INTRODUCTION

Consumption, savings and investment are the key macroeconomic aggregates which are

crucial in determining an economy’s equilibrium level of employment, and therefore, income.

A change in any of these aggregates will have a multiplier effect on the level of national

income. Therefore, to attain the macroeconomic goal of full employment, and consequently,

the attainment of the other goals of price stability, good balance of payment position and a

fair rate of economic growth, these three core aggregates must be stable and equitable.

For the purpose of this paper, we will focus on the issue of consumption, discussing the

concepts of consumption, the consumption function and theory, the extended hypotheses, the

determinants and implications.

CONCEPTS OF CONSUMPTION

Consumption can be defined as the act of using goods and services to satisfy human wants

and encompasses household expenditure on goods and services that yield utility in the current

period. This means that consumption expenditure refers to the expenditure on finished goods

and services produced within a given current time period.

Savings is a flow variable which is measured over time. According to Keynesian economics,

it refers to the difference between income earned and consumption. Savings, therefore, can be

defined as the amount of income, per time period, that is not consumed by economic units.

Within the households, savings is represented by that part of the disposable income that is not

spent on domestically produced or imported consumption goods and service; within firms, it

is represented by the undistributed business profits.

Keynesian economics stipulates that income is either saved or consumed. Keynes

Fundamental Psychological Law of Consumption says that an increase in the level of

income will lead to an increase in consumption expenditure but not by the same degree as the

increase in income and vice versa. Stemming from this, we can then say that for every unit

increase in income, a fraction is consumed and a fraction is saved. The fraction of additional

disposable income that is consumed is called the Marginal Propensity to Consume (MPC)

while the fraction that is saved is called the Marginal Propensity to Save (MPS).

The value of the MPC determines the size of the multiplier and is determined by the slope of

the linear graph of the consumption function. Therefore, MPC can be defined as the ratio of

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the rate of change in consumption to the rate of change of in income. Symbolically, it is

represented thus:

MPC = ∆C/ ∆Y

In line with Keynes Fundamental Psychological Law of Consumption, the value of the MPC

must lie between 0 and 1 i.e. 0<MPC<1.

The MPS is the slope of the savings function and can be defined as the ratio of the rate of

change in savings to the rate of change in income. Symbolically, it can be written thus:

MPS = ∆S/ ∆Y

Since, by theory, income is either saved or consumed, the fraction of a unit increase in

income that is saved is equal to the unit increase less the fraction that is consumed. Therefore,

symbolically, MPS can also be written thus:

MPS = 1 – MPC

Stemming from this, we can then say that the sum of the fraction of an increase in income

that is saved and the fraction consumed must equal the total increase in income i.e.

MPC+MPS = 1

Given a certain income, an individual will save some of it and use the rest for consumption

expenditure. The fraction of the TOTAL income that is spent on consumption and saved

refers to the Average Propensity to Consume (APC) and the Average Propensity to Save

(APS) respectively.

The APC is defined as the ratio of total consumption to total income and is represented

symbolically as

APC = C/ Y

The APS is defined, pretty much like the APC, as the ratio of total savings to total income. It

is represented symbolically as

APS = S/ Y

THE INTERTEMPORAL ASPECT OF CONSUMPTION BEHAVIOUR

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Economic theories of intertemporal consumption seek to explain people's preferences in

relation to consumption and saving over the course of their life. The first author to make use

of the preference maps in the study or intertemporal consumer choice was Irving Fisher. He

suggested that for such a choice to exist, there must, first, exist the possibility of substituting

a portion of one year’s income with the income of another year. He, along side Roy Harrod,

described 'hump saving', and hypothesized that savings would be highest in the middle years

of a person's life as they saved for retirement.

In the 1950s, more well-defined models built on discounted utility theory and approached the

question of inter-temporal consumption as a lifetime income optimization problem. Solving

this problem mathematically, assuming that individuals are rational and have access to

complete markets, Modigliani & Brumberg (1954), Albert Ando, and Milton Friedman

(1957) developed what became known as the life-cycle model (which will be discussed

subsequently). Their basic premise is that over time, the consumer allocates his consumption

expenditure in order to maximize his overall level of satisfaction. This model predicts that

people consume an annuity of their expected lifetime income at all points in their life. Thus,

the lifetime consumption profile was expected to be essentially flat, with people borrowing

against future earnings during their early study and working life when income is low, saving

greatly during their most productive working years and consuming saved assets during

retirement. Windfall gains would be treated the same way as an unexpected increase in

income - its lifetime annuity value would be consumed and the rest saved.

Attempts to test the life-cycle model against real world data have met with mixed success. In

a review of the literature, Courant, Gramlich and Laitner (1984) note "but for all its elegance

and rationality, the life-cycle model has not tested out very well." The main discrepancies

between predicted and actual behaviour is that people drastically 'under consume' early and

late in their lifetime by failing to borrow against future earnings and not saving enough to

adequately finance retirement incomes respectively. People also seem to 'over consume'

during their highest earning years, the elderly do not consume from their assets as would be

expected (particularly from their household equity) and also treat windfall gains in a manner

inconsistent with the life-cycle model. Specific alterations to the theory have been proposed

to help it accommodate the data; a bequest motive, capital market imperfections such as

liquidity constraints, a changing individual utility function over time or a particular form of

expectation as to future income.

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Behavioural economists have proposed an alternate description of intertemporal

consumption, the behavioural life cycle hypothesis. They propose that people mentally divide

their assets into non-fungible mental accounts - current income, current assets (savings) and

future income. The marginal propensity to consume (MPC) out of each of these accounts is

different. Drawing upon empirical studies of consumption, superannuation and windfall gains

they hypothesize that the MPC is close to one out of current income, close to zero for future

income and somewhere in between with respect to current assets. These differing MPCs

explain why people 'over consume' during their highest earning years, why increasing

superannuation contributions does not cause current savings to be reduced (as the life-cycle

model implies) and why small windfall gains (which are coded as current income) are

consumed at a high rate but a higher proportion of larger gains is saved.

