Macroeconomics (AgEc 6012)

Chapter -3
Consumption Function
By
Zemen Ayalew
Bahir Dar University
College of Agriculture and Environmental Sciences
Department of Agricultural Economics
April, 2021
 Introduction
 To understand an economy as a whole, we must understand
households and firms that make up the economy.
 That is we need to understand the microeconomic models that
help refine our macroeconomic analysis.
 How do households decide how much of their income to
consume today and how much to save for the future is a
microeconomics question but its answer has macroeconomics
consequence.
 Consumption decision is crucial for long-run analysis because of
its role in economic growth.
 For example in the Solow Growth Model saving rate is a key
determinant of steady state capital stock and thus of the level of
economic well-being
 Contd….

Consumption decision is also crucial for short-run analysis

because of its role in aggregate demand.
Since consumption is often about two-third of GDP,
fluctuations in consumption are a key elements of booms
and recessions.
Change in the consumers confidence can be a source of
shocks to the economy, and that the marginal propensity to
consume (MPC) is a determinant of the fiscal policy
multiplier.
ΔY/ΔG = 1/(1-MPC) and
ΔY/ΔT= - MPC/(1-MPC).
Contd….

Since Macroeconomics began as a field of study,

many economists have written about the theory of
consumers behavior and suggested alternative ways
of interpreting the data on consumption and income.
Among these, we discuss the views of four prominent
economists roughly in a historical order
These are:
1, John Maynard Keynes
2, Irving Fisher
3, Franco Modigliani
4, Milton Friedman
3.1 John Maynard Keynes and the Consumption
Function
We begin by the study of consumption with John
Maynard Keynes's General Theory, which was
published in 1936.
Keynes made the consumption function central to his
theory of economic fluctuations, and it has played a
key role in macroeconomic analysis ever since.
We start with what Keynes thought about the
consumption function, and then see what puzzles
arose when his ideas were confronted with data.
A. Keynes's Conjectures
Instead of relying on statistical analysis, Keynes made
conjectures about the consumption function based on
introspection and casual observation.
 1st and most important, Keynes conjectured that the
marginal propensity to consume (MPC) - the
amount consumed out of an additional dollar of
income - is between zero and one.
 Consumers increase their consumption as their
income increases, but not by as much as the increase
in their income..
Contd…

 The marginal propensity to consume was

crucial to Keynes's policy recommendations for
how to reduce widespread unemployment.

The power of fiscal policy to influence the

economy - as expressed by the fiscal policy
multipliers - arises from the feedback between
income and consumption.
Contd….

2nd Conjecture: Keynes posited that the ratio of

consumption to income, called the average
propensity to consume (APC), falls as income
rises.
 He believed that saving was a luxury, so he
expected the rich to save a higher proportion of their
income than the poor.
 Although not essential for Keynes's own analysis,
the postulate that the average propensity to consume
falls as income rises became a central part of early
Keynesian economics.
Contd….

 3rd conjecture: Keynes thought that, income is the

primary determinant of consumption and that the
interest rate does not have an important role.
This conjecture stood in stark contrast to the beliefs of
the classical economists who preceded him.
 The classical economists held that a higher interest
rate encourages saving and discourages
consumption.
Keynes believed that the short-period influence of the
rate of interest on individual spending out of a given
income is secondary and relatively unimportant.
 Contd….

 On the basis of these three conjectures, the

Keynesian consumption function is often written as:
C = Ĉ + cY , Ĉ > 0, 0 < c < 1,
Where: C = consumption,
Y = disposable income (Y-T),
Ĉ = a constant sometimes called autonomous consumption, and
c = is the marginal propensity to consume.
This consumption function, shown in the following
figure is graphed as a straight line
Figure 3.1. The Keynesian Consumption Function

Absolute Income Hypothesis (AIH)

Consumption Depends on Current Disposable Income
C
C = Ĉ + cY

Consumption
MPC
1
APC
APC
1 1

Income Y
Note: The MPC is the slope of the consumption function. The average
propensity to consume, C/ Y, equals the slope of a line drawn from the
origin to a point on the consumption function,
Contd….

