Question

Consider the consumption theories

a) Explain the Keynes’ consumption puzzle?

b) How does Modigliani’s consumption theory resolve the puzzle?

c) How does Friedman’s consumption theory resolve the puzzle?

Answer 1

a) Keyne's consumption puzzle stated three things:

1. The marginal propensity to consume lies between 0 and 1.

2. The amount of consumption decreases with increased income.

3. Income is the main cause of consumption and not interest rate.

The puzzle on the consumption of Keyne's theory happened because it was based only on short run. Long run consumption suggests the average propensity to consume remains the same with increased income.

b) Modigliani could resolve the puzzle by dividing the life period of an individual into two parts. He said in long run wealth and income grows together resulting in the propensity to consume to be constant.

c) Freidman solved the puzzle by permanent income hypothesis. According to him the average propensity to consumption depends on the ratio of permanent income to temporary income. He says the average propensity to consumption increases temporarily when current income falls below permanent income and vice versa. Friedman suggested Keynes should have used the theory of permanent income hypothesis to resolve the problem of average propensity to consume.