THE CONSUMPTION FUNCTION

The consumption function refers to the functional relationship between consumption and

income. It expresses the functional relationship between consumption expenditure and all its

determinants. It is a single mathematical function used to express consumer spending. In its

simplest form, it is represented thus:

C = f (Yd)

Where

C = consumption

Yd = disposable income

The consumption function was developed by John Maynard Keynes and is detailed most

famously in his book The General Theory of Employment, Interest, and Money. The function

is used to calculate the amount of total consumption in an economy. It is made up of

autonomous consumption that is not influenced by current income and induced

consumption that is influenced by the economy's income level.

The simple consumption function is shown as the linear function:

C = c0 + c1Yd

Where

C = total consumption,

c0 = autonomous consumption (c0 > 0),

c1 is the marginal propensity to consume (i.e. the induced consumption) (0 < c1 < 1),

Yd = disposable income (income after taxes and transfer payments, or W – T)

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Autonomous consumption represents consumption when income is zero. In estimation, this

is usually assumed to be positive.

FACTORS DETERMINING THE CONSUMPTION FUNCTION

Broadly speaking, there are two categories of factors, which influence the level of

consumption and hence, the consumption function in the long run. They are

Objective factors.

Subjective Factors.

Objective factors:

These are those factors which depend on merits and facts. They are quantifiable factors that

determine how much of their disposable income people are willing to spend on consumption.

In this case personal factors will not come into picture. The following are some of the

important objective factors, which influence consumption.

Income Level: This is the main and singular most important factor that affects an

individual’s level of consumption. An individual must presently earn or must have

previously earned a certain level of income to be able to consume. According to

Keynesian Economics, consumption rises as income rises and vice versa.

Income Distribution: Those in the higher income bracket, who have already met

their basic needs, tend to spend less on such needs and so, invariably, spend less on

consumption. Those in the lower income bracket, however, have not yet met all of

their basic needs and so spend more of their income satisfying those needs. Therefore,

if the income distribution tends more towards the higher income bracket, the

aggregate consumption expenditure will fall.

Price Level: Recalling the law of demand that the higher the price, the lower the

demand and vice versa, we can say that the price level determines consumption, since,

for a commodity to be consumed, it must be demanded. If the general price level is

high, consumption expenditure will fall.

Availability of Credit Facility: Take, for instance, the US where individuals are

allowed a given value of credit which is equal to a percentage of their quoted monthly

income. This allows individuals to spend on present consumption and pay at a later

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date. The availability of this and/ or any other kind of credit facility will increase

consumption.

Cost of Credit: This refers to the interest on loans. At first glance, we can say that a

high interest rate will deter consumption on credit, thereby, having a negative effect

on consumption. On closer examination though, we see that the negativity of the

interest rate is outweighed by the benefit from the consumption of that particular

commodity at that particular time. For example, if a firm takes a loan of $10,000 from

a bank at an interest of 25% and uses that $10,000 to purchase goods which are sold

and yield a profit of 60%, the firm will enjoy a financial benefit of $3,500.

Fiscal Policy: The main tools of fiscal policy are taxation and government

expenditure. An increase in income tax, will reduce the disposable income of

individuals, thereby, reducing consumption expenditure and vice versa. An increase in

commodity tax by way of VAT and exchange duties will increase the price of

commodities and reduce consumption and vice versa. This means that taxation has a

negative effect on consumption expenditure. Government expenditure, on the other

hand, has a positive effect on consumption. Increased government expenditure by way

of transfer payments, production of public goods and services, unemployment benefits

etc, increase employment, the income level and psychologically, create an air of

relaxation, thereby causing people to spend more.

Stock of Durable Assets: This factor has both a negative and positive effect on

consumption expenditure. For example, a person who bought a car on the 1st of

November will not spend money on a car in the near future. This encompasses the

negative effect on consumption expenditure. However, the ownership of a car

necessitates the regular consumption of petrol. This encompasses the positive effect.

Therefore, we can say that the initial consumption of durable assets will have a

negative effect on consumption expenditure but the consumption of the necessary

complimentary goods and services which come with the previously consumed durable

asset, have a positive effect on consumption expenditure.

Wealth Holding: Wealth holding refers to the total value of a person’s net assets.

Take, for instance, a person who has saved up a lot of money and assets over the

years. He/she is under no pressure to save more money for future expenditures and so

will spend more of his or her current income in present time. Also, if this same person

decides to consume from his/her reserve, this will have a positive effect on the

aggregate consumption expenditure for that period. Also, if the value of the wealth

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increases, say as a result of higher interest on savings or an increase in the price of the

non-liquid assets the person owns, there is far less pressure to amerce more wealth

(save) so he/she will spend more. If, however, an individual has a low wealth holding

or does not decide to spend from his/her reserve (avarice) or if the value of wealth

reduces by way of calamities, low interest on savings etc, the reverse will be the case.

Other objective factors include:

Windfall (Sudden) gains and losses

The level of consumer Indebtedness,

Social and life insurances,

Business policies of corporations,

The objective factors generally remain unchanged in the short period. Thus, propensity to

consume in the short period is generally stable. It is because of this, Keynes places his

reliance on investment for the purpose of increasing employment during depression.