This figure graphs a consumption function with the

three properties that Keynes conjectured.
1. The marginal propensity to consume c is between
zero and one.
2. The average propensity to consume falls as income
rises.
3. Consumption is determined by current income.
Notice that this consumption function exhibits the
three properties that Keynes posited
Contd…

First it satisfies Keynes's first property because the

marginal propensity to consume c is between zero and
one, so that higher income leads to higher
consumption and also to higher saving.
Second this consumption function satisfies Keynes's
second property because the average propensity to
consume APC is
APC = C/Y = Ĉ/Y + c
As Y rises, Ĉ/Y falls, and so the average propensity to
consume C/Y falls.
Contd…

• And finally, this consumption function satisfies

Keynes's third property because the interest
rate is not included in this equation as a
determinant of consumption.
 B. The Early Empirical Successes
 Soon after Keynes proposed the consumption function,
economists began collecting and examining data on
consumption and income to test his conjectures.
 The earliest studies indicated that the Keynesian
consumption function is a good approximation of how
consumers behave.
 They found that households with higher income
consumed more, which confirms that the marginal
propensity to consume is greater than zero.
 They also found that households with higher income saved
more, which confirms that the marginal propensity to
consume is less than one.
Contd….
In addition, these researchers found that higher-
income households saved a larger fraction of their
income, which confirms that the average propensity to
consume falls as income rises
In other studies, researchers examined aggregate
data on consumption and income for the period
between the two world wars.
 These data also supported the Keynesian
consumption function. In years when income was
unusually low, both consumption and saving were low,
indicating that the marginal propensity to consume is
between zero and one.
Ctd…

In addition, the ratio of consumption to income was

high, confirming Keynes's second conjecture.
Finally, because the correlation between income and
consumption was so strong, no other variable
appeared to be important for explaining
consumption.
Thus, the data also confirmed Keynes's third
conjecture that income is the primary determinant of
how much people choose to consume.
 C. Secular Stagnation, Simon Kuznets, and the
Consumption Puzzle

Although the Keynesian consumption function met

with early successes, two anomalies soon arose
concerning Keynes's second conjecture that the
average propensity to consume falls as income rises.
The first anomaly became apparent after some
economists made prediction during World War II.
 On the basis of the Keynesian consumption function,
these economists reasoned that as incomes in the
economy grew over time, households would
consume a smaller and smaller fraction of their
incomes.
Ctd…

They feared that there might not be enough profitable

investment projects to absorb all this saving.
If so, the low consumption would lead to an
inadequate demand for goods and services, resulting
in a depression once the wartime demand from the
government ceased.
In other words, on the basis of the Keynesian
consumption function, these economists predicted that
the economy would experience what they called
secular stagnation - a long depression of indefinite
duration - unless fiscal policy was used to expand
aggregate demand
Contd…
Fortunately for the economy, but unfortunately for the
Keynesian consumption function, the end of World
War II did not throw the country into another
depression.
Although incomes were much higher after the war
than before, these higher incomes did not lead to large
increases in the rate of saving.
 Keynes's conjecture that the average propensity to
consume would fall as income rose appeared not to
hold.
Contd…

The second anomaly arose when economist Simon

Kuznets constructed new long-term data on
consumption and income from 1869 – 1940.
 Simon Kuznets later receive a Nobel Prize for this
work.
He, discovered that the ratio of consumption to
income (APC) was remarkably stable from decade to
decade, despite large increases in income over the
period he studied.
Ctd…

Again, Keynes's conjecture that the average

propensity to consume would fall as income
rose appeared not to hold.
The failure of the secular-stagnation
hypothesis and the findings of Kuznets both
indicated that the average propensity to
consume is fairly constant over long
periods of time.
The Consumption Puzzle?
 This fact presented a puzzle that motivated much of
the subsequent work on consumption.
 Economists wanted to know why some studies
confirmed Keynes's conjectures and others refuted
them?
 That is, why did Keynes's conjectures hold up well in
the studies of household data and in the studies of
short time-series, but fail when long time-series were
examined?
 The evidence suggested that there were two
consumption functions.
Ctd…

