TSR Wiki > Study Help > Subjects and Revision > Revision Notes > Economics > Other Theories of the Consumption Function
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
- Their Long-Run, or Lifetime, income, and
- Income Expectations.
(NB – both theories assume some liquidity – i.e. can borrow on strength of future income)
Friedman’s Permanent Income Hypothesis (PIH)
- The Individual’s consumption is based on the individual’s permanent income (Yp)
- Technically – return on PV of an indiv’s wealth (i.e. what can be consumed whilst leaving his wealth intact).
- More Generally = some sort of LR average income, or normal income, which can be counted on in the future.
= indiv’s actual/measured income in any period made up of
= permanent income
= 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.:
F = factor of
Where:
= wage rate
= ratio of human to non-human wealth
= catch-all variable component (age & tastes; major components)
will rise if:
- (wage rate) rises – indivs assumed to be more secure as to future returns from asset holdings.
- (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 would be approximately = (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 () so measured nat inc () greater than permanent income ().
- 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)
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
in Tax & Exp for AD boosting.
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