Subjective Factors:

These factors basically underlie and determine the form and amount of consumption. They

are internal or endogenous in nature and hence, not quantifiable. They depend mainly, upon

the personal decisions taken by the respective individuals as regards what to consume and

what amount to consume. Keynes, who also referred to this group of factors as the

psychological factors, listed eight main motives, which compel people to refrain from current

spending. They are the motives of precaution, foresight, calculation, improvement,

independence, enterprise, pride and avarice. In addition to these, he also added a list of

motives, which induce consumption, which includes enjoyment, short sightedness,

generosity, miscalculation, ostentation and extravagance. Also, peer group pressure,

social class stratification and consumer expectation/ taste may cause consumers to either

consume or not consume. Here are the explanations of some of these motives.

Precaution: This attribute refers to the need to be prepared for emergencies and

unforeseen calamities. Take for instance, a man who is concerned about accidents and

unforeseen emergences, he would engage in less immediate consumption than a man

who isn’t. Precaution causes the individual to save more of his/her income.

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Foresight: An individual who thinks and acts in terms of the long run benefits will

tend to save more. For example, a man who plans to get married five years after his

first day at work and who has a fair picture of how he wants he’s wedding to be will

tend to save more of his income in a bid to amerce enough to take care of his wedding

bills.

Calculation: Assuming a person calculates that she will need, say $100 in the next

two months to purchase, say, a new mobile phone. That person can calculate the

amount of money she needs to save, every day/week/month in order to have the $100

in two months and save accordingly. This will reduce the amount of money available

for consumption.

Independence: Take for instance, a young man who is dependent on his parents for

accommodation. To gain accommodative independence from them, he will have to

build a house or rent one. To do this, he would need to save up more of his money.

Avarice: Avarice is the insatiable need to accumulate wealth. A person with avarice

would like to make money and save it instead of spending it. Such a person may also

save more with the intention of bequeathing his/her wealth to successors.

Enjoyment: A person who likes to “enjoy each day to the fullest” will tend to spend

more than one who doesn’t.

Short sightedness: The inability to make long term plans and work towards them

make a person short sighted. Short sightedness causes a person spend more in a short

period.

Ostentation: By definition, Ostentation is a show of affluence in a bid to impress.

Obviously, an ostentatious person will spend much more of his/her income.

Extravagance: Some people are just spenders. Take for instance, the late king of pop,

Michael Jackson. He spent billions of money that he didn’t have and lived the latter

part of his years in debt. He passed on with a debt burden running into hundreds of

millions of dollars.

Peer Group Pressure: This refers to the influence on a person’s consumption, from

the other people whom he or she associates with. For instance, a person who earns

£20 a month but who has friends who earn £40 a month may be pressured into

spending more of his income in order to meet up with the lifestyle and company of

his/her peers.

Taste: A taste for more expensive variations of products which serve the same

purpose will cause more expenditure on consumption.

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The above determinants, objective and subjective, also double as the determinant of saving.

Empirical evidence from the Nigerian economy on the role of some of the factors in

influencing savings behaviour (and hence, consumption) is mixed. Iyaben, in a study of “the

determinants of Savings Behaviour in Nigeria; 1961 – 1980” found that the role of actual

price level in determining savings behaviour in the Nigerian economy cannot be said to be

strong. He also detected a somewhat positive relationship between expected inflation and the

level of personal savings. This is a finding which, according to him, appears to be consistent

with classical theory of savings. He also concluded that although the existence of savings

outlets (indicated by the number of bank offices) exhibited a positive relationship with

savings (meaning that a higher number of bank offices in Nigeria would encourage savings

culture), it was a significantly weak determinant. Furthermore, he found that the relationship

between income and savings was positive indicating that people were more willing and able

to save when they earned a higher income.

Howard, in the study of “Personal Savings behaviour and the rate of Inflation” found that in

the United Kingdom and the United States of America, expected inflation had a positive

effect on savings behaviour but the same variable had a negative effect on savings behaviour

in Japan within the same period covered in his study.

Also, a study undertaken by the World Bank showed that personal savings responded

significantly to substantial increases in interest rate.

THEORIES/ HYPOTHESES OF CONSUMPTION

Stemming from the importance of consumption expenditure in determining the size of a

nation’s aggregate income, accounting for an economy’s level of employment and the

attainment of other macroeconomic goals of a society, it is only natural that a number of

theories have been propounded to explain the determinants and behaviour of consumption in

the long and short run. The existing theories/ hypotheses are:

Absolute Income Hypothesis (AIH)

Relative Income Hypothesis (RIH)

Permanent Income Hypothesis (PIH)

Life Cycle Hypothesis (LCH)

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Absolute Income Hypothesis (AIH):

This is the first theory of consumption and was propounded by John Maynard Keynes. It is

often regarded as a fall out of his fundament psychological law of consumption. The AIH

only bases consumption on current income and ignores potential future income (or lack of).

In other words, it emphasises that an individual’s level of consumption is based upon the

absolute level of his current income. The hypothesis states that the level of consumption rises

with an increase in income but not to the same degree as the increase in income. This means

that the consumption-income relationship is not proportional.

Features of the Absolute Income Hypothesis

1. Consumption and savings are directly related functions of disposable income and

exhibit a stable relationship.

2. It is possible for consumption and savings to exhibit non-linear functions. The

graphical representation of this would show curves and we will find that MPC falls as

income rises and MPS rises as income rises.

3. The APC falls with increase in income but it is greater than the MPC. This results

from the existence of an intercept term in the consumption function, viz, the

autonomous consumption. The implication of this is that at very low income levels or

at zero income, consumption expenditure will be higher than income or will still exist

respectively.

Empirical investigations undertaken by James Tobin and Arthur Smithies in separate

studies, found that Keynes’s hypothesis was true ONLY in the short run. They found that in

the long run, the consumption-income relationship is relatively proportional. This was found

to be due to the influence of other factors, asides income, on long run consumption. Tobin

found that such factors as asset holding, introduction of new consumer goods, rural-urban

migration, and population of dependents cause the consumption function line to shift upwards

by almost the amount needed to produce a proportional consumption-income relationship

over the long run.