For the household data or for the short time

series, the Keynesian consumption function
appeared to work well.
 Yet for the long time-series, the consumption
function appeared to have a constant average
propensity to consume.
Figure 3.2. The Consumption Puzzle
C
oC Long-run consumption
n function (constant APC)
s
u
m Short-run consumption
p function (falling APC)
t
i
o
n
Income Y
Notice that the short-run consumption function has a falling average propensity
to consume, whereas the long run consumption function has a constant average
propensity to consume
 Contd….
 Economists needed to explain how these two consumption
functions could be consistent with each other.
 In the 1950s, Franco Modigliani and Milton Friedman each
proposed explanations of these seemingly contradictory
findings.
 Both economists later won Nobel Prizes, in part because of
their work on consumption.
 But before we see how Modigliani and Friedman tried to solve
the consumption puzzle, we must discuss Irving Fisher's
contribution to Consumption theory.
 Both Modigliani's life-cycle hypothesis and Friedman's
permanent-income hypothesis rely on the theory of consumer
behavior proposed much earlier by Irving Fisher.
 3.2. Irving Fisher and Intertemporal Choice
 When people decide how much to consume and how much to
save, they consider both the present and the future. The more
consumption they enjoy today, the less they will be able to enjoy
tomorrow.
 In making this tradeoff, households must look ahead to the income
they expect to receive in the future and to the consumption of
goods and services they hope to be able to afford.
 The economist Irving Fisher developed the model economists use
to analyze how rational, forward-looking consumers make
intertemporal choices that is, choices involving different
periods of time.
 Fisher's model shows the constraints consumers face and how
they choose consumption and saving.
A. The Intertemporal Budget Constraint
Most people would prefer to increase the quantity or
quality of the goods and services they consume.
 The reason people consume less than they desire is
that their consumption is constrained by their income.
In other words, consumers face a limit on how much
they can spend, called a budget constraint.
 When they are deciding how much to consume today
versus how much to save for the future, they face an
intertemporal budget constraint.
 To understand how people choose their level of
consumption, we must examine this constraint.
 Contd….
 For simplicity, assume a consumer who lives for two periods.
 Period one represents the consumer's youth, and period two
represents the consumer's old age.
 The consumer earns income Y1 and consumes C1 in period
one, and earns income Y2 and consumes C2 in period two. (All
variables are real terms -that is, adjusted for inflation.)
 Because the consumer has the opportunity to borrow and
save, consumption in any single period can be either greater or
less than income in that period.
 Consider how the consumer's income in the two periods
constrains consumption in the two periods.
Contd…
 In the first period, saving (S) equals income minus
consumption. That is;
S = Y1 - C1
 In the second period, consumption equals the accumulated
saving, including the interest earned on that saving, plus
second-period income.
That is:
C2 = (1 + r)S + Y2 where. r is the real interest rate.
 Because there is no third period, the consumer does not save
in the second period.
 Note that these two equations still apply if the consumer is
borrowing rather than saving in the first period.
 Contd….

 The variable S represents both saving and borrowing.

 If first-period consumption is less than first-period income, the
consumer is saving, and S is greater than zero.
 If first-period consumption exceeds first-period income, the
consumer is borrowing, and S is less than zero.
 For simplicity, we assume that the interest rate for
borrowing is the same as the interest rate for saving.
Contd…
To derive the consumer's budget constraint, combine
the two equations above.
 Substitute the first equation for S into the second
equation to obtain
C2 = (1 + r)(Y1 - C1) + Y2
Rearranging terms
. (1 + r)C1 + C2 = (1 + r) Y1 + Y2.
Now divide both sides by (1 + r) to obtain
C2 Y 2 = consumer's intertemporal
C1+ = Y1+ +
1+r 1 r budget constraint.
Contd…

This equation relates consumption in the two periods

to income in the two periods.
It is the standard way of expressing the consumer's
intertemporal budget constraint.
If the interest rate is zero, the budget constraint
shows that total consumption in the two periods
equals total income in the two periods.
In the usual case in which the interest rate is greater
than zero, future consumption and future income are
discounted by a factor 1 + r.
Contd….

