Question

Briefly explain the " consumption puzzle" . What solutions have been proposed to solve it and to what extent they have been successful ?. DISCUSS.

Answer 1

Consumption Puzzle---- Consumption puzzle is the confusion created due to differences in keynesian and Kuznets'arguments regarding Consumption function.

Keynesian views ------

* Consumption depends primarily on income, rate of interest plays no role.

* As income increases, people tend to save a part of their income ( psychological law of Consumption)

* As income increases, APC ( Average propensity to consume) falls

* Short run is the realistic phenomenon, in the long run, we are all dead.

Kuznets views-------

* Long run is the realistic phenomenon instead of short run.

* APC remains constant in the long run,it doesn't fall.

These differenences in views put confusion among economists regarding Consumption function.

Graphic view ---

Proposed solution to solve Consumption puzzle

The Consumption puzzle is attempted to solve by two economists , Frannco Modigliani & Milton Friedman .

# Lifecycle Hypothesis by Modigliani------:

As per this hypothesis, people plan their Consumption and savings behaviour over their life cycle.

Young age. Low income. Low saving rate

Middle age. High income. High saving rate

Retirement age. Low income. Negetive saving

# Permanent income hypothesis by Milton Friedman--------:

People spend money at a level consistent with their expected long term Average Income.. According to this hypothesis, Consumption depends not on current income but on permanent Income of Consumers.AP depends upon the ratio of permanent Income(PY) to current income(CY).

If CY>PY-----APC falls

If CY <PY------ APC rise

This way,keynes must have used permanent Income as a basis for APC

Thus life cycle hypothesis and permanent Income Hypothesis are successful in solving the Consumption puzzle