Consumption

Lecture IIIa

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 Introduction
In this chapter we will look at
• Determinants of consumption
• Early Keynesian Absolute Income Hypothesis
of consumption
• Friedman’s permanent income hypothesis

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 Determinants of consumption
• Income
– It has positive effect on consumption
• Wealth (e.g. physical or human capital)
– An individual (or community) having same income, but different
wealth, consume differently. More wealth, more consumption.
• Inflation
– Lower inflation allows more consumption maintaining the real
value of liquid assets.
– Higher inflation erodes the real value of liquid assets. People tend
to increase saving (decrease consumption) to maintain the real
value of liquid assets.
• Interest rate
– It has two opposing effects on consumption.
– It raises the rate of return on saving and produces a substitution
effect in favor of more saving and less consumption
– It makes it easier to accumulate a given sum of money and
thereby produces an income effect in favor of less saving and
more consumption.
– Direction of net effect is unclear!
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 The Absolute Income Hypothesis (AIH)
• AIH is derived from the analysis of Keynes in his
General Theory, ”The fundamental psychological
law ... is that men are disposed, as a rule and on
the average, to increase their consumption as
their income increases, but not by as much as the
increase in their income” (Keynes, 1936: 96)
• According to AIH, consumption is assumed to be
partly autonomous and partly related to current
(disposable) income, with a marginal propensity
to consume out of current income which is
positive but less than unity.
• That is, C = a +bY, 0 < b < 1.
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 AIH
• In AIH, the average propensity to consume (APC) gets
smaller as income rises. This results from the existence
of the autonomous component, which does not change
as income rises.
a
APC  C/Y (a  bY)/Y  b
Y
• AIH relates consumption to actual (absolute, or
measured) income with a constant MPC and a declining
APC.
• AIH is derived from Keynes’s work but it differs in that
Keynes thought the MPC would decline at higher levels
of income whereas the MPC in the AIH is constant.
• Stylized facts also conform to the predictions of AIH

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 The Permanent Income Hypothesis (PIH)
• People’s consumption depends in a proportional
manner, not on the income they actually receive
in the current period (absolute or measured
income) but to their ”permanent” or ”normal
income”.
• Permanent income is the income which people
expect to receive on a continuing basis.
• Friedman distinguishes b/n permanent income
(Yp), measured income (Ym) and transitory income
(Yt).
• That is, Ym = Yp + Yt, Yt ><0.

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 • He also distinguishes similarly b/n permanent,
measured and transitory consumption, although it
is less important since overall transitory
consumption will be zero with some people
spending more or less than normal!
• In an economic boom, Yt >0 and Ym>Yp, while in a
recession consumers as a group are likely to earn
less than normal (Yt<0) and Ym<Yp.
• PIH is thus a proposition that consumption is
proportional to permanent income. That is:

C  cY p , 0  c  1.

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 • This r/ship has the property that the MPC out of
permanent income is equal to the APC out of
permanent income, and neither MPC nor APC
varies with income.
• However, PIH assumes that people can borrow
without difficulty against expected future incomes
but if they cannot do so, consumption may be
constrained by current measured income and the
AIH may be more relevant.

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 The PIH with rational expectations
• The previous discussions were based on ”adaptive
expectations”, where consumers are thought of as
forming expectations of their permanent income on the
basis of current and past experience.
• However, this was displaced by ”rational expectations”,
which is that economic agents form their expectations as
if they were making predictions on the basis of correct
model of the economy, which includes the systematic
behaviour of the government as well as that of other
economic agents.
• Expectations are ”forward-looking” rather than
”backward-looking”.

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 • Using rational expectations, the PIH is still the same,
i.e., C  kY p , 0  k but
 1, Yp now is the rational
expectation of future income.
• According to rational expectations, expected
income is the best prediction that can be made on
the basis of the currently available information.
• The expectation can therefore change only if new
information becomes available which could not
have been predicted.
• Such new information must essentially random or
arbitrary, for otherwise it could have been
predicted.

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• The first key result is that consumption in one period must equal
to consumption in the previous period plus some random
element which reflects the impact on expectations for newly
available information.
• Technically, consumption ”follows a random walk,”, which means
no systematic trend (or cyclical movement) in any direction.
• The second key result relates to the size of short-run multiplier.
• In adaptive expectations-based PIH, the multiplier is relatively
small because people adjust their idea of permanent income
only slowly in response to the mistakes they find they have
made.
• In rational expectations-based PIH, e.g. Gov’t policy brings about
a change in expectations that will have a large and immediate
impact on consumption because expected income is adjusted
rapidly and fully.

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