 Because the consumer earns interest on current income

that is saved, future income is worth less than current
income.
 Similarly, because future consumption is paid for out of
savings that have earned interest, future consumption
costs less than current consumption.
 The factor 1/(1 + r) is the price of second-period
consumption measured in terms of first-period
consumption:
 it is the amount of first-period consumption that the
consumer must forgo to obtain 1 unit of second-period
consumption.
Figure 3.3.Consumer's budget constraint
B

Second-period C2
.
consumption Consumer's . budget
Y2
constraint

(1 + r)Y1 + Y2 A
C
Y1 C1

First-period consumption
Y1 + Y2/(1 + r)
Contd….
 At point A, first-period consumption is Y1 and second period
consumption is Y2, so there is neither saving nor borrowing
between the two periods.
 At point B, the consumer consumes nothing in the first period and
saves all income, so second-period consumption is (1 + r) Y1 + Y2.
 At point C, the consumer plans to consume nothing in the second
period and borrows as much as possible against second-period
income, so first-period consumption is Y1 + Y2/(l + r).
 Of course, these are only three of the many combinations of first
and second-period consumption that the consumer can choose: all
the points on the line from B to C are possible..
Ctd…

If he chooses points between A and B, he

consumes less than his income in the first
period and saves the rest for the second
period.
If he chooses points between A and C, he
consumes more than his income in the first
period and borrows to make up the difference
B. Consumer Preferences
The consumer's preferences regarding consumption
in the two periods can be represented by indifference
curves.

An indifference curve shows the combinations of first-

period and second-period consumption that make the
consumer equally happy .
Figure 3.4. Consumer Preferences

C1

First-period consumption
Ctd…

The slope at any point on the indifference curve is

the marginal rate of substitution (MRS) between first-
period consumption and second-period consumption.
It tells us the rate at which the consumer is willing to
substitute second period consumption for first-period
consumption.
The MRS depends on the levels of consumption in the
two periods.
Ctd…

The consumer is indifferent among combinations W,

X, and Y, because they are all on the same curve.
If the consumer's first-period consumption is reduced,
say from point W to point X, second-period
consumption must increase to keep him equally
happy.
 If first-period consumption is reduced again, from
point X to point Y, the amount of extra second-period
consumption he requires for compensation is greater.
C. Optimization

Having discussed the consumer's budget constraint

and preferences, we can consider the decision about
how much to consume.
The consumer would like to end up with the best
possible combination of consumption in the two
periods-that is, on the highest possible indifference
curve.
But the budget constraint requires that the consumer
also end up on or below the budget line, because the
budget line measures the total resources available to
him.
Figure 3.5. Optimization

Second-period
consumption

First-period consumption
Ctd…
 The highest indifference curve that the consumer can obtain without
violating the budget constraint is the indifference curve that is tangent
to the budget line, point O.
 This is the best combination of consumption in the two periods
available to the consumer. At this point the slope of the indifference
curve equals the slope of the budget line.
 But the slope of the indifference curve is the marginal rate of
substitution (MRS) and the slope of the budget line is 1 plus the real
interest rate (1 + r).
 Therefore, at Point O MRS = 1 + r
 The consumer chooses consumption in the two periods so that the
marginal rate of substitution equals 1 plus the real interest rate.
D. How Changes in Income Affect Consumption

 An increase in either Y1 or Y2 shifts the budget

constraint outward.
 The higher budget constraint allows the consumer to
choose a better combination of first and second-
period consumption.
That is, the consumer can now reach a higher
indifference curve.
The consumer chooses more consumption in both
periods.
 If a consumer wants more of a good when his or her
income rises, economists call it a Normal good.
 Figure 3.6. Effect of an increase in income

First-period
consumption

Old budget New budget

constraint
C1 constraint

First-period
consumption
 Ctd…

 If consumption in period one and consumption in period two

are both normal goods, this increase in income raises
consumption in both periods.
 The key conclusion from Figure 3.6 is that regardless of
whether the increase in income occurs in the first period
or the second period, the consumer spreads it over
consumption in both periods.
 Because the consumer can borrow and lend between periods,
the timing of the income is irrelevant to how much is
consumed today (except, of course, that future income is
discounted by the interest rate).
 Contd….
The lesson of this analysis is that consumption
depends on the present value of current and
future income-that is, on
Y2
Present Value of Income = Y1 +
1+ r
In contrast to Keynes's consumption function, Fisher's
model says that consumption does not depend primarily on
current income.
 Instead, consumption depends on the resources the
consumer expects over his lifetime
E. How Changes in the Real Interest Rate Affect
Consumption?
There are two cases to consider: the case in which the
consumer is initially saving and the case in which he is
initially borrowing. Here we discuss the initial saving
case.
In the following Figure, an increase in the real interest
rate rotates the consumer's budget line around the
point (Y1, Y2).
This change alters the amount of consumption he
chooses in both periods.
That is, the consumer moves from point A to point B.
 The first-period consumption falls and second-period
consumption rises.
Figure 3.7. Effect of an Increase in Interest Rate

