NTA-UGC-NET | Concept of Consumption Function

Components of AD

NTA-UGC-NET | Concept of Consumption Function

By How much Consumption will Change w.r.t Change in Income?

NTA-UGC-NET | Concept of Consumption Function

Propensity of Consumption

NTA-UGC-NET | Concept of Consumption Function

Propensity of Consumption

NTA-UGC-NET | Concept of Consumption Function

Propensity of Consumption

NTA-UGC-NET | Concept of Consumption Function

Propensity of Consumption

NTA-UGC-NET | Concept of Consumption Function

Aggregate Supply

NTA-UGC-NET | Concept of Consumption Function

Propensity to Save- APS and MPS

NTA-UGC-NET | Concept of Consumption Function

Saving

NTA-UGC-NET | Concept of Consumption Function

Saving Function

NTA-UGC-NET | Concept of Consumption Function

Saving Function

NTA-UGC-NET | Concept of Consumption Function

Derivation of Saving Curve from Consumption Curve

NTA-UGC-NET | Concept of Consumption Function

Derivation of Consumption Curve from Saving Curve

NTA-UGC-NET | Concept of Consumption Function

Consumption Theories

• Absolute Income Hypothesis Keynes

• Relative Income Hypothesis Duesenberry

• Permanent Income Hypothesis Friedman

• Life-Cycle Hypothesis Modigliani

NTA-UGC-NET | Concept of Consumption Function

Absolute Income Hypothesis [Fundamental Psychological Law]- Keynes

• As per this law, consumption depends upon

A priori knowledge of human nature

Based upon experience

• He stated that as Y , C (less than Y), which implies

• He also mentioned that HH current consumption is

• FOUR PROPERTIES

Real consumption spending is +ve, which is a function of real

consumption disposable income [as it is SR]

0 < MPC < 1

MPC < APC

MPC ad Y

1C

Y

& Current Consumption f Current Absolute Income

& 0d

CC f Y

Y

C C

Y Y

NTA-UGC-NET | Concept of Consumption Function

Absolute Income Hypothesis [Fundamental Psychological Law]-

Keynes

MPC < APC

• While Keynes mentioned MPC < APC, Keynesian

mentioned it as MPC = APC

C C

Y Y

As Y rises, as per AIH people don’t spend the

entire incremental income on consumption–

indeed save (for crisis in future)

Till pt B, C > Y & after B.

C < Y . This means that initially MPC

rises faster (slope) and thereafter it rises slowly.

But in reality, MPC is stable and is constant.

Empirical analysis by Keynesians found MPC to

be stable and they draw it in red colour

NTA-UGC-NET | Concept of Consumption Function

Drawback of Absolute Income Hypothesis [Fundamental Psychological Law]-

Keynes

• Based upon experience and not on observation. It was based upon

introspection

• Simon Kuznets refuted Keynes (1929-41) on the following grounds, when

he researched the data for the period of 1869 to 1929 & found

• C = cY [where c = 0.9]

• MPC is fairly stable at 0.9

• MPC = APC

NTA-UGC-NET | Concept of Consumption Function

Relative Income Hypothesis- Duessenberry

• He used the data of Income-Consumption of 1940s. And found that

C = f (Relative Income). He meant, relative income is relative in sense to the

income of people living in the same locality.

• It states that the proportion of income consumed by a HH depends on the

level of its income in relation to the HH with which it identifies itself

• HH imitates the consumption behaviour of the other HH in the society

• HH having lower income will (spend more of his income, if lives in higher

income society) and will (spend less of his income, if lives in lower income

society) Demonstration Effect [Keeping up with the Joneses]

NTA-UGC-NET | Concept of Consumption Function

Relative Income Hypothesis- Duessenberry

FOUR PROPOSITIONS

• If income of all HH belonging to the society by the same rate, then C of all

HH (including mine) at the same rate. This implies C/ Y is same for all

HH, if their Y by the same amount.

• If my income remains at the same level of relative income and my absolute

income , then my absolute consumption and saving but my C/ Y

remains the same as it was before the rise in my income.

• If my income remains constant, but income of all other HHs , then my C/

Y , even though my income is constant.

