Chapter 16: Consumption

John M. Keynes: Absolute Income Hypothesis

Consumption is a linear function of disposable personal
income,
C = C + cY

C = consumption expenditure
Y = disposable income
C = autonomous consumption (intercept of the line)
c = marginal propensity to consume (slope of the line)

Properties of Consumption Function

Consumption is determined by current income
Marginal propensity to consume (MPC = C/Y) is
between zero and one (0<c<1)
Average propensity to consume (APC = C/Y) falls
as income rises

Short-run Consumption Function

Consumption expenditure

C = C + cY
Constant APC

c
C
Disposable income

Empirical Evidence
High income families have a higher marginal propensity to
save (MPS = 1 MPC)
High income families have a higher average propensity to
save (APS = 1 APC); APC falls with the level of income
In the long-run, autonomous consumption falls to zero
(C = 0)

Long-run Consumption Function

Consumption expenditure

C = Y
Variable APC;
=0

Disposable income

Irving Fisher: Intertemporal Choice

Consumption decisions are based on current and future
income
Current period income = current income plus present value
of future income: Y1 + Y2 / (1 + r), where r is a discount rate
Future period income = future income plus future value of
current income: Y2 + (1 + r)Y1

The Intertemporal Budget Line

Future Period
B
C2
A

Y2
C2
C1

Y1

C1

C
Current Period

The Intertemporal Budget Line

Along BC, there is a trade-off between current and future
consumption spending
Along AB, C1<Y1, but C2>Y2: consumers would save in
current period to finance consumption in second period
Along AC, C1>Y1, but C2<Y2: consumers would borrow in
current period and will pay off debt in future period

Consumer Preferences
Consumer preferences are shown by a family of
indifference curves
Any combination of current and future consumption along
an indifference curve provides the same level of
satisfaction for the consumer
A higher indifference curve yields combinations with
greater satisfaction

Consumer Preferences
Future Period

Combination B is preferred to
combination A because it yields
more in both periods

B
A

Current Period

The Consumers Optimum

Consumer equilibrium is achieved at the tangency
of the highest attainable indifference curve and the
budget line
The tangency determines the optimum allocation
of consumption spending in both periods; i.e.
highest level of satisfaction within the budget

The Consumers Optimum

Future Period
Higher income shifts the budget
line up, positioning the consumer
on a higher indifference curve and
consumers optimum
C2f
C1f

B
A

C1c

C2c

Current Period

Franco Modigliani: Life Cycle Hypothesis

Consumption depends on income and wealth
C = Consumption expenditure
W = Consumer wealth
R = Length of productive life time
T = Years of life

Consumption Function
C = (W + RY)/T = (1/T)W + (R/T)Y
Define:
= 1/T is the MPC out of wealth
= R/T is the MPC out of income
C = W + Y

Consumption Function
Consumption expenditure

C = W + Y

W
Disposable income
For the United States, = 0.02 and = 0.60.

Consumption Function
Consumption expenditure

W2
W1
Disposable income
Increased wealth shifts the consumption function upward.

Consumer Behavior over Life Time

Consumption spending is a stable function of income
Consumers save their leftover income
Consumers accumulate wealth during the productive
lifetime
Consumer finance retirement by dissaving and selling-off
their assets

Consumer Behavior over Life Time

$
Wealth
Income
Saving
Consumption

Dissaving

Years

Milton Friedman: Permanent Income Hypothesis

Measured income consists of permanent and
transitory income; Y = YP + YT
Permanent income is the average income we
make during years of productive life
Transitory income is the random variation from the
average

Consumption Function
Consumption is a function of permanent income
C = YP
Consumers use saving and borrowing to smooth
consumption in response to transitory changes in
income

Determinants of Consumption
Combining all the theories, we can conclude that
consumption depends on
Current income
Expected future income
Wealth
Interest rate