Second-period
consumption
(1 + r)Y1 + Y2

ΔC2

Y2

Y1
ΔC1
Y1 + Y2/(1 + r) First-period
consumption
 Contd….
 Economists decompose the impact of an increase in the real
interest rate on consumption into two effects: an income effect
and a substitution effect.
 The income effect is the change in consumption that results
from the movement to a higher indifference curve.
 Because the consumer is a saver rather than a borrower, the
increase in the interest rate makes him better off.
 If consumption in period one and consumption in period two are
both normal goods, the consumer will want to spread this
improvement in his welfare over both periods.
 This income effect tends to make the consumer choose more
consumption in both periods.
Contd….
 The substitution effect is the change in consumption that
results from the change in the relative price of consumption in
the two periods.
 In particular, consumption in period two becomes less
expensive relative to consumption in period one when the
interest rate rises.
 That is, because the real interest rate earned on saving is
higher, the consumer must now give up less first-period
consumption to obtain an extra unit of second-period
consumption.
 This substitution effect tends to make the consumer choose
more consumption in period two and less consumption in
period one.
Contd….

The consumer's choice depends on both the income

effect and the substitution effect.
 Both effects act to increase the amount of second-
period consumption; hence, we can confidently
conclude that an increase in the real interest rate
raises second-period consumption.
 But the two effects have opposite impacts on first-
period consumption.
Hence, the increase in the interest rate could either
lower or raise first-period consumption.
3.3. Franco Modigliani and the Life-Cycle
Hypothesis
 In a series of papers in the 1950s Franco Modigliani and his
collaborators used Fisher's model of consumer behavior to
study the consumption function with a goal to solve the
consumption puzzle.
 According to Fisher's model, consumption depends on a
person's lifetime income.
 Modigliani emphasized that income varies systematically
over people's lives and that saving allows consumers to move
income from those times in life when income is high to those
times when it is low.
 This interpretation of consumer behavior formed the basis for
his life-cycle hypothesis.
A. The Hypothesis
One important reason that income varies over a
person's life is retirement.
People expect their incomes to fall when they retire.
 Yet they do not want a large drop in their standard of
living, as measured by their consumption.
To maintain consumption after retirement, people
must save during their working years.
What does this motive for saving implies for the
consumption function?
Contd….

Consider a consumer who expects to live another T

years, has wealth of W, and expects to earn
income Y until she retires R years from now.
 What level of consumption will the consumer choose
if he wishes to maintain a smooth level of
consumption over her life?
The consumer's lifetime resources are composed
of initial wealth W and lifetime earnings of R x Y.
Assume an interest rate of zero for simplicity.
The consumer can divide up her lifetime resources
among her T remaining years of life.
Ctd…
We assume that she wishes to achieve the smoothest
possible path of consumption over her lifetime.
Therefore, she divides this total of W + RY equally
among the T years and each year consumes:
C = (W + RY)/T
We can write this person's consumption function as
C = (1/T) W + (R/T)Y
Contd…
For example, if the consumer expects to live for 50
more years and work for 30 of them, then T = 50 and
R = 30, so her consumption function is
C = 0.02W + 0.6Y
This equation says that consumption depends on
both income and wealth.

 An extra $1 of income per year raises consumption

by $0.60 per year, and an extra $1 of wealth raises
consumption by $0.02 per year.
Contd…..