Consumption

CL

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B CS2

CS1

A

Income

Fig 1

The above figure (fig 1) shows the long run consumption-income function to be proportional

as we move along the long run curve, CL. At points A and B the APC and MPC are equal. CS1

and CS2 represent the short run consumption functions. Due to the factors stipulated by Tobin,

they tend to drift upwards, from point A to B along the long run curve.

In 1946, Simon Kuznets compiled and published estimates of aggregate consumption and

income for overlapping decades over the period 1869 – 1938. He, like Tobin and Smithies,

found that over a long period, the consumption-income relationship tends to be proportional.

This indicated a significant variation in the long and short run behaviour of consumption. In a

bid to explain this variation, a series of new theories were propounded, each one, replacing

the absolute current income with a variant of income.

Relative Income Hypothesis (RIH):

This theory was developed in 1949 by James Duesenberry and states that an individual’s

attitude to consumption and saving is dictated more by his income in relation to others than

by abstract standard of living. So an individual is less concerned with absolute level of

consumption than by relative levels. The percentage of income consumed by an individual

depends on his percentile position within the income distribution.

He argued that Keynes had mistakenly assumed that the consumption of one family or

individual was completely independent of another family or individual. If, for instance, the

AIH is applied to the behaviour of a cross section of individuals, it would imply that each

level of income would be related to a particular level of consumption expenditure. This

would mean that if an individual with an income of $50 consumes $40, another individual

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who previously earned $40 dollars and then enjoys an increment to $50 would also consume

$40 like the individual who initially earned $50. As a consequence, the APS would depend

solely on the absolute income. Duesenberry argued the unrealism of this independent nature.

He suggested the existence of a demonstration effect, which is the influence on an

individual’s consumption from the consumption of other individuals with whom he/she

relates. A rich individual would have a lower APC because he would need less of his income

to maintain his consumption pattern. A poorer individual, who may want to live up to the

standards of his rich counterparts, would have a higher APC since he would spend more of

his income on consumption. The high and low APCs of the poor and rich individuals,

theoretically, balance off in the long run and lead to the long run proportional consumption-

income relationship.

Secondly it hypothesises that the present consumption is not influenced merely by present

levels of absolute and relative income, but also by levels of consumption attained in previous

period. It is difficult for an individual or a family to reduce a level of consumption once

attained. The aggregate ratio of consumption to income is assumed to depend on the level of

present income relative to past peak income. Duesenberry argued the Keynesian assumption

that consumption is reversible. He stated that an individual or family would easily make

improvement in their expenditure but would have a hard time reducing consumption as a

result of reduced absolute income. Thus, as income falls, consumption falls but by a far less

degree than the drop in income. This is because the consumer ‘dissaves’ (spends from

savings/reserves) to fund consumption. On the other hand, a recovery period that leads to an

increase in income causes a gradual increase in consumption and a speedy increase in saving

in the bid to replace what was ‘dissaved’.

Both of Duesenberry’s arguments may be combined symbolically, thus:

Ct

Y t

=a−bY t

Y o

Where Ct = consumption at current time period

Yt = income at current time period

Yo = income at previous peak

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a = autonomous consumption (constant)

b = consumption function

In the above equation, the current consumption-income ratio is a function of the current

income-previous peak income ratio. If this ratio is constant, the dependent ratio will also be

constant. This is obtainable in periods of steadily raising income. During periods of

recession, when the current income falls below the previous peak income, the dependent ratio

will rise.

Graphically, the RIH is illustrated thus

Consumption

CL

E2 CS2

C2

CS1

C1 E1

Eo

IncomeO Y0 Y1 Y2

Fig 2

The above figure shows CL as the long run consumption-income relationship function and CS1

and CS2 as the short run relationship function. Assuming income is at the peak level of OY 1

where consumption is E1Y1 and income falls to OY0. Because the individuals have attained

the consumption level of E1Y1, consumption does not reduce to E0Y0. Instead, consumption

moves backwards along the CS1 curve to C1, indicating a less than proportionate reduction in

consumption as a result of the reduction in income. When the recovery starts, consumption

still moves sluggishly along the CS1 curve to E1. If income continues to rise to Y2,

consumption, after attaining the previous peak of E1 start to rise along the CL curve, to E2 on

the new short run function, CS2. If another recession occurs, having attained the consumption

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level of E2Y2, consumers’ consumption will decline sluggishly from E2 to C2 along the new

short run consumption function in response to the drop in income from Y2 to Y1 instead of

going back to the previous consumption of E1 when income was Y1.

The RIH suggests the following behavioural relationship between APC and MPC in relation

to the direction of the change in income:

1. If income grows at a constant rate, the APC and MPC will be equal and constant.

2. If current income falls below a previous income level, the APC would be rising and it

would be greater than the MPC.

3. If income rises but is still below a previous peak level income, the APC would decline

while the MPC would rise. However, the APC will still be greater than the MPC.

4. If income rises and is above a previous peak level income, the APC would be constant

while the MPC will move to be equal to the APC.

DEFECTS AND CRITICISMS OF THE RIH

A major defect of the RIH lies in its emphasis on the habitual behaviour and demonstration

effect arguments as the factors underlying consumption decisions. These factors are sharply

varied from the utility maximization assumption and the rational behaviour assumption of the

consumer theory.

The RIH assumes a proportional consumption-income relationship. However, increase in

income along the full employment level does not always lead to a proportional increase in

consumption.

Also, it assumes that the consumption-income relationship is direct. Historically, this has

been seen to not hold as recessions do not always lead to any decline in consumption. This

was the case during the US recessions of 1948 – 1949 and 1974 – 1975.