• If I move up from a lower income group to a higher income group, then my

C/ Y . This is because, HH with low income have high APC and those

with high income have low APC

NTA-UGC-NET | Concept of Consumption Function

Relative Income Hypothesis- Duessenberry

AIH C in proportion to in Y

RIH C does not in proportion to in Y [Because of

RATCHET EFFECT]

It means that HH resist to C when their income

When Y C , but when Y , then C does not immediately

Because:

1. HH has been used to certain standards of living in LR so

when Y their C less than proportionately.

2. When C does not in proportion to the in Y, then APC

& MPC [RATCHET EFFECT]

MPC < APC [SR] | MPC = APC [LR]

NTA-UGC-NET | Concept of Consumption Function

Life Cycle Hypothesis [Ando & Modigliani]- 1960s

AIH C = f (Yc) Current & Absolute Income

RIH C = f (Ycr) Current & relative income

Ando & Modi C = f (Wr, Yc)

It states that individual consumption in any time depends on:

1. Resources available to the individual [Net wealth and

Present Value of all his current & future labour income]

2. Rate of return on his capital

3. Age of individual

A rational consumer plans consumption on the basis of all his

resource and allocates his income to consumption over time

so that he maximizes his TU over his lifetime

NTA-UGC-NET | Concept of Consumption Function

Life Cycle Hypothesis [Ando & Modigliani]- 1960s

Basic Propositions

1. Total Consumption (depends) Current Physical & Financial wealth and

his lifetime labour income

2. Consumption is financed out of the lifetime income and accumulated

wealth

3. Consumption is more or less constant over his lifetime

4. Weak connection between Current Income and Current Consumption

Thus, as per 1 and 2, lifetime consumption function is

Where, Wr = real wealth | Y = Labour Income | a = MPC of wealth income

c = MPC of labour income

r LC aW cY

NTA-UGC-NET | Concept of Consumption Function

Life Cycle Hypothesis [Ando & Modigliani]- 1960s

Example- Expected life is N years, YL = Annual

Labour income, Retirement Age is R, Starts working

at B, Working Life = R – B |

Lifetime Income = YL (R – B)

Now as per LCH, an individual plans his Lifetime

Consumption such that LC = LY

Lifetime Consumption = His entire life x consumption

= C x N

LY= YL (R – B)

This implies that only a fraction of labour income is

consumed annually and rest is saved and accumulated.

LY R BC

N

NTA-UGC-NET | Concept of Consumption Function

Friedman’s Theory of Consumption (Permanent Income Hypothesis)

AIH C = f (Yc) Current & Absolute Income

RIH C = f (Ycr) Current & relative income

Ando & Modi C = f (Wr, Yc) Real wealth & lab income

PIH C = f (Yp) Permanent Income

C = kYp

Where, Yp mean of all income (expected) by the HH in LR

Income accrues from Human wealth (labour) + Non-Human

Wealth (Capital)

Yp = rW Permanent Income = Total Wealth x Rate of return

NTA-UGC-NET | Concept of Consumption Function

Friedman’s Theory of Consumption (Permanent Income Hypothesis)

Income (Gains) can be

• Permanent Income (expected in LR)

• Transitory Income (like special bonus, lottery, capital gains)

Losses can be

• Permanent Losses (unforeseen)

• Transitory Losess (due to unemployment, sickness, unpaid

leaves, theft, fire)

Permanent Income +Transitory Income Transitory Losess

Effect is Zero

pY

Net

NTA-UGC-NET | Concept of Consumption Function

Friedman’s Theory of Consumption (Permanent Income Hypothesis)

NTA-UGC-NET | Concept of Consumption Function

Friedman’s Theory• APC ( Ct / Y, ) depends on the ratio of permanent to current income Yp/ Yt . Thus

when current income temporarily rises above the permanent income the APC falls;

the opposite happens when current income temporarily falls below Yp.

• HYG will have some people with a high transitory income, who have a lower

propensity to consume than the average.

• LYG will contain some people with a low transitory income, who will have a higher

propensity to consume than the average.

• Thus, we find a falling APC as we move from lower to HYG.

• On the other hand, when we are considering long run, the

fluctuations even out and any increase in income in the log run

reflects a permanent increase in the average income level. Hence

in the log run time we are likely to observe a constant average

propensity to consume.