saving allows the consumer to achieve smooth consumption.

Assuming that the consumer has initial wealth stock of W, a regular or constant annual income
until retirement, Y. The consumer has R years until retirement, and lives a total number of years.
T. Assuming that real interest rate is zero for simplicity and the consumer considers consumption
smoothing as an optimal decision. Based on the above information, the consumer’s lifetime
resource is given by:

LTR=W + RY (6.8)

To achieve smooth consumption, the consumer divides her resources equally over her life time:

C=(W +RY )/T (6.9) or

C=αW +βY (6.10)

where

α =1/ T is the marginal propensity to consume out of wealth and

β=R /T is the marginal propensity to consume out of income.

Life-cycle hypothesis has one important implication. It addresses or solves what is called the
consumption puzzle. According to the life-cycle hypothesis, the Average Propensity to Consume
(APC) is given by:

APC=C /Y =α(W /Y )+β (6.11).

Cross sectional effect of change in income on APC: Assuming that wealth does not change as
much as income across households, high income households would have a lower APC than low
income households.

Overtime effect: Both aggregate wealth and income grow together, and thus causes APC to
remain constant.

Birr

Wealth
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Income
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Saving
Income

Consumption Dissaving
Time
Retirement = R
6.5. The Permanent Income Hypothesis

The theory of Permanent Income Hypothesis (PIH) is due to Milton Friedman (1957). According
this theory, current income Y is the sum of two components. The first component is called
P
permanent income (Y ), an average income, which people expect to persist into the future. The
T
second component is transitory income (Y ), which is temporary deviations from average
income. Consumers use saving and borrowing to smooth consumption in response to transitory
changes in income; but consumption depends principally on permanent income.

C=αY P (6.11);

where α is the fraction of permanent income that people consume per year.

Permanent income hypothesis solves the consumption puzzle. APC in the PIH is given by

APC=C / Y =αY P /Y (6.12)

To the extent that high income households have higher transitory income than low income
households, the APC will be lower in high income households. Over the long-run, income
variations’ is due mainly, if not solely to variation in permanent income. If this the case, income
and permanent income will not vary significantly in the long-run, which implies a stable APC or
almost invariant APC.

What is the similarity and difference between PIH and LCH? In both theories, people try to
achieve smooth consumption in the face of changing current income. In the LCH, current income
changes systematically as people move through their life cycle. In the PIH, current income is
subject to random or chance or transitory fluctuations. Both hypotheses try explain the
consumption puzzle by their own.

6.6. The Random-Walk Hypothesis

The Random-Walk Hypothesis (RWH) is contributed by Robert Hall (1978). RWH is based on
Fisher’s model & PIH, in which forward-looking consumers base consumption on expected
future income as well. Hall adds the assumption of rational expectations, that people use
available information to forecast future variables like income. Assuming that PIH is correct and
consumers have rational expectations; consequently consumption will follow random walk: or
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changes in consumption becomes unpredictable.

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A change in income or wealth that was anticipated has already been factored into or considered
as expected permanent income, so it will not change consumption. Only unanticipated changes in
income or wealth that alter expected permanent income will change consumption.

Note: If consumers obey the PIH and have rational expectations, then policy changes will
affect consumption only if they are unanticipated.

The Psychology of Instant Gratification

Theories particularly from Fisher to Hall assume that consumers are rational and act to maximize
lifetime utility. David Laibson and others consider psychology of consumers as one the
determinants of consumption. Studies indicated that consumers consider themselves as imperfect
decision makers. They think that they do not save as much as they are supposed to do so for
retirement. Laibson argued that the “pull of instant gratification” explains why people do not
save as much as a perfectly rational lifetime utility maximize would save. Thus, psychological
instant gratification affects consumers’ consumption decision making.

6.8. Conclusion

The most fundamental contribution to the theory of consumption is Keynes, which assumes that
consumption principally depends on current income. Keynes indicated that MPC is between 0
and 1; APC falls as income rises. Empirical studies based in household level short-time series
data confirmed the Keynes’ conjectures or assumptions. However, the long-time serried data
indicated that APC does not fall as income rises.

Fisher’s theory of inter-temporal choice considers both income and interest rate as determinants
of consumption. Consumer chooses both current and future consumption to maximize lifetime
satisfaction subject to an inter-temporal budget constrain. Thus, current consumption depends on
lifetime income, not current income, provided that the consumer can borrow and save.

The Modigliani’s Life Cycle Hypothesis suggests that income varies systematically over the
lifetime of consumers. Consumers try use saving and borrowing to smooth consumption. Thus,
consumption depends on income and wealth.

Friedman’s Permanent Income Hypothesis says that consumption depends mainly on permanent
income; consumers use saving and borrowing to smooth consumption in the face of transitory
fluctuations in income.

The Hall’s Random-Walk Hypothesis combines PIH with rational expectations and concludes
the following: Changes in consumption are unpredictable; they only occur in response to
unanticipated changes in expected permanent income.
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