Absolute Income Hypothesis - Keynes
Secular Stagnation Hypothesis
Kuznets Findings
The Relative Income Hypothesis- Duesenberry
Demonstration Effect
Ratchet Effect
The Permanent Income Hypothesis (PIH) - Milton Friedman
Relationship between Consumption and Permanent Income
The Life Cycle H...
“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 the
income”
According to Keynes an individual consumer’s consumption depends upon absolute level of
income. He also proposed that consumption income relationship is non- proportional. It
implies that as income increase, consumption also increases but the increase in consumption
is less than proportionate to increase in income. Since Keynes lays stress on the absolute size
of income as a determinant of consumption, his theory of consumption is also known as
absolute income hypothesis.
Keynes hypothesized that the consumption function has the following characteristics
1. Consumption is a stable function of real disposable income. That is Ct = f(Yt)
2. The consumption income relationship is reversible. That is people will reduce
consumption when their income falls
3. Consumption pattern of one group of consumers is quite independent of that of
others
4. In the long run a smaller proportion of income will be consumed as income increases
The Keynesian Consumption function takes the following form
C = a + bYd
where, C = Consumption Expenditure , a = Autonomous consumption(consumption
expenditure independent of the level of income), .b = the Marginal Propensity to Consume
'MPC' andYd = Current Disposable Income.
Major conjectures of Keynes
1. 0 < MPC < 1
2. Average propensity to consume (APC ) falls as income rises. (APC = C/Y ) =
a/Y + b. As income rises, consumers save a bigger fraction of their income, so
APC falls
3. Income is the main determinant of consumption.
The graph given below examine the nature of Keyne’s consumption function.
Figure showing MPC Figure showing APC
C C
C = a + bY C = a + bY
dC/dY APC = a/Y +b
MPC is slope of Csn function slope of APC
a
Y Y
(explain the graph)
, Several theoretical implications can be developed by ratio of consumption expenditure to the
level of disposable income, that is APC.
For the cross-section we would expect that lower-income groups would consume a greater
proportion of their income relative to high-income groups:
APClow income > APChigh income
With time series data we would expect that over time and as disposable income increases the
APC should decline:
APCt-1 > APCt
Anomalies in Keynes Absolute Income hypothesis
Secular Stagnation Hypothesis
One the basis of Keyes consumption function, some economist reasoned that as income in the
economy grew over time, households would consume a smaller and smaller fraction of their
incomes. Low consumption means inadequate demand for goods and services, which would
probably results in another depression. Therefore, economists predicted that the economy
would soon experience a secular stagnation. However, as contrary to this prediction, the
economy was not thrown into another depression after the world war II.
Kuznets Findings
Another setback to Keynes consumption was the finding of Simon Kuznets. He constructed
new aggregate data on consumption and income dating back to 1869. He discovered that the
ratio of consumption to income was remarkably stable from decade to decade, despite large
increases in income over the period he studies. (that is constant APC). Thus, Keynes
conjecture that the APC would fall as income rise appeared not to hold. The failure of secular
stagnation hypothesis and the findings of Kuznets both indicated that the APC is fairly
constant over long periods of time.
How the average propensity to consume has remained stable despite the substantial increase
in income has been a great puzzle in consumption theory. We shall study below how modern
theories of consumption such as Duesenberry’s relative income theory of consumption life
cycle hypothesis and Friedman’s permanent income theory succeed in resolving this puzzle.
First, Duesenberry has propounded that consumption expenditure depends on income of an
individual relative to incomes of others rather than the absolute size of his own income. His
theory is therefore called Relative Income Theory of Consumption. Secondly, Modigliani put
forward a theory known as life cycle hypothesis, according to which an individual plans his
even consumption profile in his lifetime which depends not so much on his current income
but on his expectations of income in the whole lifetime. Further, a famous American
economist Friedman has advanced a hypothesis regarding consumption behaviour, called
permanent income hypothesis, according to which consumption of an individual depends on
permanent income rather than current level of income.
(2) The Relative Income Hypothesis- Duesenberry
An American economist J.S. Duesenberry put forward the theory of consumer behaviour
which lays stress on relative income of an individual rather than his absolute income as a
determinant of his consumption. Another important departure made by Duesenberry from
Keynes’s consumption theory is that, according to him, the consumption of a person does not
depend on his current income but on certain previously reached income level.
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