The theory is based on the assumption that the distribution of income remains almost

unchanged with the change in the aggregate level of income. If, with increases in income,

there is an upward redistribution of income, the general APC of both the rich and poor will

reduce. Thus the consumption curve will not shift upwards from CS1 to CS2 when income

increases.

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The greater the time elapsed between the peak income and the recession, the less the

reversibility of the consumption level. Even though we can see how a consumer consumed at

the previous peak period, it is not possible to say how he will spend it in the current time.

Also, the theory assumes that the present consumption level is dependent on the previous

peak income and neglects other factors such as wealth holding, urbanisation, new

consumption goods etc.

Another rather unrealistic assumption of the RIH is that consumers’ preferences are

interdependent, implying that a consumer’s consumption expenditure pattern is related to that

of his richer peer/neighbour, regardless of his/her income level. Empirical evidence from

Professor George Katona’s study revealed that expectations and attitudes play a significant

role in the consumer spending. According to him, these have a greater influence on consumer

spending than the demonstration effect.

The Permanent Income Hypothesis (PIH)

The PIH was developed by Milton Friedman as a solution to the contradiction between the

non-proportional short run n proportional long run consumption-income relationships. In its

simplest form, the hypothesis states that the choices made by consumers regarding their

consumption patterns are determined not by their current income but by their longer-term

income expectations. The key conclusion of this theory is that transitory, short-term changes

in income have little effect on consumer spending behaviour. Friedman, instead of current

income, uses permanent income as the income determinant of consumption. He split

consumption and income into permanent and transitory components. That is

Y = Yp + Yt

C = Cp + Ct

The sub-texts of p and t represent permanent and transitory, respectively.

By definition, permanent income is the amount a consumer can expend on consumption while

keeping his/her wealth intact. It is dependent on the time horizon and long sightedness of the

consumer and includes non-human wealth, the personal attribute of the consumer (attributes

of economic activity like occupation, geographical location etc). Permanent income is

determined by a consumer's assets; both physical (shares, bonds, property) and human

(education and experience). These influence the consumer's ability to earn income. The

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consumer can then make an estimation of anticipated lifetime income. Transitory income, on

the other hand, refers to the difference between permanent income and the measured income.

Friedman concluded that the individual will consume a constant proportion of his/her

permanent income; and that low income earners have a higher propensity to consume; and

high income earners have a higher transitory element to their income and a lower than

average propensity to consume.

In Friedman's PIH model, the key determinant of consumption is an individual's real wealth,

not his current real disposable income. The theory is based on the following assumptions:

1. There is no correlation between transitory and permanent incomes

2. There is no correlation between transitory and permanent consumptions

3. There is no correlation between transitory income and transitory consumption

4. Only differences in permanent income affect consumption systematically

According to the PIH, people with a measured income that is higher than their permanent

income will consume smaller fractions of their measured income than those with a measured

income that is less than their permanent income. We get a short run consumption function,

thus: C = a + bY where bY measures the difference in consumption associated with income

differences.

The value of bY is given as bY= k. PY where k is the ration of permanent consumption to

permanent income, which is a constant and PY is the proportion of difference in measured

income that is attributed to difference in permanent income.

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0

E1E2

E0

E4

E3

CL

C2

C0

C3

CS

Y3 Y4 Y0 Y2 Y1

Fig 3

In figure 3, CL is the long run consumption function, representing the proportional

consumption-income relationship. The various transitory incomes cancel out to create

proportionality between the permanent income and consumption relationship. CS is the non-

proportional short run relationship and consists of permanent and transitory components. At

point E0, changes in permanent and measured income are equal and income is equal to 0Y0

while consumption is 0C0. At this point, transitory factors do not exist. A movement to point

E3 on the short run curve shows a decrease in income to Y3 as a result of negative transitory

factors. The permanent income of 0Y4 is greater than the measured income and so,

consumption stays at 0C3. This shows that when the permanent income is higher than the

measured income, consumption will remain higher than the measured income as a result of

the relative stability of the permanent income which does not allow measured consumption to

decline at the same rate as the decline in measured income, since the individual’s wealth

position is unchanged. On the other hand, if there is a rise in measured income to 0Y 1,

causing a movement along the short run curve to point E1, consumption rises to 0C2. This new

consumption level, however, can be maintained at the permanent income level of 0Y 2 at point

E2 on the long run curve. This is as a result of the positive transitory components of the rise in

income. Thus, from the above analysis, we can then say that Y3Y4 represents the negative

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transitory income component i.e. windfall loses and Y2Y1 represents the positive transitory

income component i.e. windfall gains.

POLICY IMPLICATIONS OF THE PIH

Unless the consumer views an income increase as permanent rather than transitory, a change

in income will not necessarily have an appreciable effect on their consumption behaviour. For

policies designed to affect disposable income, the implication is that, unless the consumer is

able to adjust their expenditure in response to an income change, regarding such a change as

permanent rather than transitory, the desired effect of the policy will not be achieved.

DEFECTS AND CRITICISMS OF PIH

The major defect of the theory is the difficulty in observing the permanent income variable.

The elusive nature of the key variables of permanent income and permanent consumption,

make them difficult to isolate and statistically verify. The permanent income is determined by

past experiences and expectations and these determinants change, thereby causing a change

in the permanent income.

The PIH assumption of no correlation between measured income and consumption does not

conform to the basic laws of consumer behaviour. The assumption implies that, given and

increase or decrease in income, the consumption level does not increase or decline

accordingly as the individual would immediately save or ‘dissave’. In reality though, a person

who gains sudden extra income does not head to the bank to save it all...he/she enjoys all or

part of extra income on his/her present consumption. In the same vein, a person who, for

instance, gets robbed of his/her wallet, does not head straight to the bank to withdraw the

same amount of money, instead he reduces or postpones his immediate consumption.

