Other Theories of the Consumption Function
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Post-Keynesian Theories of the Consumption Function:

- more deeply rooted in micro of cons behaviour.  Both PIH and LCH – position that cons’rs plan cons’n on the basis of i.) Their Long-Run, or Lifetime, income, and ii.) Income Expectations.

(NB – both theories assume some liquidity – i.e. can borrow on strength of future income)

2.  Friedman’s Permanent Income Hypothesis (PIH)

- The Individual’s consumption is based on the individual’s permanent income (Yp)

Yp = (i) Technically – return on PV of an indiv’s wealth (i.e. what can be consumed whilst leaving

     his wealth intact).

(ii) More Generally = some sort of LR average income, or normal income, which can be counted on in the future.

Y = Yp + Yt                Y   = indiv’s actual/measured income in any period made up of

                        Yp = permanent income

                        Yt  = transitory income (+ve if unexpectedly good year; -ve if unexp bad

         year)

(Simplest form of PIH)

Consumption is a constant proportion of permanent income, i.e.:

C = kYp                                 F = factor of

Where                         i  = wage rate             

k = F ( i, w, x )                       w = ratio of human to non-human wealth

                                               x = catch-all variable component (age & tastes; major components)

k will rise if:

i (wage rate) rises – indivs assumed to be more secure as to future returns from asset holdings.

w (ratio of non-human wealth (e.g. money & shares) to human wealth (e.g. future labour income) rises in total wealth holdings. 

Thus if the economy grows steadily, with no fluctuations, then Yp would be approximately = Y (Measured National Income) and – constant proportion of income consumed; - constant proportion of Nat Inc consumed.

Friedman’s Explanation as to why SR consumption function flatter than LR consumption function (& hence lower mpc): (able to explain it)

-         In booms, more people will think they’re doing better than normal than think doing worse than normal: for economy – positive transitory income(Yt) so measured nat inc (Y) greater than permanent income (Yp). 

-         Unexpectedly high measured inc will have little impact on consumers’ views of permanent income unless long-lasting boom, since seen as transitory.

-         As consumer spending plans based on permanent income, a short-lived boom will have little effect on consumer spending.  Unexpected increases in income thus largely saved. 

-         (If boom long-lasting – people revise permanent income upwards, at which point consumption, which is based on permanent income, will increase.  If not, then proportion of income consumed (apc) will fall below initial level k during the boom – see fig 2).

-         If slump, income will fall, and although permanent income may be revised downwards a bit, it will fall less than measured income (so apc rises – unless long-lived slump)

3.  Modigliani’s Life Cycle Hypothesis (LCH).

-         Similar to PIH but stresses the age of consumers: consumers try to even out consumption over lifetime, though income fluctuates widely.

-         Youth & Old Age – low income; consumption maintained by borrowing/drawing on savings; so consumption a high proportion of income.

-         Middle Age – income relatively higher, pay off debts & save for retirement consumption (low apc)

-         Implications:

-         A – Demographics: Accounts for fact that low income households have higher apc than others – high proportion of young & old.  Higher income (more middle age: lower apc).  So for instance decline in 45-64 age group as prop of population: likely to reduce the savings ratio.   

-         B – Income Distribution/growth/Level: so rise in pop in Africa (poor & young – higher apc: Increase in saving mitigated.  If poor: few savings – consumption follows current disposable income more closely. 

-         Like PIH, able to reconcile flatter SR consumption function than LR consumption function.

-         So for both theories: Low SR mpc – limited multiplier – by-product attack on SR Δs in Tax & Exp for AD boosting.

Other Notes in this Category

1. Access to credit / Financial Deregulation
2. Consumption
3. Consumption and Saving Exam Questions
4. Determinants of Consumption
5. Inflation
6. Interest Rates and Monetary Policy
7. Key Points
8. Other Theories of the Consumption Function
9. Problems with Consumption Functon
10. Unemployment/Consumer Confidence/Uncertainty
11. Wealth Effect – Asset Prices, Debt Burden, and Windfall Gains

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