Economic Principles Ch16. Consumption Function Theory: From Keynes to the Life Cycle Hypothesis

Chapter 16. Consumption Function Theory: From Keynes to the Life-Cycle Hypothesis

What determines consumption ($C$), the largest component of national income? This chapter examines the mechanics of consumption, from Keynes’s simple model to modern theories that reflect people’s rational, long-term planning.

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1. Keynes’s Absolute Income Hypothesis

This theory holds that consumption is determined solely by current disposable income ($Y_d$).

• Features:
  • $0 < c < 1$ (the marginal propensity to consume lies between 0 and 1).
  • As income rises, the average propensity to consume ($APC = C/Y_d$) falls.
• Empirical result: It fits the short run, but cannot explain Kuznets’s finding that $APC$ remains constant over the long run.

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2. Duesenberry’s Relative Income Hypothesis

This hypothesis says that consumption is influenced by the consumption level of people around us and by one’s own previous peak consumption level.

1. Demonstration Effect: The tendency to imitate neighbors’ consumption levels.
2. Ratchet Effect: The tendency for consumption not to fall irreversibly when income falls, because of past consumption habits.

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3. Friedman’s Permanent Income Hypothesis

This theory holds that consumption is determined not by temporary income but by permanent income, the average income one expects to earn over a lifetime.

• Permanent income: Income reflecting asset values and expectations about the future.
• Temporary income: Windfall income such as a bonus or lottery winnings.
• Implication: A temporary tax cut has little effect on permanent income, so its power to stimulate consumption is limited.

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4. Modigliani’s Life-Cycle Hypothesis

This theory holds that people try to smooth consumption over youth, middle age, and old age by considering income across their entire lives.

• Youth: income < consumption (borrowing).
• Middle age: income > consumption (saving).
• Old age: income > consumption (using savings accumulated in middle age).
• Policy implication: Changes in population structure, such as aging, have a profound effect on a country’s overall saving rate.

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5. Conclusion: Consumption Is Confidence in the Future

The essence of consumption is not simply spending what one earned today; it is planning today because one trusts one’s future self. Modern macroeconomics evaluates the effectiveness of economic policy through consumers’ expectations and budget constraints.

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📖 References

• [Macroeconomics] - Jeong Byeong-ryeol: Mathematical models of consumption functions.
• [Principles of Economics] - Gregory Mankiw: Determinants of household consumption.

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Well done. Next, we will study investment function theory and the accelerator principle, which concern firms’ decisions about the future.