The theory says that the APC of all individuals are equal, irrespective of their income level.

This is against the ordinary observed behaviour. A lower income earner tends to save far less

than a higher income earner in order to meet his immediate necessities. Even among

individuals with the same level of income, for mainly subjective reasons, the saving and

consumption patterns vary.

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Also, Friedman did not differentiate between human and non-human wealth and includes

income from both in a single term in his analysis. Also, he did not clearly state what sort of

income changes may be considered transitory and what sort can be considered permanent.

Life Cycle Hypothesis (LCH)

The Life Cycle Hypothesis (LCH) is an economic concept analysing individual consumption

patterns. It was developed by the economists Irving Fisher, Roy Harrod, Albert Ando and

Franco Modigliani.

Unlike the Keynesian consumption function, which assumes consumption is entirely based on

current income, LCH assumes that individuals consume a constant percentage of the present

value of their life income. The life-cycle model also predicts that individuals save while they

work in order to finance consumption after they retire. Miller, however, carried the stable

consumption pattern by observing that people would try to stabilize consumption over their

entire lifetime. He stressed that the way consumers save their YP is based on forward looking

expectations, therefore, an individual’s consumption over his/her lifetime should be equal to

Individual Y + Holding of assets that come from sources other than work, e.g. gifts.

As, according to the theory, consumption is a function lifetime expected income of the

consumer, the consumption of the individual can be said to be dependent on the available

resources, the rate of return on capital, the spending plan and the age at which the plan is

made (in relation to the retirement age of the individual). The theory makes the following

assumptions:

1. There is no change in price level during the life time of the consumer

2. Interest rate is stable throughout the consumer’s life time

3. The consumer doesn’t inherit any assets and his net assets are as a result of his own

savings.

The Life Cycle Hypothesis can be explained by the equation

C = (W + RY) / T ........................................................................................... eqn 1

Where W = Initial endowed wealth

R = Retirement age

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W0W1

Y0 Y1

C2

C1

C0

Y = Income

T = Number of years of the individual's lifespan.

Rewriting eqn 1, we obtain

C=( 1T )W +( R

T )Y ...............................................................................................eqn 2

If every individual plans their consumption in such way, the aggregate consumption function

of the economy, will take the form

C = aW + bY...................................................................................................eqn 3

where a = the marginal propensity to consume out of accumulated wealth

b = the marginal propensity to consume out of income

Example

Fig 4: Depiction of a consumption function

The short run consumption function, W0, represents the initial endowed wealth level of the

consumer. In the short run, an income increase will lead to a consumption increase, as

represented by the shift from C0 to C1. In the long run, this will increase the consumer's

income from Y0 to Y1 and will cause an increase in the consumer's wealth level. This, in turn,

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Y0

C

SB

Y1

C1

Y

Consumption

Time (age)

0 T1 T2 T

C1Y

Early life Middle ageRetirement age

will cause an upward shift of the consumption function, as shown by the shift from W0 to W1.

This implies an increase in consumption from C0 to C2 instead of C1. Connecting the

coordinates C0Y0 and C2Y1, we derive the upward sloping long run consumption function.

Fig. 5

The consumer’s aim of maximizing his utility over his lifetime depends on the total resources

available to him during his lifetime. As a rule, an individual has the highest income at his mid

ages, when he/she has income earning abilities like knowledge, skill, qualification, physical

health etc. As a result, the consumption level, throughout his life, is somewhat constant or

rises slightly. This is illustrated in fig 5 by line CC1. The arced curve, Y0YY1 shows the

individual’s income flow through his lifetime, 0T. During the early life period (0T1), the

individual’s consumption level is at CB which is greater than the income, Y0B. At this stage,

the area CY0B is ‘dissaved’ to sustain the individual’s consumption, which is fairly stable. In

the middle age period of the consumer, T1T2, he earns income as high as point Y but has a

consumption level that is fairly constant and equal to his lowest possible income during this

middle age period. This consumption is shown by BS. Since the individual’s consumption is

depicted by area BST2T1, the area BSY signifies the individual’s savings. In the individual’s

old age, the retirement age, T2T, he no longer has enough physical strength to work but he

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still consumes SC. This consumption is funded by his middle age savings and entails a

‘dissaving’ equal to area C1SY1.

DEFECTS AND CRITICISMS OF THE LCH

The major fall back of the LCH is a lot like that of the PIH. The inability to observe life cycle

income makes it difficult to empirically test the hypothesis. Furthermore, as no one knows

exactly how long they will live, it is difficult to know exactly what level of savings would be

sufficient for the retirement period. Also, the theory does not specify the age points that

signify the entry into middle age or retirement age.

The assumption that a consumer plans his consumption over his life time is unrealistic

because observed behaviour show that consumers are concerned with their present needs and

immediate future needs. Also, the theory ignores the fact that a person’s attitude towards life

affects his/her consumption. Given the same assets and income, two people, even within the

same geographical area will have a varying consumption pattern.

However, of all the theories discuss previously, the LCH is the most superior (although it has

not being subjected to rigorous empirical verification) because it not only includes assets as a

variable in the consumption function, but it also explains why MPC < APC in the short run

and APC is constant in the long run.

CONSUMPTION AND SAVINGS UNDER CERTAINTY

Consumption/saving under certainty refer to the saving/consumption decisions of an

individual, who can anticipate the future with certainty. From the previously discussed

theories, this should encompass the PIH and the LCH; indeed, in some text books, both

theories are only discussed under the concept of consumption under certainty.

Assumptions

1. Consumption is the only source of individual utility.

consider an individual who lives for T periods and has a lifetime utility of

U=∑t=1

T

u(C t), U’(C) > 0, U”(C) < 0

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2. Both interest rate and discount rate are zero.

