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.