If every individual in the economy plans consumption

like this, then the aggregate consumption function is
much the same as the individual one.
In particular, aggregate consumption depends on both
wealth and income.
That is, the economy's consumption function is
C = αW + βY
 where the parameter α is the marginal propensity to
consume out of wealth, and the parameter β is the
marginal propensity to consume out of income.
B. Implications

Consumption

αW

Y
Income
Figure 3.8. The Life-Cycle Consumption Function
Ctd…

 For any given level of wealth, the life-cycle model, yields a

conventional consumption function, such as in Figure 3.8.
 However, the intercept of the consumption function αW is not
a fixed value but depends on the level of wealth.

The life-cycle model says that consumption depends on

wealth as well as income.
In other words, the intercept of the consumption function
depends on wealth.
 Contd…

 This life-cycle model of consumer behavior can solve the

consumption puzzle.
 According to the life-cycle consumption function, the average
propensity to consume is
C/Y = a(W/Y) + β
 Because wealth does not vary proportionately with income
from person to person or from year to year, we should find
that high income corresponds to a low average propensity to
consume when looking at data across individuals or over
short periods of time.
 But, over long periods of time, wealth and income grow
together, resulting in a constant ratio W/Y and thus a constant
average propensity to consume..
3.4. Milton Friedman and the Permanent-Income
Hypothesis
 In a book published in 1957, Milton Friedman proposed the
permanent - income hypothesis to explain consumer behavior.
 Friedman's permanent - income hypothesis complements
Modigliani's life-cycle hypothesis: both use Irving Fisher's
theory of the consumer to argue that consumption should not
depend on current income alone.
 But unlike the life-cycle hypothesis, which emphasizes that
income follows a regular pattern over a person's lifetime, the
permanent-income hypothesis emphasizes that people
experience random and temporary changes in their incomes
from year to year.
A. The Hypothesis
Friedman suggested that we view current income Y as
the sum of two components, permanent income YP
and transitory income YT. That is,
Y = YP + YT
Permanent income is the part of income that people
expect to persist into the future.
Transitory income is the part of income that people do
not expect to persist.
Put differently, permanent income is average income,
and transitory income is the random deviation from
that average.
 Contd…..
 Friedman reasoned that consumption should depend
primarily on permanent income, because consumers use
saving and borrowing to smooth consumption in response
to transitory changes in income.
 For example, if a person received a permanent raise of
$10,000, his consumption would rise by about as much.
 Yet if a person won $10,000 in a lottery, he would not consume
it all in one year. Instead, he would spread the extra
consumption over the rest of his life.
 Assuming an interest rate of zero and a remaining life span of
50 years, consumption would rise by only' $200 per year in
response to the $10,000 prize.
Contd….

Thus, consumers spend their permanent income, but

they save rather than spend most of their transitory
income.
Friedman concluded that we should view the
consumption function as approximately
C = aYP

where a is a constant.
 The permanent-income hypothesis, as expressed by
this equation, states that consumption is proportional
to permanent income
B. Implications
The permanent-income hypothesis solves the
consumption puzzle by suggesting that the standard
Keynesian consumption function uses the wrong
variable - errors-in-variables problem.
According to the permanent-income hypothesis,
consumption depends on permanent income not
current income
To see what Friedman's hypothesis implies for the
average propensity to consume, divide both sides of
his consumption function by Y to obtain
APC = C/Y = aYP/Y
 Contd….

According to the permanent-income hypothesis, the

average propensity to consume depends on the ratio
of permanent income to current income.
Where current income Y = YP + YT
When current income temporarily rises above
permanent income, the average propensity to
consume temporarily falls; when current income
temporarily falls below permanent income, the average
propensity to consume temporarily rises.
Ctd…

 Friedman reasoned that household data reflect a

combination of permanent and transitory income.
Households with high permanent income have
proportionately higher consumption.
If all variation in current income came from the
permanent component, the average propensity to
consume would be the same in all households.
 But some of the variation in income comes from the
transitory component, and households with high
transitory income do not have higher consumption.
Contd….
 Therefore, researchers find that high-income
households have, on average, lower average
propensities to consume.
Concerning the studies of time-series data, Friedman
reasoned that year-to-year fluctuations in income are
dominated by transitory income.
Therefore, years of high income should be years of low
average propensities to consume – APC declines in
the short – run.
Ctd..

But over long periods of time-say from decade

to decade - the variation in income comes from
the permanent component.

Hence, in long - term, one should observe a

constant average propensity to consume –
APC is constant over the long run.