3. Borrowing or lending is allowed provided that repayment is ensured. The individual’s

budget constraint is:

∑t=1

T

C t ≤ A0+¿∑t=1

T

Y t ¿

where A0= initial wealth

Yt = labour income

Behaviour

The Lagrangian for the maximization problem is:

L=∑t=1

T

u (Ct)+ λ¿ + ∑t=1

T

Y t- ∑t=1

T

C t ¿

The first-order condition for Ct is:

∂ L∂ C

=0⇒U ' (C t )=λ

Marginal utility is constant for all t. Since the level of consumption uniquely determines its

marginal utility, consumption is equal across all periods:

C1 = C2 = ... ... = CT

Substituting into the budget constraint yields:

C t=1T

¿ + ∑t=1

T

Y t ¿¿

The term in parentheses is the individual’s total income, thus, the individual divides lifetime

resources equally among life periods (PIH)

Implications

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1. A rise in wealth by A1, raises consumption only by A1

T

2. A temporary tax will have little effect on consumption

3. Saving is affected substantially

St = Yt – Ct = [ Yt - IT∑t=1

T

Y t ¿¿− 1T

A0

saving is high when income is high relative to permanent income, and negative when

current income is less than permanent; thus, the individual uses saving and borrowing

to smooth the path of consumption (PIH and LCH)

4. Wealthy individuals save higher fraction of their incomes than the poor do.

5. Individuals adjust their consumption to follow that of other.

Empirical Application: Understanding Estimated Consumption Functions

According to Keynes:

- The amount of aggregate consumption depends mainly on the amount of aggregate income.

- Higher absolute level of income leads to a greater proportion of income being saved.

Testing, empirically, Keynes’ theory of a consistent stable relationship (between

consumption and current income)

Case 1: Across households at a given point in time, the Keynes’ arguments hold. So if we

plot a consumption function it will be like:

C

C= a + bYa > 0, b < 1

Y

Case 2: Aggregate consumption within a country over time is a proportion of aggregate

income.

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C

Y

C = bYB

C

Y

White

Black

Case 3: Cross-section consumption function differs across groups. For example, the slope of

the estimated consumption function is similar for whites and blacks, but the intercept is

higher for whites.

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CONSUMPTION AND SAVINGS UNDER UNCERTAINTY (THE RANDOM WALK HYPOTHESIS: RWH)

Consumption and savings under uncertainty refers to consumer decisions, when there is no

absolute certainty for the future, which is often the case in reality. The RWH was introduced,

in 1978, by Robert Hall, in response to the Lucas critique. He incorporated the idea of

rational expectations into his consumption models and sets up the model so that consumers

will maximize their utility. The model uses the Euler equations to model the random walk of

consumption and has become the dominant approach to modelling consumption.

Considering a two-period case, the Euler equation for this model is

  

  

(1)

where δ is the subjective time preference rate,

r is the constant interest rate,

E1 is the conditional expectation at time period 1.

Assuming that the utility function is quadratic and δ = r, equation (1) will yield

E1c2 = c1   

  

(2)

Applying the definition of expectations to equation (2) will give:

c2 = c1 + ε2   

  

(3)

where ε2 is the innovation term.

Equation (3) suggests that consumption is a random walk because consumption is a function

of only consumption from the previous period plus the innovation term.

The use of the Euler equations to estimate consumption has being shown to have advantages

over traditional models. On the one hand, it is significantly simpler than the conventional

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methods. This avoids the need to solve the consumer's optimization problem and is the most

appealing element of using Euler equations to some economists.

The RWH makes the following assumptions:

1. Both interest rate and discount rate are zero.

2. Individual wealth is such that the marginal utility of consumption is positive:

U’(C) > 0, C > 03. Individual budget constraint:

∑t=1

T

C t ≤ A0+¿∑t=1

T

Y t ¿

The implication of this theory is that If consumption is expected to rise, current marginal

utility of consumption is greater than the

expected future marginal utility of consumption and thus the individual is better off raising

his current consumption. The individual adjusts his current consumption to the point where

consumption is not expected to change.

CRITICISM OF RWH

The major critic of the RWH is its inability to uncover consumer preference variables such as

the intertemporal elasticity of substitution. Controversy has arisen over using Euler equations

to model consumption because of the trouble of explaining empirical data when the Euler

consumption equations are applied.

CONSUMPTION AND RISK ASSETS

Assume that individuals can invest in many assets i with different return ri. If an individual

reduces consumption in period t by an amount and uses the resulting saving to raise

consumption in period t+1, at the optimum this change should leave expected utility

unchanged, using the Euler equation.

u' (Ct )= 11+ p

Et [ (1+rt+ii )u' (C t+1)] for all i

⇒u' (Ct )= 11+ p

¿

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For quadratic utility,

u (C )=C−a2

C2∧u' (C )=1−aC

⇒ u' (Ct )= 1

1+ p¿}

Implications:

1. The variance of single asset returns does not affect the holding of an asset: the

individual is not concerned with how risky the asset is, considers only the asset’s

expected return.

2. Holding of an asset depends on the link between its payoff [ 1 + rt+ii ] and

consumption, C t+1

Suppose that an individual is given the opportunity to buy a new asset whose return r equals

the rate of return on a risk-free asset. If r is high when marginal utility is high (that is, when

consumption C is low), buying one unit of the asset raises expected utility by more than

buying one unit of the risk-free asset does. As the individual invests more in an asset,

Cov {rt+ii ,C t+1} becomes less negative

The individual invests up to the point where Cov {rt+ii ,C t+1 }=0

Conclusively, the choice of asset holding is not influenced so much by the risk of the

particular asset but by the risk which the individual generally faces for instance, A worker in

the US automobile Industry, is faced with a risk of windfall losses in US automobiles. He

should, therefore, invest in assets whose returns move inversely with the health of the US

automobile industry such as foreign automobile companies or the US rail industries. This

argument implies that hedging risk is crucial to optimal portfolio choices.

