CHAPTER SIX

CONSUMPTION

Chapter overview
• This chapter surveys the most prominent work on
consumption:
 John Maynard Keynes: consumption and current
income: Absolute Income Hypothesis
 Irving Fisher: Intertemporal Choice
 Franco Modigliani: the Life-Cycle Hypothesis
 Milton Friedman: the Permanent Income Hypothesis
 Robert Hall: the Random-Walk Hypothesis
 David Laibson: the pull of instant gratification
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 Keynes’s Conjectures
1. 0 < MPC < 1
* Based on surveyed households and collected data on consumption and
income; Households with higher income consumed more, which confirms
that the marginal propensity to consume is greater than zero. They also
found that households with higher income saved more, which confirms that
the marginal propensity to consume is less than one.
*In addition, these researchers found that higher-income households saved a
larger fraction of their income, which confirms that the average propensity
to consume falls as income rises. Thus, these data verified Keynes’s
conjectures about the marginal and average propensities to consume.
2. APC falls as income rises
where APC = average propensity to consume
= C/Y
3. Income is the main determinant of consumption

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The Keynesian Consumption Function

A consumption function with the properties Keynes

conjectured: C  C  cY
c
c c = MPC
= slope of the
C
1 consumption
function

Y
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 The Keynesian Consumption Function

• As income rises, the APC falls (consumers

save a bigger fraction of their income).
c C  C  cY
C C
APC    c
Y Y
C

slope = APC
Y

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 Early Empirical Successes:
Results from Early Studies
 Households with higher incomes:
 consume more
⇒ MPC > 0
 save more
⇒ MPC < 1
 save a larger fraction of their income
⇒ APC ↓ as Y ↑
 Very strong correlation between income and consumption
⇒income seemed to be the main determinant of
consumption
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 Problems for the
Keynesian Consumption Function
 Based on the Keynesian consumption
function, economists predicted that C would
grow more slowly than Y over time.
• This prediction did not come true:
 As incomes grew, the APC did not fall, and C
grew just as fast.
 Simon Kuznets showed that C/Y was very
stable in long time series data.

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The Consumption Puzzle

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•THE END

•THANK YOU!
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