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Bibliography

Anyanwu J.C. (1995). Modern Macro Economics: Theory and Application in Nigeria. Pp 50-72

Branson, W.H. (1972) Macro Economic Theory and Policy. Harper International Edition. Pp 169 - 197

Consumption. Retrieved from http://www.aueb.gr/Users/kalyvitis/Consumption_Transparencies.pdf on 6th Nov, 2010

Consumption. Retrieved from http://www.econ.uoa.gr/UA/files/183214820..pdf on 6th Nov, 2010

Consumption Theory. Retrieved from http://tutor2u.net/economics/content/topics/consumption/consumption_theory.htm on 3rd Nov, 2010

Howard H.D. (1976). “Personal Savings Behaviour and the rate of inflation”. The Review of Economics and Statistics. Pp 800

Jhingan M.L. (2003). Macro Economic Theory. 11th ed. Vrinda Publications, India. pp 103 – 133

Jhingan M.L. (2003). Economics of Development and Planning. Vrinda Publications, India.

Keiser N.F. “The Consumption-Income Hypothesis and Some of the Evidence”. Income Theory, Consumption and Investment. Pp 55-60

Life Cycle Hypothesis. Retrieved from www.economyprofessor.com/economictheories/life-cycle-hypothesis on 3rd Nov, 2010

Permanent Income Hypothesis. Retrieved from http://www.ingrimayne.com/econ/FiscalDead/PermIncome.html on 3rd Nov, 2010

Romar D. Advanced Macro Economics. Pp 331-367

Tobin .J. “Relative Income, Absolute Income and Savings”. Income Theory, Consumption and Investment. Pp 69-71

Veneiris, Y.P. and Schold, F.D. (1977) Macro Economic Models and Policy. John Willy and Sons, New York. Pp 362-397

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From the above review of the theories of consumption,

QUESTION #1

The marginal propensity to consume is less than the average propensity to consume because of errors in measuring permanent income. True or False? Explain your answer.

True because current income is not a good measure of permanent income. Increases in observed current income levels in the economy are typically part permanent and part transitory. Permanent increases in income affect consumption but transitory increases do not. Thus, even though consumption will typically be a more or less constant fraction of permanent income and thus vary in roughly the same proportion as permanent income, it will vary less than proportionally with changes in current income because only a portion of changes in current income are typically permanent. If consumption is a constant fraction of permanent income, the marginal propensity to consume out of permanent income will equal the ratio of consumption to permanent income. This ratio of consumption to permanent income is also the average propensity to consume out of permanent income. The marginal propensity to consume out of current income, on the other hand, will typically be less than the ratio of consumption to current income (or average propensity to consume out of current income) as indicated by the Keynesian consumption function

(1) C = a + b Y,

where C is consumption, Y is income, and b, the marginal propensity to consume, is less than the ratio C/Y, which is in turn less than unity. Note that in the current-income consumption function above, the average propensity to consume out of current income (C/Y) will fall as current income increases.

The relationship between the current and permanent income consumption functions can be seen from FIGURE 1.

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The average level of both current and permanent income income is given by Yo. When current income is above Yo, permanent income (denoted with a P superscript) is also above Yo, but by a smaller amount. Consumption depends on permanent income according to the consumption function

(2) C = kYp.

Consumption varies less than current income because permanent income varies less than current income. As a result, the current-income consumption function, given by equation (1), is flatter than the permanent-income consumption function, given by equation (2). The marginal propensity to consume out of current income, which is equal to the slope b, is less than the marginal (and average) propensity to consume out of permanent income, which is equal to the slope k. The average propensity to consume out of current income is given by the slope of a line (not shown in FIGURE 1) drawn from the point on the current income consumption line associated with the amount of consumption to the origin. The slope of such a line will be smaller, and the average propensity to consume will therefore be smaller, the greater the level of consumption.

Return to the Index

QUESTION #2

Zero time preference implies that consumption is the same in all years regardless of income. True or False? Explain your answer.

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False! Zero time preference would only lead to equal consumption in all years if the interest rate were zero. In a two-period model, consumption will be the same in both years if the rate of time preference equals the real rate of interest. Assume that the individual's two-period utility function is of the time-separable form

U = U(C0) + [1/(1 + p)] U(C1)

where C0 and C1 are the levels of consumption in year 0 and year 1 respectively and p is the rate of time preference. It can be shown that -(1 + p) is the slope of the individual's indifference curves where they cross the 45 degree ray from the origin (along which C0 equals C1). If the individual is endowed with incomes Y0 and Y1 in the two years and and can borrow and lend at the constant real interest rate r, his two-period budget line will have a slope equal to -(1 + r). The indifference curve and the budget line will therefore be tangent at the 45 degree ray from the origin, and consumption will be the same in both years, when (1 + p) = (1 + r) ---that is, when p = r. If p is zero but r is not zero, the positive r will result in the individual consuming less in year 0 than in year 1. This is shown in FIGURE 1 below.

Given zero time preference (p = 0), the slopes of all indifference curves where they cross the 45 degree ray from the origin are equal to -1. If the interest rate is positive, the slope of the consumer's budget line will be steeper than -1. The individual will consume the combination C0 and C1 in the respective years. Since this combination is to the left of the 45 degree ray, more is consumed in year 1 than in year 0.

For consumption to be the same in both years the interest rate would have to equal the rate of time preference. Since the rate of time preference is the slope of the indifference curves where they cross the 45 degree ray, equality of the rate of time preference with the rate of interest would imply that the indifference curves and the budget line have the same slope along the 45 degree ray from the origin. Tangency of the two curves would then occur where consumption in the two years is the same.

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